Please ensure Javascript is enabled for purposes of website accessibility

Hercules Capital: Forget About It

By Jordan Wathen - May 15, 2017 at 4:39PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Hercules Capital's board of directors scuttled a plan to externalize the manager, but shareholders aren't eager to bid shares of the BDC back to its pre-plan price.

When Hercules Capital (HTGC 0.00%) proposed a conversion to an externally managed company, shareholders voted with their feet and sent the company's share price down more than 12% in a single trading day.

On Monday, its board of directors nixed the plan, and the stock rallied by as much as 7% intraday, but this story seems far from over.

Why Hercules is folding

Externalizing the management team was a good plan for insiders -- until they faced competition for the right to manage the business-development company (BDC).

TCW proposed an alternative to Hercules Capital's plan last week, which included a number of shareholder-friendly provisions. TCW's proposal included a promise to invest 50% of the incentive fees it earned to purchase shares of Hercules' stock. Under the incentive structure, TCW would also be penalized for losses just as it would be rewarded for any gains, a feature that was missing in Hercules' proposal.

A cartoon magnet attracting dollar signs

External management contracts frequently extract 40% or more of a BDC's would-be earnings power. Image source: Getty Images.

When it comes to alignment, TCW's proposal may go down as one of the best fee structures ever offered to shareholders of a publicly traded BDC, whether in the form of a competitive bid for a management contract or as part of a fresh IPO. And it came from a company with credibility -- TCW manages more than $190 billion in assets, which includes a successful BDC with $1.7 billion in assets, TCW Direct Lending.

With a superior offer on the table, the Hercules team correctly assessed that the status quo was better for their interests than a public bidding war over a management contract.

What's next?

Hercules' shares still trade for 13% less than they did immediately prior to the unveiling of the externalization plan, and its status as one of the most richly valued BDCs may be forever impaired.

The externalization proposal was all about who should benefit from the company's success and scale. It was a management compensation plan by another name, as it served to direct the benefits of the company's scale to management rather than shareholders.

Shareholders know better. Hercules doesn't have to externalize to reward its insiders. For years leading up to its merger with Ares Capital, internally managed American Capital was a serial shareholder abuser, issuing as many stock options as the law allowed despite its poor performance. Hercules could easily follow the same route.

If this externalization plan really was all about compensation -- and it does seem that way -- it stands to reason that compensation expenses will be heading higher, even if the company remains internally managed. Investors shouldn't bank on the board of directors for protection. The same crew that signed off on the externalization plan will likely give the rubber stamp on employee pay, too.

The bottom line: Hercules Capital built its record by marrying good underwriting with low expenses, but the expense part of the equation may be gone for good. The only question now is just how much more management can and will carve out for itself.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Hercules Capital, Inc. Stock Quote
Hercules Capital, Inc.
$15.56 (0.00%) $0.00

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/17/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.