By now I’m certain that you have heard the recent college admission scandal. One chief executive of a public company was on the list. Manuel A. Henriquez stepped down as CEO, president and executive chairman of Hercules Capital (HTGC, Financial). He is also the co-founder of the company.
Right before the news got out on March 12, just before noon, Hercules Capital was trading around $13.40. From a valuation point of view, $13.40 represented about 1.35x P/NAV. It also had a dividend yield of 9.3%.
After the news was released, Hercules fell about 7% instantly to below $12.50. Then it surged back to around $13.00, probably finding support in some automated strategies that failed to keep up with the news updates. Shortly after it reached $13.00, it started a gradual but steady decline for the rest of the day, and closed at $12.14, for a 9% drop.
Historically, shares of Hercules were valued as high as 1.6x P/NAV, which they were as recently as late April 2017.
Source: GuruFocus
Right before the scandal was exposed, Hercules traded around 1.35x P/NAV. While this is some distance from its high of 1.6x P/NAV, it is still a much higher level than its peers.
The chart below shows how valuation of Hercules compared to its peers historically.
Source: HTGC fourth-quarter 2018 presentation
It is apparent that Hercules has always traded at a premium to its peers. This premium was above 0.5x for the majority of its history and narrowed to 0.3x in its more recent history.
Does Hercules deserve such a long sustaining premium?Â
If so, does the current price of $12.40, or below 1.3x P/NAV, undervalue its business, and did it only happened because of the scandal in the CEO’s personal life, which had nothing to do with the business?
If we look at the operating results of Hercules, it qualifies as a well-run company in its own playing field.
Hercules is a business development company (BDC). BDCs are specialty finance companies, a subgroup of asset managers. BDCs focus on providing loans to middle-market companies. Depending on the strategy of the BDC, these loans can be anywhere in the capital structure of the investment companies -- senior, subordinate, mezzanine and even preferred. Common shares and warrants might also be included as part of the deal.
Hercules has a special niche among BDCs. It focuses on "high-growth, innovative venture capital-backed companies in a variety of technology, life sciences and sustainable and renewable technology industries." You can understand this emphasis knowing that this finance company is based in Palo Alto.
This is a special niche and has higher barrier of entry due to the complexity of loans. A leader in the BDC industry dipped its feet in a bit, but decided it wasn’t for them and sold their portfolio in venture lending. The CEO commented once:
“… The loans are small, they're complicated. They require a lot of oversight, and they just became something that was for us too challenging to monitor in terms as a percentage of fair value.”
Relationships with venture capitalists are also important. Once trust is established with venture capitalists, they are willing to yield some of the potential gains to lenders. It’s not surprising to see a three-year loan with a 15% interest rate, at 95% original issue discount, with an exit fee or prepayment fee of a couple hundred basis points more. On top of these already very lucrative terms, lenders might also receive some common shares or warrants for free or at very low cost.
Below are the exits of Hercules' investment companies in the past.
Source: HTGC fourth-quarter 2018 presentation
And here are the current warrant holdings of Hercules. A couple of these have held or are in the process of holding initial public offerings: Lyft, Nextdoor and Palantir, to name a few.
Source: HTGC fourth-quarter 2018 presentation
So far, we have identified one reason to why Hercules’ premium over its peers is justified.
There’s another, more dominant reason. To explain will require giving a bit more background on the industry.
As mentioned previously, BDCs are a subset of asset management; they have managers (or "advisers") that charge a fee for managing investments. Currently the prevailing fee structure in BDCs is very similar to that of hedge funds – a base fee of 1.5% on total assets, plus a 20% incentive fees on both earnings and capital gains (with hurdle rate of 7%).
For example, there is another BDC that is also based in the Bay Area and also shares the same focus on venture capital-backed high tech. This BDC has a typical fee structure of 1.75% base fee and 20% incentive fee. All in, its expenses (including fees and other SG&A) are about 5.6% of its total assets. Taking into consideration that this other BDC is smaller in size, and hence perhaps lacks economy of scale, total expenses can be normalized down to about 4.9% of total assets. This in turn translates to about 9.5% on equity since BDCs usually run leverage of just under 2.0x A/E.
Now here comes the important part. This 2/20 fee structure does not apply to Hercules. Hercules is internally managed, does not have a manager and does not pay a management fee to anyone. Under this internalized structure, Hercules' total expense is about 2.9% of its assets -- roughly 5.5% on equity.
The net 4% difference is 4% extra return on equity for the shareholders.
Below is a chart of how return on equity compares among Hercules and its peers.
Source: HTGC fourth-quarter 2018 presentation
Comparing the chart above to our estimate, it seems that the 4% savings from this difference in fee structure is higher than Hercules' actual outperformance in return on equity most of the time. In other words, Hercules' main advantage is its fee structure. It’s traded at a premium to peers most likely because of this fee structure. Without it, Hercules isn’t outperforming peers significantly. In certain years, it actually underperformed its peers!
Now let’s turn our attention back to center stage: ex-CEO Henriquez, who’s involved in the scandal. How much was he getting paid under this fee structure?
Bloomberg shows that in 2017, total compensation to Henriquez was $8.2 million, with $3.2 million in cash. His pay was about a quarter of the company’s total expense on compensation.
Source: Bloomberg
The million that he bribed his children’s way into college with is really just a drop in the bucket.
Yet, he wasn’t satisfied.
I’m not sure if you noticed this on the first take of the price history of Hercules. The company suddenly took a nose dive right after the share price reached a high of 1.6x P/NAV around late April 2017.
Volume exploded as well.
Source: GuruFocus
Doesn’t it look so very similar to the price movement after the recent scandal?
Exactly.
On May 4, 2017, Hercules announced that the company was considering an externalization. After that math exercise earlier, we know what this probably meant. It meant that management wanted some of that 4% difference in return on equity, and they didn’t care if being internally managed was the most important reason Hercules traded at premium to peers.
The proposed fee structure was a moving target. At the size and earnings power of Hercules at the time, the base fee would be 2% on assets, and incentive fee would be 30% of total earnings! Assuming 15% gross return on equity, Hercules would charge 7.3%, or half of the gross return on equity -- 150 basis points more than our estimated total expense of less than 6% while being internally managed!
Source: HTGC Form PRE 14A filed on May 3, 2017
Hercules was down 12% immediately upon the announcement of the externalization attempt.
After a few months, management announced that Hercules would stay internally managed. Maybe management saw no chance of getting the shareholders' vote on it. However, Hercules has not been able to recover to its valuation high of 1.6x P/NAV, even when the entire sector was heading higher.
Up to March 21, Hercules closed at $12.49, roughly 1.26x P/NAV. This is a relative low for them, excluding early 2016 and the end of 2018 when the entire market was trading low.
If the attempt to externalize didn’t happen first, I might consider the current price an overreaction to personal behavior that did not harm the underlying business of the company. But with the externalization attempt, I grew to question the willingness of management to watch out for shareholders – if it weren’t for this scandal, there would be something else.
The day after the scandal, Manuel Henriquez resigned as chairman and CEO at Hercules.
But he’s still on the board, and a consultant of the company. And his quote is still on the company’s website:
Read more here:Â
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