What is Venture Lending & Why is it Risky?
Venture lending is debt financing for new start-up companies, and it is utilized to fund working capital and capital expenses. In the aftermath of Silicon Valley Bank’s demise, it is no surprise that federal regulators are keeping a close eye on banks’ underwriting analysis and credit monitoring in the venture lending space.
As with any new business, the risk of failure is high. According to Forbes, 90% of new start-ups fail, and running out of cash is one of the major reasons for this. Start-ups without an established history of growth and income generation pose a higher risk to banks, who must adapt their traditional underwriting standards to evaluate a business plan. Additionally, they must institute more frequent monitoring of the business after granting credit due to the higher probability of failure and sustainable cash flow.
Without a healthy balance sheet or a history of stable earnings available, a bank’s usual methods of reviewing past financial statements and evaluating cashflows aren’t enough. In this case, banks need to get creative, while still following sound underwriting standards by evaluating the borrower’s capacity to repay and evaluate the elevated risk of borrower failure. In addition, loan facilities will need to include satisfactory loan covenants to periodically monitor the borrower’s credit risk, debt service coverage, and financials to mitigate the high-risk factors associated with venture lending.
Potential Benefits of Venture Lending
Although there are several risks for banks associated with debt financing for start-ups, there are also benefits. Engaging in venture lending:
- Supports business formation
- Opportunity to assist new entrepreneurs
- Supports local economy
- Expands banking relationship with an existing depositor/customer
Like other lending, the bank’s management should identify the purpose of the loan, source of repayment, and ability to repay.
Aspects to Consider When Looking at Venture Lending
OCC Guidance
The latest guidance issued by the OCC details the new policy surrounding venture lending, high-risk borrowers, and more. Below, we break down a few items to consider when looking at venture lending:
- Credit enhancements and underwriting standards to mitigate risk of borrower failure:
- Establish sound underwriting standards geared at evaluating the borrower and the business plan, including sustainable repayment sources.
- Evaluate factors that can mitigate the risk of venture lending, including requiring financially capable guarantors, an eligible guarantee, or qualifying financial collateral.
- Institute loan covenants requiring submission of periodic financials.
- Require periodic financial statements, and maintain documentation used to analyze the credit:
- Establish check-ins and monitoring mechanisms with the borrowers to identify any elevation in credit risk. This should include obtaining the borrower’s financial projections that assist in determining the business’ performance, liquidity, and ability to operate.
- Ongoing analysis and monitoring:
- There must be consistent monitoring of the loan portfolio. This might occur more often than the traditional quarterly review as lending could bring on risks that changes more quickly than the traditional loan portfolio.
- Financial institutions should consider independent and objective assessments of loans to ensure there is proper identification, measuring, and monitoring of the portfolio.
Compliance With Applicable Laws & Regulations
According to 12 CFR 30 appendix A, Interagency Guidelines Establishing Standards for Safety and Soundness, banks taking credit risk without identifying sustainable repayment sources usually constitute an unsafe and unsound lending practice. Therefore, financial institutions need to establish/implement a sound risk management system over this lending practice.
Impact on the Allowance for Credit Losses
The allowance for credit losses (ACL) is the dollar amount that financial institutions set aside to cover potential losses that may not be repaid in full, and the Current Expected Credit Loss Model (CECL) requires a forward-looking approach to estimating and recognizing expected credit losses. When it comes to ACL and CECL, we detail four considerations of venture lending your institution must be aware of:
- First consideration: The first consideration of venture lending and CECL is the requirement to segment loans by similar risk characteristics. If a bank starts venture loans, they should analyze if a new segment or multiple segments are needed. These loans will likely bring unique risks to the financial institution and may be in industries such as technology or healthcare, which also may be new for the institution.
- Second consideration: Next, would be the policy over individually assessed loans. If a financial asset does not share similar risk characteristics with other financial assets, it should be evaluated on an individual basis. There must be deliberation on what would be considered for an individual assessment for venture loans.
- Third consideration: This consideration would be relevant available information (internal/external) when estimating expected losses. Historical losses are often used as a starting point, and there may be limited data available for venture lending. Therefore, the financial institution may need to look to peer data for this information. Historical losses are then adjusted for current conditions and forecasted conditions. Most institutions are looking to unemployment or GDP in this calculation. However, with venture lending there could be industry specific considerations and different macroeconomic considerations, such as interest rate changes and inflation.
- Fourth consideration: The fourth item to consider would be the selected method for calculation. There is no single method required under ASC 326 and multiple methods can be used for different segments. Nevertheless, the goal is to identify a method to best estimate expected credit losses based on relevant loss drivers. This could look different for venture lending compared to the institution’s current portfolio.
Conclusion
All things considered, there are several risks and challenges associated with venture lending. From allowance for credit loss implications to compliance requirements, it is vital for financial institutions to be fully prepared for the potential outcomes, whether that poses benefits or risks to your organization. If you have any questions about venture lending risk and whether you should engage in venture lending, please reach out to a member of our team today.
