Hercules Technology Growth Capital Discusses Q3 2010 Results – Earnings Call Transcript

 |  About: Hercules Technology Growth Capital (HTGC)
by: SA Transcripts


Good afternoon and welcome to the Hercules Technology Growth Capital Incorporated third quarter earnings conference call. At this time all participants are in a listen only mode. Later, we’ll open the call to questions. Instructions for asking questions will be explained at that time. I would like to remind everyone that today’s call is being recorded. Please note that this call is the property of Hercules Technology Growth Capital and any unauthorized broadcast of this call in any form is strictly prohibited. I would now like to turn the Scott Gabel, Chief Operating Officer for Hercules. Sir, you may begin.

Scott Gabel

Thank you Sahid and good afternoon everyone. On the call today are Manuel Henriquez, Hercules’ Co-founder, Chairman and CEO and David Lund, CFO. Our third quarter 2010 financial results were just released after today’s market close. They can be accessed from the company’s website at www.htgc.com. We’ve arranged for a taped replay of today’s call as well, which will be available through our website or by using the telephone numbers and pass code provided in today’s earnings release.

I would also like to call your attention to the safe harbor disclosure in our earnings release regarding forward-looking information. Today’s conference 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 by law. To obtain copies of our latest SEC filings, please visit sec.gov or visit our website at www.htgc.com.

Now I would like to turn the call over to Manuel Henriquez, Hercules’ Co-founder, Chairman and CEO.

Manuel Henriquez

Thanks Scott, and good afternoon and thank you everyone for joining us today. I will start the call as usual by providing a quick summary of our operating results and achievements, and then follow by a few observations and discussion points on the environment as a whole and then the venture industry and the impact that we are seeing manifest itself in the investment industry to our portfolio.

That said, we completed and executed a very strong third quarter in spite of a very weak and very, very frustrating July period of time where we saw an amazing decline in activities in July and August on both new business as we as we saw manifest itself in the public markets with lack of trading.

Notwithstanding that, we actually generated for our shareholders, $8.1 million in net investment income or GAAP earnings of approximately $0.23 per share which I think at last estimate is $0.01 above the street consensus on our performance.

In addition to that, starting in Q3 of this year, we’re going to start reporting DNOI which was approximately $0.25 per share, of which David Lund, our CFO to kind of expand upon the DNOI reporting – I apologize, it’s a new word for me – to report on.

In terms of total commitments, despite a fairly soft Q3 and something that we have forewarned previously, the quarter was actually not a bad quarter. It was completed with $83 million of new commitments were executed in the quarter of which $55 million were to new companies and the balance existing companies which we renewed or restructured credit facilities.

Beyond that, we saw approximately $44 million of funding – excuse me, my mistake. We are seeing a very good momentum in Q4 as we now have seen $44 million, pardon me, of commitments that we have closed in the first month of the fourth quarter and the issue with that and why I’m raising it is that part of those transactions closed in the first week of October, and we are seeing at least in the third quarter, a longer delay in getting transactions closed that we had forecasted and anticipated closing in the third quarter, which basically closed in the first week or so of October, representing $44 million.

Beyond that, we have approximately $100 million of signed term sheets leading into Q4 and we have a pipeline that is now exceeding $1 billion and giving us very strong visibility to Q4 and Q1 and beyond in terms of closing new commitments.

But I have to once again give attention to this statement. Commitments do not necessarily reflect funding. It is frustrating for us because we cannot control the actual amount and date of fundings, but that is evidenced on our continuing building backlog you’ll see us report here every quarter, which is called the unfunded commitments that we talked about.

More importantly, we just achieved a significant milestone. Since going public, we have now reached and exceed a total of $2 billion in committed capital to venture stage and life sciences companies and technology life sciences industry.

Personally, it’s a very proud achievement and now we see over 150 companies and that would not have been done without the extremely hard work and dedication of all the employees at Hercules Technology who have worked diligently to perform very, very hard to realized these $2 billion numbers, but more importantly than the $2 billion achievement is the credit performance by which that was done.

We achieved over $2 billion of commitments to Technology Life Science companies with only $42 million in total losses net during our six year period of time, which of course, I’ll let David Lund, our CFO, provide a bit more color on that as well.

In terms of our assets, we finished the quarter at approximately $408 million in assets, slightly down from that of the third quarter, and as I said earlier, that was primarily driven by early pay offs that took place at the end of the quarter, and most of those assets have already been recouped in terms of new investments leading into the fourth quarter as we look forward.

In addition to that, we successfully received the ability to lock in our SBIC debentures at an interest rate of 3.215 on $25 million of capital. This affords us a very strong visibility to having locked in costs of capital that are quite accretive in the event that interest rates were to go up in the future.

Lastly, on our performance, the Board of Directors have once again declared a $0.20 dividend which as we continue to build our dividend and earnings, it is highly likely that we will see some form of either a dividend at the end of the fourth quarter or potential spillover as we continue to originate assets during the fourth quarter. We will periodically revisit that and make any appropriate announcements to our shareholders on that.

I am proud to say that as evidenced in our earnings, we continue to focus on earnings growth, and you’re seeing that manifest itself into that with our EPS of $0.23 in earnings.

Now, let’s turn our attention to the venture capital industry. Despite all the media claiming that the venture capital industry is dead, it is far but that. Personally, I saw that the third quarter originations were quite robust.

In fact, we were expect to see a number lower than $5.5 billion and we actually saw a number of $5.5 billion take place in Q3 to approximately 660 companies, representing a 2% increase from that of 2009. On a year to date basis, we saw $18 billion of venture capital invested so far in calendar 2010 to over 2,000 companies representing a 10% increase over the same period last year.

These are critical factors as we look to the venture industry to continue to show resilience and commitment to deployed capital to various companies in different sectors.

Now on sector specific; the largest sector receiving capital continues to be information technology, which received approximately $1.8 billion or up 35% from the same period last year, making it the largest recipient of capital during the third quarter.

Life Sciences on the other hand, the second largest category, received $1.7 billion in capital; however, it was down approximately 11% as compared to same time last year, with medical devices making up the lion’s share of that decline, being down 26% over the same period last year.

We also saw business services and financial services receive $841 million of capital, up 19% over the same period last year, while consumer services, and even evidence our own portfolio, which we have been declining consumer services, is down 20% to approximately $560 million for the same period last year.

And our newest category that we’re now breaking out and reporting, Clean Tech, also known as green technologies received approximately $359 million and although the number is down 20% year on year, it is primarily driven down lower by two large investments that were made in calendar ‘09.

Now, no conversation of the venture industry is complete without looking at the totality of the ecosystem, and that means that I’m turning my attention to venture capital exits, also known as liquidity achieved in the venture industry.

In the third period, we saw 111 venture capital companies achieve exits totaling $6.4 billion. 102 of those exits were in the form of M&A, representing approximately $5.7 billion, up 5% from the prior year of the same period.

Now, the most important part of this statement is IPO’s. Albeit on a historical basis, the IPO activity is still nascent, but when compared to the same period 2005, we basically saw a 500% increase in IPO activity in Q3, 2010 as compared to Q3 ‘09, meaning we saw nine IPO’s go effective in the third quarter raising $723 million. This is up from two IPO events in the same period in 2009.

What makes this interesting is that currently today, there are approximately 49 venture stage companies who have unfiled IPO registration statements, five of which, or say it this way, 10% of those are Hercules portfolio companies.

We currently have at the end of the third quarter, five companies in registration, one of which was declared effective, Aegerion Pharmaceutical went effective in October giving us a net four companies in IPO registration as of this call today.

These are important signs, and encouraging signs. But, let me share with you some insight after my 25 years of doing this business that are important, and I consider very, very critical details on why my optimism is running so high currently.

M&A companies are seeing a 20% decline from the first round of venture capital investment in the company through an exit event have declined by 20%. They also saw a 30% increase in more capital to achieve this liquidity event.

What is important is, if you look back to what occurred in 1993, ‘95 and ‘99, to draw some historical correlations, the tighter the compression of time to liquidity means that additional capital is needed to differentiate yourself to arbitrage the valuation differential between public coms and that of the private coms.

In layman’s terms, you will start seeing a lift in valuations of private companies to start matching the increase in valuations we’re seeing in the public marketplace. This bodes extremely well for our warrant portfolio, but also makes debt a highly sought after asset class because it’s less dilutive for companies to accelerate their windows for liquidity.

Conversely, we’re seeing a 60% decline in the time frame for the venture capital dollars invested in a company to a liquidity event, decline by 16% while the capital committed is increasing by 21%. These are actually very, very good signs and very important signs that I look to in the venture industry themselves, and I’m happy to expand those in the Q&A session.

Lastly, the environment is not complete until we see the totality of the picture and that is, venture capitalists receiving additional rounds of capital from the limited partners. In Q3, the venture capitalists received approximately $3 billion of capital to 45 funds. This is up 40% from the same period last year.

As a whole, for the year to date and Q3, $9.1 billion was invested into new venture capital funds. This data has been provided to us by Dow Jones Venture Source and Thompson Reuters NBCA data.

Now in closing, asset quality. Overall, the asset quality remained quite strong during the quarter. Clearly, we had some impairments that we chose to take during the quarter, which we felt was prudent and in keeping with the historical performance of Hercules on one particular asset that so far seems to be improving its performance, but we decided that given what we were seeing, it was prudent to take an impairment to reflect the appropriate carrying value for that asset.

Overall, we had the lowest grade five rating we’ve had in quite a long time in the portfolio today, and we’re seeing an improvement in credit quality in the portfolio.

On the liquidity situation, remains quite strong. Over $218 million of liquidity we have in the portfolio today, and that is against a growing backlog of approximately $120 million of unfunded commitments followed by the $100 million or so of new signed terms that we received today.

With that, I’d like to turn the call over to David Lund, our CFO to continue the conversation, or discussion.

David Lund

Thanks Manuel. Between our new loan pipeline, credit quality and liquidity position; we believe we remain in a strong position to grow our portfolio during the remainder of 2010 and into 2011. Today I’d like to focus on a few key areas; summary of second 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.

Let me first provide some current highlights. We closed $67 million of commitments and new existing companies and restructured one $50 million loan for total commitments of $83 million in the quarter. Additionally, at this quarter end, we have closed an additional $44 million of commitment and as Manuel indicated, we have over $100 million of pending commitments.

While our third quarter was light on origination as is historically the case, we believe these pipeline figures signal that our strategy for growth is on track for the year. Further evidence that we have turned the corner from asset protection to growth mode, is improvement in our net investment income.

Our diligence in adding high quality assets has resulted in the growth of our total investment income to $15.5 million or 8% as compared to the prior quarter. Our net interest margin increased to 12.3% in the quarter from 11.3% in the last quarter as we added high yield debt investments during the quarter.

Our effective yield on our debt investments during the quarter was 16.2% compared to 16.7% in the second quarter of 2010. This slight decrease was driven by a quarter over quarter drop and one time fees of approximately $600,000.

We see this metric, the reduction of one time fees as an additional indicator that our portfolio is stabilizing and we are entering into new quality originations. That being said, one time fees and early payments are highly unpredictable and we have limited control over when they occur.

Operating expenses for the quarter excluding interest expense and loan fees was $5 million as compared to $5.3 million for the second quarter of 2010. This decrease is primarily attributed to lower compensation related expenses.

Our Q3 net investment income was $8.2 million or $0.23 per share for the quarter as compared to $6.9 million or $0.19 per share in the prior quarter, reflecting a 19% decrease in NII. As Manuel indicated, we are disposing DNOI, or distributable net operating income, and this is comprised of our NII and then add back for non-cash compensation related to our stock options, and that was approximately $751,000 in the third quarter, and that reflected a $0.25 per share DNOI for the quarter.

I would like to note that we have four loans on non-accrual at the end of the quarter representing less than one tenth of one percent of our portfolio add value, relatively consistent with prior quarter.

As to our realized loss in the quarter, we were forced to liquidate one investment and as a result, realized $18.7 million loss on the investment. As you may recall from our second quarter call, this company was severely impacted by these unprecedented economic times and would have required significant additional capital in order to stabilize the company. This loss was fully written down on an unrealized basis in the second quarter.

I would like to point out that this realized loss brings the total net realized loss since inception to just $41.6 million, representing just 2% of total commitments of $2 billion since inception. On an annualized basis, this represents just 35 basis points based on total commitment s for the same period.

The net realized and unrealized gains and losses we recognize during the quarter were the primary contributors to the decrease in our net asset value or NAV during the quarter.

Turning to liquidity, we have maintained solid liquidity and capital resources, which positions us to meet the capital requirements of the pipeline statistics I just reported to you. As of September 30, we have over $218 million of liquidity comprised of $82 million in cash, access to $50 million of borrowings under the facility with Wells Fargo and $20 million of borrowing capacity with Union Bank subject to advance rates, and approximately $65 million capacity in our second NCA license subject to regulatory limitations.

In addition, our only debt outstanding was approximately $160 million under the FDA program. Again, as Manuel indicated, we did lock in $29 million of borrowings under the SBA program at a historic low rate of 3.215% exclusive of the annual fees.

I’d also like to remind our investors about the amortization of our portfolio. Our normal principal collections are approximately $20 to $25 million a quarter. However, we are unable to forecast with clarity what early repayments may occur during future periods evidenced by the early pay off of $30 million in the third quarter.

We believe our liquidity position based on available capital and principal repayment as I have just discussed, places us in a very advantageous position to invest in the remainder of 2010 and into 2011.

Moving on to dividends, we distributed a dividend of $0.20 per share during the third quarter and then announced that we have declared a $0.20 dividend payable in the fourth quarter. As I have indicated, we expect to continue to see earnings growth over the next several quarters as we grow our investment portfolio, which should result in higher earnings and dividend growth for our shareholders.

We also remind our shareholders that in August, Hercules extended its share repurchase program through February of 2011. However, during the third quarter, the company did not repurchase any of its shares of common stock.

In conclusion, we believe we have laid a very solid foundation for continued growth. We have a robust pipeline and 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. (Operator Instructions) First question comes from John Hecht from JMP.

John Hecht – JMP

Afternoon guys, thanks for taking my questions. A couple of things. One is, can you guys talk about InfoLogix. You talk about in your press release and you’d said there’s a fair value impact that it sounds like you recognized in Q3. Maybe can you just give some more details on that?

Manuel Henriquez

Sure. InfoLogix is a significant investor for us and a control investment for us but we got it consolidated investment for Hercules, because Hercules does not control the Board, nor do we control the operations of the business.

With that, the company most recently, on or about October 21, 22, did in fact receive its de-listing notice. It was unable to comply with the various exchange requirements to remain listed, and it fell, it actually fell through remaining compliances now traded on the bulletin boards.

With that, we own basically two classes of securities there. We have registered shares and unregistered shares and we felt strongly that the issues on the unregistered shares should receive some additional impairment in the carrying value, and those securities were written down post event given the materiality of the investment to reflect a more cautious carrying value for the security itself.

We do not at this point feel the need to make any impairment or adjustments on the carrying value of the debt instruments that we have on the company. As the company has continued to be a going concern operation and also its continued to explore numerous adoptions for itself.

Beyond that, I would feel uncomfortable getting into any additional color. That really should be directed more towards the company itself and the independent Board members of InfoLogix as opposed to me getting into more proprietary color there.

John Hecht – JMP

OK. Well I guess a little further on credit, I mean you guys had dramatic decrease in your grade four and grade five levels so I wonder if you’d comment on that, just the way you see the world from a credit perspective and how you feel about the current credit quality for the new loans you’re writing.

Manuel Henriquez

As an example, if you turn to – and if you see in the disclosure events that we have in the earnings release, we have a lot of events that are taking place close to quarter end that would have fairly accretive impact in the credit portfolio as a positive.

We have Aegerion was increased in credit rating when it successfully completed its IPO and capitalizing the business quite successfully. So that was automatically caused an increase in the credit rating attributed to that.

We also had another transaction, AVIO, also announce completion of a PIPE, further recapitalizing the company and a very strong balance sheet, which definitely makes the credit outlook for that company even stronger than we had reflected as of the end of Q3, and that’s also subsequent event that took place.

So you have a lot of events that have taken place post the quarter that would be accretive from a credit rating, credit performance point of view, that continue to develop in the portfolio itself. I’d also like to say that we are in fact aware of two additional portfolio companies of ours that have indicated to us the possibility of completing an M&A event between now and year end, but as I always do, I don’t put a lot of reliance on M&A pre-announcements until I see a much more solid footing that the M&A will be imminent as opposed to simply giving us a heads up that they’re pursuing that.

I’m encouraged by those signs clearly, but until they happen, we’re going to be cautious as we always are.

John Hecht – JMP

Final question related to portfolio trends, it sounds like you’re off to a pretty strong start Q4 in terms of commitment levels. Is this kind of a seasonal slip from Q3, people trying to rush to get things done before the end of the calendar year? And then the second part of that question is, how do you feel about repayment rates in Q4 given the trends that you’re seeing right now?

Manuel Henriquez

Sure, unlike the lower belt market, middle market, especially finance companies, Hercules’ business model is not predicated upon changes in tax laws or imminent issues in tax laws triggering an M&A event. They’re less catalysts driven and more simply seasonality that is typical on the portfolio.

Just to remind our investors both new and old that we generally experience about 35% of new commitments are experienced in the fourth quarter while historically 10% to 15%, and this year is more in the lower end, 10% is typically seen in the third quarter.

As I said in my opening remarks, July and August were horrific. There’s no way of putting it but just blatantly that way. It was just dry out there. September was certainly a lot more perky and October has been a roaring lion from business activity, and November so far shows no letup in demand for capital right now that we’re seeing from portfolio commitments, so that’s all encouraging.

Your last question related to anticipated early payoffs. Unlike the – and I use the word that I usually don’t like using – unlike the guidance or update we provided investors in the second quarter, we don’t have any visibility in the third and fourth quarter, excuse me, of any anticipated early payoffs as of right now.

Unlike in the second quarter, we had some belief on expectations of $20 to $30 million, they actually did come in, but interesting enough, it came in almost all at the end of the quarter as opposed to more at the beginning and middle of the quarter, which is why you see a strong earnings performance, but yet the overall assets are lower at the end of the quarter when you take a snapshot.

But we don’t anticipate from what we know today, and I have to preface that, with what we know today, any expected material early payoffs right now.

John Hecht – JMP

All right. Thanks for the color Manuel.

Manuel Henriquez

Thank you.


Thank you. Our next question comes from Troy Ward from Stifel Nicolaus.

Troy Ward – Stifel Nicolaus

Great, thank you. Manuel can you, just a follow up on John’s question on InfoLogix. Did I hear you correctly and say that the debt in InfoLogix is still market par and do you expect full repayment of that debt?

Manuel Henriquez

As of what I know today and the various options that the company is exploring, we feel that the carry value for the debt more than adequately reflects the ability to recover that that investor’s action in the event that we have to do so.

The mere fact on fair value accounting as it relates to the equity, we have to take into account the event of de-listing on a prospective basis as well as – and I can’t remember the whole FAS127 issue related to this – but it’s somewhat complicated.

You have to either account an event that occurred even after the quarter in consideration that had you known these variables, you adjust your fair value on your equity securities. And as a reminder to everybody, the securities for InfoLogix at the end of the quarter were approximately $4.22 and post the de-listing, the shares traded as low as I believe $1.35 and stabilize somewhere in the neighborhood of $1.75 to $2.00 a share.

We felt strongly that carrying a higher value to secure equity at the end of the quarter without taking into account de-listing would have been an over inflation of our net asset value given the events taking place on a de-listing issue, but at this point, we feel the debt is adequately covered in the enterprise value of the company itself.

Troy Ward – Stifel Nicolaus

OK. And can you remind us, a little bit of history behind InfoLogix. When was that made? What kind of the group it falls in. Is this one of your middle market loans?

Manuel Henriquez

I would say that InfoLogix is arguably a tweener – that’s a (inaudible) term. It truly is a lower middle market credit. You know the company is interesting. The company at one point had north of $100 million plus of revenues. It’s well positioned or the health care reform and it has a very good foundation of clients and the various hospitals and health care practitioners.

What has fallen unfortunately is, it has not adequately and fast enough adjusted for its capital needs to counter shifts in business that we saw develop in ‘09 and the early part of 2010. But the company is making great strides in that area, but again I have to encourage everybody to direct those more specific questions related to InfoLogix’s performance to the InfoLogix Board members and company itself.

Troy Ward – Stifel Nicolaus

Very well. And then just quickly on the balance sheet, when you think about the SBIC availability of 65 and the 83 of cash, how do you look at those two buckets as you think about putting capital to work. Obviously the SBIC next lock will be in March and if it’s anywhere near as low as it was this time, it would seem like you’d want to get a lot of that locked by March. How do you think about that?

Manuel Henriquez

Well (inaudible) people’s temper and understand that the equation is not as simple as being asked. The SBA in particular has multiple different requirements of the underlying assets to conform to. But notwithstanding that, there’s also, since we have two licenses, each license has a different cap on the aggregate securities that we place into that from a single obligor, meaning a single credit.

So we’re constantly tempering the different assets that we’re originating with a different qualification of respective credit buckets that we have, meaning we have the Union Bank of California credit bucket. We have a Wells Fargo credit bucket and we have two SBIC licenses. From a qualification point of view, the assets are the same but the size of the asset is going to be placed in license number one versus license number two are slightly different.

For example, I’ll let David answer the actual size of license one versus license two

David Lund

License one allows us to put in a loan at $22.5 million whereas license number two allows us to put in a loan the size of $11.25 million. So there are restrictions on the size for each one of these individual licenses.

Manuel Henriquez

And as to your first question, absolutely I want to maximize the earnings for our shareholders by minimizing the cost of capital in doing so. So it remains our mission to look to first leverage the balance sheet as we continue to grow the portfolio, but credits still remain quite aloof out there.

As you’ve seen, most BBC’s (inaudible) report, three particular BBC’s have decided to out the securitization route because of the difficulties in securing long term and stable commercial lines of credit from commercial banks, and we’re not seeing any difference in that and the consternation of commercial banks extending credit to companies out there. Not much has changed right now on that front.

Troy Ward – Stifel Nicolaus

Thanks gentlemen.


Thank you. Our next question comes from Jason Deleeuw from Piper Jaffray.

Jason Deleeuw – Piper Jaffray

Good evening and thanks. Just following up on what you were just discussing. Can you give us a little bit more color on your appetite for seeking out new credit facilities at this point just given the portfolio growth you’re expecting and what you’ve already done and also if you could talk about other sources of capital, equity capital. I mean what are your thoughts regarding capital needs to grow the business from here?

Manuel Henriquez

Well my thirst for leverage capital is insatiable. My ability to quench that thirst is painful. Essentially, as of Q3, we have zero leverage in our balance sheet. I would love to see us leverage the balance sheet first and foremost as we continue to build assets.

The processes by which to secure a line of credit from a commercial bank in this country remain extremely difficult and extremely elongated. We are still continuing to dance with three to four credit providers who have all indicated that they are substantially either complete or materially through most of the diligence process, but somehow term sheets don’t seem to come.

It’s a painful process. We continue to look to leverage the balance sheet first. That is our first and foremost preference. However, with a very, very strong pipeline, with continued weak competitors, demand for Hercules capital continues to increase every day more and more.

The pipeline for the fourth quarter is getting stronger. There’s a balance that we constantly walk on looking at new asset originations that are earnings accretive and hopefully based on capital that’s not book dilutive. And so our preference is to continually as we’ve now done, and just to remind everybody, the last time Hercules Technology raised capital, equity capital, was June of 2007.

We have shown our discipline to manage through and maintain liquidity through the most difficult times, but also be cognizant to our desire to continue to have earnings growth and dividend growth without it minimizing dilution to our shareholders.

Leverage is first, but we will not rule out the ability to raise equity capital, in the next, I don’t know – foreseeable future is what I would say. I mean given the fact that you have $120 million or so unfunded commitments, $100 million in signed term sheets and $200 million of liquidity, it doesn’t take much to do the math that we’re probably approaching those points.

Jason Deleeuw – Piper Jaffray

OK. That’s helpful. And then can you give us an update on the competitive environment, especially with it seems like more deals, the activity really started to ramp up in September and even more it sounds like in October. Can you just give us an update on what you’re seeing on the competitive front?

Manuel Henriquez

I guess back to more the same. Hercules has never been and nor will ever be the cheapest provider of capital. Many of our competitors that we’ve seen chose the route of being the lowest cost provider of capital out there, and as a result experienced credit losses or curtailment of their own access to capital because they either have negative spreads or no margin on their new asset origination.

So we maintain a very disciplined approach in how we originate new assets and we’ll toggle originations directly correlated to our cost of capital and our spreads in how we look at the business, and that discipline will not change much.

That said, as the liquidity markets, as I indicated in my opening remarks, seem to be accelerating, you’re seeing a more rapid desire to arbitrage the valuations that are being seen in the public markets with the lag in valuations being had in the private markets.

And this is a fairly typical arbitration that takes place. More typically we’ve seen on the wave of ‘97 through ‘99 and more seen again in 2003, 2007. I think that you’re seeing the technology take rally pretty strong recently. You’re seeing large pharma re-igniting their acquisitive interest, meaning acquisition interest, with the life sciences into private companies.

These data points all bode extremely well for our portfolio and with that, companies are now more willing to accept a slightly higher cost of capital for a more stable capital provider such as Hercules, one that had the depth, the breadth and the liquidity on a very transparent basis of over $2 billion in commitments since its inception that our venture capital partners are seeing a much more comfort in dealing with a larger player than some of these small $100 million, $150 million capital providers that exist out there that are only able to do a $5 or $4 million transaction. Those transactions are coming more and more our way.

Jason Deleeuw – Piper Jaffray

Great. That’s a benefit of being in a strong position coming out of the downturn, so that’s great. Thanks a lot.

Manuel Henriquez

Thank you.


Thank you. Our next question comes from Vernon Plack from BB&T.

Vernon Plack – BB&T

Manuel, I want to make sure that I understood you. You mentioned at the beginning of the call something about a dividend. Did you mention that there might be a special dividend at the end of the year or there’s the thought of a dividend increase or, I wasn’t exactly sure what you said there.

Manuel Henriquez

Sure. Let me not mince words and not be ambiguous. We made the policy of the Hercules Board of Directors that we want to match our earnings capability to our dividend on at least a four rolling quarter basis, is what we do.

Notwithstanding the fact that we made $0.23 in GAAP and NII and $0.25 in DNOI for the third quarter, we only paid out a $0.20 dividend meaning that it will give rise to some form of a carryover for the fourth quarter and probably some carryover that may occur with the earnings momentum in Q4 that will lead to one of two things.

Either A, the Board of Directors may elect at the end of the year to actually declare a special dividend, a fifth dividend if you will, or they may elect to simply have a spillover to be determined of anywhere between zero to one or two or three cents; that all depends on the continued momentum in the third quarter.

But our policy remains the same that we re-evaluate every year at the beginning of the year what the earnings rate will be and we establish a fixed dividend by which point we unequivocally earn and re-look at topping it off if required, or need be, at the end of the year. So that will be revisited here in the next 60 days or so.

Vernon Plack – BB&T

OK. So we should know something in terms of what you’re thinking about regarding dividend within the next 60 days.

Manuel Henriquez

Think of it as a Hanukkah present or a Christmas present that will hopefully manifest itself as the asset growth and earnings growth occur in the fourth quarter as it will signal if a special dividend or spillover is approved by the Board of Directors, yes.

Vernon Plack – BB&T

OK. Well happy holidays and we’ll be looking forward to that. Sort of a bigger picture question and I know that you don’t provide guidance, and I’m not looking for guidance per se, but one of the benefits as well as a challenge is that your investments pay off relatively quickly and we’ve been through some challenging times here lately, and with that, how are feeling about growth? Are you – should we see over the next 12 months a meaningful growth in the portfolio? I know you’ve talked about what a more normalized rate is in terms of repayments which is around $20 million a quarter, but for at least the past five quarters that number has been way above that and it’s obviously a very difficult thing to gauge, but should we see meaningful net portfolio growth over the next 12 months?

Manuel Henriquez

My response may surprise you. I see enormous growth ahead of us. My biggest constraint for achieving that growth is the form of liquidity to fund that growth, and it strongly my preference for the benefit of our shareholders to fund a substantial portion of that growth by leveraging our balance sheet, which is not leveraged today.

Not having that strong visibility or said this way, the strong confidence that I have a stable, predictable access to leverage beyond my SBA, growth may be limited by making sure that if driven by equity capital raises, those equity capital raises are done with discipline and are accretive to shareholders and not merely done as a sloppy capital raise.

And why I say it that way, Hercules is one of the few remaining internally managed BBC’s and internally managed BBC’s have thus far shown a greater discipline on ensuring that they don’t be dilutive capital raised for the benefit of aggregating assets for management fees.

And I remain steadfast in that interest. As one of the largest shareholders of Hercules, I hate dilution myself personally. And so I’m looking to drive growth first and foremost with access to leverage, but leverage becomes more and more challenging, but I am seeing signs of improvement.

Now, we got a little gift this week, and that is, if I remember correctly, the Senate had originally passed, and I may have this backward. I apologize if I do. The Senate had passed originally HR3854, 3654, I always get those (inaudible), the Small Business Lending Act that increases the SBA leverage cap from $225 million to $350 million in capital.

Now that the Republicans control the House, it is highly likely than not, that the passage of that bill should occur making it a highly accretive event whereby Hercules will be able to tap another $125 million of SBA capital at a very effective cost of capital, which would be a dramatic accretive event for our shareholders as we’re seeing assets originated in a 12% to 14% range today with a cost of capital anywhere between 3% and 3.5% more or less range.

Vernon Plack – BB&T

That’s very helpful. Do you think the repayment rate is going to go back to a normal level?

Manuel Henriquez

Well let’s talk about normal level. Just as a reminder, it’s typical when new assets are originated, on a very high level average basis, typically a new asset originated has anywhere between a six to nine month interest only, which means a big significant portion of the assets originated.

Most people don’t realize and I should have highlighted this, Hercules on track right now to have a record year since inception of the largest new capital committed in a single year, could be this year already with what’s going on right now.

That seems to be lost in all the noise because there’s so much stuff going on, but we’re on a trajectory of a record year of potentially over $500 million of new asset commitments this year, which dwarfs the majority of our competitors in the private and most recent public in size in terms of capacity, we’ll do this fiscal year alone.

Vernon Plack – BB&T

OK. That’s great. Thanks.


Thank you. Our next question comes from Henry Coffee from Stern Agee.

Henry Coffee – Stern Agee

Good afternoon everyone. Obviously making tremendous progress here. How much Manuel of your thinking, and maybe this should be transparent, your portfolio has always actually had a fairly high turnover rate, but in days gone by you had fairly regular access to liquidity, so you were able to be out there as an aggressive originator and both the liquidation of existing assets wasn’t that big of an issue because you were quick to replace that. So much of your current liquidity situation is being defined – I’m sorry – your current view on originations is being defined as your ability or inability to have ready access to funding and how much of it is really a direct function of the marketplace and where you think pricing is?

Manuel Henriquez

We are feeling the same pain that you read about in the media and you hear about in the news about main street America not getting access to credit and credit availability. It is absolutely a governor or impediment for us to realize the greater value for our shareholders because without having readily available and stable predictable leverage source of capital, I have to then look to run the business with a combination of SBA capital as well as equity capital, and as I said, I don’t want to go out and do excessive capital raises that are accretive to shareholders.

But I need to temper that of course by saying that strategically deployed capital raises, maybe doing smaller bit sized capital raises is probably a better solution than doing a large significant capital raise to deploy the capital, make it accretive and go back out again as the market improves in the credit performance.

So there’s no question Henry that the inability to have strong visibility and confidence into predictable lines of credit is serving as a governor of the growth that I’m seeing available to us in 2011. 2011 could be a dramatic year for us in terms of asset originations had we had a predictable, stable source of growth capital in front of us to leverage the balance sheet. No question about that.

Henry Coffee – Stern Agee

Could the SBA funding, should you get this second additional round, should this new bill be approved and the amount of rhetoric on this subject is amazing related to the amount of action, but should Congress actually expand the SBA program and over some relatively reasonable period of time give you access to an additional license as you’re suggesting, and I’m assuming how that would work. Would you need another license or would they just expand the capacity of the existing licenses that you have in place?

Manuel Henriquez

I think that you may have asked and answered the question on your own. I think that the notion of a third license is a concept that has been tossed around. Certainly within the many parties and many constituents, but there is not clarity as to whether or not it will be done as a third license, will be done as simply increasing the leverage from a two to one leverage or a three to one leverage or will be done by increasing the cap to 350, but maintaining a two to one leverage, which means you have to fund additional equity to give you the capital into your license.

All of these factors Henry, are totally unknown at this point and I would wish that our newly elected legislators would get their act in gear and help this country get back in doing what it does best and get capital flowing to all parties because we are seeing an inordinate amount of opportunities. We could help companies grow and get employment going again, but this constraint on capital is a problem.

Henry Coffee – Stern Agee

But under the assumption that this door was open to you, do you believe that you could build a viable business model around SBA lending given some of the restrictions that are inherent in these programs or do you think you would still be struggling with the current situation.

Manuel Henriquez

I think that a way of looking at it as a really simple math, if you look at the Hercules organization and you presume that we have for example, 12 originators or 14 originators if you will and each have the capacity say for example, 40 $30 million, whatever number you want to choose, you’re looking at the ability to do $500 million, $600 million in new assets next year alone with the embedded capacity we have today for origination machine.

So therein lies the rub. It is our preference to go out and attack a market in 2011 to the tune of three, four, five, $600 million a year, even more if you will, but we’d rather leverage the balance sheet, which is zero leverage today.

I have the ability to go up to something like $360 million of leverage without taking our any of my BBC’s one to one ratios. I can easily exhaust that capital. Then you lump on an additional $125 million from the SBIC program that gives us visibility to say for example, $480 million of new loan capacity of which I expect to generate between $20 to $25 million a quarter in amortization.

However, by Q3, Q4 of next year that number would probably in the neighborhood of $25 to $35 million in amortization. So it’s a toggle that is completely contingent upon the legislators from the SBA point of view, which would be highly accretive, and the various large commercial regional banks that we’re talking to on releasing liquidity in the form of leverage to us that would further accelerate the growth that we’re seeing in front of us.

Henry Coffee – Stern Agee

Thank you.


Thank you. Our next question comes from Jason Arnold from RBC Capital Markets.

Jason Arnold – RBC Capital Markets

Hi guys. In terms of the new investment opportunities in the pipeline, are you seeing more concentration still on the IT related end of the equation or is it more across the board in the sub industries that you’re participating in right now?

Manuel Henriquez

If you look at the portfolio, excuse me, if you look at the pipeline for October and the early part of November, it is squarely broadly distributed right now through all of our sectors that are out there. It is a tidal change difference from what it was in July and August. It is completely different world starting in October of what we’re seeing.

It’s encouraging signs by no stretch of the imagination, but with that I don’t want to lose our stream of credit discipline that we’ve build and successfully managed Hercules through one of the most challenging periods of time in this country’s history, and lose our compass on credit simply to originate.

We will maintain that strong, rigorous credit underwriting as best as we can as we’ve done historically to remain credit performance, but it is a dramatically different with a lot of our competitors having limited capital pools available to themselves, and we’re just seeing this massive increase in demand.

Now, I want to couch that by saying that just because I see over $1.2 billion pipeline, does not mean that all those opportunities are worth of the credit underwriting standards of Hercules, so I need to couch that because we still kill many percentage transactions that we review, we still pass on.

Henry Coffee – Stern Agee

OK. Terrific. Thank you very much for the color and nice job this quarter.

Manuel Henriquez

Thank you.


Thank you. Our next question comes from Jesper Bergs from Macquarie.

Jesper Bergs – Macquarie

Just starting off with, sticking on with the top of credits, I believe the Wells facility matures in August next year. Just on that specifically, do you think you’ll be able to extend that facility or are most of the people you’re talking to looking at new facilities?

Manuel Henriquez

I mean we are in dialog with Wells Fargo, and what we really want to do and most of discussions with Wells Fargo has been around putting in the new credit facility. We’ll let the other one pass away and then we’ll put in a new one, a new complete facility that we prefer to have in the two to three year longevity to it.

Let me defend Wells a little bit here. In all fairness to Wells, we haven’t borrowed yet, so I think they’re a bank and they would like to see asset growth themselves. So we’re (inaudible) on not giving them what they’re looking for from their business and that is they want to have outstandings.

It really wasn’t until the fourth quarter that I could say that we would have the visibility of having outstandings. There’s no question as I look to the fourth quarter growing pipeline and certainly look to the first quarter, that we will have outstandings for Wells Fargo in their facility as well as any new lender coming into the facility.

That goes a long way on getting lenders to participate into the credit line we have for Wells Fargo for example.

David Lund

We have a great relationship with Wells Fargo. I don’t mean to imply anything else to them. They’ve been a great partner.

Jesper Bergs – Macquarie

OK. Thank you. And as always thank you guys for all the frankness on the call. Sticking with the topic you just mentioned, maybe two, three years for Wells and the SBA’s obviously a long term and reliable funding, if you were to look at even longer term funding maybe in the range of notes or preferred equity, how would you look at sort of an acceptable interest rate. And I guess to phrase another way, what do you think is a long-term return across multiple cycles in your business model on the equity side and what sort of spread would you require?

Manuel Henriquez

Jasper, I’ll opine on your piece you wrote a couple of weeks ago which is a very good piece on the spread over 10-year treasuries spread over sort of B rated bonds.

Look, I’m old school. I believe that (inaudible) anywhere between 350 and 450 over 10-year Treasuries is the way I look at the business. So that’s one way of saying yields should be somewhere in the neighborhood of – and I know this is different from your view, so I’m not taking an issue with your view – but I’ve got so many advocates of view of anywhere between 7% to 8%. BDC yields and (inaudible) 8% to 10% yields if not a little higher.

I think that with the Treasury – with the Fed – excuse me, going into the open markets and doing the quantitative approach, I think that you’ll see a drive towards lower interest rates that will naturally gravitate and spill over to the BDC. They will naturally drift down into the 7% to 8% yield range.

Now, you’re asking a very important question. You left out a very important element and that is, securitization. Noticed somewhere that some of the 300 BDC’s have done. I think that the securitization market is a very interesting market, and one that’s emerging as a promising area even for us to look at.

So we are actively involved. Dave and I are actively involved looking at every permutation of capital raising that is accretive to our shareholders and be the lowest cost to our shareholders as possible, and clearly you’ve seen a fairly broad bid and spread between securitizations on a 30 year securitization that’s completed versus a three year or five year securitization that’s completed.

We have a little bit of all these different flavors in the market. I think that unless the commercial banks in this country step up to the plate, I think you’ll see more and more BDC’s gravitate to a securitization type approach on a five to seven year type of credit facilities from a debt conduit.

Jesper Bergs – Macquarie

OK. Thank you for your commentary. That’s helpful. Sort of changing tact’s here, looking at the SBA funding being fixed rate and pretty reliable, are you thinking about changing sort of your fixed to floating rate assets and maybe picking up a little bit more yield relating to fixed rate assets?

Manuel Henriquez

Well I think we need to be careful here. If I remember correctly, well let me start at a higher level. Close to 90% or 93% of our assets are all first lien senior secured credit facilities. We don’t rely on mezzanine or subjects or masking a so called one stop shop to try to inflate our yields.

Our yields are being gotten by first security interest in the assets of the companies themselves. The next issue something that seems to be lost and I grapple whether or not to start including it in these disclosures. I believe it’s in our 10-Q. And that is, substantial large portion – 80% plus, may 85% of our portfolio is in fact floating rate loan with a floating rate and a spread and some of those have a floating rate with a hard LIBOR four.

So we would be quite happy in a rising interest rate environment given our $160 million or so of fixed cost of debt today that is making up a significant portion of the capital of our portfolio. So we benefit in a rising interest rate environment quite tremendously, and we’re downside protected as I had forecasted, was a declining LIBOR.

Some folks took out LIBOR swaps with the fear of LIBOR going up, and LIBOR’s going down. The last thing you want to do is lock in a LIBOR swap.

Jesper Bergs – Macquarie

OK. And in terms of the floor, the interest rate floors, where are those? Or how much would interest rates have to rise in order for you to start appreciating that spread extension?

Manuel Henriquez

Immediately. I mean, the way our portfolio is structured, especially our floating rate loans, any increase in the index rate of LIBOR will automatically cause an accretion in earnings to our shareholders.

Jesper Bergs – Macquarie

I guess on the 80%, it does have a floor. What’s the average floor there?

Manuel Henriquez

No, no, you misunderstand. The floor, the way the floor – let me explain the floor. For example, let’s say you have a deal price – I’ll just pick a number here – L700 and you may have a LIBOR floor of two. And LIBOR today could be at 30 basis points or 80 basis points.

So it doesn’t matter what LIBOR does. Before you get an increase you have to see the LIBOR. To your point, LIBOR would have to go from the 30 basis points or 40 basis points up to the 200 basis points before you see a change in rates for us. And (inaudible).

Jesper Bergs – Macquarie

Is 200 basis points a typical LIBOR floor on your ...

Manuel Henriquez

It varies. It ranges from two to some that are three, to some that are four. Every transaction is different and every credit is different. Every risk is a different risk.

Jesper Bergs – Macquarie

OK. That’s helpful. And I guess just one more quick question before I hop off. Looking at what happened with InfoLogix I guess post quarter end, when you have liquidity with them or specifically in IPO, sort of how do you determine when you actually fully exit the investment and what sort of lock up periods are you seeing.

Manuel Henriquez

Well, in 25 years I’ve maintained a belief that you do not deviate from your underlying thesis on once an investment achieves a hurdle rate IIR return, you don’t look to top take the investment. In other words, I don’t run a public cash fund. I don’t run long investments from a public securities point of view.

Our investors do that. Our mutual funds do that. So once an investment has achieved an expected return that we modeled in when we first did the investment and get revaluated, upon achieving that, the strike price on the security we will vacate or liquidate that position generally in a controlled manner.

Now, the second part of your question, it varies. Not all of our public securities have a mandate that we’re locked up for the traditional 180 days post IPO. It’s a negotiated item because we’re a minority investor – we only invest in 100 basis points, 50 basis points of the deal, being locked up seems a little bit silly.

So every transaction is different and not all transactions have pre-requisite lock up periods associated with them. But the vast majority that do, are 180 days.

Jesper Bergs – Macquarie

OK. Well great. Thank you guys very much and good job this past quarter.

Manuel Henriquez

Thank you.


Thank you. Our next question comes from Douglas Harter from Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. My questions have been asked and answered.

Manuel Henriquez

Thanks Doug.


Thank you. Our next question comes from Troy Ward from Stifel Nicolaus.

Greg Mason – Stifel Nicolaus

Great. This is Greg Mason. Just wanted to – you started talking about DNOI this quarter, distributable net operating income, so how are you thinking on the dividend going forward? Are you going to be matching it closer to the distributable net operating income that you’re now reporting or closer to the traditional NII.

Manuel Henriquez

Let me explain why we’re doing DNOI. It’ll take me a while to get this little acronym going here. We’ve been – it was self-evident to us as we go on our periodic non deal road shows and meet with investors at the end of every quarter that there seems to be a lack of commonality as to comparing BDC’s.

You have, BDC’s are for taxable income. Other BDC’s aren’t for taxable income. Some BDC’s report NII. Other people report net operating income, NOI. Others report DNOI. And my advice to the whole BDC industry is, let’s all coalesce around a standard reporting mechanism so our shareholders can ratably review all the investments equally because everyone has a little bit different messaging out there.

So Hercules decided to take the high road and basically start disclosing the two other items so people can see it. Now as a caution to you, DNOI is not a direct proxy to that of taxable income, and I’ll defer to our CFO because I can’t even explain what amalgamation is going to derive taxable income.

David Lund

As you’re aware Greg, that taxable income will be impacted by certain items that have to be treated as capital gains when you have (inaudible) and so on. You may also have stock options exercised in the quarter that are deductible for tax purposes, but are not necessarily deductible for GAAP purposes.

So there’s a myriad of reasons why there is a difference between book and tax, and so we typically as a company, want to make sure that we’re paying dividends based on taxable income because we don’t like to see, and we’re very dead set again, wanting to have a return of capital to our shareholders.

Manuel Henriquez

The best thing to tell you is that the greatest influence to deriving at a taxable income versus DNOI will be any acceleration of early payoffs. I mean that is by far the largest driver. What that means in layman’s terms is because Hercules adopted the most conservative accounting principles, meaning that any fee that we derive upon the onset or the substantial majority of the fees that are derived from the onset of a new investment are actually accretive using the interest rate method over the life of the duration of the loan.

So this is why unlike most BC’s, Hercules has a very large, or growing I should say, deferred income number that simply grows every time originating new assets. In the event of an asset paying off earlier than initially planned, you will see an acceleration of those deferred revenues that will impact the issue related to taxable income. That’s the high level.

Beyond that, I suggest you could talk to David on the more specific issues offline, but those are the kind of high level differences between NII, DNOI and taxable income.

Jesper Bergs – Macquarie

Great. Thanks guys.


I’m showing no further questions at this time.

Manuel Henriquez

Well first of all, great questions everybody. I’m tired. Great questions. Thank you operator and thank you everyone for continued interest and support of Hercules Technology Growth Capital. As we’ve always done, over the course of the next few weeks, holidays aside, David and myself will be planning on visiting with investors across the country over the coming weeks. If you’re interested in meeting with us, please notify your respective investment bankers, sorry, your research analysts and feel free to contact David Lund or myself here at Hercules at 650-289-3060. Again, thank you very much. Thank you to our shareholders and go Giants.


Ladies and gentlemen thank you for participating in today’s conference. This concludes our program for today. You may all disconnect and have a wonderful day.

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