Investing 2019 October (part 2) ... Hercules Technology Growth Capital
[Disclaimer: I am an amateur investor and not a financial advisor. I blog here to chronicle my investment journey. My stock purchases and sales are unique to my temperament, life situation, risk appetite and investment goals. All information that you find on my blog such as ideas, commentaries, predictions, or stock picks, whether expressed or implied, are not to be construed as personal investment advice. I repeat, I am only an amateur investor. I cannot and will not be held liable for any action that you take as a result of what you read here. Do your own due diligence and/or seek the help of a qualified financial advisor.]
If you've watched Showtime's tv drama "Billions", you would know of Axe Capital, the hedge fund managed by the character Bobby Axelrod. Of course, Axe Capital, as is Taylor Mason Capital (founded by Axelrod's protege), is purely fictional. Oh, if you've not watched this drama, you might want to. It's pretty entertaining.
In real life, there are companies such as Axe Capital, and one of such companies caught my attention in my research for new stocks to invest in. Introducing Hercules Technology Growth Capital, or Hercules Capital in short.
Just what kind of company is Hercules Capital?
Hercules Capital is classified as a business development company. For my own understanding of this kind of company, I did a simple diagram/chart:
Because of the nature of externally managed BDC, it is a safer bet to go with internally managed BDC, of which Hercules Capital is one.
Hercules Capital is "the largest business development company focused on venture lending, and the lender of choice for innovative entrepreneurs and their venture capital partners." Hercules Capital provides financing to IPO and M&A, and focuses on a high-growth venture capital-backed companies in a broadly diversified variety of technology, life sciences, SaaS finance, and sustainable and renewable technology industries.
Hercules Capital largely invests in senior secured first liens which represented 81.8% of its investment portfolio as at the end of June 2019. A first lien is the first to be paid when a borrower defaults, and the property or asset was used as collateral for the debt (https://www.nuwireinvestor.com/first-lien-position/). In the unfortunate event of loan default or borrower liquidation, in 81.8% of cases, Hercules Capital will be the first to be paid since it is in a first lien position, which is a very good thing for a BDC.
Hercules Capital, structured as a BDC, does not need to pay any corporate tax but is required by law to distribute most of its profits to shareholders (just like Reits). According to the latest investor presentation, as of June 30 2019, Hercules Capital's annualised dividend yield is a whopping 10.1%!
How well has Hercules Capital been doing in its business? A lot can be written on this. I'll let a chart do the initial talking (http://investor.htgc.com/quarterly-results):
Hercules Capital has seen a steady increase in portfolio assets, total investment income and NII since 2011. As can be seen from the chart, 2018 was a very good year for Hercules Capital as demand for new capital in its core sector investment businesses remained high ... and 2019 looks set to be an even better year for Hercules Capital.
Hercules Capital's ROA and ROE are better than those of its peers such as Main Street Capital Corp and PennantPark Investment Corporation:
Hercules Capital 2018 ROA (6.8%) vs Peer 2018 ROA (5.4%)
Hercules Capital 2018 ROE (13.6%) vs Peer 2018 ROA (10.6%)
Hercules Capital's dividend distribution has been on an upward trajectory since its IPO days. For illustration sake, in 2014, $9.99 was paid out; in 2018, $14.95 was paid out. In 2019, by the half year mark, $15.90 was already paid out!
Since Hercules Capital provides financing to other businesses, one particular ratio needs to be looked at carefully, and that is the non-accrual loan ratio. The non-accrual loan ratio basically tells how much of a company's loans are in default. Hercules Capital's non-accrual loan ratio is excellent. As of June 30, 2019, the Company had 4 debt investments on non-accrual with an investment cost and fair value of approximately $8.8 million and $4.8 million respectively (0.4% and 0.2% as a percentage of the Company's total investment portfolio at cost and value, respectively).
In addition to the ROA, ROE and non-accrual loan ratio, another metric needs to be looked at as well, and that is the NAV/share value (which indicates the quality of the management team). A good BDC will have a NAV/share value that is above 1.0, and is accretive over time. A poorly-managed BDC or one that engages with an unreasonably high cost structure will destroy shareholder value by decreasing NAV/share over time. The market knows how to price the highest quality, most successful BDCs at a premium to NAV/share, i.e. if the BDC has good loan books, pays out secure dividends, and has consistent payout growth rate. This is one thing most Reit investors are familiar with.
Hercules Capital 2017 NAV/share (1.11) vs Peer 2017 NAV/share (0.86)
Hercules Capital 2018 NAV/share (1.21) vs Peer 2017 NAV/share (0.93)
The recovery in Hercules Capita's NAV/share is encouraging, considering it had an even higher NAV/share score in 2016 (1.43) and 2017 (1.32).
One last indicator to look at is the portfolio yield. A BDC must take risks but not go overboard with it. Remember the disaster of the sub-prime loans? A BDC's portfolio is in good shape if the average portfolio debt yields is between 13% to 15% (industry standard). A lower figure means that the BDC is more conservative in its investing strategy. Hercules Capital's portfolio yield has stayed within the industry standard since 2016, averaging 14.2% for the last 3 years.
As mentioned before Hercules Capital's NII has been increasing over the years (see chart above). This ensures a steadily increasing dividend payouts year on year.
While Hercules Capital has done well, it nevertheless faces some risks. In general, BDCs faces these risks (http://www.blueharbinger.com/free-reports-1/DayofWeek/2016/12/9/big-risks-facing-the-bdc-industry):
2. Higher interest rates
3. Credit cycle
4. Performance mean reversion
With regard to the risks faced by Hercules Capital, I noticed these:
1. 97.7 of Hercules Capital's loans are floating rate loans, and will be affected when the Federal Reserve cuts or raises interest rates i.e. when Federal Reserve raises interest rates, Hercules Capital's loan rate floats higher consequently. When Hercules Capital's loan rate floats too high, businesses come under pressure and may find themselves unable to repay their loans and therefore default on the loans. On the other hand, when the rate floats too low, Hercules Capital's income will take a severe hit. We don't want a trend of decreasing NII, do we?
2. Any breakdown or deterioration of the fundamentals in the start-up sector will spell great trouble for Hercules Capital i.e. less demand for new venture/growth capital, compressed debt yields, and increased defaults on existing loans. These scenarios could be triggered by an economic downturn, and would lead to Hercules Capital registering lower NAV and decreasing NII. Not a nice picture. I'm glad to see Hercules Capital engaging with diversification to counter this risk factor. To mitigate risks, Hercules Capital adopts an investment approach that employs 4 key diversification strategies:
A. Financial Sponsors: more than 1000 venture capital firms & investors
B. Industry Sectors of Technology, SaaS Financing, Life Sciences, Sustainable & Renewable, Special Situations
C. Stages of Development: Expansion or Established
D. Geographic Location: Palo Alto, Boston, New York, Washington DC, Chicago, Hartford.
Is Hercules Capital a safe or a surefire bet? Certainly not. BDCs are high risk (https://seekingalpha.com/article/4273135-dark-side-bdc-investments). Considering the underlying risk, my investment in Hercules Capital is a small one, just 200 shares @ $US13.65 and dividend yield at 9.38%.