An offshore investment worth picking?

Hercules Technology Growth Capital Inc. (Hercules) is a US listed company that primarily provides debt and equity growth capital to technology - and life sciences-focused mid- and small-sized privately held companies in the US.

Hercules is registered as a Business Development Company (BDC).

This is a special US legal structure which avails Hercules of tax incentives but requires the payout of more than 90% of taxable income as dividends to shareholders (good news for shareholders) and that the debt-to-equity ratio remains below a healthy 100% (which seems prudent).

To my mind, Hercules is a particularly interesting BDC for these three reasons:

1. Shareholders get diversified exposure to a compelling sector with a single holding.

• Companies that develop exponentially improving technologies to address problems in the healthcare sector, one of the USA’s largest sectors, have an enormous market to serve, but this highly profitable opportunity attracts intense competition. A spread across some of the most promising candidates is wise because change happens rapidly in this sector, and it is quite uncertain who will emerge as king of the hill. Hercules gives shareholders exposure to this exciting industry, but with diversification across different business models and different product focuses.
• The managers of Hercules have skill and specialist expertise in selecting these niche investments as well as re-balancing the portfolio periodically, and maintaining diversification over time for shareholders.
• A large majority of Hercules’ investments are made via senior secured debt rather than equity stakes. In this high-risk sector, claims on senior debt are considerably less risky than equity stakes. This greatly limits potential losses during foreclosures of any of Hercules’ portfolio holdings in downside scenarios while some upside is still afforded through select equity and warrant investments. Being one of the few financiers willing to service this industry, Hercules earns a good yield – in the mid-teens – on the loans that it grants.

2. Shareholders enjoy a staggeringly high yield of around 11%. Usually a yield this high means the market is factoring in a calamity around the corner. But this doesn’t seem to be the case for Hercules. Shareholders are able to lock this high yield in, with the opportunity for long-term share price appreciation too, if one of the equity investments turns out to be a bonanza. But even with no share price appreciation, an 11% yield remains a very decent likely minimum return.

3. The stock was recently over-sold for the wrong reasons. “High-yield” assets were sold off indiscriminately last year because of the expectation that the US Federal Reserve would raise interest rates. When higher interest rates are expected, high-yield assets are sold off essentially because lower-risk alternatives become relatively more attractive.

While this may have hurt performance for high-yield assets last year, it creates an opportunity now.

This is especially interesting given that most of Hercules’ loan assets are priced at floating interest rates. So, when interest rates increase, so does Hercules’ interest income (by far the largest inflow on its income statement).

The stock price thus decreased last year when the expected future income had increased – this kind of irrational divergence usually does not persist on stock markets for very long and, in this case, seems likely to close in the favour of the Hercules shareholder.

Given the legalities of a BDC, shareholder interests should continue to be well represented.

Hercules serves a compelling niche and provides a high yield for shareholders, along with a level of risk that seems lower than typical high-yield investments.

It also seems that the market sold the stock off along with high-yield assets last year while failing to take into account the potential increase in income for the company.

For these reasons, on a price-to-earnings ratio of 10.7 times, Hercules Technology Growth Capital is my stock pick for long-term investors, especially those who are looking for offshore yield income.

*Dylan Martin is an investment analyst at Cannon Asset Managers

This article originally appeared in the 25 February 2016 edition of finweek. Buy and download the magazine here.