Description

Price Target: $18.00 (45%, including dividend); Downside Risk: $11.50; U:D of 3 to 1

TriplePoint Venture Growth is a high quality lending franchise with a leading position in a small, but attractive market niche. A recent large equity issuance has put pressure on the shares, but we view the issuance as one of several key events over the past year that set the stage for TPVG to structurally improve its ROE to 15%+. This will enable it to raise its (double-digit) cash dividend and highlight its status as the cheapest of the quality BDCs at under 7x pro forma earnings.

What is venture lending?

Venture lending is the business of lending money to startup companies. Due to the nature of startups (no assets, negative cash flows), there is little competition from banks and other traditional lenders. Because startups are small, new and VC-sponsored, most venture loans are sourced through relationships with VC sponsors.

What are the economics of a venture loan?

Venture loans are structured differently from traditional loans. While a typical middle market loan has a five year term and an average duration of 3.5-4 years, a typical venture loan has half that duration, and it is not uncommon for a loan to be paid back in less than one year. TPVG’s venture loans typically have LIBOR-linked cash coupons that range from 6-12%.

Venture loans will often have delayed draw features, whereby the lender commits to provide the agreed upon loan at a set future date, contingent upon the company’s achievement of certain KPIs. The lender collects a fee upfront for making the commitment. Significant additional economics are built into the principal payback in the form of “end-of-term” (EOT) payments that range from 5-10% of the principal. From the lender’s point-of-view, EOT payments ensure that they are able to get an adequate return from a loan that gets called soon after issuance; from the borrower’s point of view, this helps to back-end a bit of the cost for the cash-burning startup. The cash coupon, commitment fees, EOT payments, and other fees combine to generate an attractive mid-teens return – TPVG’s weighted-average yield on their loan portfolio over the past three years has been just under 16%. This compares to the HYG/JNK yielding a bit over 5% and the middle market loan portfolios of quality BDCs yielding 9-12%.

Finally, the venture lender will also usually get some slice of equity or warrants in the startup.  The way TPVG does it, equity is a small part of the deal, but there are some venture lenders that view the equity co-invest as the main form of consideration. TPVG has gotten cashed out on their equity in some high profile startups over the past few years: Dollar Shave Club was acquired by Unilever; jet.com was acquired by WalMart; PillPack and ring.com were both recently acquired by Amazon.

What are the economics of the BDC (how do the loan economics flow-through to shareholders)?

The fee structure at TPVG is 1.75% base & 20% incentive over an 8% ROE hurdle. We wrote in detail in our ARCC writeup about BDC fees & flow-through economics, but the basic outline is:

[gross asset yields] – [base management fee] – [other expenses] = [net asset yield]

[net asset yield] levered [leverage ratio] @ [cost of debt, adjusted for WC] = [pre-incentive ROE]

[pre-incentive ROE] x [1 – incentive fee] = [NII ROE to the shareholder]

Historically, most of the key variables above have conspired to lower the flow-through of TPVG’s high asset-level yields to the ROE experienced by the shareholder. A key leg of our investment thesis is that changes have taken place (see catalysts, below) that will structurally improve those variables to the benefit of shareholders.  These variables are:

• Other expenses – TPVG’s small scale has meant poor operating leverage around other expenses – these have averaged over 1.5% since TPVG’s IPO, compared to ~85bps for the average BDC and under 50bps for the largest & most efficient. We believe that TPVG’s large equity raise in August gives it the scale to take this number under 100bps.
• Leverage ratio – regulatory limits, scale, and rapid turnover have all conspired to make TPVG’s balance sheet inefficient. In 2017, TPVG’s leverage averaged 0.5x D:E (under 35%) and even fell as low as 0.25x D:E (20%). TPVG’s newly increased scale, combined with an increase in the regulatory leverage limits, should allow it to run a much more efficient balance sheet with average D:E of 0.8x (45%).
• Cost of debt – TPVG refinanced its baby bonds at the end of 2017, lowering the coupon from 6.75% to 5.75%.  More recently, it lowered the margin on its credit facility and reduced the undrawn funds fee. Cross this with a more efficient balance sheet, and we expect its cost of debt to fall ~100bps, despite rising LIBOR

These changes should structurally raise the ROE by ~300bps to 15%, which implies an earnings multiple under 7x.

How can one responsibly underwrite a loan with no hard assets & negative cash flows?

Different lenders take different approaches, but below are some of the key pillars in TPVG’s lending strategy/philosophy:

• Focus on later-stage growth companies – While TriplePoint (the manager/lending platform) lends to startups in all phases, TPVG exclusively lends to later-stage growth companies with real revenues, proven business models and visible paths to profitability. These companies are close to an exit event (IPO or sale).
• Keep loan duration low – TPVG loans are underwritten for ~3 year terms and on companies that are close to an exit event (IPO or sale). When companies are closer to exit, it’s easier to underwrite what they’re worth, there is less room for an issue to arise, and you’re closer to getting your money back. Sometimes these companies have already gotten buyout offers, but the sponsors think an extra 6-18 months of runway (funded by a TPVG loan) will further maximize their exit price.
• LTVs and LTCs – with negative cash flows, normal leverage and debt service terms don’t apply.  However, funding round valuations and equity capital invested are both real numbers to underwrite to.  TPVG’s typical deal is underwritten to 5-20% LTVs and has several-fold more equity capital invested behind them.  This compares to LTVs and LTCs above 50% for more traditional middle market deals.
• Work with only the top VC firms – in the Valley, the best new startups want the most prestigious backers, which makes the most prestigious VC firms even more prestigious. Thus, if you want the best deal flow, align with the best VCs.
• Get in deep with the VC firms that you work with – TriplePoint generally tries to have a critical mass (five or more) of portfolio companies with each sponsor that it works with (this includes earlier stage companies whose loans are in other TriplePoint funds). This ensures better alignment when one of those companies hits a snag.
• Good covenants & funding hurdles – when a loan is underwritten to 10% LTV, often several things need to go wrong for it to become impaired. Through strong covenants and tying delayed-draw funding to firm KPI achievements, the lender can move to protect their principal before it is impaired.
• ABLs where possible – some startups have capital equipment or receivables; secure loans against these where possible.

Who does TPVG compete with?  What are barriers to entry?

Competition in venture lending is driven by relationships and speed/reliability of capital. The VC world is fairly closed and secretive, and many entrants without the right relationships or structure have failed (e.g., FSC, ARCC).  VCs, for their part, are willing to sacrifice a bit of yield to work with partners that they trust – even 16% debt can be accretive if one is underwriting to gross equity IRRs over 30%! Other barriers to entry include: complexity (the loans are hard to underwrite, structure, and monitor), regulation (hard for banks to lend to startups with no hard assets or cash flow), and scalability (with a sub-$5bn TAM, bigger lenders only have so much incentive to penetrate this niche). Finally, the low duration and small scale of these loans means compressed MOIs and lower absolute-dollars-of-profit-per-loan, relative to more mainstream middle market lending. Readers may find it worthwhile to read ARCC’s discussion on their decision to exit the space in Q3 2017.

There are a number of venture lenders in the market. Some are small, private funds; some focus on early stage companies; some view venture debt primarily as a mechanism to access the VC warrants and equity co-invests.  Apart from TPVG, there are two sizable public venture lenders: SVB (Silicon Valley Bank) and HTGC (Hercules BDC). SVB is a strong competitor that leverages its many other banking products (e.g., cash management, mortgages for principals) to solidify its relationships with entrepreneurs and sponsors. However, as a regulated bank, there are limits to how flexible and responsive it can be.

Hercules is viewed by most BDC investors as the clear leader in the venture lending space.  We agree that it is the leader in size ($1.5bn portfolio), but not in much else. On the face, there is nothing dramatically different between the TPVG & HTGC portfolios: historical loss rates are similar in the 1-2% range; TPVG yields are maybe a point higher; however, we view HTGC’s book as diversified into some lower-quality investments, and that is consistent with what we have heard from others who have looked closely at the space.  More importantly, we think TPVG management (Jim & Sajal) are more thoughtful and shareholder-oriented than HTGC (Manuel), a view that was validated when Manuel tried to externalize the HTGC manager without compensation last year. For those so inclined, we think a long TPVG/short HTGC pair is compelling, given that TPVG offers higher quality at a 30% discount (and a positive spread).

The biggest other competitor of note is VC equity – insofar as capital flows into VC funds and compresses target IRRs, it can make sense for startups to use less venture debt. The primary aggressor that concerns us here is Softbank.  However, their impact has thus far been low, as they don’t write checks that are small enough to compete with TriplePoint.

What about the credits? What happens when borrowers get into trouble?

TPVG’s net loss rate has been 1.7% in the 4.5 years since its IPO; it’s loss rate prior to the IPO was nil (TriplePoint was underwriting venture debt in private funds since the early 2000s). Peer HTGC – whose public track record extends through the financial crisis – has a similar net loss rate, though it jumped to ~6% in 2009 & 2010, some of which it clawed back in subsequent years. We view these loss rates and profiles as generally in-line with quality BDCs or B/BB credits.

The portfolio itself is impossible to underwrite independently: all loans are direct to private (and fairly secretive) companies. That being said, we have found management willing to speak about specific credits, both on the calls, as well as offline.  We walk through the biggest credit issues they have faced:

• Coraid – easily the worst credit problem in TriplePoint’s history, and it showed up a few quarters after their IPO. A flaw in Coraid’s technology limited its ability to achieve its targeted scale.  TPVG was able to find a related company to assume the debt in exchange for Coraid’s assets, but that company was also unable to overcome the core technical issue. This was a total loss on a $15mn loan.
• HouseTrip – this was the AirBnB of Europe.  When KPIs started trending the wrong way, TriplePoint worked with their VC sponsor to find a deal whereby TPVG would have been made whole.  As they were hammering out the contract, the November 2015 Paris bombings occurred, nixing the deal. TPVG scrambled to find a new deal, ultimately taking a 75% haircut on the $6mn loan.
• MindCandy – the owner of Moshi Monsters and Petlandia video games for children. Their original loan was meant as a bridge to a new product launch, but the new product underwhelmed. This has been on their watchlist for years. They carry the loan at ~80, and we have long expected further markdowns, but they keep finding parties willing to inject new equity underneath them as they continue to develop new products. Our understanding is that they now generate material revenue through offline book and merchandise sales.
• Virtual Instruments – this was a larger loan where TriplePoint had to step in and negotiate a deal whereby LoadDynamix assumed the loan with a lower coupon, and LD’s sponsor injected substantial new equity capital to facilitate the deal. TPVG carries the (new) loan at 90, but this is a reflection of how they accounted for the lower coupon at the time of the deal, rather than any re-emergent credit issue.
• KnC Miner – this was a smaller loan to a Scandinavian bitcoin miner. They were ultimately able to get a full recovery on this loan after the assets were sold in bankruptcy, though the process was fairly drawn out.
• Xirrus – this was a larger loan that they downgraded several quarters ago. They facilitated the sale of the whole company for a full recovery one quarter after they downgraded.

How do you get comfortable with the structure & governance of this externally-managed BDC?

The fee structure at TPVG is high among BDCs (1.75% base & 20% incentive over an 8% ROE hurdle), but it is not the highest. We find a higher fee level to be appropriate, given the higher cost of venture lending relative to more traditional middle market – smaller loan sizes and higher turnover means more cost-per-dollar of AUM. This observation is supported by the high cost structure at internally-managed peer HTGC. Importantly, the 8% hurdle has a FULL lookback feature with respect to capital losses/markdowns, which is unusually shareholder-friendly within the BDC space, and provided significant benefit to the shareholder in the wake of the losses in Coraid & HouseTrip.

TPVG’s shareprice has traded below NAV for most of its history, but it has not raised equity below NAV. On the occasions where it has raised equity, the manager has eaten some of the deal fees to ensure the raise was not NAV-dilutive. When Goldman Sachs Asset Management (GSAM) did a PIPE with them last year, the TriplePoint principals participated alongside them at a meaningful level.  GSAM also “cornerstoned” TPVG’s most recent offering in August, and they own a bit under 10% of the shares.

What is the right valuation for this unusual BDC?

Quality BDCs trade at 9-13x net investment income, and TPVG trades at the low end of that range, on a trailing basis. Thus, we value TPVG at 9x pro forma earnings (NIIps of ~$2.00).  One could argue for a higher multiple, given the abnormally high ROEs and greater potential for accretive inorganic growth: 13x forward earnings would imply a $26 price target and a double over the next year, but we doubt the market would ever get that high, given that only one BDC has achieved a P/NAV that high in recent years (MAIN).

This $18 price target represents a 8% current dividend yield, which is within range for quality BDCs (though we would expect them to raise the dividend as the ROE expands). This $18 price target is 1.3x forward NAV, which is high for an externally-managed BDC, but we think the abnormally high ROEs justify it.

In the downside case, we note that TPVG has faced a fairly adverse set of conditions over the past four years (i.e., TriplePoint’s worst two credit losses in the past 15 years; a subscale G&A burden; a high cost of debt & equity capital, etc.), yet it has been able to cover its double-digit dividend and deliver a ~10% annualized total return since the IPO – I wish all my mistakes did that!

We’re nearly five years out from the IPO; what makes this work now?

This is a catalyst-laden investment. Four things happened earlier this year that should structurally improve TPVG’s base ROEs and propel the shares higher:

• August equity issuance – TPVG did a huge equity issuance in August that increased its market cap above $300mn, increased its float by ~50%, and increased trading liquidity four-fold (to ~$20mn/wk). This gives them the size and liquidity to merit more attention. There have been two new sell-side initiations since the deal. The equity raise will give them the ability to further grow and diversify their portfolio, which has suffered from the chunky size of their larger loans. Finally, this will directly enhance ROEs by spreading their G&A over a larger base.
• Lower cost of debt – in late 2017, they refinanced their baby bonds to save 100bps. More recently, they upsized their credit facility, reduced the rate they pay on undrawn funds, and lowered the applicable margin.
• Regulatory leverage limit raised – in the spring, the regulatory limit on leverage within a BDC was raised from 1:1 D:E to 2:1 D:E.  For most BDCs, we view this regulatory change with concern, as we think this will incentivize external managers to take more risk without proportionate benefit to shareholders. However, we see TPVG shareholders as uniquely poised to benefit, as it enables TPVG to manage its balance sheet more efficiently. By way of example, TPVG hit the high end of its target leverage range in early 2017 (D:E of 0.8x), preventing it from funding new deals.  Over next few months, it received an unusually high level of prepayments, causing its leverage to plummet (to D:E of 0.25x). Its balance sheet was so under-levered that it was funding a bit of its baby bonds with cash! This caused substantial earnings volatility and left the dividend uncovered in H2 2017. Having the flexiblility to bring up leverage a bit more when the pipeline is strong should mitigate this volatility, and the issue should be further mitigated by a larger capital base.
• Exemptive relief – in March, TriplePoint received relief from the SEC to allow them to allocate the same investment across various funds in their platform. This enables them to take down larger deals without getting too concentrated within the BDC. Larger deals (such as the recent ring.com deal) tend to be higher quality/lower risk.

Taken together, these catalysts: raise TPVG’s profile, quadruple its liquidity, increase its scale & operating leverage, reduce concentration risk, increase the quality & number of deals that it can do, increase the efficiency of its balance sheet, and reduce the volatility of its earnings.  Most importantly, these changes enable it to structurally boost its ROE from ~12% to ~15%, which should enable it to increase the dividend and lead to a rerating of the shares.

Catalyst

As noted above, most of the catalysts catalysts required to raise their profitability have materialized.  Now they just need to deploy the newly-raised capital and raise the dividend.