Co-produced by Austin Rogers for High Yield Investor
There’s more than one way to skin a spade, and there’s also more than one way for investors to gain exposure to innovative, high-growth tech companies.
In this article, we Take a look at two different ways to gain exposure to this high-risk, high-reward segment of the economy:
- A listed index fund holding innovative but mostly not yet profitable stocks public shares, represented by Cathie Wood’s ARK Innovation ETF (ARKK).
- Business Development Companies (“BDCs”) that specialize in high-yield, short-term loans and selective equity investments in innovative but mostly not yet profitable businesses. private companies, represented by Hercules Capital (HTGC) and Trinity Capital (TRIN).
ARKK is an active ETF with a fairly high turnover and an expense ratio of 0.75% which falls somewhere between what is charged by passive and actively managed funds.
The ETF typically holds between 35 and 55 stocks with a median market capitalization of around $5 billion, but there is a fairly wide variety of company sizes within the portfolio. Although all holdings can be considered “innovative” or “advanced technology” companies, they operate in a range of fields/industries:
- The “genomic revolution” and other DNA-based biotechnologies
- Automation and robotics
- Energy storage and battery technology
- Artificial intelligence
- Fintech (financial technology)
ARKK is a long-only, equity-only ETF that focuses on innovation (and usually recently floated) listed on the stock exchange companies. Sometimes these companies are profitable and sometimes not, but a large portion of them remain in cash burn mode as they continue to invest for growth.
On the other hand, HTGC and TRIN are BDCs that specialize in venture debt – specialized loans typically 2-4 years for fast-growing private companies that are not yet profitable but are backed by equity funds- risk. Additionally, they often co-invest by taking equity or warrants in their portfolio companies to gain exposure to the high returns of the handful that turn out to be the big winners.
These are largely the same types of companies that would be owned by the ARKK ETF, except that they are still private and have not yet completed an IPO. The IPO is one of the potential liquidity events that can lead to eventual capital repayment (and ideally return on invested capital) for companies like HTGC and TRIN.
In some cases, ARKK can even provide liquidity by buying IPO shares of technology companies. As such, it is important to recognize that ARKK invests in the same types of businesses, broadly speaking, as HTGC and TRIN, only those that are further along in their early growth process towards profitability.
Here are some examples of TRIN’s portfolio investments, and for many if not most of them the company also had equity exposure:
And here are some examples of HTGC’s portfolio, specifically equity and warrant holdings:
From the perspective of the stock market investor, it is important to note the difference between the primary sources of return for each investment.
- ARKK does not pay a dividend and its only source of returns is capital appreciation resulting from rising share prices of its underlying holdings.
- Both HTGC and TRIN pay out most of their distributable cash flow to shareholders as dividends and thus offer high single-digit or low-double-digit returns. Returns come primarily from dividends, but can also come from capital appreciation.
Let’s compare ARKK to HTGC and TRIN to see why investors might choose BDCs over Cathie Wood’s popular ETF.
Stability vs. Popularity
ARKK has approximately $76 billion in assets under management, which is nearly 30 times the total assets of HTGC and nearly 80 times the total assets of TRIN. Again, ARKK is a fund that owns dozens of companies while HTGC and TRIN are individual companies.
Even so, ARKK’s median stock market cap of $5 billion is several times larger than HTGC’s market cap of $1.7 billion or TRIN’s ~$550 million.
Obviously, ARKK is the most popular investment. Indeed, he has become a phenomenon in the financial world during the pandemic as his high-tech stock consolidation has benefited from the stay-at-home trend and his chief spokeswoman Cathie Wood has become an oft-interviewed oracle on the financial media. .
And yet, the massive increase in stock picking success and capital inflows that ARKK enjoyed during the 10-11 months after the start of the pandemic proved to be short-lived as ARKK completely reversed its steps. to return to its pre-pandemic level – below, in fact. Since the beginning of the year, ARKK seems to have stagnated after a loss of more than 50%.
Compare that to the price performance of HTGC and TRIN, which also lost value but not almost to the same degree as ARKK.
Zooming in further, we see that ARKK has seriously has underperformed HTGC and TRIN based on price alone since TRIN’s debut on the public markets in January 2021.
But price obviously doesn’t tell the whole story, as the main source of return for HTGC and TRIN is dividends. When we factor in dividends to arrive at a total return comparison, we find that the difference in performance between BDC and ARKK since TRIN’s IPO becomes even more extreme.
Omitting TRIN in order to go back further with a direct comparison of ARKK and HTGC over the past five years, we find that HTGC has outperformed, even after ARKK’s huge gains during the pandemic and the 25% drop in the HTGC’s share price over the last several months.
However, once the bear market is over, should investors expect ARKK to resume its massive outperformance?
There are a few reasons to believe so. Due to Cathie Wood’s outspoken defense of its strategy and investors’ fear of missing out on another rally, ARKK could enjoy a strong rebound out of the current bear market.
Again, the massive surge ARKK has enjoyed during the pandemic should also be seen as a one-time event that is very unlikely to repeat itself. ARKK has benefited from stay-at-home mandates and social distancing as well as pandemic-era stimulus money that people used to gamble on the stock market. This mod is over. And we probably won’t have another once-in-a-century pandemic for quite some time.
In addition, as interest rates rise, investors place more importance on running income rather than profits expected to come in the distant future, as is the case for ARKK’s holdings.
On the other hand, as interest rates rise, HTGC and TRIN benefit directly, as the majority of their portfolio loans are floating rate. In the first quarter of 2022, approximately 60% of TRIN’s loans are variable rate:
For HTGC, the percentage of variable rate loans reaches nearly 95%:
Additionally, both BDCs have interest rate floors on their loans, which minimizes the downside of falling rates. Generally speaking, these loans are the best of both worlds, as the downside of floating rates is limited while the upside is potentially huge.
The biggest risk for early stage companies
For all early growth companies that are still in cash burn mode as they invest to grow their business, there is a constant need to raise more and more capital. This becomes a problem when capital markets dry up and money becomes scarce.
Without the ability to raise capital at reasonable prices, growing startups can easily run into trouble.
Is this a bigger problem for venture capital lenders like HTGC and TRIN or equity investors like ARKK?
I would say this is a bigger issue for equity investors, because the inability to raise capital at a reasonable price can severely impair the ability of early-stage companies to grow, which should then result in poor stock price performance. This then results in poor price performance for ARKK.
On the flip side, venture lenders like HTGC and TRIN are in a stronger position, as venture capital-backed companies will prioritize servicing their existing obligations to avoid defaults. Preventing defaults or going bankrupt is almost always better than any other option.
Of course, when capital markets dry up, outflows of stocks or warrants may have to wait or produce returns below expectations. But this is a relatively minor part of the total returns generated by the venture debt business model practiced by HTGC and TRIN.
Cathie Wood is undoubtedly a smart person with a keen eye for innovative technologies. Its research department is among the best not only at identifying technology trends, but also at capturing the imagination and interest of investors. It’s no surprise that his confident, unwavering and prolific marketing of ARK Invest has paid off in recent years.
But it seems unlikely that its flagship ETF, ARKK, will experience another massive surge following the current malaise as it has during the pandemic. COVID-19 has created a very beneficial environment for ARKK to thrive, and these unique circumstances are unlikely to recur anytime soon.
However, investors have the flexibility to invest in companies substantially similar (often the same) to those held by ARKK while benefiting from greater stability, less downside risk, some upside opportunities through exposure to stocks and warrants of portfolio companies, and quarterly cash returns in the form of dividends.
It’s great to invest in America’s innovation machine, and at High Yield Investor, we look forward to strong returns while participating in human advancement. But there’s more than one way to do it. Investors looking for high returns and relatively low volatility would do well to dive deep into HTGC and TRIN.