Minimizing Risk Through Diversification

By: Logan Henderson | Published: 03/16/2023
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4 minutes

In the aftermath of the Silicon Valley Bank (“SVB”) collapse this week, there are numerous factors that you can point to – Fed policy and rising rates, a classic “run on the bank” scenario, poor management of liabilities and investments on its balance sheet, accounting policy on “held-to-maturity” assets, a lack of interest rate hedging, a failed capital raise – which led to the demise of the bank.

Taking all external factors out of the equation and looking at the situation from a fundamental perspective, there are a few notable conclusions that you can draw which relate to broader investment strategy and portfolio management:

Lack of Diversification

SVB saw no risk in its highly concentrated base of technology businesses and did not try to diversify beyond that base, continuing to add more products oriented towards technology businesses, their employees and investors.

  • We’ve spoken about herd mentality when a specific sector gets momentum and creates a hype cycle (re: “The Hype Cycle: Stages and Opportunities”), and we saw the exact mentality play out with the speed and amount of capital that moved out of SVB driven by investor sentiment and fear of missing out… or fear of being left behind (i.e., money being left at the bank).
  • Proper diversification is the key to long-term success and building a portfolio of uncorrelated assets – be it investments or customers – helps insulate you from market volatility. 

Lack of Financial Management

Poor corporate treasury management was the downfall of SVB and nearly the downfall for thousands of businesses that were customers of SVB. Thankfully, the US Treasury, Federal Reserve, and FDIC stepped in to guarantee SVB depositors for all money held at the bank.

  • Effective treasury management can help businesses manage their cash flow, liquidity, and financial risks, leading to better financial outcomes. However, many startups neglect this function due to limited resources, a lack of expertise (most do not have teams with the necessary financial knowledge or experience), or a lack of focus (growth vs. financial health).
  • Running a business is similar to an investment portfolio in that you need to forecast liquidity needs, manage risk, and orient toward long-term outcomes rather than short-term goals.

Lack of Specialization

SVB is unique in that it was part depository institution, part venture lender, part venture investor, and part network. While all of these functions are helped by being ingrained in the technology industry, it is very difficult to be good at everything.

  • SVB made nontraditional loans to somewhat nontraditional borrowers, many of which would look alarming to traditional lenders given the financial health of the underlying asset. They saw this as an opportunity as others were not set up to cater to the technology industry’s specific demands, but with the new market dynamics only time will tell how this portfolio performs.
  • SVB Capital manages $9.5 billion in assets with stakes in numerous venture firms in addition to direct investments in startups. Many of these investments were driven via their sphere of influence – provide lending facility to the Fund > invest equity in the Fund > invest in the Fund’s portfolio companies – and created a situation where they are interconnected and dependent on one another. If one card falls, the entire structure could come crashing down. Every investment decision should be made with thorough research and due diligence to reduce the risk of herd mentality and identify potential weaknesses in an investment.

While the outcome and impact of SVB will continue to playout over the next few weeks and months, there is one simple takeaway: By spreading investments across different asset classes and sectors, investors can reduce their exposure to any one particular category and minimize their risk of a single failure causing a domino effect within the portfolio.

-Logan Henderson, Founder and CEO

Worth a Read

Understanding Venture Fund Time Horizons

Time horizons are an important consideration for venture funds and investors. Read more.

Embracing the New Frontier: Retail Investing Accelerates in Private Markets

As investors of all types become increasingly aware of alternative investments, portfolio allocation to private markets will continue to grow. Read more.

Member Webinar

Meet the Manager: Salil Deshpande of Uncorrelated

This month, join us live for an interactive session featuring Gridline Founder and CEO, Logan Henderson, in conversation with Salil Deshpande, General Partner of Uncorrelated Ventures on Thursday, March 30th at 1:30 pm EDT / 10:30 am PDT

This webinar is open to Gridline Members. If you would like to join us, please complete the process to sign up for access to Gridline and if you would like to join us we will send you your personal link to join the live webinar.

A Final Thought

Preqin just published its “Investor Outlook: Alternative Assets, H1 2023”, with some notable findings from the comprehensive investor survey:

  • In spite of macroeconomic conditions, 35% of respondents plan to increase their private capital investments, 46% don’t plan on changing, and only 18% plan to reduce them.
  • 60% of investors are allocated to private equity. But 31% of respondents expect to commit more capital. Only 13% expect to commit less. 
  • 35% of respondents expected an imminent correction in VC valuations – even before last week’s collapse of SVB shook fund managers and companies. More investors are shifting to early-stage and seed strategies than previously.
  • Diversification benefits and reliable income streams continue to attract investors to private debt and infrastructure. Just under three-quarters of respondents said private debt assets were either undervalued or fairly valued. In infrastructure, the figure was 65%.

Let us know what you think – please don’t hesitate to reach out.

-The Team at Gridline

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