Shareholders of Triangle Capital (NYSE: TCAP), Ares Capital (NASDAQ: ARCC), and Hercules Capital (NYSE: HTGC) should look at these stocks' sky-high yields with skepticism. As business-development companies (BDCs), these stocks reward investors with high yields, thanks to a requirement that they distribute 90% of their income to shareholders. BDCs can be thought of as closed-end funds that make loans and equity investments in small, private companies around the United States.
Recently, the yields BDCs can earn on new investments have come down, and loan losses have increased. It's likely that these three companies will have to cut their dividends to align their payouts with their true earnings power.
In 2012, Triangle Capital was flying high as one of the most richly valued BDCs on the market. It rapidly issued stock to deploy new capital, but time has shown that it grew by sacrificing lending standards rather than by finding a new pool of vast opportunity.
In the third quarter of 2014, cracks began to appear when the company wrote down investments by $0.79 per share in a single quarter. It papered over the loss with a large equity offering, which helped the company show an increased book value on a per-share basis, but it was a warning sign of what was to come. The company ultimately slashed its regular quarterly dividend from $0.54 per share to $0.45 per share starting in the second quarter of 2016. That cut may not have gone deep enough.
Triangle Capital has recently failed to earn its dividend from operating income, reporting $0.42 in net investment income in each of the last three quarters against a dividend rate of $0.45 per quarter. On a recent conference call, executives explained that the shortfall was partially because Triangle isn't operating at capacity, pointing out that it has $500 million of dry powder to make new loans and equity investments. This could, theoretically, generate about $0.07 to $0.08 in additional operating income per share on a quarterly basis if it were deployed in full.
I buy their math, but I'm not buying that it will be easy for Triangle to responsibly grow its portfolio fast enough for income to rise to meet the dividend. Over $120 million of investments at fair value will come due by the end of 2018. Add its dry powder of $500 million to repayments of $120 million and you have $620 million of investments that Triangle Capital needs to make in the next 18 months to become fully invested, an amount that doesn't include any unexpected repayments or future loan losses. Loan losses are the wild card; it seems likely that we have yet to see the full brunt of losses from investments made during its rapid expansion period.
Lenders can generally grow quickly, or grow responsibly, but only rarely can they do both simultaneously. In the past, Triangle's rapid loan growth led to large losses, as the company prioritized growth over underwriting quality. Given this, cutting the dividend by 10% to 15% to give it ample dividend coverage in the here and now is perhaps the most responsible thing to do.
Ares Capital Corporation
The bellwether of the BDC industry grew larger when it closed on its acquisition of American Capital at the beginning of 2017, growing its equity base by roughly 40%. But that acquisition may have been untimely, if only because it gave Ares Capital excess capacity to underwrite new loans, just as yields were plummeting. Like Triangle, Ares Capital has substantial capacity to underwrite new loans and equity investments, but yields are much less attractive than they were just a few short quarters ago.
Based on my analysis of its most recent quarterly filing, the company has about $961 million of investments that will mature by the end of 2018, plus another $1.9 billion of capital that will come back as it winds down a relationship with a subsidiary of GE Capital.
Management looked at its capital differently on the conference call, suggesting that it has about $3 billion of total capital to rotate into new investments, a figure that includes $1.1 billion of low-yielding assets it acquired from American Capital, plus the $1.9 billion coming back from the unwinding of its partnership with GE Capital.
But no matter how I slice and dice the amount of capital that Ares Capital has to invest, it's my view that the math simply doesn't work. I calculate that Ares Capital needs a 10% yield on its entire investment portfolio to maintain its dividend, a return that it hasn't been able to achieve. And any loan losses only add to the required-return hurdle. A blue sky loss assumption of 1% of loans -- which would be remarkable, given where we are in the credit cycle -- would put the required return Ares needs closer to 11%.
Even for the industry's largest company, $3 billion is a lot of money to rotate into new investments, equal to roughly one-fourth of its asset base. Furthermore, Ares Capital is on borrowed time. A fee waiver that adds about $0.10 to annual operating income on a per-share basis is only in effect for 10 quarters.
A combination of lower yields on available investment opportunities, temporary earnings support from fee waivers, and a need to deploy $3 billion of capital, makes it likely that Ares Capital will cut its dividend in the not-so-distant future.
This business-development company lost a lot of luster when it proposed a change to its operating model. At issue was how its employees are compensated. Under the current model, Hercules pays employees directly. Under the proposed model, Hercules Capital's employees would go to work for a management company owned by Hercules' current CEO, and Hercules would pay a fee, based on the size of its assets and its returns, to the management company.
Shareholders voted on the proposal with their feet. After trading at roughly 1.6 times book value, shares cratered, and have found a new valuation range between 1.3 and 1.4 times book, reflecting the lost trust between Hercules and its shareholders.
Although the plan was scuttled when it became clear that management lacked the votes necessary to approve externalizing its management team, it's my view that the issue will come up again in the future. Hercules' CEO Manuel Henriquez said on a conference call that followed its announcement that he had "spent nearly four years working on this project" to externalize the management team. Rarely are big plans allowed to die so easily.
Henriquez has a huge incentive to push the issue. He owns just over 2% of the company -- thus he receives roughly 2% of the value created by its low-cost internal-management structure. If externalized, his newly created management company would effectively collect 100% of the value created. It's fair to characterize the externalization proposal as a complicated payday for Henriquez.
Compensation appears to be the crux of the issue. Henriquez stated on a conference call following the announcement that the effort to externalize the management team was "there to hopefully retain and encourage those valuable employees to continue to remain at the asset manager and continue to develop value for our shareholders."
There are multiple ways for managers to extract value from a business development company -- externalizing is only one way. I'm left to believe that if Hercules cannot externalize its management team, compensation expenses will likely trend higher. Hercules' expenses will go up, and earnings will go down. With operating income of $0.28 recently failing to cover its dividend distributions of $0.31 per quarter, and management dreaming up plans to extract more value from the BDC, I think this 9% yield is living on borrowed time.
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