One type of business that income-oriented investors may have come across is a business development company (BDC). Debt and equity of middle market companies. However, BDCs can employ very different strategies and are not all created equal.
Let's take a look at two popular BDCs. Hercules Capital (HTGC 1.15%) and pennant park investment (PNNT 1.59%)see which one suits your portfolio.
different approaches
Hercules Capital invests primarily in high-growth technology and life sciences companies prior to their initial public offering. Almost 89% of the company's debt investments are first lien, senior secured (meaning, in the event of a default, no other debt takes priority and the loan is backed by collateral). Additionally, approximately 96% of fixed income investments have floating interest rates.
The company's investments typically come with warrants that can be converted into stock, giving Hercules a way to participate in the rise of the companies it invests in. As of the end of 2023, the company had acquired warrants in 103 companies and made equity investments in 74 companies.
Pennant Park, on the other hand, has a more diversified portfolio, investing across 30 industries. Approximately 96% of the company's debt portfolio is senior secured loans, but only 58% of the total portfolio is first lien. Approximately 96% of the company's bond portfolio has variable interest rates.
This BDC focuses on small and medium-sized businesses with earnings before interest, taxes, depreciation, and amortization (EBITDA) of $10 million to $50 million, which tend to have less competition for funding. Pennant Park typically invests in the lower middle market, allowing it to invest in companies with lower leverage while obtaining stronger contractual terms.
credit quality
When evaluating a BDC, it is most important to focus on its credit quality. If a portfolio company becomes insolvent and is unable to repay its loans, the value of the investment will decline and the income received will decline.
Last quarter, Hercules made one investment in non-interest status (where interest is more than 90 days past due). This investment cost him $30.9 million, representing 1% of his portfolio. The investment is currently valued at a fair value of $0.
Pennant Park also had one accrued investment last quarter, representing 1% of the portfolio at cost and 0% at fair value.
In the midst of the pandemic, with its portfolio under stress, Hercules had seven debt investments in accrual status representing 1.3% of cost and 0.5% of fair value of the portfolio at the end of 2020. Pennant Park had no outstanding investments. At the end of September 2020, there were two investments in non-accrual status representing 4.9% on a cost basis and 3.4% on a fair value basis.
Although both BDCs have experienced write-downs and defaults in the past, they have maintained high creditworthiness through bond investments for many years.
Dividend and yield
Hercules currently pays a base quarterly dividend of $0.40, which equates to a yield of 8.8%. BDC's dividend is covered by net investment income (NII), and Hercules' net investment income last quarter was $0.56 per share. It also paid an additional dividend of approximately $0.08 per share.
PennantPark currently pays a monthly dividend of $0.07 and has a yield of 12.2%. Last quarter, the company recorded his NII of $0.24 per share.
Notably, both BDCs benefit from rising interest rates given their floating rate bond investments. A decline in interest rates could reduce NII's income and affect its dividend.
evaluation
BDCs are typically valued as a multiple of net asset value (NAV), which represents the value of the underlying portfolio. These values can go up or down based on the performance of the underlying asset. In particular, the equity portion of your portfolio may fluctuate.
By this metric, Hercules trades at approximately 1.6 times its year-end 2023 NAV per share of $11.43. This is a relatively high valuation, but the stock typically commands a premium, typically trading between 1.1x and 1.7x.
Pennant Park, on the other hand, trades at around 0.9 times NAV of $7.65 per share, despite some pressure on equity investments and a decline in NAV over the last year. Now, these issues appear to be behind the company, reducing its equity exposure.
Image source: Getty Images.
better investment
Although more expensive, Hercules is a better option for investors looking for upside potential. The company can provide exposure to up-and-coming technology and life science companies while offering a well-covered and attractive dividend yield.Past investments include: Palantir Technologies and door dash.
Pennant Park, on the other hand, is a good option for investors looking for high yields and monthly dividends. Dividends may be reduced slightly if the Federal Reserve lowers interest rates, but the stock is trading below its base price, making it an attractive price.
