On November 1, 2023, the Office of the Comptroller of the Currency (OCC) issued detailed guidance (the Bulletin) to national banks and federal savings associations addressing risk management standards and safe and sound lending practices for venture lending (i.e., lending to “high-risk borrowers in an early-, expansion-, or late stage of corporate development”).[1] Asset-based lending with full monitoring and controls are excluded from the Bulletin. Moreover, venture lending does not include: (i) loans to businesses that primarily rely on their own internally generated cash flow (as opposed to equity infusions) to maintain and grow operations, (ii) loans made with the support of federal, state, or local government guarantees (e.g., U.S. Small Business Administration guarantees), or (iii) loans made under special purpose credit programs.
The OCC does not prohibit or discourage banks from making venture loans. However, the OCC has signaled that it is more closely considering banks’ standards for evaluating venture borrowers’ ability to service debt. According to the Bulletin, venture borrowers may present heightened risks of non-payment because they often exhibit one or more of the following characteristics: unproven cash flows, untested business models, difficulty projecting future cash flows, high liquidity needs, high investment spend, and limited refinancing or business takeout/exit options. To manage these risks, banks are expected to establish appropriate risk management practices, underwriting standards, and risk-rating practices. The Bulletin indicates that venture loans encompass loans to (a) early and expansion stage companies, which include pre-revenue businesses or businesses with limited operating history, to businesses in an expansion stage of development which often have high expenses, and (b) later stage companies that may have significant scale but may have negative, intermittent or insufficient cash flow to service debt.
While the OCC did not explain in detail the timing of the Bulletin’s publication, it clearly is responding to concerns with some banks that are exploring the venture lending market following the recent failures of multiple banks active in venture lending.
Lending Standards for Venture Loans
Risk rating is an integral component of a bank’s credit risk management, and the OCC expects that a bank’s credit risk rating at the time of inception of a venture loan reflects the bank’s realistic assessment of the likelihood of repayment based on repayment sources, such as reliable cash flows and/or structural protections. The OCC advises venture loans to be evaluated similarly to other commercial and industrial loans. Banks should avoid “weakening underwriting standards to accommodate venture loan originations.” Regulatory ratings of “pass” for venture loans should be the exception rather than the rule absent sustainable primary and secondary sources of repayment. Examples of sustainable primary sources of repayment include (i) sufficient current and expected business cash flow to cover fixed charges and repay debt and (ii) controlled collateral support. According to the Bulletin, venture loans originated with a “non-pass” risk rating generally are inconsistent with safe and sound lending operations.
To assist banks in evaluating venture borrowers’ repayment capacity, the Bulletin provides the following examples:
- An uncommitted future equity raise is not a satisfactory primary source of repayment and is not a sustainable source of cash. Accordingly, banks should generally avoid loans that are underwritten from this equity perspective rather than a credit perspective.[2]
- A venture borrower’s unrestricted and declining cash balance is normally not a sustainable primary source of repayment, although abundant initial balance-sheet cash can be credit-positive.[3]
- In recurring revenue loans, a borrower’s recurring revenues, while credit-positive, is not equivalent to sustainable repayment capacity, and the bank should continue to consider all other relevant factors when determining whether there are satisfactory repayment sources.[4]
Risk Management and Governance Practices for Venture Lending
The OCC expects that banks engaging in venture lending have in place appropriate operational and managerial standards consistent with safe and sound practices as articulated in the “Interagency Guidelines for Establishing Standards for Safety and Soundness” (the Interagency Guidelines).[5] The Interagency Guidelines establish standards relating to (i) internal controls, information systems, and internal audit systems, (ii) loan documentation, (iii) credit underwriting, (iv) interest rate exposure, (v) asset growth, and (vi) compensation, fees, and benefits. In addition, concentration risk in venture lending can manifest in unique ways—for example, across industries or borrowers at the same stages of development—and banks should implement enterprise risk-management practices for venture lending related to liquidity risk and capital planning.
The OCC does not set risk limits or establish a bright line limiting a bank’s volume of venture lending. As with other bank activities, it is the responsibility of the board of directors and management to establish risk appetite and risk limits and demonstrate to examiners that the bank’s activities are consistent with the bank’s established risk appetite, maintained within established risk limits, appropriately documented and underwritten, accurately risk-rated, and sufficiently reserved.
Key Takeaways
The Bulletin signals greater focus by the OCC on the venture lending activities of national banks and federal savings associations. While the Bulletin was issued by the OCC, banks supervised by the Federal Reserve or Federal Deposit Insurance Corporation would be well-served by reviewing the Bulletin in connection with their current or planned venture lending activities. In addition, banks with material growth or overall exposure in venture lending should expect higher supervisory expectations regarding risk management (e.g., stress testing and MIS) and greater amounts of supervisory attention.
[1] “Commercial Lending: Venture Loans to Companies in an Early, Expansion, or Late Stage of Corporate Development,” Bulletin 2023-34 (Nov. 1, 2023).
[2] According to the Bulletin, although “new funding from new or existing investors may be one avenue for loan repayment . . . [such] new capital is only deemed a reliable repayment source when there is documentation of a legally binding commitment from reputable investors or lenders with the willingness and capacity to fund and the intent to use those funds to repay existing debt. When relying on committed new fundings, banks should verify that investors, as individuals or through financial vehicles or funds, have the ‘dry powder’ and the legal right to honor their commitments. Legal enforceability is an essential requirement when considering whether financing is sufficient to mitigate risk of loss when other sources of repayment are insufficient.”
[3] The Bulletin includes additional discussion on the treatment of underlying collateral secured by a first-priority blanket lien (e.g., unrestricted cash on the balance sheet) as a reliable source of repayment and a loan structured with a remaining month’s liquidity covenant.
[4] According to the Bulletin, “risk rating recurring revenue lines of credit should normally begin with base-case cash flow projections inclusive of all planned expenses and capital expenditures representing the expected borrower financial performance using assumptions that are deemed most likely to occur.” In addition, examiners will scrutinize the “harvest approach” (i.e., an approach that “eliminates what are deemed as ‘nonessential’ expenses from cash flow projections, resulting in cash flows that would be achieved from remaining pre-existing contracted revenues in an orderly wind-down scenario when going-concern expenses are absent.”).
[5] 12 C.F.R. Part 30, appendix A. Large national banks are subject to appendix D of Part 30 (“OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches”).
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