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Hercules Capital: Externalization Debate Redux

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We reviewed the Hercules Capital IIQ 2017 earnings press release, and read the transcript of the Conference Call. We’ll be getting to the 10-Q shortly. The earnings themselves were pretty much as expected. As has been the case of late HTGC gets covered on these pages for other reasons, as we shall see:


NEVER GIVE UP

The most important take-away from the Hercules Capital (HTGC) Conference Call came right at the end of the prepared remarks by its CEO Manuel Henriquez. After all the regular discussion of second quarter performance and discussion of expectations for the rest of the year, the BDC’s CEO returned to a controversial theme: externalization.

WE EXPLAIN AS BEST WE CAN

For those of you unfamiliar with the subject we refer you to our previous posts on the subject when Mr Henriquez first raised the subject a few months ago. In a nutshell, HTGC is an internally managed BDC rather than externally managed. The key benefit is that operating costs tend to be significantly lower at internally managed BDCs, which means higher returns for shareholders. Mr Henriquez wants HTGC to be externally managed by a firm that he will found, run and own. He proposed that switch to stakeholders at HTGC. Of course, the Board co-operated with what would be a monumental change of managerial format and one which would greatly enrich Mr Henriquez at no cost to himself. Investor reaction was not encouraging.

However, Mr Henriquez did not give up then and he has not given up now. Instead, the ever co-operative Board tasked themselves with going back to the drawing board and hiring investment advisors to determine what would be the best management format for the BDC and for its shareholders. The results would then decide which way forward the BDC might go.

NOT GOING AWAY

Some investors thought this a face saving way for Mr Henriquez to drop the proposal. The BDC Reporter – which has followed the hard charging CEO’s career at HTGC for over a decade – had no illusion that the issue was closed. The stakes are just too high for Mr Henriquez and whichever other senior managers are in support of the externaliuzation plan to give up on.

ON THE DOCKET

On the Conference Call we learned very little: advisors have been hired and results should be available by the third or fourth quarter of 2017. Asked a direct question by an understandably perplexed analyst, Mr Henriquez demurred when asked which firms had been hired to provide an independent assessment of the issue. He only suggested that the advisors involved were well known industry names.

GOING AWAY ?

As a result, we have confirmation that Mr Henriquez and the Board will be spending a great deal of the BDC’s money – on the shareholders dime (which admittedly includes Mr Henriquez himself)- asking a question that when last posed caused the stock price to drop sharply, and never fully recover. We also have confirmation that Mr Henriquez remains petulant on the subject of retaining senior managers (presumably himself included) if the externalization structure is not implemented. For a second time – in answer to a question – Mr Henriquez equated keeping senior managers employed at very high salaries with slavery. Here is the full quote:

“Leslie Vandegrift: All right. Thank you. And then just one other quick question on that, in that same section. The other risk on staying internal that’s discussed seems to be the risk of key personnel leaving, and it specifically calls out senior management, and I’m just curious if there have been offers to senior management to leave if you stay internal, or if you yourself have considered that?

Answer – Manuel A. Henriquez: I think that we are in a highly competitive environment, and when you have the quality of platform that we have and the high caliber of professional individuals that we have who are highly trained in the venture lending platform and world, the answer is, just like our loan portfolio is being assaulted by folks looking to take loans off our books, you can imagine that our highly skilled and talented individuals are equally receiving similar offers, which is why you’re seeing our compensation go up a little bit on the SG&A level as well. But we don’t have slavery in this country. Everyone is a free agent, and we want to make sure that we offer an attractive compensation program that certainly allows us to motivate and retain critical individuals in the organization.”

TOUGH TALK

We mention the above not just to highlight the CEO’s inappropriate analogy – a faux pas we’ve all made at one time or another (or twice in this case) – but to underscore the strong rhetoric already being used here and which will only get stronger. What Mr Henriquez – presumably with the support of the Board – seeks to do here is very controversial and many shareholders are wary of an externalization structure and proposed fee arrangement that will raise operating costs; reduce shareholder returns and enrich the CEO at the stroke of a pen. To cause the proposal to be reviewed, debated and implemented is going to require much in the way of stick and carrot by Mr Henriquez.

The stick in this case is the implied threat that if externalization is not approved many talented managers will leave for other firms. Of course, most of those managers would still be employees – albeit very highly compensated ones – at whatever firm they joined. HTGC already pays its senior staff very well and has been able to increase the ranks of its senior managers over the last few years despite being an internally managed BDC.

Unsaid – but implied in the BDC Reporter’s reading between the lines – is that Mr Henriquez himself is the most at-risk senior manager at HTGC should externalization not be approved. Shareholders are being asked to consider what the BDC might be worth without him at the helm and whatever senior managers might join him. That’s a big stick for any senior manager to wield. We imagine unconvinced shareholders and the firm’s CEO will be staring one another down in the months ahead to see who will blink first.

By getting the Board to support externaliuzation – armed with a potential supportive analysis by brand name investment bankers paid a hefty fee – Mr Henriquez might be able to ward off any rival approach for control of the firm, like the one offered up by TCW days after the externalization issue was broached.

(POOR) CHOICES

The BDC Reporter has followed enough of these epic struggles for governance to know that if Mr Henriquez is to win and receive shareholder approval the Board has to offer up a choice between a less-than-exciting alternative and a wholly unpopular one. Moreover, other would-be managers have to be sidelined or ignored. If not, the terms of the externalization might not be the money maker which its proponents were hoping for as they would have to match or improve on what the other wanna-be managers would be offering. We get the impression Mr Henriquez wants – based on the terms of the initial proposal – to both take control of HTGC’s external manager AND on some of the most manager-friendly terms out there. A tall order and one which will require some fireworks to achieve.

At the end of the day this is setting up for shareholders having to make the choice of staying internally managed and potentially losing Mr Henriquez and (presumably) other senior managers (the wholly unpopular choice) or agreeing to externalization and keeping the current team intact (the less-than- exciting alternative). We imagine the Board will deem TCW’s offer or that of any other contestant to be not as attractive as that of Mr Henriquez’s new firm and provide shareholders with a stark alternative: agree to the switch or lose the management team. Under both alternatives HTGC drops in value, but much of that has already occurred, but the stock did drop again after the Conference Call. 

EYE TO EYE

Who will blink ? The first time round Mr Henriquez and the Board did the blinking. The second time round – armed with the investment bankers report which staves off the risk of lawsuits or regulatory interference (always a long shot) and a CEO clearly determined to forge ahead – the shareholders are the most likely to blink.

Still, nothing is for certain even in BDC corporate governance where most everything favors the insiders – whether internal or external – so investors should expect much rocking and rolling in the stock price in the months ahead as this matter comes to a head. Unless TCW and any other would-be manager and the dissatisfied institutional shareholders just melt away (which may occcur) there is going to some drama involved. Or, to put things another way, there will be uncertainty and that results in volatility in the stock price.

INVESTMENT STRATEGY

We have no current position in HTGC’s common stock even though we remain impressed with the historic performance of the BDC over the years. The current imbroglio is keeping us from investing for the long term as part of our Income Strategy, given that externalization might mean a different return outlook and retaining internalizatioon against the wishes of the CEO risks management distraction and continuity. If you’re going to tie up your investment capital for several years you can’t be wondering about who will be running the firm you’ve invested in 6 months from now and on what terms. HTGC will probably survive even a harsh struggle for control, but why take the risk of being invested in the midst of that maelstrom, especially with the still high stock price involved ?  We’ll only be revisiting the stock when this episode is put to bed, which may be as late as early in 2018.

We have HTGC on our Buy List for our Special Situations strategy. At some point – and we’re getting way ahead of the current Quiet On The Western Front situation – the stock price might drop to an attractive level in the midst of the projected battle for control. We don’t have a target price as yet, but will be playing the matter by ear and taking into account developments yet to come.  We could also short the stock at some point, but can’t yet envisage a scenario.

Baby Bonds

We have no position in HTGC’s Baby Bonds. That’s not due to any credit concern from the subject above, but just because of the high price involved and the risk of early redemption. Notwithstanding all the drama involving who will control HTGC, the broad diversification of the portfolio and the still healthy industry dynamics keeps the Baby Bonds on our prospective Buy List.

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