Hercules Capital: Fear Discount Likely To Persist Over The Short Haul

Summary

• Hercules Capital’s management was seeking management externalization in May.
• However, the BDC has withdrawn its proposal of a new investment advisor relationship.
• HTGC has not yet recovered much, suggesting that a lot of uncertainty still weighs on the BDC’s shares.
• Positive asset sensitivity and potential for NII growth in higher interest rate environment biggest reason to buy into the BDC.
• An investment in HTGC yields 9.34 percent.

Hercules Capital, Inc.'s (NYSE:HTGC) management upset shareholders in May when it announced that it would hold a special meeting for investors to approve a new management and compensation structure. Shareholders didn’t like the idea of an externalized management and dumped its shares. Uncertainty is likely going to continue to weigh on Hercules Capital’s shares over the short haul. However, if management decides to stick with an internal management structure, shares could edge higher.

Fear Discount Likely To Persist Over The Short Haul

Hercules Capital said in early May that it would seek to externalize management for "strategic reasons". According to management, externalization would allow the company to "broaden the size and categories of assets under its future management". Seasoned BDC investors, however, know what this means: A change in compensation structure would likely imply higher management fees, which in turn would create an incentive problem. Management’s primary motivation would be to increase the size of assets under management in order to earn incentive fees rather than focus on maximizing shareholder value.

In fact, internally-managed investment companies have better reputations in the stock market largely because of their superior incentive structures compared to externally-managed investment companies whose management can siphon off a lot of cash at the expense of shareholders. Prospect Capital’s (PSEC) shares, for instance, sold for a large discount to Net Asset Value for a long time primarily because of its high management fees.

Two weeks after the initial announcement, however, Hercules Capital postponed the Special Meeting of Stockholders previously scheduled for June 29, 2017, after shareholders voiced their dissatisfaction with the new management and compensation structure. However, the damage had already been done. Hercules Capital’s shares were obliterated in early May, and shares have yet to meaningfully recover from the sell-off.

Source: StockCharts.com

Hercules Capital’s shares have stabilized after the sell-off, but will likely continue to trade sideways in my opinion until shareholders gain some more clarity as to whether the company will follow the externalization route or not. Should Hercules Capital decide to follow through with externalizing its management, I would expect the share price to drop further as investors disapprove of an unfavorable compensation agreement.

On the other hand, shares appear to have bottomed out for now, and could edge higher if management commits to an internal management structure. In any case, I have closed my long position in Hercules Capital because of the company’s request for a Special Stockholder Meeting in May.

What About The Positives?

Hercules Capital has seen strong growth in the last six years, with Total/Net Investment Income reaching new highs nearly every year as smaller BDCs took market share from bigger banks that cut back on lending to higher risk clients.

Source: Hercules Capital

That being said, the biggest justification for buying Hercules Capital today relates to the BDC’s highly rate-sensitive loan portfolio. In short, the higher the short-term interest rates climb, the stronger the NII tailwinds for Hercules Capital are going to be.

The Federal Reserve has hiked rates three times in the last seven months. Each 25 bps rate hike is expected to lift Hercules Capital’s Net Interest Income $0.03/share each year. In other words, the more aggressive the Fed is about its rate policy, the better the odds are for continued NII growth and, potentially, a dividend hike.

Source: Hercules Capital

Your Takeaway

I had a lot of confidence in Hercules Capital and its operating results before the company unnecessarily injected a mountain of uncertainty into the investment by proposing a management structure that is and will not be in the best interest of shareholders. However, management has withdrawn its proposal of an external investment management structure for the time being, which is a good thing. The best case scenario right now would be for management to commit itself to an internal management structure while the Federal Reserve continues to lift rates. Hercules Capital is a "Buy" only in the best case scenario in my opinion. Otherwise, I would expect the fear discount to persist and Hercules Capital's shares to trade sideways for a longer period of time.

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