Hercules Capital: 11.7% Yield, Now My Largest BDC Position (NYSE:HTGC)

With a weighted-average dividend yield of more than 13%, Hercules Capital, Inc. (NYSE:HTGC) is now my largest BDC position in my investment portfolio.

After the recent fall of Silicon Valley Bank, the valuations of tech-focused business development companies were slashed. Having said that, Hercules Capital’s 1Q-23 earnings provided reassurance to me that passive income investors don’t have to be overly concerned, at the present time, about the BDC’s operating performance, portfolio quality, or dividend coverage.

Hercules Capital maintained strong portfolio quality with a perfect non-accrual ratio (based on fair value), and despite the BDC’s valuation rebound, I continue to see HTGC as a top investment option for passive income investors.

Strong Investment Portfolio With Excellent Credit Quality

Hercules Capital is a senior debt-focused business development firm focused on the technology and life sciences sectors. Approximately 93% of Hercules Capital’s investments were in senior secured loans, with smaller amounts ranging from 1% to 4% invested in warrants, equity, and unsecured debt.

Hercules Capital’s equity exposure allows it to potentially earn outsized returns on its invested capital in a good economy. In a slowing economy, however, there is a theoretical risk of Hercules Capital turning unrealized losses into realized ones.

Hercules Capital has seen strong YoY growth in interest income and net investment income due to the fact that 95.6% of the BDC’s investments are in floating rate debt.

Hercules Capital’s 60% YoY growth in interest income in 1Q-23 was aided by the central bank’s push to uplift short-term interest rates. Passive income investors should not expect those growth rates to continue in perpetuity.

Hercules Capital’s interest income growth will be significantly lower as the central bank reduces rate hikes.

Hercules Capital is now my largest portfolio position because the BDC manages credit risk extremely well. With a non-accrual ratio of 0.0% (based on fair value), Hercules Capital maintained excellent credit quality in the first quarter.

Hercules Capital’s non-accrual ratio in the first quarter was 0.0% (based on fair value). However, non-accrual ratios are impossible to predict and a change in credit market conditions or changes in the operating environment of borrowers could result in an increase in loan defaults moving forward. A BDC’s non-accrual ratio should be careful monitored in order for investors to catch changing trends in credit performance early.

Hercules Capital Achieved 120%+ Dividend Coverage In 1Q-23

The business development company maintained excellent dividend coverage in the first quarter, which is especially noteworthy given the high levels of uncertainty and selling pressure in the financial and BDC sectors in March.

Despite these challenges, Hercules Capital earned $0.48 per share in net investment income, a 60% increase YoY due to a higher weighted average debt investment portfolio and higher debt yields.

Hercules Capital pays a well-covered quarterly dividend of $0.39 per share with a 1Q-23 dividend coverage ratio of more than 120%. In addition, the BDC currently pays a $0.08 per share supplemental dividend, which will be paid each quarter in 2023.

At the beginning of the month, Hercules Capital announced a total cash dividend of $0.47 per share dividend for the first quarter, which will be paid on May 23, 2023 to record holders as of May 16, 2023.

The fact that Hercules Capital maintains its regular dividend (as well as its supplemental dividend) despite the stock market’s difficult first quarter speaks to the quality of Hercules Capital’s 11.7% yield.

Hercules Capital Is Deserving Of A NAV Premium

Hercules Capital is almost cheap in comparison to its valuation history: the BDC’s stock has historically traded at a price range of 1.1-1.7x NAV.

While many BDCs are now trading at discounts to net asset value due to interest rate uncertainty and the possibility of higher non-accruals in a contracting economy, HTGC is still trading at a 25% premium to NAV. This premium, in my opinion, is well-deserved and primarily due to HTGC’s excellent credit quality (low non-accruals) and impressive dividend coverage.

Downside Risks For Hercules Capital’s Valuation

Hercules Capital’s valuation could fall due to deterioration in credit quality and dwindling dividend coverage. Given the BDC’s excellent credit quality, I don’t believe Hercules Capital’s dividend is in jeopardy.

A headwind for Hercules Capital could be the central bank lowering interest rates, which would harm the BDC’s strategic floating rate positioning.

My Conclusion

In March, I aggressively increased my position in Hercules Capital and recommended the tech-focused business development company to passive income investors looking for a high covered dividend yield. I’m still buying HTGC and am content with Hercules Capital as my largest BDC holding. Despite the premium valuation, I believe HTGC deserves it given its strong 1Q-23 results.

In my opinion, the U.S. bank crisis is also largely under control, and Hercules Capital has not suffered as a result.

HTGC remains a top investment choice for passive income investors in my opinion, with the dividend robustly covered by NII.