2 Tech Stocks With 9%+ Yields

Co-produced by Austin Rogers

When most people think about venture capital, what comes to mind is “high risk, high reward.” But what if I told you that there is a form of venture capital that offers high yields and significantly less risk than the average venture capital investment?

Enter “venture debt.” There are a handful of business development companies (“BDCs”) that specialize in this small but growing asset class. Two of the best companies in this space are:

• Hercules Capital, Inc. (HTGC)
• Trinity Capital Inc. (TRIN)

Over the last few years, as the investment community has voraciously sought to allocate capital to the venture space, these two BDCs have performed phenomenally well.

But during the market selloff over the last few months, HTGC and TRIN have sunk further than the S&P 500 (SPY).

We believe the current pullback offers a good dip-buying opportunity for investors wanting to get into publicly traded, high-yielding venture debt stocks.

Before we discuss HTGC and TRIN specifically, let’s get a better handle on how venture capital works and what exactly venture debt is.

What Is Venture Debt?

Venture debt refers to specialty loans for early-stage growth companies that are backed by venture capital and are not yet profitable. These are companies that have proven the viability of their product or service or business model but are not yet cash flow positive. They are still burning cash.

That is why interest rates for venture debt are high – i.e., the high single-digits or low double-digits. Early-stage companies in the growth phase constantly need to raise more capital, not only to fund the operations of the business but also to pay the financing costs of previously raised capital. If the capital markets sour on these early-stage companies and their fundraising abilities become impaired, then they will eventually run out of cash and be unable to service their debts.

In some ways, venture debt is the opposite of venture equity investing. Venture equity firms invest in a wide swathe of startups in full knowledge that most will either fail or merely do well enough to break even. It is those precious few high achievers that become huge success stories where the vast majority of venture equity investors’ profit is made.

Venture debt investors, on the other hand, extend short-term loans typically lasting 2-3 years, with the expectation that most borrowers will be able to service the full contractual interest and fee payments as well as repay the full principal. Only a minority of loans will default and need to be worked out somehow or another.

Many venture debt investors, however, also participate in the potential upside of their early-stage companies via small equity stakes or warrants. As for venture equity investors, many of these equity stakes don’t ever generate a return, but some portion of them do. And a handful of the ones that do produce a return are huge winners.

The vast majority of venture capital is in the form of equity investments. The venture debt market is only about 10-20% the size of the venture equity market. Historically, lenders haven’t made a habit of extending loans to businesses in cash burn mode. But the appetite for high-growth companies on the public markets and among big, cash-rich corporations has made debt more attractive to founders than equity dilution.

For most early-stage, venture-backed companies, the terminal liquidity event for much of the capital raised during its growth phase is either to be bought out by another company or to IPO on the stock market. The equity shares sold to a buyer or on the public markets provide the return to venture capital investors.

With that said, let’s take a look at two high-yielding BDCs that focus on venture debt investments.

1. Hercules Capital

HTGC is a leading venture debt provider to high-tech companies primarily in four key industries: technology, life sciences (biotech), software, and green energy/sustainable technologies.

HTGC has a debt portfolio of around $2.4 billion, as well as warrants in 103 of its borrower companies and equity investments in 76 of its companies. These early-stage growth companies include many of the country’s most up-and-coming brands and innovative technology developers.

Critically, ~95% of HTGC’s debt portfolio features floating rates, which gives it substantial earnings upside if the prime rate increases further from here. Considering how serious the Federal Reserve seems right now about raising its key interest rate, this should give HTGC significant upside in the next few years.

Also, HTGC enjoys a strong balance sheet, modest debt to equity of 100%, and an investment-grade credit rating of BBB+, which helps the company keep its own borrowing costs low.

In Q1 2022, HTGC’s net asset value per share suffered a 3.6% decline from $11.22 at the end of 2021 to $10.82 at the end of March 2022. This was primarily because the value of HTGC’s equity holdings dropped along with the broader stock market and especially the tech-heavy Nasdaq index (QQQ) and ARK Innovation ETF (ARKK):

Now trading at a price to NAV of around 1.35x, HTGC is valued a little bit below its historical median premium to NAV of 1.4x, based on a historical range of 1.1x to 1.7x. But if the BDC’s NAV per share just bounces back to the $11.22 level where it finished 2021, HTGC’s price to NAV would fall to 1.3x.

2. Trinity Capital

TRIN shares virtually the same business model as HTGC. The BDC provides debt capital to growth-stage, venture capital-backed, high-tech companies in various fields. TRIN has a portfolio of 79 debt holdings worth $865 million as well as warrant positions in 70 companies and equity stakes in 22 holdings.

Unlike HTGC’s heavy tilt toward biotech, software, and Internet companies, TRIN’s portfolio features greater diversification across business models, though with a similar emphasis on innovation.

TRIN appears to take a bit more risk in its borrowers than HTGC, at least judging by TRIN’s 12.9% core debt yield compared to HTGC’s 11.1% core yield.

On the other hand, TRIN also has a lower percentage of floating rate loans in its debt portfolio (~60%) than HTGC, which gives it slightly less upside from rising interest rates. It should be noted, though, that TRIN has been steadily increasing its portfolio share of floating rate loans.

TRIN’s balance sheet is also strong, though not quite to the same caliber as HTGC. Compared to HTGC’s BBB+ credit rating, TRIN’s credit rating is BBB. Compared to HTGC’s debt to equity of 100%, TRIN’s debt to equity is 120%.

That said, TRIN is also cheaper and higher yielding than HTGC. With NAV per share ending Q1 at $15.15, TRIN currently trades at a price to NAV of around 1.1x.

Moreover, TRIN covers its quarterly dividend quite comfortably. In Q1, net investment income per share of $0.57 covered the $0.40 dividend at a 143% coverage.

Bottom Line

For investors hunting for high yields with upside from rising interest rates, BDCs are generally a great option. And it is also nice to participate in the growth of the country’s most innovative, venture capital-backed growth companies.

For those comfortable with the particular set of risks that go along with extending debt capital to mostly cash flow negative (but established and fast-growing) companies, HTGC and TRIN are great, high-income opportunities to consider.