We covered an earlier version of this ad back in January of 2022, so much of what follows is unchanged… though the story has changed a bit, and we’ve added some updates throughout. The teased stock is the same, and is down by about 23% since January.

Here’s a little bit from Tim Plaehn’s email that introduces this ad:

“Most folks dream of a single stock retirement.

“No more worry about running out of money (or the next market crash)…

“Just one investment with the power to fund your dream lifestyle forever.

“I’ve found that one stock you’ve been searching for. “

And here’s the language he was using back in January…

“I’d wager not 1 in 10,000 investors know this income stock exists…

“See, this company is funding the biggest startups coming out of Silicon Valley in industries worth over $5 trillion…

“In 2021 alone, 10 of their portfolio companies went public. Including…

“A provider of mission-critical life science technology, including new vaccines and gene therapies ($18 Million)

“A revolutionary biotech company developing stem cell treatments for life-threatening cancers ($20 Million)

“The best part…

“Thanks to a nearly forgotten law passed in 1940…

“90% of profits MUST be paid out to shareholders.

“And you can start collecting this extra income with their next big upcoming payout.”

The ad is a pitch for Plaehn’s Dividend Hunter newsletter ($49 first year, renews at $99/yr), and the big promise is that he’ll send you a special report about this “#1 ‘Buy, Hold, & Retire’ Tech Stock of 2022” that lets you “Collect legal ‘backdoor’ income from pre-IPO Silicon Valley startups…”

What’s the story? Well, he teases a “forgotten law passed in 1940” and makes reference to the fact that 90% of earnings are paid to shareholders, without corporate income tax, means he’s pitching a Business Development Company (often abbreviated BDC).

BDC’s are special investment vehicles that are supposed to make it easier to gather capital for investing in small and midsize companies, the ones who are too small to really go to Wall Street for financing but also maybe too large for the local bank. They are generally required to focus their lending on smaller companies, they can’t use a lot of leverage (debt can’t exceed equity), and they have to pay out 90% of their taxable earnings to shareholders as dividends (they usually pay out more).

Most BDCs are what’s frequently called “mezzanine” lenders, often cooperating with the Small Business Administration to facilitate small business lending and offering loans that also take on some of the risk of the business, and may be exposed to the equity or cash flow of the borrowing companies in various ways… but there are other kinds of BDCs, too, with a sector focus or a different strategy, and this appears to be one of the outliers.

Other clues? We’re told they have over $2 billion in “managed assets,” and we get some projections about the returns you might see:

“If you’re younger, you can start today with just $25,000 and set yourself up for a cushy retirement with this tech stock.

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“But if you’re at retirement age with more money to invest …

“It works in just 36-months, and I estimate you can collect upwards of $55,715/year in passive income.

“Plenty to pay your bills for life and retire comfortably.”

You can see why this is a tempting ad — we all want a little excitement and growth from being exposed to hot tech ideas, but we also want our money to accumulate and we’re not crazy about taking lots of risks, especially now that we’ve had a bad year in 2022 so far, and pretty much everybody loves the idea of “passive income.”

That’s a pretty wild promise, though, collecting $55,715/year in passive income — so I assume there’s a missing step here. That’s not going to happen in three years from a one-time $25,000 investment in a relatively low-risk BDC… that $55,715 must either be a longer-term projection, or there’s an assumption that you’re building up to a lot more than $25,000 invested. Even a BDC that offers a 20% dividend (which is insanely high, I don’t know of any that are currently at that level — most are in the 8-12% range), if you reinvest that dividend for three years, would only be spitting out about $8,500 a year after that. That’s lovely, those kinds of high dividends can certainly compound into an impressive return over time, but it’s not $55,715/year.

So what’s being teased here? The Thinkolator says that what Plaehn is teasing is (still) Hercules Capital (HTGC), which used to be called Hercules Technology Growth Capital, a BDC that specializes in “venture lending” — essentially, using BDC-style lending, but to earlier stage venture technology companies, and getting some equity exposure that helps to make up for the fact that sometimes these companies don’t have a lot of cash flow to repay traditional loans.

This one has been around for a long time as a tempting “venture” style investment that also pays a solid dividend, I’ve written about it being teased a few times over the past 15 years or so, and the long-term returns have been very decent. Most of the gains come from dividends, and particularly from reinvesting those dividends and letting them compound, but over the past decade the performance has been pretty impressive — they’ve roughly matched the return of the S&P 500, and have been more volatile, but that’s better than a lot of BDCs have done… and much better than the other popular “get in early on technology venture capital” funds have done. The purple line here is Hercules Capital’s total return, over the past decade, compared to some popular BDCs (Ares Capital (ARCC) in blue, Prospect Capital (PSEC) in light green, Main Street Capital (MAIN) in dark green), and the two most popular VC investment for individual investors (Firsthand Tech Value (SVVC), pink, and SuRo Capital (SSSS), brown) and the S&P 500 (orange):

And yes, the clues still match quite precisely, the ad hasn’t changed much — Hercules Capital has grown a little bit since Plaehn’s pitch was put together, so they have now funded “more than 540” companies, including all the specific ones hinted at in the pitch, and had about $2.6 billion in assets under management as of last quarter, and they’ve made more than 1,000 investments since they were founded, with more than 220 IPOs or M&A exits since the fund was started (a little over 15 years ago). They have a year-in-review summary of their activity in 2021 here, if you’d like some perspective, and their latest investor presentation is here.

And they get pretty strong returns from their lending, particularly when the market for IPOs or growth stocks is good, helped by the addition of warrants to a lot of their financing deals — they get an effective yield of about 11.5% on their loans now, down from about 13% but still strong, which means returns can add up quickly as long as there aren’t many defaults. And while inflation will bite all income investments, it shouldn’t be of particular concern for HTGC, their loans are generally pretty short term, amortizing, and floating rate (meaning that if rates climb quickly, they’d reset to those higher levels fairly fast)… and as a nice bonus recently, they were a beneficiary of the SPAC mania and the surge in IPOs in the past year or two, since that provided a lot of liquidity and cash cushions for many of their portfolio companies.

What’s not to like? Well, that cushion from the SPAC mania and the liquidity of the stock market during the boom times won’t last forever, so if we have a prolonged downturn for small growth companies they could stagnate, without their investee companies having “exits” by going public at premium prices, or, if the downturn lasts longer, they could have a much more meaningful number of real defaults and business failures in the portfolio.

They’re well off their highs when it comes to historical valuation, but they’re not down at the “bear market” lows we’ve seen in the past — they usually trade at a premium to their net asset value (NAV, effectively the value of the portfolio of loans, equity and warrants they own), and that premium generally ranges from 10% to about 50% most of the time, and we’re now down to the middle of that range now at about 1.25X NAV. That may be justified, they’ve grown and gotten better and more efficient over the years, and it’s better than the 1.5X NAV they traded at when we first wrote about Plaehn’s tease back in January… but it does mean there’s likely more “downside” risk the next time the market panics a bit about HTGC, or about BDCs or venture capital in general.

Because you’re not buying when it’s dramatically beaten down or trading at a discount to NAV or book value, (1.5X book value is about as high as HTGC has ever gotten), There’s not likely to be a big rise in the share price from here — over time, almost all of the returns from HTGC and most BDCs come from the dividend payments, and because investors buy them for the dividends you should expect the share price to crash if they ever have to cut the dividend in a meaningful way… or if investors begin to insist on a much higher yield. That can still work out if the dividend remains solid and you let your income compound into new shares, but there’s less room for error when you’re paying a very full price.

The positive outlook? Buying HTGC at 1-1.2X book value has been a good bet, historically, and we’re almost there now… and the stock has rarely gone more than a couple years without a drop to trade near book value.

And the shares have rarely traded much below book value, the longest stretch of that was during the 2008-2009 crash, when leveraged lenders all had a rough time.

Does that ring some alarm bells? It might… leveraged lending is tough right now, because inflation and the extremely rapid increases in interest rates are wreaking havoc with the net interest margins for these kinds of companies… they have had a very strong net interest margin over the years, but that is almost certain to shrink this year as they have fewer big “exits” that give them some bonus returns from equity or warrants, and as their cost of capital increases with rising interest rates (they fund their investment portfolio with roughly half debt and half equity, like most BDCs… and if they can borrow at 5% and lend at 12%, that means they can pay their overhead and still offer more than a 10% yield to equity investors, even if they have to issue new equity to cover half of their new funding commitments.

The good thing is that their lending and their borrowing are both fairly short term, effectively going out only 3-4 years, and they’re pretty well matched, but they’ve also been a big beneficiary of the past few decades of gradually falling interest rates, and the strong market for tech and growth stocks in the past decade, so it’s very possible that returns will be much weaker from this point even if there isn’t a calamity on the horizon (like a wave of defaults from their borrowers).

So… what’s to like? Well, considering their small size they are pretty well diversified across sectors and companies, and their high net interest margin means they have been able to pay a high dividend even as the value of their portfolio rises. They say they’re disciplined in their underwriting, but, of course, everyone says that — you can have some faith in their track record, but keep in mind that probably everyone’s underwriting got looser over the past five years. Free money has a way of making you overpay for things.

The dividend is a combination of regular and special dividends, but that’s been true for a long time, and they have kept the dividend steady or rising slowly over the past several years (it did drop meaningfully in 2009 with the crash, but I don’t think it’s been cut since then) — right now they are paying a total of 50 cents per quarter, which would annualize to a 15% yield at the current $13 share price… but keep in mind that they try to separate the “windfall” returns from the “normal” returns. Only 35 cents of the current dividend is what they call their “base dividend”, the other 15 cents is a supplemental dividend that could be more easily canceled without freaking out investors, should the cash flow drop in future quarters. Still, at 35 cents that’s $1.40 per year, so that’s still about an 11% yield.

That’s about average for BDCs, the Van Eck BDC Income ETF (BIZD) reports a current yield of 11%, and all of these kinds of income-focused investments, including REITs and MLPs as well as BDCs, have taken it on the chin as interest rates have reset so rapidly in the past six weeks or so… but, to be fair, Hercules has certainly done better than the average BDC in recent years.

The beauty of a high dividend is that it doesn’t take much growth to give you very strong compounding power — so that’s what Tim Plaehn is probably really looking for as his retirement boon. If they are able to grow the dividend by 3% a year from here, and the share price also goes up 3% a year to keep the “base” yield fairly steady in the 11% range, then in ten years of reinvesting dividends your investment would do a little better than triple in value… your 100 shares would grow into 300 shares, and each of those shares would still be (one hopes) paying a yield from that point. The magic of compounding requires patience, and it’s not so great to bet on just one company because anything can happen to a single company… that scenario would have the share price of HTGC rising to just $17.50 in 2032, for example, but we should also note that the stock also fell from $18 to $13 in just the past seven or eight months, so big downturns can quickly wipe out what you envision as a decade of future riches, particularly if a downturn shakes you out of the stock and you interrupt the compounding by selling.

But if you can find companies with high yields that have any growth at all, and can survive whatever you think the future might be, you’re putting the odds in your favor. As long as you can be patient enough to let it work. Just keep in mind that there are no guarantees, which is why most people diversify — no matter how tempting the “one stock retirement” might be, it’s perilous to rely too much on even one sector, let alone one stock.

Will Hercules Capital work? That I don’t know — in their favor, they’ve been doing this for 16 years, through some very different market environments, and have held up pretty well and grown for most of that time. The skeptic says that the wild venture capital boom of the past few years, which meant venture funders had lots of exit possibilities even if they made a mistake, was a one-time boom for them… and that inflation, with higher yield expectations from investors and higher costs of debt likely to gradually roll through the portfolio if rates remain high for a few years, could squeeze the future returns at HTGC. But if this reset is not a generational shift, if we’re just in a bear market and the next decade is something like the past decade, the valuation is certainly looking more appealing now.

So there’s no magic answer, you’ll have to think for yourself — HTGC might be a nice way to get a high dividend yield that’s fueled by their lending to startups, and it’s cheaper than it was back in January and February… but it’s also still subject to some valuation (and borrowing) risks from inflation and rising interest rates, and from any further potential “bubble bursting” in venture capital that could lead to more defaults by their borrowers. Worth your money at a current 11-15% yield? Prefer other BDCs or high-yield investments for those kinds of high-income cash returns? Let us know with a comment below. I’ve left the comments from our original article back in January attached as well, hopefully they can provide a little perspective.