TPVG - TriplePoint Venture Growth: Who Can Resist The 15% Dividend Yield?

2023-12-24 07:00:00 ET

Summary

• TriplePoint Venture Growth is a BDC that specializes in venture debt and targets companies in the growth stage.
• Venture debt is a growing market, reaching $47 billion in 2021, and offers high yields for investors.
• The company's portfolio generates high cash flow and has a strong track record, but there are risks associated with non-accruals and leverage.

This article was co-produced with Williams Equity Research ("WER").

Introduction

Before we get into today's focus, we need to learn the fundamentals of a part of the investing world that may be new to you. It's the same reason why you wouldn't invest in ABC Drilling & Exploration if you didn't know the first thing about oil and gas.

You may skip to the "Strategy & Assets" header if you'd like, but the introductory sessions are critical to understanding the risks and potential upside in my opinion (hence why I took the time to write them).

We all know publicly traded companies. Most have some familiarity with private equity, which is broad category encompassing investments into all sizes and types of businesses.

Angel investing is at the bottom in scale. It could be a $100,000 investment in a 3-store franchise of local ice cream stores. The top of private equity are gigantic leveraged buyouts ("LBOs"), which may involve tens of billions.

Kinder Morgan ( KMI ), PetSmart, Nabisco, Hilton Hotels, and many other household names have been involved in LBOs. Between these extremes lies venture capital .

Venture capital is money for private companies that aren’t large enough to attract most institutional investors or the major brands on Wall Street like Blackstone ( BX ) or KKR & Co. ( KKR ). But they aren't start-ups either.

Venture capital includes companies with $5-10 million in revenue to more than $100 million. Venture capital is attractive because it strikes a compelling balance between risk and reward.

Venture companies often still have 10x, 25x, or even 100x upside for investors. That's impossible for most publicly traded stocks over a short-to-medium timeframe.

Obviously, you can hit any return figure over a long enough period of time by simply reinvesting dividends, but we are talking 15-50% internal rate of returns ("IRRs"). That matters because humans don't live forever, and we have even less time to save and compound capital.

On the other hand, most quality venture-sized companies are past the risky start-up stage. They have a proven business model, significant revenue, and identifiable technology or other types of competitive advantages.

Their management teams often have experience running other companies and understand the needs and desires of investors.

Venture Debt Versus Equity

Just like there is private equity and private debt to serve that segment of the market, the same applies to the smaller venture capital segment.

While debt to large private companies may only cost 3-5% more than a comparable publicly traded company, venture debt is more costly for borrowers. Typical yields on venture debt are 11-18%. It varies depending on the industry, financial health, and operating history of the company.

Government regulations make it all but impossible for large private companies to borrow from banks. It's even harder for venture sized firms.

Venture debt had $5 billion in activity just prior to the Great Recession. That part of the capital markets was just getting traction.

A decade later just prior to the pandemic, it grew to $25 billion. Now, with the crash in global stock markets and a big move to "risk-off" in 2020, I wouldn't blame anyone who thought the sector's rapid growth might have met its match.

Far from it. In 2021, it had nearly doubled to $47 billion. It doubled again in 2022.

This is clearly a lucrative and growing market, so how do we take advantage? Today's focus company .

Private Capital & BDCs

Regular readers know that BDCs loan to private companies. You may also recall that BDCs focus on stable, cash flowing businesses. That’s a key reason none of the quality BDCs cut their dividend during the pandemic.

What allowed "risky" double-digit yielding BDCs to withstand the pandemic with many "safe" companies slashed their dividend?

As "complicated" as BDCs may seem, it's a simple business. They mostly loan to boring, predictable companies. Larger BDCs, like Ares Capital ( ARCC ) and Blue Owl Capital ( OBDC ), need to work with larger private companies to make the numbers work. They have $10+ billion gross portfolios, so they need at least a $50-$100 million loan for it to make business sense.

To be fair, the multiple layers of the capital structure involved (on both the BDC and borrower's side) do make BDC financial statements and operating results difficult to understand for the average investor.

That's why we spend extra time on education.

Without it, people tend to make bad decisions.

BDCs have a great and proven model, but like all strategies, it has drawbacks. Most BDCs don’t have the tools, incentives, and or time to work with venture-sized companies. The due diligence is just as difficult and time consuming as with larger companies, and the loan sizes are just too small.

This makes it even more challenging (code for "expensive" in lending) to borrow money. So not only will banks and typical lenders not work with venture-sized companies, but even most BDCs are out. Now, you understand why venture debt is so expensive.

But that leads us to an important question. If we were in charge of a successful venture firm, why would we pay 15% or more for debt instead of raising equity? Venture companies don't pay dividends, so isn't the equity "free?"

Those of us that have had the displeasure of owning a company that constantly dilutes shareholders know where I'm heading.

Believe it or not, issuing shares is often more expensive . A lot more. And that's especially the case because most venture firms are still led, at least in part, by founders. These are people with serious skin (money) in the game.

If a company eventually grows in value by 100x, every dollar in equity that a founder issues is worth $100 long-term. And since the founders are the ones with most of the equity, it's going directly from their pockets to investors.

On the other hand, paying interest is different math. The company, not the founders, pay the ~15% interest. Sure, they give up a little profit in the short-term, but they don't care nearly as much about short-term cash flow as they do long-term capital gains.

By borrowing expensive venture debt, the founders aren't diluted. The other investors, which often include high-net worth investors, family offices, and venture capital private equity shops, like it too. They don’t want to be diluted either and their goal is 10x+ their investment, not receiving a little more cash flow in the current period.

We know Blackstone and other giant Wall Street heavyweights shy away from venture capital for scale reasons. BDCs are more flexible but even they prefer larger private companies. And regular banks can't get involved even if they wanted to for regulatory reasons.

So who fills the gap?

That’s where TriplePoint Venture Growth ( TPVG ) comes in. There are a few other BDCs that play at least partly in this sandbox: Horizon Technology Finance ( HRZN ), Hercules Capital ( HTGC ), Trinity Capital ( TRIN ), Runway Growth Finance Corp. ( RWAY ).

Each company's strategy has its nuances.

TriplePoint are experts at every step of the venture debt process and usually negotiate warrants into each deal.

As a reminder, warrants are like call options in that they only become valuable if a trigger is met. Most of the time, that’s if the company is successful and increases in value. This gives the BDC capital gains potential at little to no cost.

So what are the drawbacks of a company involved in venture debt? It can’t make the same returns as top venture equity investments. That makes sense because the debt is safer.

And although venture debt generally has a strong track record, there are obviously risks loaning money to smaller, less established companies over large ones with long track records. Venture is also more sensitive to shifts in the broader economy and may suffer disproportionately in a severe economic downturn. Management's skill in underwriting the borrower and structuring the loan properly is the key to long-term success.

But venture debt certainly has its upsides. Venture debt generates yields among the highest you'll come across. And with a good manager, loan losses are manageable.

On average, quality venture debt managers ( subscription required ) have beaten the S&P 500 index by double-digit percentages since data started being collected about 20 years ago. Based on a survey of publicly available information, the average venture debt fund currently yields 14.5-16.5% net to investors after expenses.

And unlike venture equity, which is usually illiquid for 5-10 years, venture debt provides immediate cash flow to investors. And by using a publicly traded BDCs as the investment vehicle, liquidity isn't an issue.

Strategy & Assets

TriplePoint targets venture companies with a specific profile . The first is it needs to be the right size where TriplePoint has a competitive advantage: venture.

It also needs to be what's called the "growth" stage. That's the last stage before a company graduates from venture sized.

Provided the company remains successful, not long after the venture growth stage it'll be able to attract capital from traditional private equity investors. TriplePoint gets in just before that.

I would make a slight edit to TriplePoint's diagram above. There are 2-3 additional columns between venture growth and publicly traded in most cases.

Akin to the NBA, it's possible to take players straight out of high school (smaller private firm goes public), but usually they go to college for a few years first (the private firm gets closer to a $1bn market cap before it tries the public markets).

Second, it partners with companies that have established venture equity companies with skin in the game. For TriplePoint to lose any loan principal, the private equity firm has to lose everything.

The final criteria is industry related. TriplePoint prefers technology, life sciences, and a few other high growth industries that have consistently repaid venture loans in good times and bad.

For long-term readers, you'll know that I stress the industry exposures of larger BDCs in every article. And most successful BDCs have similar exposures (enterprise software, healthcare, et cetera). That is no coincidence.

TriplePoint usually incorporates warrants in its loan terms. There are two much larger BDCs that you've heard of that take a similar approach: Main Street Capital ( MAIN ) and Ares Capital Corp ((ARCC)).

These much larger top tier BDCs usually have 25% or more of their portfolios in equity/warrants. That's enabled them to grow their net asset value ("NAV") and pay hefty special dividends over time.

So what's the difference between what TriplePoint and those guys do? TriplePoint’s venture-backed companies pay even higher interest rates. And its equity holdings have even greater upside potential.

Unsurprisingly, that carries higher risk in certain situations. We discuss that in the Balance Sheet and Risk section later on.

Let's get a strong grasp on the engine that delivers TriplePoint's 15%+ yield.

You can see that the company's net investment income ("NII") return on equity recently broke the 20% level. In laymen's terms, that means the portfolio generates roughly $0.20 in cash flow for every $1 in equity each year .

Another way to interpret this is the maximum sustainable portfolio yield (it's not exactly that, but close enough).

What caused the profitability of the portfolio to increase significantly in recent years? Higher interest rates are a big one. Like most BDCs, TriplePoint's portfolio is primarily floating rate. The loans have "floors" to protect from significant declines in interest rates, but the portfolio's profitability is still correlated to interest rates.

The other primary variable is a tougher environment for venture capital fundraising. We all remember the madness of tech company valuations in 2020 and 2021. That same irrationality flowed through to private equity companies of all sizes. That story is over .

And since the industry came back down to earth, TriplePoint's average loan yield has doubled since 2021 .

What about those warrants? When they work, they turn into equity investments. TriplePoint's equity investments have done well overall.

TriplePoint's investment in Crowdstrike generated a 26x return for a $27.1 million gain. The BDC achieved over 100x returns on Toast and Medallia.

Before you get too excited, that netted shareholders about five million dollars. Remember, TriplePoint's balance sheet is mostly debt. The warrants/equity positions provide "bonus" income and aren't large enough to cause the stock to double overnight or anything along those lines.

Cash Flow & Dividend

Let's start with the big picture and work our way down.

Since TriplePoint's initial public offering ("IPO") in Q1 2014, the stock has paid $15.05 per share in distributions. That's versus the current share price of $10.50 and IPO price around $16.

Since I know readers are curious about the real-world returns of high-yield stocks over time, I did the math for an IPO investor with quarterly dividends reinvested at 12% annually through this quarter.

It came out to a 134% total return (9.9% annualized) for taxable accounts and 148% return (10.4% annualized) in a retirement account. That's right in line with the S&P 500's long-term 10-year return of 10-10.5%.

Even as someone cognizant of the power of reinvesting elevated dividends, I was surprised an IPO investor in TriplePoint did that well given the stock price declined by a third.

With the high-level view covered, let's talk more recent data. In 2023, TriplePoint increased its dividend by 11.1%. During the difficult 2020 calendar year, TriplePoint paid significant bonus dividends to investors.

Impressive no doubt, but what about the payout ratio?

TriplePoint earned $0.54 per share in NII last quarter, the most common way to measure a BDC’s cash flow. The resulting 74% payout ratio means TriplePoint can continue to safely increase the dividend for years to come (provided the financials stay on their current path).

Without getting too far in the weeds, externally managed BDCs like TriplePoint (and most others) charge a base management and performance fee. The terms of these are at least slightly different for every externally managed BDC, with significant deltas in how the incentive/performance fees are structures.

For TriplePoint, it charges a 1.75% base management fee (higher than the industry average of 1.25-1.5%) and 20% of cumulative profits over an 8% hurdle (about average).

Why does this matter? Performance fees weren’t owed to the external manager last quarter because of the 20% cumulative requirement. When these eventually normalize, the payout ratio becomes the industry average of 80-85%.

As of the end of last quarter, TriplePoint had $12.6 million in unrealized gains on its warrants. Provided the valuations of the venture companies hold up, investors should expect more special dividends.

To put it into context, that's $0.90 per share in undistributed profits or ~9% of the entire market capitalization of TPVG.

Balance Sheet & Risks

All BDCs have loan problems, and TriplePoint is no exception. I look at many variables, but the realized loss ratio is arguably most important. That's when a theoretical loss becomes a real one.

TriplePoint’s cumulative net losses are 2.6% of its loan commitments. Given the company had its IPO in 2014, that’s only 0.27% (about one quarter of one percent) annually. If that sounds good, it's because it is. That's among the best in the industry.

And remember that its peers generally loan to much larger, more established, and less risky companies. Taking into account the borrower profile of TriplePoint, its historical loan losses are remarkable. Before you get too excited and go buy 1,000 shares, keep reading.

TriplePoint is small with a market cap of $377 million. This matters for several reasons. For starters, at least to my knowledge, no company that small has been awarded an investment grade credit rating from a "first tier" issuer (Fitch, Moody’s, or S&P).

That doesn’t automatically make it riskier, but we prefer an investment grade rating from a major issuer. TriplePoint has a BBB rating from DBRS. DBRS and Kroll are “second tier” rating agencies. In my experience, they do a reasonably good job and their ratings make sense. That said, I find they give one notch higher than the first-tier rating agencies (e.g. if BBB+ from DBRS, S&P/Fitch would award BBB).

If we apply that logic, TriplePoint would likely receive a BBB- rating from Fitch or S&P if it were large enough to qualify. That's still investment grade. There are plenty of BDCs to pick from with investment grade ratings, so I don't blame investors who prefer to select from that group only.

Leverage is another critical area to understand for all companies and especially BDCs. TriplePoint’s leverage ratio climbed from below the industry average in 2021 to above average in 2023.

If we adjust for the $105 million of cash on the balance sheet, the ratio falls to a much more palatable 1.34x. That’s still above the peer average of 1-1.2x, but not excessively. I’d prefer management to get leverage below 1.2x. That also happens to be their stated goal.

I recognize why leverage has increased. Venture companies have less access to capital, and that means higher margins for TriplePoint. Since the company refuses to issue shares below NAV, the only option is higher leverage until the share price improves.

If I were management and believed these loans will mostly work out, it makes sense to increase leverage with the objective of it improving NAV as the financial results demand it.

The strategy has mostly been successful. In my opinion, the current leverage profile is one reason that the stock trades at net asset value ('NAV') instead of at a premium. That provides us an attractive entry point, but it limits upside unless it declines. NAV per share has also declined over time, another negative attribute of the firm that needs to reverse.

Now we get to the most important risk I want you to understand today: non-accruals. These are loans or portfolio companies with a material problem. TriplePoint’s non-accrual rate was 1-2% of fair value in past years.

That’s steadily increased in the past year to today’s level around 4.4%. If you combine the higher leverage with elevated non-accruals, that's not a pretty picture. 4.4% of gross assets is about 6% of equity (leverage adjusted for cash on the balance sheet).

$0.72 per share was removed from NAV due to Health IQ’s bankruptcy filing and other borrower problems. After closely analyzing its portfolio, it’s possible that TriplePoint’s NAV takes another 2-4% hit in Q4's financial release.

The external manager is effectively subsidizing a good portion of those loan losses. The external manager doesn't automatically earn performance fees. Given the portfolio issues, the BDC hasn’t been required to incentive fees for five consecutive quarters.

And we aren't talking drops in a bucket. In Q3 2023, not paying incentive fees saved the company $3.8 million. This leads us to another tailwind: management is seriously incentivized to sort out the current loan problems.

At a macro level, venture capital markets are getting back to normal after the chaos of 2020/2021. Capital dried up after the tech bubble popped, and that stressed the finances of many companies in the BDC's portfolio.

Valuation & Recommendation(s)

At the end of the recent tech bubble, TPVG was flying high at $19 per share. Investors over just about any time frame had S&P 500 crushing gains.

Then the collapse in valuations technology companies of all size caused the share price to dip below the 5-year average of $12-$14 per share to current levels around $10.50.

I've been watching this stock closely since the share price started declining in early 2022. For those comfortable with the risks I outlined above, $10.50 is a great entry point in my opinion.

Reinvesting the current level of dividends alone will provide an attractive return for most people (significantly better than S&P 500 long-term averages).

The stock trades close to its latest NAV per share of $10.37. Historically, it's traded with a double-digit premium. It was well over 50% in 2021/2022.

If the current loan problems are resolved in the next two quarters, a share price of $14-$15 is reasonable. That’s a ~40% capital gain plus the annual distribution yield on cost of 15.3%.

If it takes longer, I do not expect the current share price to decline materially so the return is the current yield.

Alternatives

What if TPVG's risk profile isn't right for you? Hercules Capital ((HTGC)) is a $2.4 billion BDC with a business model that overlaps with TriplePoint's. Its larger size helps it earn a BBB- investment grade rating from Fitch. In turn, that's allowed Hercules Capital to issue bonds at attractive rates and lower its cost of capital.

Hercules' loss rates are also very attractive and it's consistently earned more in cash flow than it has paid out in dividends.

So what's the catch? Hercules' dividend yield of 10% is two thirds of TPVG's. That's primarily because it's trading with a steep 1.45x premium to NAV.

If it was trading at the same 1.0x to NAV ratio, it would also yield 15% just like TPVG. The share price is also less than $2 per share from all-time highs. While not a useful metric on its own, it reinforces that HTGC's valuation is almost the polar opposite of TPVG's.

If exposure to faster growing, smaller companies isn't attractive to you, Ares Capital ((ARCC)) or Blue Owl Capital ((OBDC)) are great alternatives. They are also investment grade rated by major issues, great dividend and operating track records, and low loan losses.

But they are also trading near highs and have yields below 10%. Blue Owl, for example, one of our long-term favorites and top picks last year, is up over 32% in capital gains alone in the past 12 months. I recently took profits on Sixth Street Specialty Lending ( TSLX ), another top quality BDC that's up over 30% on a total return basis in the past year.

From the lens I look through, risk isn't just about portfolio metrics or loan losses. Those are important, but they can be overshadowed by another element that often gets less attention. Margin of safety and relative valuation.

That's where TPVG shines, and it matters.

Now you understand why TPVG, and despite its issues, is one of the more attractive overall buys in the BDC sector today.

Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

For further details see:

TriplePoint Venture Growth: Who Can Resist The 15% Dividend Yield?