Description

Hercules Technology Growth Capital is a BDC that provides debt and equity growth capital to technology related and life sciences companies. Being in the financial services sector, the stock has gradually declined over the past six months even though the performance and credit quality has remained excellent. The NAV of Hercules is approximately $12 and historically since HTGC went public in 2005 it has sold above book value. In the current environment it is not a surprise that Hercules is trading at a discount to NAV. 

 Hercules has no sub prime exposure, mortgage exposure, or CDO/CLO exposure and has a substantial amount of cash available to lend in this environment. At the end of the 3^rd quarter the debt outstanding only accounted for 14% of the equity capital. Hercules has an impressive record since making its first loan commitment in 2003. Since that time Hercules has made commitments of over $750 million and the gross loss has been $5 million and the net loss after bankruptcy workouts has been $1 million.

It may seem counterintuitive to invest in a finance company when credit markets are nervous and unstable. First of all, the credit environment for the specific area that Hercules operates in runs somewhat counter to traditional credit cycles. In fact, management stated that a broad economic decline would affect them less than most people think. Last quarter U.S. venture capital investments reached their highest level since Q1 of ’01 to $8.07 billion. In addition, there were 67 venture backed M&A deals during the third quarter, resulting in a dollar value twice as large as the same period in the prior year. The IPO activity recently in the technology and life science sector that Hercules operates in has been on the rise.

Hercules will not need any new financing for at least a year with a debt to equity ratio of just 13%. Hercules is projecting $25-30 million per quarter in normal amortization during ’08 which will give them additional capital for deals in addition to their available cash and credit lines. Costs have been kept in line with an efficiency ratio of 29% and 3.5% operating expenditures to total assets.

 While the majority of the companies that Hercules provides funding for are cash flow negative, Hercules has 92% of its loans as senior loans and little to no PIK. Hercules also controls its risk by having short term loans (average loans are 36 months). By lending money to companies that have close to12 months of cash already on their balance sheets, that means the first 1/3 of the amount borrowed is covered. Hercules has forged solid relationships with Venture Capital firms and Private Equity firms that provide subsequent rounds of financing to pay off the loan.  In addition, most of Hercules loans involve warrants or options to acquire the stock of the company it loans to. In addition Hercules has a warrant position in 75 companies with a value of $13.2 million compared with $9.2 million a year earlier.

To give you an idea of HTGC’s investment portfolio consisted of 82 companies and at the end of the third quarter was comprised of the following:

Investment Grading                   Dollar Amount (Million)            Percent of Portfolio

1 (Highest)                             $  20.9                                        5.4%

2                                              $279.5                                      72.3%

3                                              $  80.3                                       20.7%

4                                              $    4.1                                         1.1%

5                                              $    2.0                                           0.5% 

Hercules is internally managed and has an SBIC license. The SBIC license is valuable and not reflected in the current valuation. An SBA loan currently has a rate of roughly 175 basis points above the 10 year treasury rate (with no principal repayment for 10 years), this offers long term money and a lower cost of funds to Hercules. This also allows Hercules to go above the 1:1 BDC leverage restriction.

Hercules has already announced $45 million in funding since the end of the third quarter. With a record $133 million of executed non binding term sheets, HTGC should have $75-$80 million of funding activity in the 4^th quarter.

Competition in the space that Hercules operates in is not a significant factor. The deal size that they focus on is typically too small for most banks and not liquid enough for hedge funds since the money would be tied up for 3-4 years. Silicon Valley Bank is one competitor in the early stage start up company space. Hercules has less than 10% of its portfolio in early stage companies.

With $218 million available on the credit facility and $107 million available on the SBA program, Hercules will be able to grow its debt to equity closer to a 100% debt to equity ratio in the next 12 months. This will be a key to growing its net investment income and thus its dividend. I believe that with the increase in loan activity that is very visible over the next few quarters, Hercules will increase its dividend to $1.28 in ’08. This should be fully paid for out of its Net Investment Income. Assuming that in one year the company can trade for 1.1 x its NAV an investor today would be looking at a total return of over 25%.

The President/CEO owns over 500,000 shares and there has been additional insider buying throughout 2007. Hercules’ largest shareholder is Farallon Capital which owns over 1 million shares. Although after speaking to management it sounded like they were restricted from buying more shares.

Catalyst