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Hercules Technology Growth Capital (NYSE:HTGC) is a business development company, or BDC, strategically headquartered in Palo Alto, California, near the heart of the Silicon Valley, where it focuses on lending to tech companies in various stages of development. HTGC has paid out over 98% of its taxable earnings as dividends to shareholders the past two years, and currently offers a yield over 9%.

BDCs are also known as mezzanine lenders, often supplying a level of debt subordinate to the senior level of debt, but senior to the equity layer. Companies in various stages of development are widely seen to be underserved by the traditional lending community, particularly since the credit crunch began in 2008. The venture capital industry has improved this situation by investing over $32 billion into more than 3,000 entrepreneurial companies in 2011, which was a 10% increase over 2010. They supplied another $46 billion into merger and acquisition transactions in 2011, which was a 30% increase over 2010. And, they supplied another $5 billion into IPO transactions in 2011, an increase of 65% over 2010. As you can see, this is a thriving and growing industry.

How Hercules Makes Money

Hercules structures loans, typically between $1 million and $25 million, with maturities usually between two and seven years, with an average maturity of three years. The company charges interest rates between prime and 14%, collects a variety of fees, and obtains equity interests in the companies it lends to. This all combines to a targeted 12% to 25% annualized return from investments.

How Hercules Minimizes Risk

Hercules maintains a database of over 26,000 potential customers. Before lending, the company applies a diligent underwriting process led by a team of investment professionals with an average of 15 years of experience in the field. Hercules then attempts to minimize risk using multiple aspects of diversification:

1) Lending to companies at various stages of development: while some BDC's focus on lending seed money to start-up companies, Hercules lends to companies in the emerging growth stage, the expansion stage, the established stage, as well as some publicly listed, targeting companies already backed by a venture capital or private equity sponsor.

2) Types of lending: some debt is senior secured, some is senior secured with warrants, with very little of the second-lien variety, and some equipment loans, all structured with various terms, covenants, warrants, and equity rights.

3) Lending across various technology sectors: drug development, internet services, clean tech, drug delivery, information services, media, software, communication, etc. with no more than 20% exposure in any one of these sub-sectors, and no more than 7% of net assets in any one company.

4) Geographic spread: although most lending is done to U.S. companies, Hercules also lends to companies in England, Iceland, Ireland, Canada, and Israel.

This strategy to minimize risk has served Hercules well. Since inception in 2003, Hercules has lent $2.7 billion to more than 190 companies. Net realized losses have totaled $50 million, which is only 1.8% of total commitments, or an annualized loss rate of just 25 basis points per year.

The Equity Kicker

Hercules structures its loans to include warrants, preferred stock, and/or common stock equity rights in the pre-IPO tech companies it lends to. The company does this hoping to add a capital appreciation stream to its interest and fee income streams. Hercules holds warrant positions in 109 companies in its portfolio, and direct equity positions in 35 companies. This strategy has produced some impressive gains.

In 2011, Hercules benefited from equity positions in seven different companies. One was the sale of its position in InfoLogix, which booked a gain of over $8 million. One of the most talked-about IPO's in 2012 (no, not Facebook (NASDAQ:FB), which is a Hercules equity holding) was Annie's (NYSE:BNNY), which vaulted from an IPO price of $19 to over $43 per share in its first month of trading. Hercules booked a gain of $2.3 million on Annie's, as well as a $3.5 million gain from the sale of its equity positions in BARXX Medical and Aegerion Pharmaceuticals. Hercules saw three other portfolio companies complete IPO's in the first quarter of 2012, including Cempra (NASDAQ:CEMP), Enphase Energy (NASDAQ:ENPH), and Merrimack Pharmaceuticals (NASDAQ:MACK). Two more portfolio companies, Facebook and WageWorks, plan to complete IPO's in the second quarter of 2012, where Hercules also expects a gain of $5.2 million from the acquisition of NEXX Systems.

Results

Hercules grew commitments in 2011 to $630 million, an increase of 20% over 2010. Total investment assets grew to $653 million in 2011, an increase of 38% over 2010. Net asset value per share grew to $9.83 per share at the end of 2011, an increase of 3.5% over the prior year. Hercules raised 2011 dividends by 10% over 2010, and HTGC boasts a total return to shareholders that has outpaced the S&P 500 Index since 2008.

In the first quarter of 2012, Hercules grew total investment assets to $694 million, an increase of 6% over the prior quarter, and reported record total investment income, up 16% from the year before. This resulted in distributable net operating income of $0.26 per share, and Hercules raised the dividend by 5% to $0.23 per share for first quarter, and by another 4% to $0.24 per share for second quarter, marking the company's 27th consecutive quarterly dividend payment. Hercules also completed a follow-on equity offering of 5 million shares at $9.61 per share to raise $48 million, and benefited from the equity sales mentioned above. Net asset value per share decreased slightly to $9.76 per share. Hercules originated another $101 million in new commitments, funded another $65 million in investments, and ended the quarter with $178 million remaining in liquidity including $48 million in cash.

Timing Your Buy of HTGC

The stock price of HTGC fluctuated between $8.20 and $11.40 in 2011. Using the year-end net asset value per share of $9.83, these prices represented a trading range between a 16% discount to NAV up to a 16% premium over NAV. Buying at the low would give you a current annualized yield of 11.7%, while buying at the high would give you a more modest 8.4%. As you can see, selecting a good entry price to HTGC is critical, whether you're trying to maximize yield or looking to sell shares for a gain.

In 2012, HTGC has fluctuated between $9.53 and $11.50, and currently sits at $10.54, right in the middle of the 2012 trading range. Over the past few months, HTGC participated in both the run-up due to pre-IPO Facebook excitement and the fall-off due to post-IPO Facebook disappointment, based on its (relatively small $9.6 million) equity position in Facebook. The current price would give you a current annualized yield of 9.1%. It is up to each investor to decide whether that yield looks attractive, or if HTGC is something to put on your watch list for a potential purchase on the next dip.

Source: Hercules Technology Growth Capital - A BDC With An Equity Kicker