While awaiting upcoming volatility, HTGC's quality and dividend coverage make it a 'hold', with the potential for better entry points in the future.
For those unacquainted with Hercules Capital (NYSE:HTGC), the Company operates within a versatile BDC sector. BDCs (business development companies) help fill the financing gap for smaller or middle-market companies that often struggle with acquiring bank or public financing. They acquire capital (primarily equity) to deploy it and generate value through investment activities.
HTGC is one of the highest-quality players in the sector with a solid track record, as we can read in its latest 10-Q statement:
Since inception through June 30, 2024, we have originated more than $20.0 billion in commitments in over 650 companies. We, our subsidiaries or our affiliates, may also agree to manage certain other funds that invest in debt, equity or provide other financing or services to companies in a variety of industries for which we may earn management or other fees for our services. As of June 30, 2024, Hercules and its Adviser Subsidiary actively manage approximately $4.6 billion of assets.
The Company concentrates on debt investments (mainly first-lien debt) but also has some symbolic share of equity investments. Its ticket (investment size) typically ranges from $25m to $100m. It has a unique sector expertise leading it to focus on five key sectors from the 'new economy'. It typically concentrates on US targets but had ~11% share of the portfolio allocated abroad (as of December 2023).
Let me present you with my outlook on the BDC sector and HTGC's valuation and its potential as one of my future investments. Enjoy the read!
Most BDCs generate income through floating-rated loans, so they benefit from rising interest rates and the high-interest rate environment. It may concern investors, as the market expects noticeable interest rate cuts to occur by the end of 2024.
There are a few aspects to consider when considering the potential impact of lower interest rates on BDCs' performance.
Firstly, income: HTGC's investments are predominantly floating-rated debt investments. While they are subject to some floors, a lower interest rate environment will negatively impact HTGC's income from such investments.
MAIN Street (MAIN) may be a better alternative for investors concerned about that, as a substantial portion of its investments are structured with a fixed rate.
A strong point of HTGC is the leading share of first-lien debt in its investment structure, amounting to 85.6%. However, there are other BDCs with more defensive portfolio structures, with (as I believe) Blackstone Secured Lending leading in that regard (BXSL).
Secondly, the cost of debt: while most of HTGC's debt is fixed, the Company has some financing sources at a floating rate. Therefore, the Company will benefit from a lower debt cost, somewhat offsetting its negative impact on its income (unfortunately, that wouldn't offset it fully).
Also, a lower interest rate environment will facilitate HTGC's refinancing activities upon upcoming debt maturities.
Thirdly, transactional market activity: with the high interest rates, the gap between buyers and sellers, as well as borrowers and lenders, is relatively wide. Interest rate cuts would narrow that gap, leading to more activity in the transactional market, i.e., better deal sourcing capabilities allowing higher selectivity and, thus, more attractive opportunities. Naturally, that's the hardest aspect to factor in the interest rate sensitivity analysis, but one that investors certainly have to be aware of.
Rising non-accruals shouldn't surprise investors, as we've been operating under a relatively hard environment for the last couple of years. Businesses faced numerous challenges, from inflation to interest rates and overall economic uncertainty. Moreover, Ares Capital's (ARCC) management predicted such a scenario during its Q4 2023 Earnings Call:
We've said this in the past that we're likely to see defaults in the industry just increased this year. It does take a little bit of time for that to manifest itself, right? So in the bottom quartile of our portfolio and probably everybody else is, you have some companies that are making interest payments but continue to live off revolver availability, cash, et cetera, but the liquidity is getting tighter and tighter.
And so my expectation is that the fall will go up this year, probably more towards the historical norm. We've had a little bit of amendment activity that's elevated; I think others probably have two but nothing that's causing us a whole lot of concern. I think it's just a regular letting out as obviously rates are higher and companies have higher debt service costs and all that. But generally, I think we'll see that as well others.
However, whether expected or not, it's a negative factor that may be upheld in the upcoming quarters, leading to higher risk across the entire BDC sector. Such a tendency also holds for HTGC, as its non-accruals amounted to 2.5% at amortized cost at Q2 2024-end compared to just 1% at 2023 year-end.
I'm a big fan of Benjamin Graham's Mr Market metaphor, implying that the market is subject to irrational swings (Mr Market's mood swings) that leave business valuations detached from their intrinsic value and long-term ability to reward shareholders.
For the reasons mentioned below, I believe we will experience increased volatility in the entire BDC sector in the upcoming quarters. Therefore, even top-tier BDCs like HTGC, MAIN, or other key players may be subject to discounts, leaving their valuations detached from their value-generation potential.
Please review the P/BV ratio for HTGC presented in the chart below.
HTGC has a solid history of trading at a noticeable premium to its net asset value. While it may discourage some investors, it is a double-edged sword.
On one hand, naturally, the better the entry point, the higher the upside potential and margin of safety. That's why it's crucial to factor valuation into the business analysis and investment decision process.
On the other hand, HTGC's long track record of trading at a substantial premium reflects its quality. It's crucial to remember how BDCs operate. They issue equity to finance their investment activities. The higher the premium to NAV, the more proceeds the company can gather at a given dilution level. In short, the higher the premium to NAV, the better the accretive potential of share issues.
After a recent pullback, HTGC came closer to the buy zone. However, history shows that HTGC was available at noticeably lower premiums than over 60% to NAV. While history doesn't have to repeat itself, given the market outlook presented earlier, I believe investors will be able to establish lower entry points, securing a wider margin of safety.
There is no denying that HTGC is one of the top-tier BDCs in the market, which is well-reflected within its metrics, track record, and market approach to its stock price (premium to NAV). It's on my list of BDCs to get involved in at a potential pullback.
However, each stock market investment is accompanied by market and company-specific risk factors, which in the case of HTGC include:
Nevertheless, while for now, I consider HTGC a 'hold', as I'm expecting better entry points in the upcoming quarters, I recognize its quality, strong position in the sector, and positive risk-to-reward ratio. Moreover, its regular dividends (DPS) are well-covered by its net investment income (NII). Please review the chart below for details.
To summarize, I consider HTGC a 'hold', as I'm wary of the upcoming market uncertainty that will likely lead to increased stock price volatility. I am willing to 'risk waiting' for a better opportunity to get involved in HTGC. Nevertheless, I believe the Company will benefit its current and new shareholders greatly.