Insights for What's Ahead
- Governments are realizing they need to provide a backstop to the tech ecosystem when it faces the collapse of financial institutions that are not financially too big to fail yet “systemic” to the sector.
- Banks specializing in the tech sector need to adopt sounder principles of asset-liability management to withstand adverse monetary conditions and shifting sentiment among influential investors in the social media era.
- After years of a boom fueled by easy money, investors are refocusing on technological content and longer-term prospects in greater detail. The scope of venture capital had expanded into the most pioneering and capital-intensive technologies, usually more associated with large groups and governmental agencies, which are stepping up their efforts amid the global technology race. Investors have now started to pay more attention to how well projects align with the recipient companies’ structure, especially in the case of start-ups.
- As the EU seeks to develop venture capital in favor of the tech sector, it needs to take into account the rising challenges of financial instability and promote long-term private funding mechanisms.
Easy Money Has Reshaped Tech Funding and Venture Capital
The collapse of Silicon Valley Bank (SVB) points to the crisis in the funding model of the technology sector, after years of euphoria—fueled by easy monetary conditions—that culminated in the extraordinary boom of the pandemic. In addition to the risk of contagion to the banking system, it is SVB’s uniquely central—indeed “systemic”—role in support of technology companies that compelled US and UK authorities to react swiftly, even though the bank was not supposed to be “too big to fail.”
Financial cycles affecting the technology landscape are often assessed on the basis of stock market indexes such as the Nasdaq, which rose tenfold from 2009 to 2021, only to fall by a quarter since then. Unlisted tech companies have experienced even stronger dynamics, both on the upside and the downside, with the reversal of monetary policy and the drain on capital flows. Beyond this latest financial debacle, the primary challenge remains that of innovation funding, which in turn affects crucial technological decisions.
Monetary tightening by the main central banks, faced with soaring inflation, spelled the end of the start-up valuation and funding boom and shook the investment logic of venture capital, which saw its activity fall by 30 percent last year. A sudden reversal took place, from a growth mindset driven by the various promises of innovations, in which profits represented only a distant prospect, to a more traditional valuation framework. This shift has upended the perception of time among private technology investors; they have started to reconcentrate on the concrete profitability prospects of the recipient businesses rather than the promise of an everlasting jump in shares valuation. The collapse in the value of an unlisted company often remains opaque, outside of revealing fundraising episodes, during which unlisted companies regularly appeared in recent months to have lost more than half their value since their peak. Banks tend to catch up with reality more quickly.
From Centralization to Herd Behavior: Tech Investment Must Refocus on Content
Venture capital is an industry that allows for specialized investment efforts on promising technologies, through either equity or loans, bypassing the rigidity and generic perspective of the traditional banking sector. It also provides personal support that goes beyond funding. However, in addition to the cyclical nature of venture capital and its increasingly concentrated pool of influential investors leading the main deals, it is worth questioning the extension of its technological scope during boom years. Its investment reach expanded from countless express delivery start-ups to space exploration and nuclear fusion, which are traditionally more associated with governments, universities, and large technology groups than start-ups.
With historical hindsight, it is certainly not possible to assert that great innovations necessarily stem from impeccable financial planning. However, a boom as phenomenal as the one that happened during the pandemic raised the question of intellectual and strategic content. The global technology race is actually focused on sectors that require enormous investments, over decades, in infrastructure as well as in skills. In the semiconductors industry, for example, it is a matter of reaching the most advanced standards of miniaturization and reliability in chip design and production in factories that cost more than $20 billion to build.
Industrial policy is often criticized for picking winners. Private investment booms, driven by central monetary policy, also lead to a form of recentralization of investment decisions through herd behavior, with a shorter-term perspective. In times of overheating markets, investment decisions in unlisted companies, although more innovative than those of administrations and large conglomerates, are not necessarily guided by better technological understanding.
The key role of venture capital in the crypto scene in particular has been striking, with its multitude of NFT projects based on often fanciful legal notions. The crypto movement was supposed to embody the very idea of monetary decentralization. In reality, the bubble grew precisely from the floods of liquidity provided by the same central banks that the crypto scene was supposed to surpass, only to fall when they tightened monetary policy. Technical and commercial development has been driven by large exchanges, offering constructions that increasingly resembled unstable financial products. This has been the case of once-promising “stablecoins.” The crypto scene lost its two main banks, Signature and Silvergate Bank, over the course of a few days. The main so-called euro stablecoin project (Circle’s Euro Coin), which was launched just last summer, used the latter for part of its deposits.
A Bank Run Rooted in a Classic Asset-Liability Mismatch, Triggered with Unsurmountable Precision
The crash of SVB, the sixteenth largest bank in the US, points to the unsustainable trends in tech funding. It had made a specialty of serving technology companies and providing funding for venture capital funds’ major investments in unlisted companies. It found itself caught between this volatile environment, its own investments induced by zero interest rates, and the good old-fashioned rules that should govern a bank’s balance sheet.
Its flaws, although glaring, are quite modest compared to the institutionalized failings of the global financial crisis, which centered on the securitization of mortgage loans and their unbridled recycling. In an environment of unlimited monetary stimulus in which the notion of bank reserves has evaporated, SVB has invested a large share of its funds in long-term bonds, whose value was cut sharply by rising interest rates. At the same time, its clients, faced with funding difficulties, tended to withdraw their deposits. The bank had to take a loss of $1.8 billion when it sold $21 billion in assets to cover its depositors’ withdrawals. The leakage obviously escalated when these losses became apparent and when venture capital funds called on the companies in their portfolios, sometimes on social media, to withdraw all their deposits from the bank. The US authorities then decided to guarantee these deposits beyond the usual thresholds in order to contain the contagion risk, while maintaining that taxpayers’ money would not be involved.
Europe Needs to Reinvent Tech Funding with Stability in Mind
SVB’s UK subsidiary, which became fairly independent of the parent company last year, reportedly serves more than a third of the UK tech sector. The banking behemoth HSBC agreed to absorb it for a symbolic pound, thus limiting the risk of a disorderly bankruptcy that would have had a disproportionate impact on the tech sector relative to the bank’s modest size.
Leaving aside the issue of contagion to Europe’s banking sector, we need to look at the financial model of the technology sector. Europe has remained far behind the US in venture capital as well as in the role generally played by capital markets to fund its economy. Looking at the transactions that actually take place in Europe in this area, US and Asian investors drive the main deals. The European Investment Bank addressed this issue recently by launching the “European Tech Champions Initiative,” which aims to inject €3.75 billion into the continent’s venture capital funds in an attempt to create a ripple effect of more massive private funds. The European Commission has also set a goal of mobilizing €45 billion in private funds for start-up growth. These initiatives are interesting, as Europe’s tech scene does need more tailored and massive funding options than those offered by traditional financial institutions. However, in light of the current market upheaval, it is also essential to design a more stable mechanism of tech funding than the venture capital investments of recent years. This model will have to withstand the roller-coaster ride of monetary cycles and allow for a full integration into the ongoing industrial revolution.
