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March 15th, 2023

Banshees of Insurance

Banshees of Insurance are felt whirling around every private equity transaction.  One of the key specialists included in due diligence is an insurance specialist.  Policy coverages and costs for healthcare benefits, business interruption, property-casualty, general liability, workers’ compensation and product liability insurance are subject to close scrutiny.  In recent years, insurance against cyber-attacks has received new attention and has become very expensive.  Insurance against acts by the prior owner, such as environmental damage, has to be assessed in addition to establishing cash escrows against known hazards.  The layering of insurance to be examined and provided continues up the organization chart to Directors and Officers liability insurance to cover legitimate decisions made by board members and by executives.  Finally, the insurance that has exploded in its use over the last decade is representation and warranty (R&W) insurance.  R&W insurance covers the seller for certain breaches of the purchase agreement.  Formerly, such breaches were the subject of extensive negotiation or litigation between the buyer and the seller.  Now, most of these disputes are handled by the buyer making a claim against the R&W policy.  Fraud is the customary exception to coverage in these situations as the banshees normally prefer a bench trial when fraud is alleged.

One insurance we have never sought is deposit insurance, neither for our portfolio companies nor for our Funds.  We have placed our Funds’ capital in a conservatively run credit-worthy bank and encourage our portfolio companies to do the same and to avoid banks with questionable practices.  We have also relied on the law protecting only $250,000 in deposits as a bright sign that protecting the balance is our duty.  The old adage of combining bad management with a good business results in management’s reputation surviving seems to have again proven true in the case of Silicon Valley Bank.  To this volatile mixture, adding a regulator again fully prepared to act once the building is on fire, left SVB in crisis.  As a consequence of free money from the Fed fueling VC activity and deposits, SVB grew by $130 Billion in assets over the past three years, well beyond SVB’s capacity to manage by creating new loans.  Instead, SVB, who missed the memo about pending rising interest rates, bought $20 Billion of long term treasury securities and $80 Billion of 1.5% ten- year mortgage securities.  Economics 101 taught us that as rates rise, fixed rate bonds decline.  As rates increased and customers asked for their deposits to feed operations, SVB sold $20 Billion of their securities for a $1.8 Billion loss and attempted to raise fresh equity to replace the losses.  Venture Capitalists and their portfolio companies sniffed the problem and ordered their companies to withdraw their funds which led to a run on the bank. After causing the bank run, the VC community then called for a federal bailout.  The regulators emerged from a long winter’s nap and failing to sell the bank, elected to bail out the depositors. Now let’s review this movie.

Mismatch of maturities between deposits and investments was an art form created by the Savings and Loan industry in the 1980’s, leading to a federal rescue, as savings and loans went down like bathyscaphes.  Lehman Brothers and Deutsche Bank have become synonymous with poor duration management and poor risk management.  The CFO of SVB was a CFO of a division at Lehman and SVB’s Risk Manager came from Deutsche Bank, akin to making Neville Chamberlain your warlord.  In 2008, the government begged for JPMorgan to buy Bear Stearns and for Bank of America to buy Merrill Lynch.  The government then sued and fined both buyers for the prior bad acts of their acquisitions in return for the favor.  Oddly, neither JPM nor BoA were dying to help the government at this time.  As far as regulators applying liquidity tests to SVB’s balance sheet and other regulatory activity, little is known, but that itself speaks volumes as apparently the regulator had the same type of information available to use to close Signature Bank and in perfect irony, its Director, due to his risk management regulatory knowledge, Barney Frank.  Five directors of SVB that helped guide this mess have been retained to guide the sale process of its assets. Q.E.D.

I’m Rob Morris and I approved this blog.

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