What is happening at Hercules Capital (HTGC) is the BDC Story Of The Year so far. There are implications here not only for HTGC’s shareholders, lenders and borrowers, as well as for the BDC Sector generally.  What’s more, we are still in the early innings just twelve days into this drama. Let’s review the chronology, and the BDC Reporter’s evolving views:

BEGINNINGS

First, Manuel Henriquez surprised Hercules Capital’s (HTGC) shareholders on May 3rd by requesting/ demanding that the BDC should switch from an internal management structure to an externally managed one, with his new firm -Hamilton Advisers- as the appointee. Moreover, to show that much planning had gone in to the proposed change the CEO of HTGC spelled out a strategy not only for the BDC but for other funds to be named later.  The goal was – and is – to create a full fledged asset management company targeted at the specialized world of venture lending with Mr Henriquez at the helm.  On a fascinating earnings Conference Call on May 4th Mr Henriquez made a vigorous case for the proposed switch from internal to external management and why HTGC shareholders should favor the move, including promises that the new compensation arrangements would not impact earnings or distributions.  Some commentators – but not the BDC Reporter – felt there was also an implied threat to get up and quit contained in the way Mr Henriquez answered questions on the CC, should the shareholders not agree to the change. Still we can’t help quoting Mr Henriquez when asked very bluntly – but appropriately- by Wells Fargo’s Jonathan Bock why HTGC shareholders should “turn over” the external management of the BDC to Hamilton Advisers “for free”:

Manuel Henriquez: …But last time I checked, Abe Lincoln abolishes indentured slavery. So I am not sure that anybody at the internal adviser – internal manager is subject to having to do what you just advocated. I think that employees and high value employees have the ability to change position and pursue economic issues. This effort is 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.

FIRST TWO CENTS

The BDC Reporter weighed in initially on May 4th with our view that the proposed change had -rightly or wrongly – more to do with Mr Henriquez’s ambitions than any fault with the internal management model. Here is our sum-up at the time :

However our initial View – which we imagine most of our readers will be quietly sharing – is that Mr Henriquez has been watching all the fortunes being made at asset management groups around the country, including those which own public and private BDCs, and has decided to grasp at the brass ring.  We refer anyone unclear at what we’re talking about to consider the huge income being received by the small number of individuals who own some of the larger BDC External Managers (Prospect Capital – PSEC – is a notable example) and the value that accrues to whoever has an Investment Advisory contract with a BDC. Thanks to the near absence of any checks or balance from “independent” Board members; a “do whatever seems right” by many shareholders” and a loose rein approach by the SEC and stock exchange regulators, External Managers can make a fortune. Given that HTGC already has mounds of equity capital raised and an infrastructure ready to go, this is essentially a cash-less Management Buy-Out by Mr Henriquez, and the opportunity to oversee his own privately-owned asset management firm.

TWO MORE CENTS

We returned to the subject the next day when we sought to point out that what Mr Henriquez seeks as an external manager is what most BDC shareholders are already operating under: a fee and corporate governance structure that is “manager friendly” to a fault. Understandably enough, Mr Henriquez might note how favorable matters are for the managers of public BDCs and say : “Why not me ?”. Unfortunately, though, as the BDC Reporter detailed in the same post, the proposed Hamilton Advisers compensation structure is one of the most expensive out there, and belies Mr Henriquez’s contention that a switch to an External Manager structure would – at least – do no harm to the expenses of the BDC. Here’s an extract from our second article which is relatively explicit on the subject:

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.

We won’t even quote what we had to say about the proposed Incentive Fees Hamilton proposes to charge. Suffice to say, the BDC Reporter felt the compensation involved was very high.

THE BOARD WAS ON BOARD

Whatever our misgivings, the Board of HTGC appeared to have been convinced by the CEO’s arguments, and recommended the switch in the Proxy materials made available to shareholders on May 3, 2017.

Matter settled ?

THEN CAME TCW

Hardly. On May 10th, we had another surprise in store. Asset management giant TCW threw its hat into the ring, offering itself up as External Manager instead of Hamilton Advisers, and with far lower pricing.  This was a formal request by the investment giant and involved Proxy materials of its own, beginning: “Dear Fellow Hercules Stockholder”, and followed up both with a denunciation of Hamilton’s approach and proposed an alternative, TCW-oriented approach. From reading the Proxy we can see that TCW moved lightning fast to get the nod ahead of its incumbent rival. A letter was delivered to HTGC’s Board on May 6th, announcing its candidacy.

To their credit, the Board of HTGC did respond to TCW (this is not always the case as many prior instances of BDC governance will attest) and promised an answer in a timely manner. However, TCW was concerned that HTGC’s Board’s idea of timeliness and their own might not be the same, and the Hamilton/Henriquez proposal might get too far ahead to be caught. That’s why TCW went public with its hat tossing offer on May 10th.

UP TO SIX CENTS

The BDC Reporter commented almost immediately on TCW’s offer on the same day as the press release and Proxy filing was made. We were less concerned with the relative merits of one proposal over the other, but more about how a contest might play out in what is a relatively new ground. We’ve had unsolicited attempts by one would-be External Manager to oust another (TICC Capital) but not a two step situation like this one where the current internal manager seeks to transform how the BDC is run and then a challenge by a new outside firm. The BDC Reporter – as part of our BDC Activist series – followed very closely all the back and forth jousting with prior managerial challenges, not only at TICC, but also at Fifth Street Finance (FSC), Fifth Street Senior Floating (FSFR), KCAP Financial (KCAP), MCG Capital (MCGC), Business Development Corporation of America (BDCA), Full Circle Capital (FULL) etc.

ONE SIDED

Maybe we’re jaded, but the track record so far – usually after small fortunes are spent (sometimes using the BDC shareholders own money) – is greatly in favor of the incumbent. Any incumbent and regardless of prior performance, behavior or honeyed promises from the contenders, many of them billion dollar plus organizations themselves.  After witnessing contender after contender bite the dust, we shelved our plans to spin-off the BDC Activist into its own online publication/newsletter.  After all, what do readers need us for when the Washington Generals lose every game ?

Nor were we alone. Most of the would-be “activists” -who are really just rival asset managers looking for an opportunity to take charge of an established pool of BDC permanent capital or large investors seeking to boost the stock price – abandoned the field. BDC investors have not seen any challenge of this kind in months, especially with the year long stock market rally lifting even the leakiest boats.

WHAT’S THE POINT ?

So readers will understand if we did not immediately start comparing and contrasting the two offers, as if the least expensive compensation arrangement would be the only factor in determining who will be running HTGC in a few weeks. Furthermore, our experience is that these mano a mano confrontations often result in both sides altering their initial price sheets to win the day, which is likely to continue to be the case here. However, we have to admit – as we stated in our May 10th article – is that we have little expectation that TCW might end up on top. Here is our uninspiring snap assessment.

We wonder if TCW – its huge size notwithstanding – realizes what a task they’ve set themselves where a BDC Board is concerned.

Even if the asset management giant gets a nod from the Board to proceed there’s many a tool in Mr Henriquez’s toolbox that might block their progress.

GALE FORCE WARNINGS

Mostly – given that the BDC Reporter sees its role as speaking to BDC shareholder interests rather than just reporting the news – we sought to warn readers that a period of instability had been created on May 3rd with Mr Henriquez’s move, and that the history and business model of the BDC would not be the same again:

“The Hercules Capital you invested in no longer exists.

The new Hercules Capital – and its new business model – is up in the air and will remain so for many weeks.

Who will be running the BDC, and whether the current group will even be involved, is also up in the air.

If you’re the type of investor who prefers a solid, uneventful BDC, this is not going to be the case for awhile.

You may want to go to the sidelines, but this competition should boost the stock price for awhile. It’s happening already.

If you don’t mind a little rocking and rolling then staying put might be OK.

However, we do suggest keeping very close tabs on what’s happening here because this could resolve quietly or spin out of control.

At the very end of the process shareholders will actually have a say and that decision will decide the fate of the BDC for many years to come.

UP TO DATE

Which brings us to Monday May 15th – when this article is being written –  and the next twist in the tale. Apparently, the independent directors on the Board of HTGC have undertaken an about face (of sorts) and have decided not to wave Hamilton Advisors bid through at this time. In fact, the Special Shareholders Meeting where this was to be voted on has been cancelled. Indefinitely.  Here is what the Board said, replicated in full:

“Hercules Capital, Inc. (NYSE: HTGC) (“Hercules” or the “Company”), the leading specialty finance company to innovative venture growth, pre-IPO and M&A stage companies backed by leading venture capital firms, today announced that the Company will expand its ongoing review designed to determine the most appropriate investment advisory structure to enhance shareholder value.

Accordingly, the Special Meeting of Stockholders previously scheduled for June 29, 2017 has been postponed indefinitely, and the proposal to seek stockholder approval to adopt an external investment management structure has been withdrawn at this time.

“We intend to reflect shareholder input we received during our most recent shareholder outreach in our considerations of adjustments and alternatives,” stated Manuel A. Henriquez, Chairman and Chief Executive Officer of Hercules. “The objective of the Company and our Board has and continues to be creating value for all of our shareholders. In light of the evolving market environment, we continue to believe that externalization will build on our competitive advantages and position the Company for continued growth. We will continue to act in the best interests of our shareholders and we look forward to building on our collaborative relationship.”

Allyn C. Woodward, Jr., Lead Independent Director of the Hercules Board, said, “Our decision to go down this path was made after careful deliberation and was informed by feedback from Hercules’ shareholders. As part of the Company’s expanded review, the Independent Directors intend to engage an independent financial adviser to consider all available options with regard to the Company’s investment management structure. We are committed to identifying and implementing the best path forward to position the Company to maximize investment returns and deliver enhanced value for all shareholders.”

The Company’s Board of Directors has not set a timetable for this review process, and there can be no assurance that the Board’s review process will result in an external investment management structure being proposed or adopted or whether a special meeting will be held, or if externalization is undertaken, as to its terms, counterparty, structure or timing. The Company does not expect to make further public comment regarding these matters unless and until the Hercules Board has approved a specific alternative or otherwise concludes its review process”.

OUR INTERPRETATION

TCW may consider the Board’s actions as a victory or vindication, but we’re into game theory now and the BDC Reporter is not so sure. You will notice that no explicit mention of TCW or its offer is involved in the press release. Apparently “shareholders” have been talked to (curiously only after the May 3 announcement and not before as you might expect before making a life changing alteration to how a BDC is run). We don’t know if the independent directors have even talked to TCW. (A harshly worded letter is not a conversation).

What’s more an investment banker has been hired (who ? Wall Street wants to know) to “consider all available options with regard to the Company’s investment management structure”.

And the BDC is going into radio silence mode.

WHAT YOU DON’T KNOW CAN…

HTGC shareholders are now left not knowing if the BDC will end up being internally managed, externally managed or A N Other. If external management is the final choice, we don’t know if the Board will continue as they started and put up the switch to a simple yes/no vote to shareholders. Or will there be a second step, which involves yet another investment banker, and a search for the most appropriate Investment Advisor ?  Even if we get the two stage process, does not Hamilton Advisors – especially if they trim their outrageous fee requirements- have the aforesaid advantage of the incumbent ? If somebody besides Mr Henriquez wins the day, will there be a mass exodus of lenders ?

YOU MAY EXPERIENCE DELAYS

What began as a relatively short interregnum as HTGC converted from internal management to Hamilton Advisors external management has become a potentially long, drawn out process with multiple potential outcomes and no clear end line in sight. All of which will be paid for by HTGC’s shareholders, as the independent members of the Board seek to show (albeit after the fact) that they are considering all options, while still inveighing that external management is the best way forward.

BETTER THAN GAME OF THRONES AND LESS BLOODY

Again, if you’re a game theorist (and you can clearly see we are not) maybe Mr Henriquez expected all along that a challenge would be forthcoming, and that an investment banker would need to be hired to validate this unusual (and some would say unnecessary) switch to external management. That might explain why Hamilton Advisors fees were pegged so high, leaving room for being reduced in the future in the face of what the investment banker and any external management rivals might offer up.

For TCW, the Board’s move puts their entire proposal on hold. (“We don’t even know if we want an External Manager” you can hear the Board say). Nor is it clear – as we mentioned above – that they’ll even be invited by HTGC to bid for the right to manage the BDC if and when the decision is made to Go External.

BOUNCING AROUND

Of course, the stock price of HTGC, which had dropped (20%) at one point, has rebounded on the TCW news and on the Board’s latest pronouncement.  Investors are convincing themselves that the Board’s change of heart (up 6% in the early hours of Monday May 15th) is a positive development. The BDC Reporter does not see this in such black and white terms. That’s because there are so many alternative endings to this story.

CURSED BY APOLLO NEVER TO BE BELIEVED

Unfortunately, we stand by our earlier Cassandra-like prognostication that Mr Henriquez has opened up a Pandora’s Box here and neither he, nor the Board nor the shareholders (who are being told one thing and then the opposite) have control on how this might play out. The Board may believe that hiring an investment banker who will validate for all to see what they originally agreed to with Mr Henriquez will allow this to play out – after some delay – as originally intended. However, that’s not a given, even though we know what the investment banker’s conclusion will be and without charging a huge fee, as a shareholder vote will be needed at the end.

Moreover, we doubt that TCW – even if stymied for the moment by the delaying tactics – will be going away any time soon. Moreover, in a world where there is more capital than there are deals and more time available to frame a proposal, we may see new would-be External Manager candidates  emerge.

SERGEANT SCHULTZ WOULD APPROVE

If the BDC Reporter was a bettor, we’d guess – just based on the historical BDC stats – that Hamilton Advisors will ultimately prevail. But how, when and on what terms is very much up in the air. So expect more price volatility ahead, especially as HTGC is going into a “I Say Nothing” mode for what could be weeks.

BORROWERS COULD VOTE WITH THEIR FEET

HTGC shareholders will have to hope – having no other form of control at this stage – that all this drama does not materially erode HTGC’s venture-lending franchise. Again, this is a world where tech borrowers have many options and may not want to be indirectly affected by a situation where they have doubts about who their BDC manager will be a few months from now when they might need a refinance, an amendment or some other change.

PLUG

The BDC Reporter will continue to stay abreast of this “developing story”  and give readers our unvarnished view.  Like the markets, we reserve the right to change our minds as the facts change. And they will.

By Nicholas Marshi from BDC Reporter