Over the next few weeks I will be assessing dividend coverage for most of the 26 BDCs that I cover in an effort to uncover companies that have the potential to sustain or increase current dividends. I will also be using this information to update my latest "BDC Rankings: May 2014." For more details regarding this series and for the dividend coverage results for FS Investment Corp (NYSE:FSIC), Ares Capital (NASDAQ:ARCC), TCP Capital (NASDAQ:TCPC), THL Credit (NASDAQ:TCRD), New Mountain Finance (NYSE:NMFC) and Medley Capital (NYSE:MCC) please see:
- Part 1: Ares Capital
- Part 2: Medley Capital
- Part 3: TCP Capital
- Part 4: THL Credit
- Part 5: New Mountain Finance
- Part 6: FS Investment Corp.
Hercules Technology Growth Capital (NYSE:HTGC) is a component in both of my suggested "Total Return" portfolios. Over the last five quarters HTGC is one of the few BDCs to increase its portfolio yield from 13.8% and 14.2%. It has been able to do this through lending in niche verticals with higher returns. HTGC focuses on venture capital backed growth-oriented companies in the technology and life sciences sectors that are pre-IPO or M&A.
HTGC has historically had higher leverage ratios than most BDCs between 0.60 and 1.00 as shown in the chart below. I am comfortable with these higher levels for a few reasons including its much safer than average portfolio mix of over 90% in high quality 1st lien senior secured loans. Excluding SBA debentures, its current debt-to-equity ratio is below the average BDC and its historical levels.
During Q1 HTGC paid off almost $35 million of its higher interest rate SBA loans. The company stated "The Q1 impact should we choose to do this will be about a penny in the first quarter, that will a drag on earnings as a result of accelerating unamortized fees on these debentures. And going forward should we decide to do this pay down starting in the second quarter, the quarterly benefit will be about a penny to earnings as a result of interest expense savings." I have taken this into account in the projections below.
Other income is mostly fee income collected in advance and includes loan commitment and facility fees for due diligence and structuring, as well as fees for transaction services and management services to portfolio companies and other third parties. Loan and commitment fees are amortized into income over the contractual life of the loan. For this analysis I have used the same amount from the most recent quarter but it will most likely be higher in the following quarters.
As an internally managed BDC, HTGC has a lower cost structure than most and this is a key advantage to investors. Externally managed BDCs pay base management and incentive fees that grow with the size of the company regardless of additional risk. Internally managed BDCs can adjust compensation expenses to allocate higher expenses during strong quarters.
The following table shows the results for the most recent quarter along with projections at various levels of leverage and using a stable yield of 14.2% to determine the impacts on dividend coverage. Each of these scenarios assumes a full quarter of benefit from interest income but also a full quarter of interest expense.
These scenarios assume the highest level of efficiency and actual results could be lower because there will always be some turnover in the portfolio (that could drive higher fee income). This analysis implies that the current dividend is sustainable and that there is the potential for growth in the coming quarters.
Side by Side Comparison:
For the side by side comparison I will be using the amount of equity as of March 31, 2014 (or most recent) along with a debt-to-equity ratio of 0.80 and current portfolio yield to project income and expenses, tracking the following metrics:
- Dividend coverage (using a debt-to-equity 0.80)
- BDC expenses (as a % of available income)
"Available income" is total interest and fee income less interest expense from borrowings and is the amount of income that is available to pay management expenses and shareholder distributions. BDCs with lower expenses can pay higher amounts to shareholders without investing in riskier assets.
The following table compares the results from the previous table for HTGC to FSIC, TCRD, TCPC, ARCC, NMFC, HTGC and MCC. You can see that the internal cost structure of HTGC is a clear advantage for investors as the company grows its portfolio. At this point I believe TCPC, HTGC and FSIC have a much higher potential for dividend increases than the average BDC. I will continue to add more companies in the following articles.
For more details including some of the potential variances to this methodology for assessing dividend coverage please see "Part 1" of this series. Investors should only use this information as a starting point for due diligence. See the following for more information:
Disclosure: I am long FSIC, HTGC, MAIN, TCPC, ARCC, NMFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.