A BDC Pair Trade Opportunity By Hecrules Capital And Ares Capital

The article identifies a recent mispricing between BDCs Hercules Capital (HTGC) and Ares Capital (ARCC), positing that HTGC is now undervalued relative to ARCC despite its historically superior total return and total return on NAV, and strong underlying portfolio quality. A recent earnings report catalyzed a significant correction in HTGC's premium to NAV, creating a potential long HTGC/short ARCC pair trade opportunity. Upcoming earnings reports for both companies are highlighted as a potential catalyst for this valuation mean reversion.

Analysis

A significant valuation mispricing has emerged between two historically top-performing Business Development Companies (BDCs), Hercules Capital (HTGC) and Ares Capital (ARCC). Despite HTGC's consistent long-term outperformance in total return and a superior total return on Net Asset Value (NAV), its valuation premium has recently collapsed. A negative earnings report in mid-2024 served as a catalyst, driving HTGC's premium to NAV down from 90% to approximately 60%, while ARCC's valuation has risen. This has caused the relative valuation spread to swing from three standard deviations in favor of HTGC to three standard deviations in favor of ARCC. Critically, this price correction appears disconnected from fundamentals, as HTGC's total return on NAV over the last year has remained strong, even exceeding its ten-year average and surpassing that of ARCC. Furthermore, credit assessments based on Moody's methodology indicate both companies maintain similarly high-quality portfolios, suggesting the valuation gap is not justified by underlying credit risk. The upcoming earnings season is positioned as a potential catalyst for a mean reversion of this valuation anomaly.

Key Decisions for Investors

• Consider establishing a pair trade with a long position in Hercules Capital (HTGC) and a short position in Ares Capital (ARCC) to capitalize on the potential normalization of their historical valuation spread.
• Closely monitor the upcoming earnings reports for both companies, as they represent the most likely near-term catalysts to trigger a convergence in their relative valuations.
• The viability of this trade depends on HTGC's continued fundamental strength; investors should verify in the next report that its total return on NAV has not deteriorated, confirming the thesis that its price decline was a sentiment-driven premium correction.
• For investors cautious of HTGC's absolute valuation, an alternative strategy is to short ARCC against a long position in the broader VanEck BDC Income ETF (BIZD) to play ARCC's overvaluation relative to the sector.