Hercules Technology Growth Capital (HTGC) is a business development company BDC) based in the heart of Silicon Valley. It maintains offices near the major new-tech corridors: Northern Virginia; Boston; Boulder, Colorado; and New York City.
Hercules lends to and invests in venture capital-backed companies active in communications technology, biotechnology, life science, clean energy, and renewables technology, and allows us to get in on the ground floor of new technology while gathering big income checks.
Its portfolio has grown to $983.4 million worth of loans and investments in 93 companies from $176.7 million in 36 companies in 2005.
By law, BDCs are required to distribute at least 90% of their income to shareholders in order to avoid corporate income taxes.
BDCs must also maintain a conservative debt-to-equity ratio of one or less and maintain an assets coverage ratio of at least 200%. There is no leveraging the farm 20-to-1 to bet on exotic derivatives or mortgage-backed securities like the major Wall Street banks did a few years ago.
Basically, Hercules Tech has a fixed capital structure, but its investment portfolio is mostly variable. When interest rates rise, which we expect this year, Hercules Tech’s capital structure will remain largely unaffected and interest expense will widen. That point spread could easily widen to seven or eight percentage points, or more.
The majority of money Hercules Tech makes is in lending to start-ups and early-stage tech companies. The histories might be scant, but the businesses are viable, and the vast majority are already positively cash flowing. Diversification further mitigates risk. Drug discovery accounts for 21.3% of the investment portfolio; clean technology is second, at 17.6%; Internet technology is third, at 16%.
Of course, diversification itself isn’t enough. Discipline and a sound lending process still matter. Hercules Tech has a limited history of defaults, with a historical annualized loss rate of a mere 13 basis points since inception.
Since 2010, the dollar-value of the investment portfolio has more than doubled, while the interest income earned on that portfolio has doubled.
Since 2010, the dividend payout has increased 30% – steadily increasing year after year.
Traditional banks withdrawing from the middle-market sector create an opportunity for BDCs. Because of the dearth of lending that plagues the middle market, legislators in Washington D.C. propose lifting the debt-to-equity ratio of BDCs to 2-to-1 from 1-to-1. The increase would allow BDCs to further leverage their balance sheets in order to get more capital to entrepreneurs and new businesses–and to grow the BDC’s own interest-earned account.
Hercules Tech’s market niche, venture-capital funding of technology, is particularly ripe for an upside breakout.
Through the first nine months of 2013, $23.1 billion was invested in 2,462 VC deals. The long-term annual average, dating back to 1997, is $31.1 billion invested in 3,150 deals.
We see the dividend growing 8% to 10% over the next 12 months. By this time next year, we expect Hercules Tech to be paying $1.33 to $1.36 annually per share. That would lift today’s cost-basis yield to close to 9%.
A higher dividend payout combined with a higher net asset value (NAV) per share should help drive the share price higher.
Twelve months from now we see Hercules tech shares trading at $18, a 16% premium. Factor in a dividend likely to yield in excess of 8% over the course of the year, and investors are looking at a 24% annual return on a low-risk, high-tech, high-yield investment.
Buy Hercules Technology Growth Capital up to $16.50 per share.
Stephen Mauzy and Ian Wyatt, High Yield Wealth, www.highyieldwealth.com, 802-434-6900, February 2014