Good day, ladies and gentlemen and welcome to the Hercules Technology Q2, 2010 Growth Capital earnings call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions). As a reminder, today's call is being recorded.
At this time, I would now like to turn the conference over to your host, Mr. Jason Gold. Sir, you may begin.
Thank you, Joe and good afternoon everyone. On the call today are Manuel Henriquez, Hercules Co-Founder, Chairman and CEO; and David Lund, the company CFO. Our second quarter 2010 financial results were released just after today's market closed. They can be accessed from the company's website at www.htgc.com. We've arranged for a taped replay of today's call which will be available through our website or by using the telephone numbers and pass code provided in today's earnings release.
I would like to call your attention to the Safe Harbor disclosure in our earnings release regarding forward-looking information. Today's conference call may include forward-looking statements and projections. We ask that you refer to our most recent filings with the SEC for important risk factors that could cause actual results to differ materially from these projections. We do not take any obligations to update our forward-looking statements unless required to do so by law. To obtain copies of our latest SEC filings, please visit sec.gov or visit our website at htgc.com.
I would now like to turn the call over to Manuel Henriquez, Hercules Co-Founder, Chairman and CEO. Manuel?
Thank you Jason and good afternoon and thank you everyone for joining us today. I'd like to start off the call by providing a brief summery of our operating performance and results for second quarter 2010, as well as my customary observations on both the venture capital environment, the overall landscape and compatible landscape and then turn the call over to David Lund, our CFO, to run some more specific performance numbers for Hercules in the second quarter.
To that let me first begin by saying that, as we indicated to you in the first quarter, we have continued and remained focused on building our invested portfolio and continued to with our desire to build our earnings growth to start increasing our dividend.
Thanks to the hard work of our employees, you say this manifest itself with over $217 million of commitments closed during the second quarter alone. When taking to account what we did in the first quarter towards commitment, we are not at a run rate, not seen since the second quarter of 2008.
A very impressive loan origination effort, while the rest of the colony continues to grow out of the recession period that we were in, in a very slow pace. To that end because of this asset growth that we've seen, we recorded $6.9 million of net interest income or NII for GAAP earnings of approximately $0.19 per share.
Total invested assets at the end of the quarter were $435 million and we are well positioned for growth for the second half of the year with both a very robust pipeline of over $1 billion in opportunity, this suddenly after harvesting over $217 million of transactions in the second quarter.
This should give you some indication of Hercules continued dominance or I should say continued growing position within the venture capital landscape as one of the largest venture debt providers in the market place,
This growth was also helped fueled by our recent and final approval for a second SPA license for $75 million. A process by which we had anticipated to have fully by the first quarter 2010 and the spilling over to May of 2010.
That said, we're grateful with our continued relations with the SPA and more importantly a very long terms stable source of growth capital to fuel the Hercules business as we look to the future for continued growth.
On the credit side, given the continued softness that we're seeing in consumer spending and giving the anemic economy that we're still seeing in market place, we very strongly that our investment in Spa Chakra, and investment that we worked very diligent through the bankruptcy process to help the company emerge our of bankruptcy, continues to show signs of languishing or inability to be able to get itself into a cash slope, positive growth business, because of that, we're forced to make a very different business decision and investor decision as to weight the differences of continue to support the company or re-evaluate strategically alternatives.
Given our concern about long term consumer spending, we though that was prudent to put the Spa Chakra investment behind us and we took measures in the second quarter of fully running down that investment to cause no further distraction for Hercules NS team on a go forward basis, since it's performance out of bankruptcy has been anything but stellar.
I'll be happy to answer more questions on that in the Q&A. On a non accrual side our non-accrual status remains flat to insignificant on a fair market value basis on assets. It basically 0.01% or insignificant in terms of non-accruals, which further validates our continued credit performance.
Overall, I am extremely happy to see the overall credit performance of the portfolio. I think that many of the credit issues that we had concerns about are now behind us. This does not mean we're not working through some of the credit issues that we have in some of our companies.
Most of the transactions have been written down, including Spa Chakra, may in fact re-come up as recoveries as we decide on different strategic options to take for those companies as we go through a more in-depth analysis on which directions the company may or may not go in and if they are able to close additional runs to equity capitals.
In terms of our investment efforts, I am happy to say that as we announce our shareholders, we have now completed $3.5 million stock repurchase at an average price of $9.60 a share which is significantly above today's closing price of approximately $10.40 a share, making those investment -- making those open market purchases accretive to our shareholders and turning out to be a very effective use of investment capital that we have available to ourselves.
Our Board of Directors declared an additional dividend -- another dividend of $0.20 per share in the second quarter, further showing strong indications and belief that dividend growth should and will continue throughout the remainder of 2010.
Now, no conversation regarding Hercules performance is complete unless we speak to that of the venture capital performance which is a critical part of the Hercules business model and should be understood by all investors because it's an integral part of what we do. Now, there are many good news in the venture capital community, many of which I am extremely happy about and encouraged to see as the market continues to gel and seeing technology companies, in particular, leading the charge of IPO and M&A activity.
More specific terms. The venture capitals invested $7.7 billion into 744 transactions in the second quarter of 2010. These, by the way represent a 26% increase over the same period of last year. Further to that, capital deployed by certain stages is another area that we spend and focus quite of bit of timeline.
Very much emulating the same performance of Hercules portfolio, we saw the venture capital community deploy approximately 60% of its capital into later stage deals which is up 56% from the prior quarter. This is very similar to the Hercules investment criteria. Seed in first round financings by venture capitals was up to 15% of total capital deployed -- was down to 50% of total capital deployed, while second round financings were basically flat quarter-over-quarter.
No surprise, and no difference in our portfolio, technology and life sciences continue to glean the lion share of all the capital invested by the venture capital community with the third category in areas which I am happy to report that we are now moving more attention towards clean technology, which in turn will see approximately $1.1 billion of the venture capital dollars financed in the second quarter.
Now liquidity, liquidities are an integral part of the ecosystem of the venture capital community. The venture capital have themselves required liquidity to be able to return back to limited partners, and those limited partners in turn return that to the venture capital community in the form of commitments.
So, liquidity in the second quarter. During the second quarter, we saw or say the industry experienced 15 IPOs which is up from three at the same period last year. Those 15 IPOs weighs approximately $900 million in IPO proceeds, making it the highest level that we've seen since 2007, a highly encouraging sign.
This sign is very encouraging because Hercules in turn has four companies currently IPO registration and hold warrant positions in over 80 venture stage technology life sciences companies, making it a high candidate for liquidity and harvesting realized gain as well as warrant portfolios in the coming quarters for years starting to market conditions.
I am proud to say that even this week, we had one of our portfolio companies, Horizon Pharma, formerly known as Horizon Therapeutics, filed with IPO yesterday as well as we have currently registration Everyday Health, Nexx Systems and Reply.com, all of which filed an active as one registrations away to go public. This is a very encouraging sign and continues to provide optimism as look to harvest capital gains from our portfolio and continue to organically grow our book values by some of those gains.
However, we have to be cautious because the IPO market is fairly skittish although it is certainly looking promising, we must be cognizant that the IPO market may change and clearly the passage of thin ray and the on-going challenges of venture stage companies related to saw it, continue to pose a challenging environment for many of those companies to continue to pursue IPL liquidities.
On the M&A input; despite some of the media, concern out there, M&A activities are quite healthy and M&A activity continues to remain very, very robust in the marketplace. There are approximately 79 M&A transaction that took place in the second quarter of 2010, obtaining liquidities of approximately $4.3 billion which is up by the way, from 2.9 billion on the second quarter of 2009. It's a very encouraging number but clearly not what it is from historical rate on a run rate that years have shown close to 14 or $15 billion in M&A activities. However, any M&A activity is encouraging in itself. Asset quality related to our portfolio.
Basically, our risk-related credit rate in our portfolio is flat quarter-over-quarter. Q2 was 2.33 while Q1 was 2.35. The minimum of change in the credit performance of the portfolio which is further indicative of our confidence in the direction of our credit performance and our expectations for our own of book.
As I spoke earlier, we have written down Spa Chakra a decision it was I think it's prudent because it simply requires to believe that consumer spending will materially improve which will have lift the performance as Spa Chakra.
At this point, our confidence in consumer spending is not so rosy and we have concerns of a consumer recovery is much more in the [mix] and much more longer to take shape than most analyst may expect in the marketplace.
Given those statements, we've note that as investors, it make sense to reevaluate our investor's strategy at Spa Chakra and get the investor behind as we evaluate multiple strategic options for the company. I will be more happy to report on this further in Q3 as we conclude our strategic analysis of which direction to take the company in.
That said, the remaining credit performance of the company is quiet strong and very, very good. Liquidity position, despite our efforts on trying to put capital work, we find ourselves still in a very solid and high liquidity position with over $210 million of liquidity, making us well positioned for a continued asset growth in the second half of the year.
Our investment base continues to be quiet strong, our pipeline remains quiet strong and we're looking to leverage our balance sheet further as deterred to the second half of the year and continued to make investments for earnings growth.
On portfolio acquisitions, many of you may recall in Q1 we made it aware that we were actively looking at buying a portfolio of one of the other BDCs in the market place. I am happy to say after extensive managed due diligence and conducting significant evaluation analysis; it is unfortunate to say that our evaluation methodologies did not coincide with the expectations of evaluation of the target that we're evaluating.
As such we have concluded that pursuing any additional acquisitions with this particular target did not make sense for us to pursue and we cannot come to terms on evaluations that we felt that were reasonable and reflected the expectations of risk which Hercules felt was the underlying challenge of the portfolio. With that said we have concluded the acquisition analysis that we did enough of the target, but we remain open on evaluating other opportunities that may comet o fruition over time.
Growth initiatives, I have to once again reintegrate our strong interest in continuing to build our portfolio and our desire to continue the controlled yet growth of our new originations. Again we have finished the second quarter with over $1 billion of investment opportunities this in itself speaks to the leadership position and the brand awareness that the market place has been with Hercules technology as a source of deal flow.
We are very grateful to venture capital sponsors, who continue to refer transactions to us and we continue to evaluate those inventive decisions to ensure that we find a match between our risk reward desires and return for what we believe the capital at risk should translate in to returns for shareholders.
That said, diversity remains a critical tenant of our strategy. I'd like to remind everybody that we spend in-ordinary amount of time looking for diversification in our portfolio by geographic region, venture capital sponsors, state and development of our companies and of course sectors which include life sciences, clean technology and of course lower middle market.
All those help serve to have a very balanced well diversified portfolio to help mitigate risk in different economic cycles and we will continue to consciously look at the balance within those diversification to ensure a well balanced portfolio.
With that end, I will like to turn the call over to David Lund to discuss our financial performance from liquidity position and then in short David and I will be happy to answer any questions you may have, David.
Thank you Manuel, between our new loan pipeline, credit quality and liquidity position we believe we remain in the strong portion to grow our portfolio during the remainder of 2010. Today I'd like to focus on a few key areas, in particular, summery of our current quarter results and operating metrics and liquidity and capital resources. During Q&A Manuel and I will be more than happy to respond to questions you have on other operating results that I do not specifically address during my discussion.
To begin, I will touch on second quarter results. We closed over $217 million in new commitments, up 128% from approximately $95 million in the first quarter and as a result, we have increased the total investment portfolio during the second quarter by approximately $52 million or 13.6% to $431.5 million.
Our diligence in adding high quality assets has resulted in the growth of our total investment income by 15.8% to $14.5 million in the second quarter of 2010. Our net interest margin increased to 11.3% in the quarter from 9.3% in the last quarter due to the conversion of our cash asset into higher yielding debt investments. We anticipate that we will maintain a NIM between 10-11% as we built the portfolio in the coming months and quarters and grow our investment income.
Our effective yield on our debt investments during the quarter was 16.7% compared to 14.5% in the first quarter of 2010. This improvement was driven by one-time fees and net in the portfolio.
Turning to operating expenses, during the quarter, excluding interest expense and loan fees, our expenses were $5.3 million as compared to $4.6 million for the first quarter of 2010. This increase was primarily attributable to new hires and increases in the bonus accruals and stock based compensation.
Our Q2 net investment income was $6.9 million or $0.19 per share for the quarter as compared to $0.16 in the prior quarter, a 19% increase quarter-over-quarter. I would like to note that we have three loans on non-accrual at the end of the first quarter, representing less than of 0.001% of our debt portfolio at value, which was flat for the first quarter.
Turning to liquidity, we believe our solid liquidity and capital resources positions us for good portfolio growth. I am pleased to confirm that we were approved in May by the SBA for our second SBIC license that would allow us to borrow up to an additional $75 million in the debenture program.
As of June 30, we have over $210 million of liquidity comprised of approximately $53 million in cash, access to $50 million of borrowings under the facility with Wells Fargo and approximately $20 million of borrowing capacity with Union Bank, subject to advance rates, and approximately $88 million of capacity under our two SBA licenses subject to regulatory limitations. In addition, our only debt outstanding was approximately $137 million under the SBA first license that we have.
I would like to remind our investors about the amortization of our portfolio. Our normal principal collections are approximately $20 million to $25 million for the quarter. However, we are unable to forecast with clarity what early repayments may occur during the future periods. For example, we had unanticipated early payoffs of $30 million in the second quarter.
Potentially, based on preliminary notifications from our portfolio of companies, we could receive $25-30 million in early payoffs in the third quarter, but these repayments are at the discretion of our portfolio of companies. We believe our liquidity position based on available capital and principal repayment as I have just discussed, places us in a very advantages position to invest for the remainder of 2010.
Turning to our dividend, we distributed a dividend of $0.20 per share during the second quarter and as announced today, we have declared a $0.20 dividend payable in the third quarter. As Manuel indicated earlier, we expect to continue to see earnings growth over the next several quarters as we grow our investment portfolio which should result in a higher dividend growth for our shareholders.
Turning to our share repurchases program. Because of our sizable liquidity position, we thought it was prudent to use our capital to repurchase our common stock when the price was below NAV, which was accreted to our shareholders. During the quarter, we repurchased approximately 377,000 common shares at an average cost of approximately $9.17 a share.
In conclusion, we believe we have laid a very solid foundation for continued growth. We have a robust pipeline and an enviable liquidity position which we will continue to leverage as a competitive advantage. Operator, we are now ready to open the call for questions.
Thank you sir. (Operators Instruction). Our first question comes from [Jason Heck].
I see that's me as a -- one of my long lost cousin is in on the phone, it's John Hecht.
Hi John, how are you?
The question I -- good, how are you doing?
Question on Spa Chakra you led mid down to zero but it sounds like you're still operating it, you may get a recovery, might that require another line of credit just from the deficit or how are you guys, how does that business fund itself at this point?
Sure, the real issue is Spa Chakra, it was -- when you look at the continued lack of consumer spending and given it's a retailed play with consumer point, we just feel the traffic on discretionary consumer spending, it's just not there. The company is performing okay, it requires a continued support of capital, the form that we have with the investment is that unless I see a tangible turn on achieving significant cash or breakeven on its own in a short period of time, it's in the investor part [how] to divest ourselves from. We have strategic very strict options we are evaluating right now and I just saw that the continued distraction on the business that do not in a our core we announced it's just not worth the continued support and distraction, as such, we're looking for options but yes, in the interim, we will continue to support the company as we evaluate different strategic directions that the company to take.
Okay and then the -- but you referred the potential acquisition that you evaluated -- was this strategic acquisition or is it a smaller or just a portfolio purchase and I guess addition related question would be, you know, how was the competitive market now for new loans?
That's exactly one of the key drivers that we felt very strongly about when we're evaluating the underlying target. It became when we have flush service liquidity that there is no way that I would ever go and do $400 million of origination one quarter if you will. So, the best way to achieving continued conversion of that liquidity into earnings assets for our shareholders was in fact well to get buying a potential portfolio to accelerated that. However, the continued strong portfolio, strong pipeline that we have and the yield of those new asset that we're looking to build onboard, clearly may be the investor's decision to continue to pursue a portfolio acquisition that wasn't to priced to yield, what we felt was a risky award with what we get in the market place, didn't really continue to make sense for us. Not only that, that the strategic synergies that were initially foreseen to be able to be had with that acquisition upon further due diligence quickly became to unravel making the whole investor decision on the acquisition questionable in my mind given the pipeline of opportunities that we have without the headaches and baggage that usually get with an acquisition.
So with that we decided that the strategic advantages of the acquisition no longer out weight the cost of doing it and the pipeline was so robust that felt that our capital can be deployed at a much apperceive rate for a shareholder to buy, could easily originate our own credit quality that we are confident -- that we are more confident in.
Okay, final question and this just me trying to understand the semantics of the business. What's the difference between a unfunded debt commitment versus a closed debt commitment, there's two different figures you mentioned for each of those in the press release.
Sure, as we used to do in 2007 and 2008, and now I'll reintegrate this for every quarter for a while to orientate investors on the sublease of our business model which is materially different from that of traditional BDCs.
For example a judicial main stream BDC that invests in lower market or middle market companies, when they think of pledging a capital to a company it is often times that that capital is fully drawn beyond that close.
In our situation our capital is committed to the companies and historically we will be only be drawn down to around 75% to 80% of that commitment. And that commitment will be drawn down in to earning assets generally over a period of three to six months. So you have the spill over that we now offer transparence purposes we believe it's quiet important and frankly investors should focus on it, is what we released as called unfunded commitments.
Unfunded commitments serve to give you or give our investors a gauge of essentially what we be equivalent to called backlog of funding what will happen but with the preceding three to six months period of time. So the $99 million or so in backlog in unfunded commitments gives you high visibility to assets that come on the books and Q3 and in early part of Q4, already they are in house.
Commitments on the other hand is a pledge by which Hercules will give you capital, so long as the due diligence process holds up and the legal documentation process holds up and the rest of warranties by which the company indicated that they were giving us warranty's will hold up and you get to a final agreement called a loan of secure agreement which then comes into a fully committed funding obligation in our part.
So there is a very big distinction between commitments which are basically signed term sheets, pending due diligence to what's called closed commitments that are funded and they have a tail called unfunded, excuse me -- the unfunded amendments of $99 million that we have today. I don't know a response now but it's a little.
I understand it now. I think it's clear and I appreciate the answers.
Sorry for loosing my voice there.
Our next question comes from Troy Ward.
Just go back to Spa Chakra for a minute, you made the comment that it's not in your core real house, that's why you got move away. So, that obviously backs the question of why is it in your portfolio. Can you just explain the history of buying that investment in that and quite honestly why you made it?
Sure. Well, first of all, the investments were made in 2008. So, it's by no sets of imagination, something that's brand new. It's been in the portfolio for 2008. The investment thesis in 2008 was the investment thesis today given the changing economic spending and the emergence out of this recession that I would I have told you in April, May look a little more encouraging than it did in the probably to the March to April than it did in May to June to July. What we had and of course we saw the debt debacle in Europe, you had the continued soft spending on consumers. And I just felt very strongly that the likelihood of that company to tune to fully recover on a cash sustain basis, that we would require to be is pay for something that's better served by maybe another private equity house who wants to buy and own a consumer asset and its just not what we do.
As to why we did it, at the time in 2008 it was one of our thesis that prior to the economic recession that took place, it was something that we were looking to put capital to work in the consumer spending side. I have made historically many investments in consumer spending including Dick's Sporting Goods.1 and various other retail box plays and retail companies that makes sense.
But at the end of the day, Spa Chakra was also a holistic play that saw a resell play and it turns out that the change in economic environment, the investment didn't make sense. And what we do professionally is that we have to make evaluation decisions as to whether or not to continue to support a company un-feathered or to make a conscious decision to move on and I think this one is one that we're valuing strategic options for. There are potential interested parties in buying the assets of the company and we'll make determinations of what to do with that company over the next 30 to 60 days.
And we're looking at the March 31 carrying cost on that revolver and I have seen your piece, I believe it was. Did both of those get taken down to zero?
Yeah, right now, effectively today as the carrying cost of Spa Chakra is zero on our books. I feel very strongly that I wanted to get this issue behind us and if in fact we end up selling the company, if we in fact end up restructuring it or reaching a joint-venture agreement or what, there is a lot of things we're looking at the company right now. That would translate into accretive recovery for shareholders. But given what I know today and until we get our arms around to change the directions of the company, and it's total capital needs, that it will require to pursue this different options. I felt that it was better to just get it behind us. Have it on the books of zero, and anything that's recover from that will be a gain for our investors.
Thanks and then on if we just look at kind of your history of strong performance, it's definitely been in technology and biotech and the VC community, how should we look at you going forward, continue to make modest talk about middle market and even looking at a BDC portfolio, how should we think about your strategy going forward from the lending perspective?
I think that's a fantastic question. And let me be straight up on my response. I have a lot of amount of concerns of what I am seeing in lower middle market and middle market companies. Maybe, we just don't get it. I don't understand we're seeing ridiculously increase in leverage in a more middle market, we're losing upper financial covenants and tighter spreads. May be we are not disciplined enough to understand those faulty but to me, I don't understand why underwriting greater risk and a lower yield with no to no covenant protection. Call me silly but I don't get move in the market on some of the deal that we've had, we've just simply walked away from it. We walked away now from $40 million on signed term sheets and lower middle market transactions that I just don't understand and I'm more than accurate how the BDC is taken. We're very yield sensitive and we're very credit sensitive and we're not big fans of five-year bullets or seven-year bullets.
So that itself is part to make our model market efforts, making us competitive which is finally with me but I think that you to see as gradually more to our strain which sustained into life science and healthcare and technology that's what we're going to look for.
What is -- why do you feel an urge to even to this, I mean, quite honestly you have the strong history, do you feel like you need to expand to diversify your model. Why are you looking in other places?
No, the biggest thing is we're almost being pulled in that direction by a lot of private equity sponsors looking for us to provide capital or help fill the void with so many other BDCs which have their own financial challenges I should say. We look at it, we're probably not -- for non-technology lower middle market, middle marketplace they book you for a five-year bullet loan or seven-year bullet loan. We're not a candidate for that company. That's actually on a -- it's not -- its how we're doing to do and we don't like that business.
Thanks. That's actually comforting and then just one last follow-up to John's question earlier about the portfolio and the other BDC. We just want to know what was the name of the other BDC we missed it?
No, you didn't miss it. I our own benefit I -- we will disclose, look at -- for our own protection, they're on-going BDC and it will be a disturbance to them for me to speak out and score on their own credit and their own evaluation issues. I would say loans in this process we're looking at multiple different portfolios out there. People evaluation discipline is not as rigorous I guess I would say as Hercules. Just like evident on our being very transparent and talking about Spa Chakra and talking a write-down I am very much, I believe we're in transparency and dealing with credits as it comes up and just addressing it.
Okay, great. Well, we tried. Thanks.
Our next question comes from Vernon Plack
Thanks very much and Manuel, I'm just interested in we've talked about this issue but want to know how you feel about the quality of the investments that you're committing to you right now. I put it this way, one BDC executive has basically this was the best environment that he's ever seen and this is over a 30-year plus period. How does that feel for you just in terms of what you're seeing on the risk of work base and how does this environment compared with us perhaps modern environment.
It is certainly an environment due to military term it's a highly target environment that we're operating in. Like all targets, well, all opportunity is you need to way in the changes in the technology marketplace that are happening and although it's an extremely rich environment, I remain cautious in ensuring that although an underlying target maybe attractive, it's fundamental underlying technology, shelf live maybe limited or said differently, it is a -- the factor obsolesces of the underlying technology is quickly diminishing, making it obsolete in the next 24 months or so.
So what makes the challenge in what we do is, even though the are lot of opportunities our there, doesn't mean those opportunities make sense. Now the benefit that we have is that, so long as the technology obsolesces doesn't implode or become reality in the 36 months or 48 month window, since our investment from a debt point-of-view makes it a great return.
It's has ample time to amortize the payoff for debt, what is does is, is place this pressure on the warrant that we have in those companies if you will. So even though we have robust pipeline in all kinder that $1 billion pipeline will probably translate into certainly 200 million to $250 million of closed transactions, meaning three quarters of those companies will probably go away because we have concerns about the technology device cycle that we are in or the public competitive landscape on technologies that are emerging from those public companies.
The problem is -- existences in this market place. By lack of liquidity in the IPL window, it allows established technology companies to catch up with R&D, where by in a very robust ideal environment, that technology companies, the (inaudible) technology companies could continue to accelerate it's growth and receive large amount of invented capital dollars because it can move faster, it's secure at that strategic position with it's disruptive technology, that in a slow growing economy favors that of larger companies.
Okay, that's great insight, that's great, thank you, a few others quick questions. Just so that I understand, it looks like you need to push another 12.5 million into your SPIC sub to have full access to your available SPA debt.
Yeah that correct, we've got $25 million invested at this point and we need to downstream another 12.5 to fully leverage the $75 million that's available into the program.
Okay and have you thought about maybe going to the SBA and asking for a waver?
Certainly putting the $12.5 million down into this particular entry, well we would reinvest it anyway. It's not initiative for us. I think that we would easily do that and be able to leverage the full 75.
Let me -- there seems some confusion in the SBA, the down stream of the talk contributed to equity capital; we won't lose at all, any kind of power in that capital. That capital is easily deployed, in fact by putting $12.5 million in as you rightly know we would have lost $24 million as leverage.
And we'll just make that happen probably in Q3, surely by early Q4.
Alright and just one final question that relates to the -- you've talked here recently about building infrastructure, I'm just curious in terms of where you are now, are you still looking to build staff and grow the company?
It think it's safe to say that as we had build some staff earlier on the lower middle market bench, I think that one factor is become very true as who Hercules is versus other BDCs at other cultures, and that's a very simple comment which is, Hercules is a credit shop. And if you don't have a hard core credit background in underwriting, just like five year, seven years bullet loans don't make sense for us, candidates that don't have a strong credit bench are probably not candidates that would thrive and grow at Hercules. With that said, we continuously are looking to add skillful talent, but our screens on hiring people is equally as rigid as it is in our originations efforts. You must have a very strong credit bench or it's not a shop that you are probably going to thrive in.
Alright, but you're still looking for people?
We are but the pace of growth is probably slowed. I have significant capacity in-house with our highly experienced origination teams. I have very, very strong quality people in this organization, as they have shown their credit performance. These people know this asset class very, very well.
Okay, that's great. Thanks very much.
Our next question comes from Jason Arnold.
Hi, guys. Good afternoon. Nice job this quarter. I was just wondering if you could share with us where you're seeing lending demand concentrated? Is it more in the life sciences in to the equation or tech end? Maybe just some broader thoughts here on low demand?
Well, the greatest demand right now that we're seeing is clearly in the cleantech sector. It's probably by far the greatest in demand. But we're going to foray into the cleantech in a very controlled way, making the cleantech, I just think of sidebar. Cleantech is sensibly an all encompassing definition of project finance, enabling technology platforms. It means a lot of things to a lot of people. And this cleantech really requires a lot more scrutiny underneath the hood, exactly what it means. But cleantech is definitely a large driver with demand. We're seeing unprecedented demand for healthcare.
But again, I would say that, we have purposely pull back a little bit on Healthcare or is it life sciences. It's not that we don't like it. We think that a lot of life sciences companies are well valued. And I think that there aspirations for capital that's being requested by them compared to the equity capital underlying the companies, we think it's is a bit of disconnect and we think that they are approaching a bit of over-leverage. So, we are kind of taking a hold on life sciences -- active life sciences investing over the next remaining quarter or two.
It's not that we're not going to continue life science investing. But I think we are going to manage the portfolio somewhere to the tune around 30-35% of total exposure as opposed to let it creep up the 45 - 50% right now. And we see other guys, other firms out there really trying to back fill, what demand we're not filling. We're fine with that. We're not bothered that some of these life sciences orders have been filled that we can't. We consider the extremely sharp and low yields. We are fine letting those goals.
Makes sense. So, just the difference between the fill and the 45-50% versus the 30-35, is it safe to assume to that fill on there maybe on cleantech?
No. We still had some portfolio exposure and we would continue to have portfolio exposure in lower middle market. We are -- there's no question that will cautiously looking to divest ourselves some pure lower middle market consumer type loans in our portfolio. You'll see that happen over the next quarter with you further and I think that we're going to focus on much more on a comfort zone in our knowledge will house which is technology healthcare and life sciences.
That's where I think you'll see us concentrating more efforts on but when we reach the pure play consumer pipeline, it's going to be hard to really get also excited about it.
Okay and then not to beat a dead horse but looking back to the Spa Chakra, looking back to the investment decision making processes, is there anything that you would point to that you might do differently next time or just a simple a case where you head the business is in the place at the wrong time and wonder being a loss.
Look at. I've been just for 25 years and history is a student for all of us to learn what to do better and how to further calibrate your investment (inaudible) and the answer to that is it's a perfect storm. In 2008, we'd anticipate that the consumer spending in 2010 would be as severe as it as it is and languishing the way it is, a double recession risk continues to be a problem.
The fundamentals of the company are still very interesting. The real issue for this Spa Chakra is how much more time do you want to give it and that's more a private equity investor decision, not only due in terms of our decision. We support companies whose bankruptcy, which we felt that the economy was improving and we are able to bring out a bankruptcy, refinance our debt out with private equity and move on.
The fact of the matter is the economy sputter on us further. The company recorded a little more capital than they wanted to and it's not in our core wheel house. This is not we'll make investments to own 100% of these companies. It's not our business model.
As such, we felt that seeking a strategic partner or a private equity partnership or divesting it entirely is probably best done and rather than continuing to have distractions in our earnings call, charging it off to a zero carrying value and if we have recovery from that, fantastic, it's a credit to our shareholders but we no longer have any credit distractions or concerns to get laid to that investment.
Okay, perfect. Makes sense, thank you very much.
Our next question comes from Jason Deleeuw.
Good afternoon. The portfolio growth was pretty solid again this quarter. I'm just wondering in other word, the midway point will head after the year, is there been any material change and how you're viewing portfolio growth for this year versus what you're seeing a quarter ago?
Well, the question is to parch to that I'm going to expand on that I think they're quite helpful. How do you ask me in the beginning of January, where did I expect to see the majority of our loan growth in the first half of the year, how to respond it back in January, saying lower middle market. And the second half of the year, I would have said venture states companies. Clearly today, primary it's my own desire to refocus back into our wheel house is venture is the leading charge of our growth. Venture calculates are deploying capital. Our brand and our market positioning allows us to have the ability to cherry pick a continue look at good adventure job there. So as we turn to the second half of the year, the discipline must be congestive of for loan growth is liquidity and clearly our preference would be to leverage the balance sheet first.
We extensively have no leverage in our balance sheet when you exclude the existing SBA debt. We have not taped Wells Fargo; we've taped Union Bank California. I can assure you that both of those lines will be drawn in the preceding third and fourth quarter.
So I look to first, continuing to secure additional line to credit to grow our portfolio and leverage our balance sheet further, but as I continue to evaluate a very strong pipeline, there is no question that an equity capital raise over the proceeding one to two, two and a half quarters it's highly probable, but it's entirely contingent upon leveraging that balance sheet, the overall equity capital markets and the most important of all a very rich yield-to-price pipeline that we convert to good earning assets.
Today I acquired a $10 million liquidity, there is no immediate rush to do anything, which is a great place to be and a very, very good pipeline of opportunities and I feel and continue feeling confident that securing new lenders to join our credit syndicate is continuously more profitable then not it's is certainly taking a hell lot long than I would like to be, but I remain pretty optimistic because two of those lenders are actually engaged -- two new lenders area actually engaged in due diligence on completing there processes to provide a firm commitment to Hercules for a line for credit.
Okay, is it -- were these lenders seeking your guys out or vice versa? Can you give us a little color on how they're processing?
David Lund's and me knuckles are bloody from knocking on doors, I think that to propose to have the arrogance that lenders have to come to me, would be delusion on my part. It is a continued effort that David an I are actively and aggressively pursuing lenders, I can only wish that to "fill the dream" I will go, they will come. No I have to go our and Dave and I had to go out and pitch Hercules to these lenders day in and day out.
Okay and then what's the cost of funds on the second SBA license?
It's the same as under the current license, it's sent to your treasury with the spread on it.
Let me phrase it differently, it's the same formula as the first license, it will no stretched imagination be priced as we have the first draw downs. It is typically expected to see the first SBA -- the second SBA license borrowing cost will probably range from 4 to 5% range, while the first license ranges from ranges from 6 to 6.5%.
Thanks that's very helpful.
Our next question comes from Henry Coffey.
Good seeing everyone and congratulations on a good quarter and the obvious questions come up her couple of times. As you look around the horizon, are there any sources of leverage, whether they are conventional or not or maybe it's an even different model where you get into an outsourcing mode or something. Is there a clearer solution out there and your experience with the Bank group, back in the Citibank, Deutsch Bank days was pretty rough. Obviously, banks are the least predictable of funding providers. Are there chances that the FDA programs could be extended beyond their current size? Is there a joint venture model you could come up with, I was just wondering as you look around for more permanent funding. Do you come across anything that might really set the bell?
Sure. I can assure you of one thing. We're more than willing and actively discussing sources of capital beyond equity capital raised, for example, away from traditional commercial banks. The quote another BDC, we recently did one, Golub Capital it's probably a good example. We just completed a $300 million securitized loan package, but what's difference n Golub and ourselves, they are traditional lower middle market, middle market credits.
So, they're able to get a bid if you will in the secondary market of what the composition of the asset portfolios are. So they're able to raise those assets quite quickly and those assets become ostensibly under the new banking finreg reform, basically Class 2 or Class 1 assets. While our assets are more deemed to be Class 3 assets, meaning that we're financing not cash deposit companies as such. The reserve requirements or I should say, the advance rates against those loans becomes little more on challenging to educate a credit syndicate. Now I would tell you that I am pleasantly surprised with my continued dialogue. We are having those sources of financing for Hercules as much more three-year, five-year sources of permanent financings that we are continuing to engage in. I would tell you that my gleaning off of that requirements in that marketplace are a portfolio that's probably $400-500 million range, having a broad portfolio-cum-distribution where no single five credits make up of 20% of the portfolio. So, it's diversity. As we get larger, there is no question that we will continue and will continue to pursue those avenues, but as we break through $500 million portfolio mark and beyond, I think that those channels become much more attractive for us, which makes it probably Q1 and Q2 event for us if the market has evolved the way I think it is.
So, you think you might be able to
Well, I am optimistic that, it looks like we might be able to do that. I have not been shown the door yet, which I think is encouraging in itself. So, I remain optimistically hopeful that some sort of structured financing credit arrangement, a lot like we were contemplating with Citibank at the time where we actually have a credit facility, the warehouse facility, that it gets, filled up and then we throw it out through a term and paces itself out preceding three to five years. I think that we are back to those days. But, that market is still slowly emerging out of its hibernation.
Yes, something with the defined exit point, not a gun to the head is what you are talking about?
Yes, you use your words. I don't like the gun to the head, the loan maturities paying me off scenarios.
Well, thank you very much.
Our next question comes from Jesper Bergs.
Hey good afternoon, everyone. Look at the venture capital market and the deal flow, do you see any impact from may be possible changes in tax law especially regarding capital gains and can you just give some commentary on what you see in the market during the 4Q and then 2011?
Jesper my comment to you is surprising, how are you? Unlike traditional lower middle market and middle market BDCs are just out there. Our deal flow is not one iota, contingent upon change in the tax law for 2010 to 2011 and it's not attributed at all to changing controls where you have generational passing of companies from one generation to another that they do change controls and recapitalize the company, as you see much more traditional in lower middle market.
The what is incredible phenomenon on venture capital is that these founders have stock that are -- at de-minimum in value or simply, penny shares if you will and they're grappling with an IPL at $15 a share or $20 a share. I can absolutely -- I'm probably going to show you that the concept of capital gains does not even factor into equation as we can get liquidity for the penny stock holdings.
Actually that's very helpful. Looking at the equity portfolio declined by about $7.5 million was that mark to market changes or was that or did you some divestiture in there?
I am sorry I didn't hear the first part of your question on what --
Your equity portfolio, it's all one down quarter-over-quarter by about 7.5 million, was that fair value changes or is that due to some divestiture in the book?
Our equity portfolio today --
It's a combination of the write-down that we had with Spa Chakra offset by some additional adjustments on a per fair value basis.
The preferred equity was included in that bucket?
Yes, that is correct.
Also hardest -- just to be clear, also hardest to have gains on the InfoLogix and answertoyou.com also allowed us to do that I mean we kind of loss in the call here that we actively have sold $3.5 million of realized gains since 3.4 million of realized gains in the portfolio attribute to investments, InfoLogix as well as in answertoyou.com.
Okay, that's helpful and then lastly. I found that your commentary you just gave on possible securitization are quite interesting. And I was wondering in terms of the structures that and how your loans fit into it, specifically fully amortizing loans, I mean how would the structure have to vary? Would you need a longer reinvestment period, have you gotten into the point where you've thought about things like that and book that what portion of your portfolio you might want to secure that?
So let me -- I rub a public company. So let me first give some disclaimers. We are actively involved in those discussions. There is nothing yet that has been solidified from an LOI point of view but to answer the question this way. Some of your indications are exactly -- some of the items that need to reconciled within the various part that we dialoged with are currently attributed to exactly your question which is, because Hercules does not do five-year, seven-year boards and because our loans are rapidly amortizing. The discussions with some restructured players is which period of time will the revolving period be open to?
Would it be a one year revolving period, be a two year revolving period. What that means is in layman's terms is as amortization is paid back to Hercules and the portfolio is de-levered is Hercules able to tender new loans to sensibly keep the balance of the low pool at 300 million or 400 million or $500 million. So yes, the revolving period of time where we're -- as loans pay us off, we're able to re-originate and put new loans in that conduit and then in turns out over a three to five year period of time.
Okay, that's very helpful. That's all I have for now.
Our next question comes from Douglas Harter.
Thanks. So I was hoping you could remind us of the seasonality that you see in investing and whether you think we'll see that in the back half of this year.
Doug, thank you for asking that. It's a very, very important question given this bizarre economic environment that we're in but on a historical basis, the metrics for everybody to remember are our lowest period of originations on a historical basis and the lowest period by venture capitals historical norms is the third quarter and the reason being is venture capitalists who are on the board are generally on vacation with the children and therefore holding board meeting is a very difficult thing to do. So capital deployment decisions are really made in an insignificant size in the third quarter.
That said, the third quarter for Hercules traditionally represents about 15 of our total originations are done in the third quarter. Conversely the fourth quarter is generally 35% of the origination activities with Q1 and 2 beating the balance around 25%.
And do you expect that too hold this year?
Right now no, right now what I am seeing is that Q3 will probably be a little uptick, I think this is probably going to be in 20% range probably. We have a $1 billion pipeline; I have a good visibility on what's going in Q3. Do I think it will be disproportionably larger than historical norms? No, but I do think it will be uptick in the 15%.
Thanks and just touching on your comment about possible capital raise, I guess is the timing that dependent upon how successful you are at adding other lending partners or is that something that would likely happen regardless?
Well the real driver in that is quite simple, it continues to be visibility to high quality loan growth; new assets are been put on the books and then clearly tampered by the assets to additional leverage in our balance sheet. It is our preference to first consume our existing leverage and cap new sources of leverage for the balance sheet but the timing of that may not be as congruent as they would like it to be, to afford us the ability to say we are not going to do nothing until Q1. I think that is a very fluid time schedule between now and Q1.
If the credit lines for example will fall into place next week, well I think the answer is for our credit -- for capital rates will be significantly lower than that. I wish I can tell you like the SBA process that are accessing you availability of credit will happen in two weeks.
I remain encouraged but it won't happen in two weeks but it should happen certainly between now and in the middle of the Q4 if not sooner.
And just following up, obviously, your regulatory capital leverage today gives you plenty of capital to grow. I guess, how do you think about the -- how to sort of optimize and sort of get Hercules into sort of a more levered position to be able to increase returns?
I think that everything that you and I and the rest of the general public reads about the United States Banking community is 100% accurate. They're not lending. Here we are, a highly profitable company, an outstanding credit performance and getting a $multi-100 billion-trillion bank to give a 25 million line of credit or even a $50 million line credit is outrageously difficult if not almost impossible to be had. I can only imagine how difficult it is for a main street, small business or even a mill market business to get preferences in personal bank in today's age. I get to tell you. We saw in Q2 earnings releases, loan growth and commercial banks in this country is just not happening. And I am just don't know on how difficult it is to get commercial banks extend credit even to extremely profitable companies like we are and have been. So, I do not know what to say, but I agree to your premise of your question, it is certainly our desire to leverage our balance sheet first.
I am sorry, no further questions on the phone. I would like to turn back over to you, sir. Thank you.
Thank you, operator and I thank everyone for continuing your interest and support of Hercules Technology Growth Capital. I can assure you that, me and my team continue to work very, very aggressively, but judiciously. I am looking to continue to build assets and continue to accelerate earnings growth and eventually dividend growth. If you would like to arrange a meeting or have additional questions, please feel free to call David Lund, our CFO or myself at 650-289-3060. In addition, if you would like to arrange a meeting with David and I over the course of the next two to four weeks as we traditionally do our visit to investors around the country, please feel free to let us know, we'll be happy to meet with you if the schedule will afford it. With that, thank you very much for being our shareholders and for continued interests in Hercules Technology Growth Capital. Thank you, operator.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect and have a great day.
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