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One of the most prominent themes of monetary policy in recent years has been an intense scrutiny of interest rates – and for good reason. In 2022 and 2023 the Federal Reserve Interest rates were raised eleven times in an attempt to suppress abnormally high inflation.
While inflation is still persistent, the current level of 2.9% has cooled significantly from the summer 2022 highs. The current picture surrounding unemployment rates and inflation trends has many economists predicting that rate cuts are finally on the horizon. Even Fed Chairman Jerome Powell It was strongly suggested that changes in policy were imminent in a speech he gave a few weeks ago in Jackson Hole, Wyoming.
There are many types of companies that can benefit from an interest rate cut. In particular, I looked closely at business development companies (BDCs). Let’s break down the ins and outs of BDCs and look at the ultra-high yield BDC stocks I have on my radar right now.
What are business development companies?
BDCs are quite interesting. At their core, they are capital providers for start-up companies looking for financing to get their activities off the ground. In addition, some BDCs, such as Ares capital, offer more advanced financing solutions, making them attractive to larger listed companies.
You might be wondering if a BDC is just a fancy term for a bank. Well, not exactly.
BDCs have an unusual corporate structure in that 90% of taxable income is distributed to shareholders on an annual basis. For this reason, BDCs are often favored by those looking for dividend income.
The chart below illustrates the dividend payments for Hercules over the past 10 years. For the most part, Hercules has not only consistently paid dividends, but also increased quarterly and supplemental dividend payments. The notable exception was a brief cut in the additional dividend in early 2020, at the start of the COVID-19 pandemic (seen in the gray shaded column).
However, not all BDCs are created equal – far from it. Many BDCs focus on specific sectors, meaning the risk profile of each portfolio is vastly different. Additionally, acceptance protocols vary from company to company. For this reason, it is very important to look at the overall performance of a BDC’s operation to gauge the strength of its portfolio and get an idea of its credit controls.
And the BDC I have on my radar is…
One BDC that I think is particularly well positioned to benefit from rate cuts is Hercules capital (NYSE:HTGC). Hercules is a BDC that focuses on emerging themes in technology, life sciences and green energy. It specializes in venture capital lending and provides high-yield loans to companies that have previously raised external financing from venture capital or private equity.
Considering that Hercules lends money to relatively young companies, you might think that its risk profile is quite high. But I don’t quite see it that way. One metric I like to use to gauge the health of a BDC is net investment income (NII). NII can be useful in assessing the profitability of an investment firm. The table below shows the NII for Hercules in recent years.
Category |
2018 |
2019 |
2020 |
2021 |
2022 |
2023 |
Six months ending June 30, 2024 |
---|---|---|---|---|---|---|---|
Net investment income per share |
$1.19 |
$1.41 |
$1.39 |
$1.29 |
$1.48 |
$2.09 |
$1.01 |
Data source: Hercules Investor Relations.
Since 2018, Hercules’ NII has been steadily rising, which I think is a good barometer of management’s underwriting and portfolio management. Furthermore, Hercules has consistently rewarded shareholders in the form of increasing dividend payments in tandem with rising NII.
Why I see Hercules as a no-brainer at this point
A reduction in interest rates could benefit Hercules in several ways.
Over time, it becomes less attractive for founders to consistently raise capital from venture capital (VC) firms. As VCs acquire equity in the companies they invest in, the opportunity cost of each subsequent capital raise creates dilution for founders and even employees. As a result, business leaders tend to allocate capital cautiously and cautiously, with the intention of achieving break-even or positive free cash flow.
Of course, lower interest rates (cheaper debt) may be especially attractive to venture capital firms that have proven they are no longer high-cash-burn operations but are still seeking access to external financing, such as a term loan or a revolving loan. credit facility. Since debt is not dilutive, Hercules could be an attractive option in situations like this, leading to a new wave of demand for its services.
I’m also not too concerned about competition from private lenders in this area. I think Hercules offers a level of flexibility that most traditional banks are simply not willing to offer. A mid-market company may turn away from a bank or may not be able to get the loan it wants as high as it expects.
Hercules differentiates itself from these companies by offering access to larger sources of capital, but at the same time protects itself by attaching covenants to its deal structures. In addition, Hercules has a unique opportunity to build strong relationships with the venture capital firms that back many of its portfolio companies. This can result in repeat purchases in the form of intra-portfolio refinancing or referral deal flow.
For these reasons, I am optimistic that Hercules will continue to generate strong growth and be able to maintain and increase its dividend payments over the long term.
Furthermore, a reduction in interest rates can also result in excess capital that would otherwise be deployed for higher interest payments. This could indirectly benefit Hercules, because the companies in the portfolio could again accelerate growth initiatives, which could lead to higher valuations in the long term.
Finally, cheaper debt may inspire some companies to reassess more strategic opportunities, such as mergers and acquisitions, because companies often borrow money to finance big-dollar transactions. Such liquidity events could be beneficial for Hercules, as some of its portfolio companies could eventually be acquired by larger companies. Additionally, because Hercules often ties warrants to its investments, I see the potential for incremental acquisitions as particularly lucrative.
At the time of writing, Hercules has a dividend yield of 10.4% – almost eight times the dividend yield of the SPDR S&P 500 ETF Trust. Moreover, its five-year total return of 152% exceeds that of the stock. S&P500.
Given the stock’s continued strong performance, coupled with its ultra-high yield and position to benefit from potential rate cuts, I see Hercules as a no-brainer opportunity at this point.
Should you invest €1,000 in Hercules Capital now?
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Adam Spatacco has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has one disclosure policy.
1 ultra-high yield dividend stock to keep on your radar as interest rate cuts loom was originally published by The Motley Fool