Description

Short – Hercules Capital (HTGC)

Hercules Capital (HTGC) is an example of a low risk, high reward short as the Company’s business model and financial stability is at risk of being materially negatively impacted by the ongoing burst of the speculative bubble in the technology and biotech sectors.  HTGC is a venture capital lender that provides high interest rate loans to risky but high-growth companies in the technology and life sciences space.  Since most of HTGC’s borrowers are unprofitable, HTGC makes loans based on a loan-to-value ratio of the borrower’s latest fundraising round or market value, which is a dangerous practice during a bubble environment.  These borrowers cannot and may never be able to even service the interest on their loans let alone begin to pay down the principal.  In fact, 26% of HTGC’s borrowers have less than 12 months of runway before they run out of cash.  Therefore, the majority of HTGC’s loans are ultimately paid off by either an IPO, a new venture capital equity round at a higher valuation, or a sale of the borrower.  This type of non-cash-flow-oriented lending model relies on ever increasing asset values and should begin to unwind if the assets underlying the loans decline in value for an extended period.  In the past, we have seen the implosion of similar lending models that depended on asset values instead of cash flows such as subprime mortgage loans when the housing market crashed in 2007 and 2008, or taxi medallion-backed loans after Uber and Lyft entered the space.  In these cases, lenders experienced negligible losses for many years followed by a barrage of problem loans after the asset bubble popped, just as we expect to happen for HTGC. 

With the Morgan Stanley index of unprofitable tech companies down 65% from its 2021 peak and the S&P Biotech index down 53%, we believe that HTGC is likely to be contending with the first extended period of asset price declines in its history.  We expect its portfolio companies to face difficulties finding new capital to repay HTGC’s loans and to be unable to invest in growth as HTGC’s interest obligations accelerate cash burn.  This should leave HTGC with a portfolio of structurally disadvantaged, zombie companies that struggle to service their interest costs while their competitors take advantage of their weak financial condition.  Ultimately, we expect significant losses in the coming years.  Even worse, HTGC has increasingly concentrated its portfolio in riskier sectors and two-thirds of its loans have been written during a period of peak bubble valuations, leaving the Company particularly vulnerable. 

Despite mounting risks to its business model, HTGC’s largely retail investor base has yet to understand the magnitude of the problems that the Company could face.  Indeed, HTGC’s shares trade at a premium to its long-term average valuation levels on an absolute basis, and its valuation premium to its peers has inexplicably widened.  These peers make traditional cash-flow-based loans to more stable companies that could be at risk in a recession but have essentially no exposure to the same risky venture space. 

We believe that HTGC’s shareholder base is myopically focused on its dividend yield.  They have taken false comfort from past dividend growth in a rising asset price environment while ignoring the significant risk of large declines in book value and dividend reductions.  To this point, HTGC’s shares have declined by a mere 4% on a year-to-date basis while shares of the largest bank venture debt lender, SVB Financial Group (SIVB), has declined by 41% as its institutional shareholders are more aware of the looming risks.  We see 50% downside potential in HTGC based on a modest 5% loss rate and a reversion in valuation multiples toward peer levels as HTGC’s risky loan portfolio begins to see rapid, unexpected defaults and declining asset values of its portfolio companies threaten its business model.  Finally, losses could be far worse than our base case assumption.  If we were to contemplate a 15% decline in the value of HTGC’s investments, the Company would have to eliminate its dividend and would likely have to contend with covenant and solvency concerns, resulting in much greater share price declines.

Risky Loans Likely to See Unexpected Defaults

Over the last year and a half HTGC has made increasingly risky loans at peak bubble valuations which should lead to accelerating defaults across its portfolio. The business development company (“BDC”) business model is based on maintaining a high and stable dividend where the BDC is forced to pay out essentially all of its earnings in dividends.  Since BDC investors buy these stocks for their dividends, BDCs are forced to try to earn enough to cover their dividends regardless of the lending environment.  In late 2020 and throughout 2021, the technology and biotech industries reached valuation levels that appeared to be well within bubble territory.  However, as a BDC, HTGC continued to deploy its capital and stretch for yield despite an extremely risky market.  With the active IPO, SPAC, and venture M&A market, many of HTGC’s loans refinanced early forcing them to redeploy capital at the peak of the market in order to maintain their dividend coverage.  In fact, over the five quarters from Q1 2021 to Q1 2022, when valuations were at peak level, HTGC funded $1.6 billion worth of loans or 67% of their total loan book. 

While this poor timing would be less relevant for cash flow lenders, HTGC typically writes loans based on the value of its borrower since most of its borrowers are cash flow negative.  HTGC’s loan-to-values are typically around 20-25% of the value of the company’s latest funding round or market value.  While this deep discount would provide strong protection in normal times, the magnitude of valuation declines for unprofitable companies over the last several quarters suggests that HTGC’s loans have very little equity cushion in front of them anymore.  The Morgan Stanley index of unprofitable tech stocks is down 65% off of peak levels and the S&P Biotech index is down by 53%. Perhaps even more relevant, when HTGC makes loans, it sometimes receives equity in the borrower companies to sweeten the deal which it tends to hold on its balance sheet.  HTGC’s public equity portfolio is down by 65% since early November.  Since HTGC’s public equity portfolio is comprised of its more successful winners, we believe that its private investments are possibly down even more in value.  Therefore, even if HTGC started with a 25% loan-to-value, if the underlying value of the company declines by 65%, the loan-to-value is now a much less comfortable 71%.  In fact, 31% of HTGC’s public company portfolio has declined by 75% or more since November which would wipe out any equity cushion entirely.

While HTGC clearly underwrote the vast majority of its loans at the wrong time in terms of company valuations, it was also faced with a highly competitive credit market.  In the two years prior to the onset of the COVID pandemic in March 2020, the average interest rate for a CCC or below credit was 11.3% according to the ICE BOFA index.  In 2021, when HTGC originated the loans that comprise around two-thirds of its portfolio, that yield on that same high risk credit index was a mere 7.4%.  Therefore, HTGC appears to have been forced to migrate out further on the risk curve in terms of the companies it lent to in order to maintain the 11.5% core yield required to continue to cover the dividend.  One clear example of this behavior is that drug discovery companies went from 24% of HTGC’s portfolio in 2017 to 40% at the end of 2021.  These companies are much more vulnerable to abrupt changes in value if something goes wrong like a failed clinical trial. 

One prominent example of this higher risk lending profile is HTGC’s loan to a drug discovery company called Kaleido Biosciences (KLDO).  In December 2019, HTGC extended a $22 million loan to KLDO which was in clinical trials with a Microbiome Metabolic Therapy to treat chronic obstructive pulmonary disease.  Through HTGC’s December 2021 annual report, it continued to mark its loan to KLDO at par and rate it as a “3” in its internal risk ratings, suggesting that the investment was performing according to plan.  Then, in January 2022, KLDO’s clinical trial was halted.  After a month-long failed strategic process, KLDO decided to wind down, leaving HTGC with a significant loss.  This example highlights the risks inherent in HTGC’s portfolio and the Company’s inability to see problems at portfolio companies with even one month notice. 

We believe this lack of visibility into its borrowers is a major structural disadvantage for HTGC in a more difficult market environment.  Many of HTGC’s competitors are banks who maintain a much broader relationship with their venture debt borrowers.  These banks can monitor their borrowers cash burn daily as they also hold the borrowers deposit account where the company keeps its cash reserves.  Therefore, as the borrower’s cash burn causes its cash balance to approach the loan amount, the bank can initiate tough conversations with the borrower to mitigate losses.  This visibility is extremely important as approximately 26% of all HTGC’s borrowers have less than 12 months’ worth of liquidity before they run out of cash.  Given the thin liquidity cushion and HTGC poor visibility into borrower finances, this should lead to more abrupt and unexpected losses like KLDO as we move into a much more difficult environment for venture-backed companies. 

Asset-Value-Based Lending Problematic in a Bear Market Environment

While HTGC has thrived over the past decade in an environment of rising values for unprofitable but high-growth technology and biotech companies, we see serious problems ahead as valuations for these companies decline.  First, while HTGC is a lender, much of its stock’s value proposition stems from the value the Company generates from its portfolio of stocks and warrants that it receives as part of its lending.  Since BDCs pay out most of their earnings as dividends, the only way to increase book value is through gains on assets, like the stock and warrants.  Those BDCs with the ability to increase book value trade at better multiples.  However, those same stocks that allowed HTGC to increase its book value in the past are now dragging book value down as they decline.  Over the last year, HTGC’s book value has declined by $1.28 per share or 11% due to the decline in the value of its equity portfolio, while most of its peer BDCs have maintained much more stable book values. 

Second, much of HTGC’s earnings that are essential to cover its dividend come in the form of non-cash payment-in-kind income, accrued loan discounts and accrued exit fees.  As a rule, HTGC tries to minimize the cash burn for its borrowers while allowing them to pay not only the principal but also much of the interest when a transaction like an IPO, sale or new funding round occurs.  Therefore, much of the interest income HTGC generates is non-cash and will be paid upon the exit of its loan, while it is required to pay its dividend to shareholders in cash.  Indeed, a whopping 29% of HTGC’s net investment income in the first quarter was non-cash.  Thus, while HTGC showed a dividend coverage ratio of 91% in Q1 2022, the actual dividend coverage through cash income was a mere 65%.  If HTGC’s borrowers are not able to exit their investment, they risk defaulting on not only the principal of HTGC’s loans but the interest as well. 

Third, in prior years HTGC had relied on early prepayment fees to cover the dividend.  Indeed, in 2021 early prepayment fees contributed $0.29 per share representing 22% of all net investment income.  Even with these elevated prepayment fees, HTGC’s net investment income only matched its dividend in 2021.  Without these prepayment fees, HTGC would have had only 78% dividend coverage, which would have been concerning to most dividend-focused investors.  With limited IPO, M&A, and new venture capital activity in Q1 2022, HTGC’s prepayment income has dwindled and HTGC has failed to cover its dividend thus far in 2022 despite levering up with risky loans. 

Finally, HTGC’s loans are not structured for its borrowers to pay the interest expense through their cash flows from day one as these borrowers are in a growth and investment phase. However, we believe that it will be difficult for HTGC’s borrowers to ever generate the margins necessary to even cover their interest let alone pay down principal on their loans because of the nosebleed valuations at which these loans were underwritten.  Below we present an illustrative transaction for a HTGC borrower.  We assume that this borrower was valued at 10.0x sales which was a normal multiple in 2021 and that HTGC extended a loan at a 25% loan-to-value ratio and an interest rate in line with HTGC’s average.

As this analysis demonstrates, HTGC’s borrower would have to earn an operating margin of 29% to even cover the interest payments of this loan.  For comparison, Facebook, or Meta Platforms as currently known, (META), with its massive scale, only achieves a 30% operating margin, and we doubt that most of HTGC’s investments can achieve anywhere near that level of success in the near- or medium-term.  This demonstrates that HTGC’s borrowers cannot rely on cost-cutting in order to service their loans.  In this situation, there is risk that borrowers will be perversely incentivized to take excess risk and prioritize growth over solvency in order to attract a potential buyer to keep their business alive.  Alternatively, borrowers that choose to cut costs will be at a disadvantage to their unleveraged peers who can spend their scarce cash to invest in growth rather than to pay interest to HTGC.

Valuation and Conclusion

While HTGC should face a much more difficult environment in the coming years than it has in the past, investors appear to be looking backward and valuing HTGC at a premium to historical norms.  Indeed, HTGC has traded at an average price-to-book-value multiple (“P/B”) of 1.3x for the 8-year period ending December 31, 2020.  However, today, HTGC is trading at a 1.5x or a 17% premium to its historical valuation multiple.  This valuation discrepancy is even more stark when comparing HTGC to its BDC peers.  Over that same 8-year period, HTGC’s peers averaged a P/B multiple of 1.0x, so HTGC maintained a 28% valuation premium relative to these peers.  However, today, HTGC’s peers are discounting a recession and trade at 0.8x P/B, a discount to their historical levels.  Therefore, HTGC’s valuation premium versus its peers has risen from 28% to a whopping 81%.  Meanwhile, we believe that the current environment poses a much greater risk to HTGC, whose borrowers lack the cash flows to service their debt and have seen their valuations plummet.  In contrast, HTGC’s peers are cash-flow-based lenders with borrowers in more stable industries that have not seen nearly the type of pressure that tech and biotech have faced.  We would venture to guess that these peer BDCs have very few to none of their borrowers expected to run out of cash in a year, compared to HTGC, with 26% of its portfolio exposed to this dynamic.  We believe that much of this discrepancy revolves around HTGC’s dividend-focused retail-oriented investor base.  Indeed, SIVB, the largest bank lender to venture companies which is more institutionally owned, has seen its stock sink by 41% this year.  HTGC’s shares are down a mere 4% and are actually positive on a total return basis including dividends, suggesting a major disconnect which we believe will be corrected as investors see losses mount over the coming quarters. 

We believe that HTGC shares are likely to decline materially as non-accruals in its loan portfolio should lead to declines in both its book value and its valuation multiple.  Any losses will be exacerbated by HTGC’s financial leverage as the value of HTGC’s investment portfolio is 1.9 times the book value of its equity.  Therefore, if the Company were to experience a mere 5% loss rate on its investments, this would wipe out over one year’s worth of dividends and result in a 10% decline in book value.  We believe that this sort of loss experience would cause investors to reevaluate their multiple expectations and value HTGC at closer to peer multiple levels as fears around the sustainability of the dividend would grow.  In this relatively benign scenario, HTGC’s shares would see a 50% decline in value.  Conversely, in the 8-year period ending December 31, 2020, the highest average P/B multiple for HTGC on a six-month average basis was 1.5x during the tech and biotech boom of 2014.  If HTGC were to experience no losses and trade at this peak multiple, the shares would have essentially no upside other than the Company’s 8.8% dividend yield, presenting an asymmetric risk reward profile of over five-to-one.  Meanwhile, we believe that a 5% loss rate is not nearly a worst-case scenario.  If the capital markets environments dried up for venture-backed companies and its borrowers began to run out of money, it is easy to envision a double-digit loss scenario.  In this situation, the shares would have much more significant downside as investors begin to worry about HTGC meeting its own covenants and regulatory risk targets.

In summary, we believe that HTGC has made increasingly risky loans to cash-flow-negative companies based on their peak bubble valuation levels.  Given HTGC’s poor visibility into the financial health of these borrowers, we believe the Company should begin to face a sudden barrage of defaults over the coming year.  These defaults should surprise the complacent, retail-oriented investor base, thereby shaking their confidence in the Company and its dividend, ultimately leading to material gains for our short position.  

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such

Catalyst

• Loan defaults pick up over the course of the year as portfolio companies run out of cash
• Dividend cut