Hercules Technology Growth Capital, Inc. (HTGC) is a mid-sized Business Development Company ("BDC"), and the top public player in lending/investing to venture-backed technology companies. The common stock saw a big run-up in early 2012, and peaked at $11.50 on May 7. That was a 21% increase from a low of $9.53 in December 2011. The stock dropped to $10.21 by May 18, but has been on the ascendant since.
At time of writing, the stock is at $11.57, a 10.2x multiple of 2013 consensus earnings, and 1% off its 52-week high. The yield is 8.3%. Certainly the stock is not cheap at these levels. We are neutral on the stock, but we do tend to be reluctant to jump on stock band wagons (HTGC is up 13% in six weeks), and have missed perfectly good rallies in the past.
However, there is another "way to play" Hercules Technology. The company is one of many BDCs that has been issuing tradable unsecured Notes, which pay interest quarterly. The first issue of Notes occurred in April and another round of $39mn in new debt was issued last week. The Notes, which come due in 2019, have a coupon of 7.0%. The ticker for the Notes is HTGZ.
For cautious investors, the Hercules Senior Secured Notes might be worth a look. To explain why that might be the case we have to go the long way around because we have generally been very cautious about the numerous BDC unsecured Note issues that have come to market in recent months (and which show no signs of abating).
BDCs that have raised term debt of one kind or another in recent months include Ares Capital (ARCC), Medley Capital (MCC), Horizon Technology (HRZN), THL Credit (TCRD), Prospect Capital (PSEC), as well as Gladstone Capital (GLAD) and Gladstone Investment (GAIN) through a Preferred Stock issuance which has all the attributes of a debt offering. We wrote an article on this subject on March 20, 2012.
Here's a run-down on why we are generally cautious about investing in BDC Notes, as a rule:
Covenant Lite or Covenant Free? Besides being unsecured, these Notes typically have very few covenant protections. To be brutally honest, there are no meaningful covenant protections.
Structural Subordination: The worst of it, though, is that the so-called Senior Notes are structurally subordinated to all the secured debt the borrower enjoys with it's bank lenders, and any subsidiary entities that have borrowing facilities. This does not make much of a difference at the current time when BDCs are doing well, bad debts are low, and cash flow is sufficient to pay interest on the Revolver, the Notes and a handsome dividend to shareholders.
However, these Notes are usually 5-7 years in length, virtually guaranteeing that the BDCs will face at least one more recession during their term. The Great Recession showed that BDCs can go from having no bad debts during good times to seeing 20%-40% of their investments getting into trouble.
Do We Have A Problem Here? Okay, you might say, but BDCs, thanks to their peculiar structure, are not highly leveraged, even when secured and unsecured debt is added together. Investment Assets at their lowest permitted level are a minimum 200% of debt. Or, in other words, a BDC would have to write-off 50% of its assets before debt holders would be in the firing line for losses. On paper, that's true, but that is not the risk we are most concerned about.
Let's assume a recession occurs, chances are the senior secured Revolving loans will go into default. Unlike the Notes, the banks that provide senior secured debt have covenants in their loan agreements. Many covenants. Even if a BDC manages to avoid defaulting under the standard 200% asset coverage test, there are fixed charge covenants, maximum write-off covenants, diversification covenants etc.
If a default occurs, and in the general atmosphere of fear and concern about the future that any recession brings on, the banks will require the BDC borrowers to repay any outstandings either on very short notice (under the age old lending theory that things are only going to get worse and that the banks are not being paid to take those kind of risks - which is essentially true), or to amortize down the loan over a longer period. In the latter case, all loan repayments received by the BDC from its portfolio companies (including interest in some cases) is applied to the repayment of the senior secured lender.
Structural Subordination: For a "Senior Note" holder, that's when being "structurally subordinated" starts to mean something. Now the bank lenders are calling the tune, and they may or may not allow the BDC to distribute sufficient cash flow to pay the operating expenses of the BDC, the dividends owed to shareholders and the interest owed to the Note Holders. Usually in the past the bank lenders have realized that operating expenses have to be paid to keep a BDC functioning, while they are getting out. As for dividends, the historic experience has been more mixed. What we don't know, but we can be pretty sure of, is that the senior secured lenders will want to ensure the Note Holders don't receive any interest payments until the default on their debt is cured.
Waiting... And Waiting: The more a BDC has borrowed from its secured lenders, the longer the Note Holders may have to wait to receive their interest. How long? Of course, it will be a company by company scenario, and will depend on many factors. Judging,though, by the experience of companies such as American Capital (ACAS), Kohlberg Capital (KCAP), Saratoga Investment (SAR), Gladstone Capital, Gladstone Investment, TICC Capital (TICC), Triangle Capital (TCAP) and Hercules itself, a default or just the prospect thereof can take many months or even years to play out. American Capital took two years to renegotiate its admittedly complex debt arrangements, and more than three years since defaults hit the fan, the company still has not returned to "normal".
In a scenario where Notes would be in suspended animation, awaiting a resolution between the BDC and its secured lenders, we can reasonably expect that Note values would drop sharply, and presumably new issues suspended. This is mostly new territory so it's hard to quantify. We would point out,though, that Allied Capital - the BDC swallowed up by Ares Capital as a result of the Great Recession and a parade of bad debts - had an Unsecured Note outstanding through the 2008-2009 period. The issue now trades under the ticker AFC, and is now an obligation of Ares Capital. However, before the buy-out, AFC - which came to market at $25 a share - traded as low as $5 during the darkest days. The issue has now recovered in price, but did trade at a discount of at least 20% for twenty-four months. Owners of unsecured Notes will have to take the long term view if what happened to AFC should re-occur with the more recent Note issues.
Why We Like HTGZ
As we warned, that's a very long explanation of why we're wary about most BDC unsecured Notes (besides the obvious interest rate risks and the right most of the issuers have kept to recall the Notes at their convenience in a few years and the relative illiquidity of the new instruments). However, investing is about not painting with too broad a brush. In the case of Hercules, there are two factors that mitigate our concerns.
First, the company has proven through the last recession (unlike a number of BDCs that have joined the party only since 2009) that, notwithstanding their exposure to a volatile industry such as technology, their credit underwriting has kept bad debt levels at modest levels. As of March 31, 2012, and following a good quarter for portfolio realizations, HTGC boasted write-offs over its history equal to 7.5% of its equity capital at par. Given that the company has been around for years, in good times and bad, it's nothing to sneeze at, and does go some way to validate the technology lending model, which Horizon Technology Finance and,most recently, Ares Capital have jumped into.
Secondly, Hercules, despite having two senior secured Revolvers with two different banks, does not appear to be relying on this source of funding as permanent capital. Instead, HTGC, perhaps because of its experience with quick-to-bolt-bankers, seems to regard the Revolvers as short-term liquidity vehicles that get refinanced in short order by long-term unsecured debt, whether the Notes we are discussing or SBIC borrowings, or by new equity raises. Thus, the risk of Hercules being caught in the next recession with heavy exposure to an unhappy secured lender is lower than in some other situations, and gives us comfort that it will be able to avoid the drama that such exposure might entail. Of course, HTGC is not committed to keeping its Revolvers as essentially back-up or warehousing facilities, so nothing is assured.
We should also point out that approximately $300mn of Hercules' $700mn in investment assets are pledged to its SBIC subsidiary, so Note Holders (which includes previously issued Notes and Convertible debt-all adding up to under $150mn have about $400mn of investment assets to look to for ultimate repayment if there is no Revolver debt outstanding. (At March 31, 2012 Revolver outstandings were zero and just $10mn at year end 2011).
BDC Reporter's Unsolicited Opinion About Unsecured Notes
We have said previously that we would be much more excited about BDC unsecured Notes generally if they were accompanied by some limitation on what the borrower could pledge to secured lenders, which would ensure assets would be available to the Note Holders, and would ensure continuing income even under a secured lender default.
Leverage Creeping Up
We'd also prefer that the BDCs keep debt to equity levels leverage at the 0.5 to 1.0 levels they were almost unanimously aiming at a few quarters ago. The availability of the new Notes, and plentiful SBIC funding, has begun to encourage BDCs to increase the use of debt by 25%-100%. However, the investment banks are able to get this debt placed without any such requirements, to both the delight of the management (cheap capital, which when deployed, pays management fees), the secured lenders (who have a pool of assets two to three times their loan commitments as collateral), the investment banks (fees and a new product) and shareholders (who will see higher earnings despite the higher cost of this new debt as BDCs are able to leverage themselves more). Down the road though, both the Note Holders and the shareholders (who will see higher credit losses from the higher leverage when the next recession comes along) may regret their enthusiasm.
Doom And Gloom Warning
Shareholders, especially, should have a hard look at the economics. With Notes typically being issued at or around 7% (versus 2.5%-3.5% for Revolver debt), and when management fees, incentive fees and incremental costs of the new business are considered, the cost of this unsecured debt capital reaches double digits.
For the sake of this discussion, let's say 10%. That means a BDC, lending out monies at a yield of 12.0% is only earning a net interest margin of 2%, where shareholders are concerned. Under a traditional Revolver, the net yield would be closer to 6.0%-7.0%. When the recession comes along, and 5%-10% of all loans go on non-accrual every year for a couple of years, the permanent impairment to shareholder value will be significantly higher than a few quarters of additional 2% interest.
Of course, BDCs are in the business of making loans, but we question whether the risk-adjusted return is worthwhile with such a thin incremental gain. The other result is that BDC stocks, which are already as volatile as an unexploded bomb on a desert highway, will only become more so when investors start to anticipate the next recession.
For The Long Term Investor... the Hercules Technology Notes, although their 7.0% yield is lower than the 8.3% dividend yield on the common stock (which also offers the promise of possible capital appreciation) may end up being the better investment.
Much depends on what happens years in the future with write-offs, presumably as the result of a recession in the economy or the technology sector. If HTGC writes off just 10% of its $700mn of investment assets (as measured at March 31, 2012), the reduction in NAV would be about 15%, the drop in earnings about 20%, and the hit to the stock price difficult to predict.
Just for fun, though, let's assume the stock price dropped 20% (in line with the earnings reduction) to $9.3. An investor would lose -$2.3 a share. By contrast, the Notes should pay off at par even if all the $70mn in written off assets came from the non-SBIC side of the business; $400mn in non-SBIC assets would drop to $330mn under this assumption, versus all unsecured debt outstanding of $150mn. That would be more than sufficient to maintain debt service and ensure Note repayment at par.
We don't recommend one option or another. We have just tried to quantify some of the variables and clarify the risks and opportunities. In fact, we are long HTGC stock, and have no position in the Notes as we wrestle with all the above.