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BDC News Of The Day: Friday May 5, 2017

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We have never failed such a flood of earnings releases, quarterly filings, company presentations, Conference Call transcripts, insider purchases and on and on as today. Here is the list Alpha-Sense for May 5th.


Hercules Technology (HTGC)

As we announced yesterday, we can’t hope to keep up during earnings season, so we promised to choose the most interesting item to comment on for readers, after we’d reviewed all the output. Well, we find ourselves back to the subject we wrote about yesterday in an article: the proposal that Hercules Capital (HTGC) should switch from an Internally Managed structure to an Externally Managed one, as proposed by Manuel Henriquez, the BDC’s co-founder, Chairman, Chief Executive, President and final decision maker on every investment decision made by the technology-based BDC.  To this end we reviewed the Conference Call transcript on Alpha-Sense (but not yet in the public domain) from May 4th, but transcribed May 5th. We also reviewed the Proxy from May 3rd.


This is a fascinating subject because the surprising demand by Mr Henriquez, which the Board has already endorsed in record time and which will be coming up for a shareholder vote before long, focuses a spotlight on the whole issue of public BDC corporate governance, and who really are the owners, what is the role of the managers who do the day-to-day work and what checks and balances are there between those two constituencies. Today we’ll be discussing HTGC, but many of the issues raised should lead BDC shareholders across the entire sector to ask themselves some existential questions, which could have distressing answers for some.


We do recommend that anyone invested in the BDC space listen to the HTGC IQ 2017 Conference Call, beginning with the answer Mr Henriquez gave to the dean of BDC analysts Jonathan Bock after he opened up the Q&A.  There’s much food for thought just in the analysis Mr Henriquez communicated about the business and governance models of several BDC peers. Mr Henriquez has obviously spent a considerable time looking at how other major asset managers which own BDCs (and REITs !) have set themselves up, and has found much to seek to emulate, if given the nod by HTGC’s shareholders.  He may have quibbles with how one BDC or another on how the Incentive Fee is pegged (he rattled off a long list of names that the BDC Reporter has been dissecting for eons) but is envious of many Externally Managed peers.

He points to how the bigger asset managers have been able to raise a plethora of private and non-traded BDC funds alongside the public BDC which they are a steward to. That’s given the platforms access borrowers and investments that would not fit in the BDC model, and allowed – according to Mr Henriquez and every asset manager who’s ever been asked- the ability to solidify their relationships with borrowers who seek a one stop solution. Mr Henriquez believes that HTGC needs that broad coverage to continue to succeed in the marketplace. We are just simple country folk, but can’t help noting that HTGC has managed to thrive over thirteen years to become the premier lending group in this niche of a sector (which itself is a niche of non-investment grade lending) without the ability to write a cheque for every type of opportunity out there. Moreover, Mr Henriquez did not make much of a case as to how the ability of Hamilton to raise and lead these other funds would benefit HTGC’s shareholders, except in a possible spreading of overhead costs over a greater base of assets under management.


What the BDC Reporter would be worried about, both where HTGC is concerned and already with many giant asset managers who run public BDCs, is the “spreading themselves too thin” phenomenon and the “go where you get the best deal”. There are only so many hours in a day and an External Manager who’s fully focused on one fund’s interests is very different from one that has fingers in multiple pies. Besides the obvious unfairness to BDC shareholders of paying full fund fees for part time work, there is the risk that deals will be placed in the funds that pay the best return to the External Manager and shareholders may miss out on some of the better transactions.  Many asset managers – now that the SEC has given carte blanche to sponsor multiple funds – are already challenged in this area. Just go to any quarterly or annual filing for an admission of the conflicts and interests, and the only partly satisfying allocation methods being employed – drawing both on the presumed good behavior of the External Manager and the gatekeeping of each BDCs “independent directors”, a term so at variance with the reality that the BDC Reporter constantly uses inverted commas.


Of even greater concern to the BDC Reporter is that in the asset manager’s wild scramble to raise and fund a number of different vehicles the priority becomes deal doing rather than good deal doing. When essentially most of your compensation comes from fees – as opposed to ownership of the assets involved – it’s easy enough for transactions to be entered into whose risk-return might not be appropriate. Or downright wrong. Who’s going to stop an External Manager in that situation ? The “independent directors” (we can’t help ourselves now with the inverted commas) ? The third party valuation firms ? The independent accountants ? We’ve seen time and time again – because this is not a new situation – that there is no check on the asset manager. Shareholders can vote with their feet and sell out but that usually occurs after the damage -which does not show up right away – is done. We point you to the fast growth at Fifth Street Finance (FSC) and what has followed as a prime example.


Unfortunately for HTGC shareholders, Mr Henriquez seems to crave the very freedom and flexibility that the BDC Reporter believes is antithetical to their interests. Moreover – now that we’ve read the proposed terms of the Hamilton Advisory Agreement – Mr Henriquez appears to have used his research into the pricing structures of External Managers to choose the most expensive and least appropriate models out there. Despite the protestations to the contrary we read in the Conference Call transcript, the Proxy sketches out a set of fees that would be charged HTGC’s shareholders which would be amongst the most expensive in an already expensive sector. Right off the bat, the proposed Management Fee would be 2% of assets. Given that HTGC has SBIC financing which doesn’t count against leverage restrictions, the BDC could readily borrow a $1 for every $1 of equity. That would mean shareholders will be paying (effectively) 4% on their equity capital in Management Fees alone.


Heck, when the Biggest Of the Biggest such as Goldman Sachs BDC  came to market, promising shareholders access to its network of contacts and the impact of its good name, the Management Fee charged was only 1.5% of assets. Solar Senior Capital, whose asset manager claims to admire, only charges 1.0% Management Fee. (Yes, we know the two types of assets being booked are very different). We would have thought that Mr Henriquez, in a bid to convince HTGC’s shareholders to hand him the Investment Advisory contract for no direct compensation, would at least have offered up bargain pricing. 2.0% of assets is not a bargain. Instead,Mr Henriquez has gone into a time machine and returned with a fee level that most new External Managers have not charged in years. (We remember fondly the levels being offered by Benefit Street and others when TICC Capital put itself into play).


Matters only get worse when the Incentive Fees are concerned, both of which are borrowed from the Worst Practices file in BDC pricing. We’ll begin with the incentive to be paid on income .  Hamilton proposes to charge an incentive fee based on recurring earnings, which would go as high as 30%, versus the standard of 20% today. That will fire up some shareholders and analysts. The BDC Reporter has a more prosaic complaint. We continue to ask why External Managers(and we’ve yet to get an answer) should be paid an incentive for increasing the yield on a portfolio. As everyone knows, with higher yields come higher risk, but there is no risk sharing built into this pricing model. This is even spelled out in the Proxy (but not in the Q& A section, but in the denser Proposal section):

Because of the structure of the Incentive Fee, it is possible the Company may pay the Income Incentive Fee in a quarter where it incurs a loss. For example, if the Company receives pre-Incentive Fee net investment income in excess of the hurdle rate for a quarter, it will pay the applicable Income Incentive Fee even if it has incurred a loss in that quarter due to realized and unrealized capital losses.

Adding insult to injury, these income Incentive Fees are tied to the fair market value of a BDC’s book value. As losses are incurred, the threshold the External Manager needs to charge the Incentive Fee goes down with NAV. The more capital you lose for shareholders, the easier the Incentive Fee calculation can be.


Turning to the capital gains fee (which typically brings in the least of the 3 fees for External Managers), Hamilton proposes that the base level on which net Realized Gains will be calculated shall be reset every year. (Most- but not all BDCs set the starting point at the IPO). So, shareholders can lose a boatload of capital to poor investments one year (which will not affect the External Manager) and still pay a 20% fee on Realized Gains the next year, as if what had come before had never happened. We call this the “Memento” clause in the Advisory Agreement, like the Christopher Nolan film from a few years back. Again with the adding insult to injury point remember that those equity investments which earned nothing fo years before being sold for a Realized Gain were incurring a 2% Management Fee every year.  If anybody was keeping track a shareholder of HTGC could see an equity investment in a technology investment log a capital gain thanks to an IPO or an M&A transaction, but on a total return basis, after all the fees associated with the investment totted up, still end up in the red.


As we’ve tried to stress what Mr Henriquez is seeking to achieve is “only” what many of the Externally Managed BDC asset managers are already achieving thanks to “independent directors” (last time) who do not push back; regulators who might feel that this is not their bailiwick; analysts with conflicts of their own and shareholders who often choose to cut and run rather than stay and fight. Plus: a strong market for a year that makes everyone feel warm and fuzzy. Whether HTGC’s shareholders – and Mr Henriquez seems focused on convincing the institutional holders – will accede to this bold request we do not know.  We doubt that Mr Henriquez would have embarked on this route without some sense that his chances were better than good. The BDC Reporter will continue to follow this story. However, whether Mr Henriquez succeeds or fails, the episode should shine a bright light on the unequal division of authority and earnings at all the BDCs out there (both public and private) and the very real life implications for future earnings.


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