“Little-known ‘Silicon Valley bank’ pays out a steady and safe 8.7% cash stream”

by Travis Johnson, Stock Gumshoe | May 28, 2014 2:45 pm

Sleuthifying the teaser pitch from Ian Wyatt's High Yield Wealth

“There’s a secret income opportunity buried deep within dusty Silicon Valley…

“It’s called the Silicon Valley bank and it churns out a steady cash stream of 8.71%.

“But unlike customary Silicon Valley deals, this unique opportunity isn’t reserved solely for big shots, private venture capital firms or Wall Street investment banks…

“In other words, this isn’t the typical “members-only” deal that happens in the Valley. It’s open to virtually everyone.

“Because you don’t need to be an “accredited investor” with a million dollar portfolio to get in.

“And even better, you won’t have to pay sky high management fees or a cut of your profits to harness this secret cash stream.

“In fact, you can start to reap the benefits with just $15.”

That’s how the latest ad from Ian Wyatt for his High Yield Wealth opens — and it sounds intriguing, no?

It is not, of course, actually a bank — or at least, not the kind that you think of that holds your CD and sends you one half of a percent in interest each year. Wyatt’s copywriters have had a habit of using that term “bank” pretty loosely, which conveys a bit more stability than these kinds of investments tend to have.

And he mentions a “secret Federal law” — which means it pretty well has to be one of the tax pass-through investments authorized by the government:

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“And an obscure 34-year-old federal law guarantees and protects the healthy cash payouts…”

None of those pass-through entities, to be clear, have “protected” payouts — the three most common types of these high-yield entities are real estate investment trusts (REITS), Master Limited Partnerships (MLPs) and Business Development Companies (BDCs), though other kinds of pass-through trusts have been increasing in popularity too (most notably oil trusts).

Since he specifically says 34 years, this is almost certainly a Business Development Company — BDCs were authorized by the Small Business Investment Incentive Act of 1980 and were designed to spur private investment into smaller businesses that were (or at least were perceived to be) starved for capital due to the regulatory environment of the late 1970s.

BDCs often use small business lending funds from the government to get low-cost capital that they use in their role as lenders to the companies that are too big or risky for neighborhood banks and too small to get good terms from Wall Street financing. So they’re kind of like a bank, in that they take lower-cost debt and equity and lend it out to other companies at higher rates and profit on the difference between their borrowing cost and their lending income… but there aren’t many banks out there that have fewer than 100 customers and pay out dividends of 5-15%. Think of them as a hybrid — half private equity fund, half midsize-business banker.

And the “pass-through” term means simply that these kinds of investments, like REITs, do not pay taxes on their earnings — they pass the lion’s share of earnings (if any) on to shareholders (or unitholders) as dividends (or distributions), and the shareholders owe tax on those earnings (typically, these dividends are not “qualified,” which means they don’t qualify for any kind of dividend tax break and they’re treated as ordinary income on your tax return … though often such companies pay out more than their book profit and are thus also giving you a “return of capital” that lowers your cost basis but doesn’t incur immediate tax liability).

Because of the high yields, these kinds of investments have historically been favored by individual income-hungry investors and were less likely to be owned by institutional investors, though that has evolved over the years with the huge variety of institutional investment strategies (though they’re getting phased out of the index funds, more on that in a minute).

So that’s the niche he’s teasing — what’s the specific stock?

“At today’s 8.71% yield, the Silicon Valley bank will pay out a total of over $76 million in cash in 2014….

“The great part is that there’s an added level of safety with this bank, too.

“Because an obscure 34-year-old federal law enforces and protects the healthy cash payouts.

“So even though an 8.71% yield might seem quite high – and therefore risky – that government mandate provides you even more safety….

“The Silicon Valley bank pays out over 1,450 times the average bank account…

“And it pays out a huge 35 times more than one year CD’s…

“It crushes money market account yields by 78 times…”

To be clear, since this is a BDC the government is not requring them to pay out an 8.7% yield — the government requires that IF they have income of $82 million THEN they must pay out at least $76 million of it directly to shareholders. If they don’t make money, they don’t have to pay out anything … and the amount can fluctuate from year to year depending on their profitability (I made up those numbers — the rule is that they must pay out 90% of income, though in practice many of them pay out significantly more than the legal minimum).

Once we get into the meat of the teaser pitch, he gets a little more clear in hinting at what this “Silicon Valley Bank” does:

“… this company focuses on one thing: lending money to… growing tech firms….

“A unique way to seed the early-stage growth businesses in Silicon Valley…and grab a chunk of their potentially unlimited profit potential

“Lending to businesses at this early stage is a sort of “sweet spot” for the Silicon Valley bank.

“Because most commercial banks don’t want to lend money to these aggressive, growing tech companies…

“They focus solely on this “sweet spot”, providing loans and capital to hungry idea-fueled tech companies rearing to grow.

“And since the Silicon Valley bank specializes in this sweet spot, they can demand high interest rates on the loans extended to these needy high growth businesses.”

And to feed the clue-hunger of the Mighty, Mighty Thinkolator, we’re told about a few of the clients of this “bank:”

“their clients include:

“The world’s largest online family history treasury, with 1.7 million paying subscribers. This massive geneaology database encompasses over 8 billion records!

“The leading digital gift company, which allows users to effortlessly send gifts from over 250 well-known brands over social networks…this is like the Groupon for gifts.

“A free, real-time answering service available both online and via text message. This innovative company has answered over one billion questions to date, and forms one of the premiere brand awareness tools for target advertising.

“The new eBay of high-end consumer electronics. This unknown company has helped sell over 900,000 boutique electronics, taking a healthy cut in the process….”

So who is it? There are more clues, including some clients in the energy space (smart grid, fuel cells, etc.) and in biotech (home dialysis, non-opiate pain treatment, etc.), but we’ve now got plenty to ID our target: This is Hercules Technology Growth Capital (HTGC)

HTGC has been suggested by newsletter pundits before, since it stands out as being somewhat more exciting than the majority of BDCs because of the connection to technology and life sciences, but that also means that it is often lending to more exciting but not necessarily profitable companies — one reason, I imagine, why they are quite diversified and have relatively small commitments to each of their client companies (the average loan is about $10 million, there are more than 80 companies in their portfolio).

If you’re curious about the detailed teaser match, the “real-time answering service” is ChaCha, the “leading digital gift company” is CashStar, the “family history treasury” is Ancestry.com, all of which are current portfolio companies at Hercules. They describe the four biggest segments of their portfolio as being in drug discovery, medical devices and technology, internet, and energy technology, all areas where profitability is not very likely at an early stage, but none of those segments is a quarter of the portfolio currently.

HTGZ is not as levered as some business development companies, but they do carry a fair amount of debt — much of it is in long-term Small Business Administration funding, which is stable and not usually a concern, and the other large chunk is in a “baby bond” that they floated a couple years ago — that bond is publicly traded ($25 principal) under two different tickers, HTGZ and HTGY, and yields 7% on the $25 principal, with a 2019 maturity date… so one way to check on any worries about creditworthiness at HTGC is through those bonds, which seem to me to be signaling “no worries” at the moment with a $26 price. Of course, lots of high-yield debt is trading at “no worries” levels at the moment, and that doesn’t mean no one is actually worried.

BDCs tend to pay out all of their excess cash flow as dividends, including any windfalls they may get from partner companies that IPO and lead to the equity or warrant positions spiking up in value (about 10% of Hercules’ portfolio is equity and warrants, which are typically provided to BDCs to “sweeten” the loan terms for companies that have more upside potential than they do cash flow, and they usually have at least a few portfolio companies go public each year)… which leads to a problem.

Did you figure out what it is?

That’s right, in order to grow they have to sell more shares. They can’t reinvest in themselves and compound their earnings, though you can compound your BDC position in your portfolio by reinvesting your dividends. Which means that you typically don’t get significant capital gains from BDC investments unless you are fortunate enough to buy them when they are trading at big discounts — like most of them did in 2009. Of course, it takes some guts to buy these kinds of stocks when they’re getting clobbered, particularly when they got clobbered during the financial crisis, because as a group they are cyclical and levered … if their cost to borrow funds goes up, their profits go down, and if the economy sinks it’s often the small and medium sized businesses they lend to who are hurt the most.

That all goes for the whole sector, though, and Hercules is at least a little bit different because the focus is so much on fairly early-stage tech, biotech and energy tech companies — which means that you’re counting on them to manage the portfolio well not just for credit risk but for the actual prospects of their client companies. They’ve done pretty well at that in many years, though it is definitely not a straight line — the portfolio fluctuates in size, the returns fluctuate, and they have generally grown their portfolio and managed if fairly well for defaults and the like, but both the portfolio and their income from it have shrunk in some years.

Don’t get dreams of huge compounded gains from Ancestry.com or ChaCha in your head — it’s possible for one great investment to give them a very good year, but the stock was at $14 or so at the end of 2006, a pretty good year, and it’s at $15 now in another pretty good year. The current dividend is $1.24 per year at this quarter’s rate, and it was $1.20 in 2006… it fluctuated significantly in between, with HTGC (and most other BDCs) hitting bargain prices (in retrospect) down 75% or so in 2008 and 2009, but when things are going pretty well these are priced as the somewhat economically sensitive, high-yielding, interest-rate-sensitive investments that they really are.

HTGC actually looks better than many BDCs to me, given the decent cash position that provides them with some flexibility to make deals, the senior/secured position of most of their loans, and their pretty stable balance sheet for at least the next five years, but there are a wide variety of BDCs to choose from if you’re interested in this kind of income investment. BDCs recently got dumped from the S&P and Russell indices, in part because the way they have to report expenses gets translated through into the reported expenses of mutual funds who own BDCs (one of the ETFs that holds BDCs, Market Vectors BDC Income ETF (BIZD), therefore looks at first glance like it has an 8% expense ratio but explained that here[1])… so it’s possible that this index change, coming over the next month or so in the next rebalancing, is helping to provide a dip in shares of the bigger players like Prospect Capital (PSEC) or Ares (ARCC), but it’s not likely to be hugely dramatic.

The list of holdings at BIZD[2] gives a starting point of some BDCs you might want to take a look at if you’re interested in this niche — compare these kinds of investments to REITs and MLPs in your portfolio planning (all three have done roughly the same over the past two years, their indices are up about 15% in that time, but they don’t necessarily move together except when there are substantial interest rate shakeups). I don’t currently own any of these and wouldn’t bet big on them at what look in many cases like reasonable but not cheap valuations right now, but I do consider them from time to time as a source of yield ballast in my portfolio — personally, I have a little more confidence in “real asset” REITs and MLPs at the moment than I do in high-yield debt, but that’s partly because of my fear that we’ll see steady and gradual increases in inflation (which might be wrong). If you’ve got a BDC favorite or other yield ideas for the gang to consider, please feel free to toss them on the pile using the friendly little comment box below.


Endnotes:
  1. explained that here: http://www.vaneck.com/market-vectors-bdc-income-etf-bizd-acquired-fund-fees-expenses-pdf/
  2. list of holdings at BIZD: http://www.vaneck.com/market-vectors/income-etfs/bizd/holdings/

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