Hercules Capital

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Hercules Capital is a specialty finance company that provides capital to venture-backed technology and life sciences companies. It invests in high-growth private companies, aiming to generate attractive returns while helping these companies reach their potential.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

  • Revenue Distribution: HTGC’s revenues primarily come from three sources:
    • Interest Income: The majority of their revenue is generated from interest payments on the loans they extend. This is highly dependent on the interest rate environment.
    • Fee Income: This includes origination fees from new loans, prepayment fees when loans are paid early, and other recurring fees charged to borrowers.
    • Capital Gains: Profits are generated when they sell equity investments and realized gains on assets.
  • Industry Trends:
    • Demand for Venture Debt: The demand for debt financing from venture-backed companies continues to be driven by a desire to finance growth without diluting equity. In recent months, the IPO market has started to heat up which is making companies in their portfolio more liquid and more attractive.
    • Interest Rate Environment: Rising interest rates are both a positive and negative for HTGC. A higher rate can drive better returns, but also increase risk and may affect the borrower’s ability to pay back loans.
    • Competition: The BDC (Business Development Company) industry is crowded. There is intense competition for high-quality deals, putting downward pressure on interest rates and fees.
  • Margins:
  • HTGC’s primary cost is the cost of capital, which is influenced by both interest rate and economic environment. The spread between the interest rates on loans and their cost of capital is a key factor in profitability. In the past few quarters the bank has seen their profit margins fall which are primarily due to increased cost of funding. As inflation cools down and the interest rates might potentially fall, these margins are expected to improve.
  • Competitive Landscape:
  • The BDC sector has a large number of competitors, but also a substantial amount of institutional investors who are also providing loans, there is often intense bidding on opportunities, making it difficult to be the sole financier of a good-quality company. However, HTGC has cultivated an excellent reputation in this space, giving it an edge.
  • What Makes HTGC Different:
    • Focus on High-Growth Sectors: HTGC specializes in providing venture debt and other capital to technology and life science companies with high-growth potential. This sector focus allows the company to tap into a segment with rapid development.
    • Origination Network: The company has built relationships that give it access to an excellent pipeline of companies.
    • Experience: Being one of the few public companies that offers venture debt, HTGC has developed expertise in this specialized field.
    • Emphasis on Senior Secured Debt: By investing primarily in senior secured debt, HTGC limits its downside risk and maximizes its ability to recoup funds in case of default.
  • Ability to Scale: Because the management team has been in place since the 1990s, they know how to handle and grow a big company. In the recent market downturn, the management has reiterated that this is the perfect environment for a skilled lender to get amazing terms on high-quality companies, and it is their expertise that helps them to manage through periods of instability and capitalize on opportunities.

Financials In-Depth:

  • Recent Earnings:
    • The company’s earnings have been impacted by the current interest rate environment and inflation, which has increased its operating costs significantly. However, despite this the bank has been showing high profitability numbers due to a high demand for private credit and strong loan growth. The bank is very optimistic for future quarters because there is a slowdown in the rate hikes from the Fed.
    • Strong Core EPS growth: In the recent quarter, core EPS showed positive growth year-over-year. This was primarily driven by income and interest rates, but that can not be considered as organic growth from actual businesses.
    • Low Non Accruals: While many companies in this sector are facing losses and issues due to defaults, HGC seems to be managing them well.
    • High Net Asset Value: HTGC has seen an impressive growth in their net asset value as well, which reflects that their investments are performing well.

  • High Dividend Yield: The bank has also maintained a high dividend yield, giving investors a continuous stream of cash. As most investors look at BDCs for high yields, this helps them retain their investors.

  • Income Statement:
    • Revenues are highly dependent on new loans originations.
    • Fees have been volatile because they depend on when and how much of companies take prepayment options.
    • Due to interest rate hikes, the bank is making more money on its interest income and this is the biggest contributor to revenue growth.
  • Balance Sheet:
  • The bank has a diversified portfolio with investments in many different companies and has a very large base of credit facilities. * The bank does have some portion of preferred stock, common stock, and warrants in its assets as well.
  • Cash levels are lower than average with less than $500 million in cash. * The company has good debt levels with a reasonable debt to equity ratio of 1.4. The debt is divided between secured bonds (63%), secured credit facilities (32%), and securitized loans (5%).
  • Cash Flow:
    • Strong cash flow generation is primarily driven by interest rates.
  • The bank is very active in repurchasing stock as well as buying new investment opportunities.

Moat Analysis (3/5):

HTGC has a narrow moat, primarily built on the following:

  • Intangible Assets (Brand): Being one of the first to focus on venture debt and also an experienced player, has created a brand for itself in a very niche sector. This does not have high brand recall with customers, but the reputation of the company is very well known to the market.
  • Switching Costs: A small portion of borrowers have high switching costs, where they are tightly integrated with HTGC. It could also be due to established agreements with these companies. Many times, moving debt to another lender is also an expensive, time-taking, and highly disruptive process which allows HTGC to command premium rates.
  • Network Effect Though limited, HTGC’s origination network helps to improve its overall brand, making it more attractive to more new borrowers and increasing its brand further.
  • Size Advantage: HTGC is one of the largest BDCs, and because the debt market requires large amounts of investment, it gives it an edge against its smaller competitors. Having a big balance sheet allows the company to lend out larger sums and also gives them a chance to pick and choose the best opportunities.

Risks to the Moat and Business Resilience:

  • Interest Rate Risk: As an institution that generates interest income, a major downside could be the fall of interest rates, which would directly affect its earnings.
  • Credit Risk: There is an increase in the default rate among the companies and the bank has to take credit losses on many of its investments.
  • Increased Competition: Newer companies in the space try to offer lower interest rates and fees in order to acquire market share and that directly impacts HTGC’s revenue and margins.
  • Regulatory Risk: Changes in regulations could impact the BDC industry and its ability to operate.
  • Economic Downturn: A significant economic downturn, including a recession can also cause defaults and make companies more sensitive to interest rate hikes. This will severely impact earnings.
  • Dilution: A new share offering, while helping the company raise capital and deploy it for new investments, also dilutes the existing ownership and can lead to negative returns in the short run.

Understandability (2/5):

  • The business model is relatively complex to understand due to financial instruments and complicated accounting.
  • The BDC industry itself is complex to understand for someone without any background in financial analysis.
  • Due to this reason, an average investor might find it hard to understand how this business creates value.

Balance Sheet Health (4/5):

  • HTGC’s debt-to-equity ratio is at manageable level.
  • The company has large amount of credit facilities.
  • The bank has enough liquidity in terms of cash, to manage short-term liabilities.
  • However, the company has faced challenges in finding a profitable new investment opportunity, given its current risk appetite. This might also indicate lack of potential for growth of revenue.

Recent Concerns, Controversies, and Problems:

  • Economic uncertainty: Given global economic uncertainty, HTGC has focused on being extremely selective about its investments.
  • Rising interest rates: The bank has seen its cost of funding rise. Management is keeping a close watch on interest rates. Although, they also say that BDCs perform well in rising rate environments, it still poses a risk.
  • Credit Losses: While the bank has had low defaults in the past, they still expect that default rates will rise due to economic conditions.
  • Competition: The BDC industry is becoming more crowded, leading to an increase in competition for opportunities.

Management Comments on the Above:

  • The bank believes that the rise in inflation is mostly temporary and does expect lower inflation going forward.
  • They feel that their conservative and disciplined investment strategy will help them navigate the tough economic conditions.
  • They have reiterated that their business model is very good at generating income even in such conditions.
  • They believe their strong origination and underwriting process helps them pick the best opportunities.
  • They have a well diversified portfolio and they feel they are in a good position to manage the downturn well.