Banks on guard for credit glitches in tech sector
There may be no more hyped sector than technology, with many financial institutions drooling to bank its up-and-coming firms. But in recent months a handful of lenders have raised concerns about growing credit risks tied to tech clients and the markets where they are concentrated.
After tech stocks were hit hard during the sell-off that occurred in late 2018, some uneasiness about the state of the tech sector began to surface. With first-quarter earnings season set to begin in just over two weeks, Sandler O’Neill analyst Aaron James Deer said he will be watching to see whether such concerns have spread.
“I think that within the banks and other lenders into that space there’s probably a little more caution,” Deer told American Banker.
Some deterioration from the sector's "exceptional" metrics of recent years is inevitable, he said.
Bank of Marin Bancorp in Novato, Calif., starting with its quarterly earnings call in January, has raised red flags about the tech sector and its ties to other parts of local economies.
The tech and commercial real estate markets are closely aligned in the Bay Area. Real estate prices were at all-time highs just before the dot-com bust in the late 1990s and the recession of 2008, and those prices are sitting around the same levels right now, Russ Colombo, the president and CEO of the $2.5 billion-asset Bank of Marin, said in an interview.
There is a correlation between venture capital funding and the price of commercial real estate in San Francisco, he said. When VC funding for startups begins to fall off, a lot of those businesses tend to disappear, and so the demand for office space declines.
A recent survey on California CRE conducted by Allen Matkins/UCLA Anderson showed that sentiment for all six office space markets in the state — including the Bay Area and Silicon Valley — has dropped. Results from the survey indicated those markets have peaked and are entering a more moderate part of the cycle. Although developers in the Bay Area did not suggest an immediate cutback in their development activity, predictions were for “a cooling down of the market” in the next two years.
Some of the worries about the tech sector are tied to the outlook for broader economy and commercial lending. Many economists are now predicting a recession in the U.S. by 2021, and some bankers — including Jamie Dimon — have warned about a possible slowdown.
Credit quality metrics will be watched closely in a wide range of commercial and other sectors. Net charge-offs as a percentage of total loans have risen steadily among banks in the San Francisco region since 2014, according to Federal Deposit Insurance Corp. data. Noncurrent loans have fluctuated, rising as high as 0.9% of total loans in 2014 and falling below 0.7% for the past two years.
Against this backdrop, it would be unsurprising to see resets on tech startup valuations in 2019 and 2020, similar to 2014 and 2015 when some companies that were not hitting milestones saw funding dry up and subsequently closed shop.
“I do think we’re going to see some elevated activity on that front,” Deer said.
David Joves, California region manager for the $1.9 billion-asset Bank of Guam, said the money for tech investors is much smarter than it was in 1999 and 2000, with the bulk of the venture capital dollars now going into the later-round, established companies rather than early-round startups.
“If you’re one of those startups that hasn’t received your money, it appears winter has come for you,” said Joves, who is based in San Francisco.
The bank does not lend directly to the technology sector but finances related apartments, office, and mixed-used industrial space. Joves said it appears that the peak of the Bay Area economic cycle was in 2015. “Although rents grew over that time, it’s well off the growth rates our borrowers experienced a few years ago,” he said.
The bank has tightened credit by limiting loan proceeds to 65% of the value of collateral compared to 70% in 2015. In addition, the company continues to shock-test cash flows under different rate, revenue and cost scenarios to determine the ability of its clients to service their debt, Joves said.
But some established tech lenders say worries are surfacing simply because no good thing can last forever.
“People are nervous because it has been so good for so long, but there is no immediate issue,” said Marc Cadieux, chief credit officer at the $56 billion-asset Silicon Valley Bank in Santa Clara, Calif.
He said 2018 was a strong year for the innovation economy with venture capitalists investing a record $130 billion. “And the stage appears to be set for 2019 to be another good year in the sector,” he said.
SVB’s Startup Outlook Report showed that technology and health care company founders and executives agree. Most U.S. startups that responded to the survey believe that 2019 business conditions will improve over last year.
Sandler’s Deer does not foresee problems rising to the level of those that led to the dot-com bust and said the coming choppiness is part of the normal cycle. The pipeline of “unicorn” initial public offerings — those valued at more than $1 billion — is strong, which will create liquidity and excitement in the sector while also helping to replenish investments, he said.
Still, many bankers seem to be reacting with caution to current economic conditions.
Although not specific to tech lending, the Fed's January 2019 survey of senior loan officers revealed that banks expect to tighten standards for all categories of business loans for the remainder of the year, while demand for most loan types is expected to weaken. Additionally, banks expect loan performance to deteriorate for all surveyed categories.
Cadieux said SVB needs to be a consistent, predictable and dependable lender to the innovation economy at every point in the economic cycle, so it doesn't think in terms of tightening or loosening underwriting standards. Rather, it is focused on ensuring that its lending is sustainable.
"As such, we are not talking about what we need to do to protect ourselves when the eventual downturn comes," Cadieux said.
Unprecedented access to capital for late-stage startups is allowing those companies to stay private longer. It has also had the ripple effect of allowing them to avoid borrowing as much from banks like SVB.
“The fight for the loan demand that remains has become steadily more intense,” Cadieux said.
Beth Mills, senior vice president of communications for the Western Bankers Association, said that, as with any lending, the key is not to be too consumed with any one sector in the event of a pullback.
“Diversification is very important,” she said. “We saw that about 10 years ago with some of the challenges banks had — many of which failed — when they were overly committed to commercial real estate.”
So what could bring the tech sector’s rapid growth to an end? A disappointing performance by those unicorn IPOs would certainly be problematic, Cadieux said.
He added that while there is uncertainty in the broader economy, the fundamentals are still solid. And although there is not an immediate catalyst for a downturn, he is on the lookout.
“And there are plenty of things to worry about,” he said.