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Hercules Capital : Impact Of Rate Increase

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Hercules Capital (HTGC) issued a press release following the Fed’s decision to raise rates by 25 basis points to discuss the impact on the BDC’s earnings in the future. Here are the details and a thought or two:

ACCRETIVE ?

The HTGC press release (see above) estimated that the additional net investment income that would be received from borrowers whose debt is tied to LIBOR or the Prime Rate would be $2.4mn or $0.03 because of the rate increase. Apparently 92.8% of HTGC’s loan assets are tied to floating rate indices. The assumption is that the Fed rate increase would necessarily result in a corresponding percentage increase in Prime/LIBOR. The press release contains a handy chart which shows the pro-forma increase in NII (Net Investment Income) for rate increases from 25 basis points up to 300 basis points.

HTGC explained that all its current debt obligations are fixed (principally in the form of Baby Bonds) so there would be no offsetting increase in interest expense on its income statement. The purported impact of the rate increase would not be reflected in HTGC’s till the third quarter of 2017 and beyond, given we are two weeks away from quarter end.

WAIT A SECOND…

The BDC Reporter has mixed feelings about this press release. On one hand, we understand that the press release is a very cost effective way to boost any public company’s stock price by pumping out “good news”. Today Main Street Capital (MAIN) issued a press release about booking a new loan as if that was important news that shareholders needed to hear, but is just a form of marketing as details provided are scarce and we are not receiving press releases when loans are getting repaid or go on non-accrual, etc.

Nor is this HTGC’s first foray into touting the supposed benefits to the BDC from a Fed rate increase. There was a similar press release last time. In fact, HTGC is highly aggressive by BDC standards in seeking to draw investor attention – typically individual investors – to its stock. Try Googling the name of a rival BDC and you’ll often see a box ad from HTGC at the top of your results. On the BDC’s Conference Calls, the CEO – more often than not – uses the opportunity to favorably compare and contrast HTGC’s performance and attributes to its peers. HTGC wants your capital and that’s fine.

BALANCING ACT

The problem with marketing is that it’s necessarily one sided.  Even those drug ads we’ve all heard on television spend a great deal more time and pretty pictures on the benefits than the potentially fatal downsides. So to provide some balance, the BDC Reporter will make a few points:

  • The Prime Rate typically does follow the Fed Funds rate, and should increase across the board. (there are caveats but not worth discussing). LIBOR, though, is not necessarily locked into what the Fed has chosen to do. The 0.25% increase may or may not show up in full or in part in the LIBOR rate going forward. The current level for 3 month LIBOR is 1.25%. We’ll be interested to see if the benchmark increases to 1.5% in the days ahead.
  • The HTGC press release does not get into which floating rate option its borrowers have access to under their loan agreements. Other BDCs have reported that borrowers who are offered a range of LIBOR alternatives (1 month, 3 month, 6 month, even 1 year) have been going LIBOR shopping when re-setting. Many borrowers have shifted from 3 month rates to the lower 1 month rate to save themselves a few basis points on millions of dollars.  The press release suggests interest paid will uniformly increase by 0.25% over the current level. While that’s possible, it’s unlikely for the reasons given.
  • HTGC does not discuss – even in one of those boiler plate advisories which lawyers like their clients to insert in such things – that higher rates may elicit a reaction from the BDC’s borrowers. In tech lending and elsewhere borrowers are in the driving seat right now, bringing down loan spreads, increasing commitment amounts and loosening loan covenants. It is unrealistic to expect that the Chief Financial Officers of HTGC portfolio companies will just sit there and take no action as rates rise 0.25% to 3.00% as the handy-dandy chart implies. Does everybody who gets a rental increase on their apartment or self storage unit just wince and absorb the higher cost, or do some take action: renegotiating, moving out, etc ? The same applies in leveraged lending and no more so than at the moment when there are a bevy of other lenders waiting to step in. Of course, estimating the effect of this push-pull (which takes several quarters to play out and get mixed in with other issues important to borrowers and lenders) is very hard. Nonetheless, expecting a straight increase as the press release suggests is disingenuous.
  • HTGC also leaves out what the downside might be – outside of the impact on earnings – of these potentially higher rates. Admittedly a 25 basis point increase – if fully charged – is unlikely to result in too much damage from a credit standpoint. However pile on a few rate increases in a row (we’re already there and might have another one before long), or if we get the huge increases suggested by HTGC’s table ( a tripling of LIBOR) many of the weaker borrowers in HTGC’s portfolio are going to feel the financial stress, with all the obvious consequences that might follow. Both HTGC’s management and its investors might want to beware what they wish for where higher rates are concerned, especially if the change is greater than business plans and financial models anticipated.

SUMMARY

  • HTGC has issued a press release showing that the 0.25% increase in the Fed Funds rate will boost earnings thanks to its borrowers facilities being tied to Prime/LIBOR and having no floating rate liabilities.
  • An accompanying table in the press release shows even greater earnings should rates move up as much as 300 basis points.
  • The BDC Reporter warns that the calculations are based on premises that may not be correct or could be affected by other factors.
  • Furthermore, any material increase in investment income that might occur in the short or medium term from Fed rate increases needs to be balanced by concerns about credit quality; borrowers leaving or a host of unintended consequences.
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