Hercules Capital (NYSE:HTGC) is one of my favorite BDCs, and for good reason too, considering that it gives income-minded investors exposure to the tech sector all while earning a way above-average dividend yield.
The stock has seen its fair share of ups and downs over the past 12 months, but the overall trend has been positive since I last my last Strong Buy rating on the stock back in May. This is reflected by the stock’s 27.6% total return since that article, far surpassing the 7.6% rise in the S&P 500 (SPY) over the same time.
Back in May, the market was rather fearful around financial stocks after the regional banking fallout in March, and has apparently come to the realization that BDCs are fundamentally different compared to banks due to their permanent equity base. In this piece, I discuss recent developments and discuss why the stock is a Buy after dipping from a high of near-$18, so let’s dive in!
Hercules Capital is one of just a handful of internally-managed BDCs and, of this bunch, is the largest one to focus exclusively on the growth sectors of technology and life sciences.
While most people are more familiar with Venture Capital companies, an often ignored, but vital component of the startup ecosystem are venture debt companies like HTGC. That’s because there is only so much equity the existing owners are willing to give up before they lose interest in running and growing a company, and that’s where venture debt comes in. Unlike equity, taking on debt doesn’t dilute the ownership of existing owners and in return, HTGC gets to collect a steady revenue stream.
This business model has worked well for HTGC, as it’s been able to grow both its top and bottom lines over an extended period of time. As shown below, Hercules has been able to its total asset base at a 10.4% CAGR and Net Investment Income has grown at a faster clip at 14.6% CAGR over the past 10 years.
At present, HTGC’s debt portfolio has a carrying value of $2.9 billion, comprised of 120 portfolio companies in technology and life sciences. On top of that, it also has warrants in 108 companies, giving it a potential equity kicker to grow its NAV/share should those investments work out well through an IPO or favorable M&A transaction (i.e. buyout from a bigger company).
HTGC is strongly benefitting from growth companies that are hungry for capital, considering that many pre-IPO remain skittish around going public in the current slow IPO environment. This is reflected by InstaCart being the only notable tech company that’s planning to go public this year. The strong demand for HTGC’s capital is reflected by its 16% effective yield on investments and this is also supported by the fact that 95.5% of its loans are floating rate, thereby benefitting from higher interest rates.
Also, during the second quarter, HTGC saw record total investment income of $116 million, an increase of 61% YoY, and it grew AUM to $4.0 billion, an increase of 19.5% YoY. While the IPO market may be slow, robust M&A have enabled HTGC to redeploy capital at higher onboarding rates. Importantly, HTGC grew its regular quarterly dividend by $0.01 to $0.40 and the dividend is generously covered by a 132% coverage ratio, based on $0.53 in NII/share.
Importantly, HTGC has $1.02 per share in spillover income, which gives it plenty of capacity to fund special dividends. So far this year, HTGC has paid out 3 special dividends that total $0.24 per share. Moreover, HTGC’s NAV/share has recovered from its trough last year (due to unrealized losses during the tech volatility), and now sits above where it was for much of the past 10 years, as shown below.
Growth in the second half of the year is supported by $381 million in unfunded commitments. HTGC should have plenty of capital to fund these opportunities, considering that it expects to see at a minimum 3 M&A transactions that were announced in the current quarter. This is also supported by $1 billion in liquidity and a low debt-to-equity ratio of 0.86x, sitting lower than the 1 to 1.3x of most externally-managed BDCs, and far below the 2.0x statutory limit for BDCs. HTGC’s liquidity and leverage are further supported by the recent 6.5 million share equity raise announced this month.
Concerns around HTGC arise from its concentration in growth sectors like tech and life sciences, which are more vulnerable to economic downturns. In addition, lower interest rates would put pressure around HTGC’s effective yield on investments and higher rates could put pressure on borrowers’ ability to pay. Nonetheless, HTGC’s current portfolio is healthy with 100% of borrowers making contractual payments and investments on non-accrual representing 0.4% of portfolio cost and 0.0% of portfolio fair value.
Turning to valuation, HTGC may not seem cheap considering that it trades at a price-to-NAV of 1.45x, based on the current share price of $15.86. However, I firmly believe that well-run internally-managed BDCs with efficient cost structures should be valued based on their earnings power rather than book value.
From this perspective, HTGC does not appear to be expensive, with a forward PE of just 8.0x and a 10% dividend yield. Notably, the dividend yield has potential to be higher considering the aforementioned spillover income and potential for special dividends. Moreover, HTGC could meaningfully grow its NAV and NII per share considering its low amount of leverage and the number of opportunities it has in the market.
HTGC is well-positioned to grow both its top and bottom lines. This is supported by low leverage, a healthy loan portfolio with strong demand from borrowers, and attractive yields on investments. While HTGC may appear to be expensive from a price-to-NAV perspective, its earnings valuation suggests otherwise. While I no longer see HTGC as being a table-pounding bargain (and therefore downgrading to a Buy rating), its high 10% yield and growth potential make it an appealing stock at the current price, especially after the recent drop.