Thursday, March 13, 2008
Interview with Joe Morgan, SVB Asset Management
There's been a lot of recent speculation about the problems with the auction rate securities market, and its impact on startups. For those not familiar with auction rate securities, they are a financial instrument which has been used to provide a better interest rate on investments, and have been particularly popular for managing cash at corporations. Recently, auctions on those securities have completely shut down, essentially locking out investors--including many venture backed firms--from their own cash. To get the details on how this might affect the startup and venture capital market, we went straight to Joe Morgan, who is Head of Portfolio Management at SVB Asset Management. Joe has been warning against auction rate securities since 2004, and has been credited as being the first to see the problems with this market. Ben Kuo spoke with Joe yesterday to get the details on the auction rate fiasco. (Editor's note: SVB is a sponsor of socalTECH, although our coverage is never influenced by our sponsors).
It looks like you've been warning about auction rates since way back in 2004?
Joe Morgan: We've been looking at auction rates for many years, from a fairly objective standpoint. I joined SVB Asset Management back in 2004. At that time, we were much smaller, and we ourselves were using auction rate securities. One of the first things I did when I showed up was to liquidate and redeploy our assets in commercial paper and agency securities, which we though were more appropriate for investors from a liquidity risk perspective.
How did venture backed firms get wrapped up in this problem?
Joe Morgan: Auction rates were marketed by the brokerage industry as cash equivalents. The idea was that you could put securities back into an auction at any auction date, and receive par back -- which is the same price you paid for it to begin with. The sales pitch was that they were as good as cash. What I discovered, and why I felt they were not as good as cash, was the only source of liquidity for these investments was the original selling broker. So, when you buy a security and you're dependent on one broker for liquidity -- as opposed to a security which is desired by a multitude of brokers--that is an extreme lack of liquidity. Most of these securities were sold through the brokerage world, and brokers were pushing these because at every auction there was a new commission to be captured. It's pretty simple from the brokerage side of the world, with an auction rate you get an annuity of a commission at each auction date, and reporting was assumed to be rather simple. You report them as cash equivalents, and because there would be no change in market value you didn't have to adjust for market valuation in your shareholder's equity balance sheet. But, as well know, that has all changed in recent weeks.
If people were aware this was an issue--it looks like you've been warning about this consistently since 2004--why have companies been caught?
Joe Morgan: There were certainly extra yields to be had. Auction rates have yielded 15 to 50 basis points over comparable commercial paper investments. If you remember in 2004, 2005, and 2006, the economy was running pretty strongly. The markets were doing very well, and the bond market in particular. What I think is, from an investors perspective, they thought -- gee, I can buy these, they're a cash equivalent, I get 15 to 50 basis points in yield more, and I want to maximize yield. That's what happens in boom times. People get complacent in terms of doing their homework, and start to feel like the market will never turn against them. So they grab that extra yield. Having lived through market cycles, I knew that was not the case. My job, and my role at SVB, is to protect my clients on the downside, as well as provide upside. That's particularly true of smaller, VC-backed companies who need available cash. We chose to give up on that yield, and in the course of that also gave up client opportunities. We had several who would have hired us if we were investing in auction rates, and they decided to go in a different direction.
What's the impact of this on startups?
Joe Morgan: Well, for existing startups who have cash, and are not in auction rates, there is an effect in terms of all investors being much more conservative, and scrutinizing their investments closely. That's probably a good thing in the long run. For clients who have auction rates, and can't access them, they are now looking potentially at other avenues to liquidity. We're fielding a lot of those calls for some sort of short term funding. For the venture capitalists, I think they are taking a harsher look at the investment standards and investment policies that they are allowing their portfolio companies to operate under, and are going to watch their cash more closely. One suggestion I had, which is rather important going forward, and what really illustrates what's going on today, is to gauge the level of fiduciary responsibility that an investment advisor has to you. If you are a registered investment advisor, you have full fiduciary responsibility to act in a client's best interest. When you're working with a broker, that's not necessarily the case. Often time a broker is in a pure sales role, even though a CFO or treasurer who the cash belongs to may realize it, the broker does not have the same fiduciary responsibility to follow the investment policy and the spirit of that policy as a registered investment advisor.
Does this potential to put startups under, or force VCs to bridge their companies?
Joe Morgan: That's not really my expertise, but it's definitely difficult times out there. There are avenues that liquidity can be gained, but probably VCs will have to take a closer look at their portfolio companies, and pull back as their capital is restrained, and look again at the their individual investment basis in those companies, if they're strong and if they will be successful, and if they will want to put more into those companies.
How long until you think this might unwrap, and will it unwrap?
Joe Morgan: I think it will, but I think it will take time. Wall street has many liquidity crises it is addressing today. This is certainly one of them. A much larger one is the mortgage industry. There is the potential for Wall Street to gather hundreds of billions of fees if they can figure out how to transition the capital to home buyers. That market is many times the size of the auction rate securities market. I think the resources of Wall Street are a bit strained, in that there are bigger problems for them to solve than the auction rate crisis. And, those bigger problems have a bigger reward when solved. While it's important, it will certainly taking a back seat to the mortgage industry.