If you asked someone to describe the ideal equity income play, their response would probably be a company that pays a high dividend yield plus price appreciation equal to or greater than the overall stock market, notes Jim Pearce, editor of Investing Daily's Personal Finance.
At the moment, it would be difficult to find a business that meets that definition better than Hercules Capital (HTGC), a business development company — or BDC. In addition to outperforming the S&P 500 (SPY) by more than 20 percentage points, the 7.4% dividend yield is more than five times the 1.3% yield paid by SPY.
Two factors have contributed to superior BDC performance during the past year: increased demand for BDC loans from businesses unable to get financing from commercial banks and a hot initial public offering (IPO) market that has resulted in several loans being repaid along with an “equity kicker” that in some cases more than doubles the return on investment to Hercules.
In that sense, the pandemic has turned out to be exactly what the BDC industry needed. At the same time that banks cut back on lines of credit to privately held small businesses that were adversely impacted by the virus, the public equity markets financed 480 IPOs in 2020 and another 670 deals through the first half of this year.
The combined number of IPOs over the past 18 months exceeds the total number of companies that went public the previous six years. So far this year, 10 of Hercules’ portfolio companies completed an IPO while another eight effectively went public via a special purpose acquisition company (SPAC) merger.
In addition, eight other companies were either merged into or acquired by another business, thereby triggering the equity warrants associated with those loans. Over 80% of Hercules’ $2.5 billion investment portfolio is concentrated in three sectors: software (27%), Internet services (25%), and biotech (31%).
In addition to the effective yield on its loan portfolio of 12.7%, Hercules is holding equity warrants for 93 of its portfolio companies and holds stock in 67 companies.
I don’t expect the next 12 months to be as lucrative as the past 12 months for HTGC shareholders, but I don’t see any reason to believe that it is likely to be considerably less, either. Its dividend yield of 7.4% appears safe even without an assist from the IPO market. We recommend buying Hercules Capital up to $18.
