- Hercules offers 8% yield with exposure to tech and life sciences funding.
- Hot IPO and special events market has been a boon.
- The pandemic strategy of building upon existing relationships is paying off.
- Hercules Advisor represents expansion opportunity.
What originally attracted me:
I was looking for a way to find some exposure to tech IPOs in January 2020 that was less volatile or overpriced than the frothy offerings that have been the norm in recent memory. Hercules Capital's (NYSE:HTGC) structure as a business development company (BDC) means that they payout at least 90% of their taxable income to shareholders as a result of direct investment into small and middle-market private companies.
As a dividend-aware investor, this looked like an opportunity for tech exposure that could provide some yield. At 8%, HTGC fit that bill. HTGC's primary focus for funding has been 1) technology, 2) life sciences, 3) financial services, and 4) sustainable and renewables. Since 2017, exposure to renewables (7.7 to 2.4%) has decreased while software has increased considerably (23.4 to 33.1%). In Q4 2020, these special situations have included IPOs or registration for the likes of Palantir (PLTR) and DoorDash (DASH) and the PIPE for Yumanity Therapeutics (YMTX) amongst others.
From Q4 2020 Investor Press
In their Q1 2020 earnings call, comparisons were made to the credit crisis and it was pointed out that HTGC's portfolio mix was more situated in expansion and established stage companies with considerably less exposure to earlier stage companies than the company was in 2008. Additionally, there is more access to liquidity in the market in 2020 than in 2008, which should allow for a substantially quicker recovery relative to 2008. Commentary was also provided on due diligence taking a bit longer due to the transition to homework, but that in the period between Feb 20 and May 1, 2020, 1.6 billion in new capital had been raised from 21 of their portfolio companies through active conversations with key VC partners. From this, it appears that management's target was a diversified portfolio while maintaining liquidity and focusing on the performance of the current portfolio companies rather than growth in a challenging environment.
Cut to Q4 2020 and the company ends the year with $673 million in liquidity, a one-year total return to shareholders of 12%, and a price/NAV ratio of 1.28 which is comparable to the last 5 years despite the challenging environment. NAV has increased by 6.7% over last year and the company has had 8 companies complete their IPOs and 14 M&A events. In Q4, this resulted in 116% coverage of the quarterly distribution resulting in an NII per share of $0.37 that was passed along via a supplemental distribution ($0.32 regular + $0.5 supplemental). This is in addition to establishing Hercules Advisor, a BDC wholly-owned registered investment advisor that will serve to broaden the accessibility of HTGC's offerings.
From Q4 2020 Investor Press
Comparing against peers:
By comparing HTGC against a company with a similar investing strategy in the Tech venture capital space, we can begin to assess relative performance within this market space. TriplePoint Venture Growth (TPVG) is a BDC that focuses primarily on late-stage companies preparing to make the jump to the publicly traded sphere. TPVG has a considerably smaller market cap than HTGC ($442.5M versus 1.82B), but both can be expected to have prepared for similar market conditions in forward earnings estimates for 2021.
Both companies have similar ranges for forward estimates in 2021 with a range of ~$14.5 to $16.9 with TPVG coming in lower than HTGC for 2022 ($13.2 to $15.3 vs $14.7 to $17.5, respectively). These estimates reflect analyst forward estimates for the next two years with the horizon for HTGC looking slightly brighter than TPVG largely due to increased forward P/E values and not NII increases. HTGC has maintained a higher average P/E of 10.54 versus TPVG's of 7.76 across the last 5 years reflecting a higher premium to NII for the larger company.
Based on this, there is more room to run with TPVG's smaller forward P/E, but in recent history, HTGC has maintained a larger multiple. Both companies seem to be fairly valued based on current earnings estimates, so ultimately the decision becomes one of forward yield (9.97% TPVG vs 7.99% HTGC) and whether you are comfortable with TPVG's smaller market cap and historic forward multiples.
Headwinds into 2021:
An uptick in prepayments in Q4 has led to some portfolio decline and will reduce the NII on a short-term basis as opportunities have to be found to rebuild and replace portfolio companies with an eye toward quality assets. Considering the record available liquidity of $673 million and low leverage of 93%, the company seems to be in an adequate place to deal with market conditions unless there is considerable unforeseen change. Changed regulatory views or increased regulatory scrutiny on SPACs could reduce the number of deals that are going through and could materially decrease the number of special event situations that Hercules is supporting resulting in reduced NII in the latter half of 2021 and early 2022.
This could result into a pivot into more traditional IPOs or result in a cooling of the rush of companies going public using alternative means and instead spending more time in the late stages prior to going public. If this occurs, it will likely involve companies raising venture capital funds, so business is likely to stay with HTGC with deals in other categories than special events.
HTGC at around $16 is a hold for me, with a price to NAV of 1.28 matching the average of 1.28 for the last five years resulting in a fair value of $14.4 with the current price reflecting a ~10% premium. The company is fairly priced and not cheap, but last March and April were an opportunity to acquire some on the cheap due to an uncertain outlook and HTGC's shares have fully recovered from the pandemic lows. HTGC's pricing has held up relatively well amid the volatility being seen through the Nasdaq since February 2021 and maintains a forward PE of 12.07, which is on the high-end for the last five years but not yet eye-watering. I will likely accumulate more shares if the price drops below $15 and alternatively, trim a little from position if it gets above $17.
The considerable price drop last March also highlighted the relative volatility that can occur with BDC's that should be considered prior to adding to your portfolio if you are looking for guaranteed income on a short time horizon. If a prolonged and severe correction in the technology sector develops, I would need to reassess my position based on forward estimate revisions and see if the attractive yield is worth the hit to my initial capital.
Currently, it looks to me as if HTGC stated its aims shortly after the pandemic hit and followed through, even increasing the outlook for future opportunity with the addition of the RIA to their services. Considering what I see as rather adept management already guided this company through a black swan event, I am happy to stick around for the 8% yield and to see what 2021 holds for HTGC.
This article was written by
Analyst’s Disclosure: I am/we are long HTGC. 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.
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