Hercules Capital Inc. (NYSE: HTGC) is a business development company (BDC) that is focused on lending capital to emerging companies.

It has funded more than 560 companies and has had over 230 exits in the form of initial public offerings or mergers.

The companies it has funded include…

• Impossible Foods, the maker of the plant-based Impossible burger
• Vela Trading, which makes market data software
• Carbon Health, which provides primary and urgent care to nearly two-thirds of the U.S.

Hercules Capital’s dividend situation is a bit unique because it regularly pays a variable supplemental dividend in addition to its quarterly dividend.

For example, in March 2022, the company paid a $0.33 per share quarterly dividend with a $0.15 per share supplemental dividend. Annualizing both payments comes out to a 10.7% yield. The prior quarter, the supplemental dividend was $0.07 per share.

Hercules Capital began paying supplemental dividends in 2018, but it didn’t start adding them to every quarter’s dividend payment until 2021.

The company hasn’t cut its payout since the financial crisis. Since then, the regular dividend to shareholders has steadily increased, though not necessarily every year.

While the Greek demigod Hercules is known for his strength, Hercules Capital’s double-digit dividend yield may be too strong.

BDCs report net investment income. This is the amount of money a BDC makes from its investments. Net investment income is the metric we use to determine dividend safety for this category of companies.

Net investment income dipped from $157 million in 2020 to $150 million in 2021. Safety Net does not like to see declining net investment income. This year, I estimate that net investment income will get back on the right track and show growth rather than further weakening.

What’s especially concerning is that Hercules Capital paid more in dividends than it generated in net investment income.

In 2021, Hercules paid $176 million in dividends while net investment income totaled only $150 million. In other words, for every $1 that Hercules Capital generated from its investments, it paid shareholders $1.17.

Making matters more troubling is the fact that the dividend payout is forecast to rise to $195 million in 2023 while net investment income still won’t come close to covering the dividend.

Hercules Capital can get away with simply reducing the supplemental dividend without it looking like a cut. But when a supplemental or special dividend is paid on a regular basis, that kind of strategy isn’t fooling anyone.

Whichever way you want to phrase it, the total dividend that Hercules Capital shareholders have come to expect is at risk. Unless the company’s net investment income surges beyond expectations this year, there is a high risk of a reduction in the total dividend.

Dividend Safety Rating: D