Hercules Technology Growth Capital, Inc. Q3 2008 Earnings Call Transcript

| About: Hercules Capital, (HTGC)
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Hercules Technology Growth Capital, Inc. (NASDAQ:HTGC) Q3 2008 Earnings Call Transcript November 6, 2008 5:00 PM ET


Jason Golz – IR Counsel, FD Ashton Partners

Manuel Henriquez – Co-Founder, Chairman and CEO

David Lund – CFO


Troy Ward – Stifel Nicolaus

John Hecht – JMP Securities

Douglas Harter – Credit Suisse

Sean Jackson – Avondale Partners


Good afternoon. Welcome to the Hercules Technology Growth Capital, Inc. third quarter 2008 financial results conference call. At this time, all participants are in listen-only mode. Later we will open the call for your questions. (Operator instructions)

I'll now turn the call over to Jason Golz of FD Ashton Partners, Investor Relations Counsel for Hercules. You may go ahead, Mr. Golz.

Jason Golz

Thank you, Paul, and good afternoon, everyone. On the call today are Manuel Henriquez, Hercules Co-Founder, Chairman and CEO; and David Lund, our CFO.

Our third quarter 2008 financial results were released just after today's market close. Please note that we've made a minor correction on our earnings release today under the Liquidity and Capital Resources section regarding 3Q '07 net asset value. We have replaced $12.21 with the correct figure, which is $11.97 per share. This release can be accessed from the Company's Web site, at hercules.com, or htgc.com. We have arranged for a tape replay of today's call, which will be available through our Web site 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 by law. To obtain copies of our latest SEC filings, please visit sec.gov or visit our Web site at herculestech.com.

I would now like to turn the call over to Manuel Henriquez, Hercules Co-Founder, Chairman and CEO. Manuel?

Manuel Henriquez

Thank you, Jason, and good afternoon and thank you, everybody, for joining us today.

I'd like to start our call today by acknowledging the unprecedented economic environment that we find ourselves in today, as evidenced further by today's stock market decline. I believe that the global financial crisis we're currently experiencing could be more far reaching than anyone would have expected and lasting longer than we have anticipated.

We continue to see a logjam or a frozen credit market in capital markets with little to no credit being extended. However, we are beginning to see encouraging signs of the fine beginning led by the Federal Reserve recent cut in the Federal funds rate, and a slowly but surely declining LIBOR rate. However, the LIBOR rate remains highly volatile.

In terms of Hercules, in our participation within the venture capital marketplace – and I want to stress that Hercules operates primarily in the venture capital marketplace, and not in the lower middle market or middle market buyout space we are seeing encouraging signs of the venture capitalists, albeit cautiously, pursuing further by the venture capital investment activities.

The venture capitalists are continuing to invest in our portfolio of companies, with $7 billion invested in third quarter alone. They're also performing triage in monitoring and managing the portfolio of companies quite closely, in order to ensure that they're prudently monitoring and actively working with their portfolio of companies during these tough economic times we find ourselves in today.

In over 20 years of working as a venture investor, I have never seen or experienced such a dramatic and rapid market dislocation affecting the global market as we've seen today. I have lived through and worked through the late 1980s and the early 1990s S&L REO banking crisis.

I've also worked through the now famous dot.com meltdown that occurred earlier this decade as well. But I assure you I've never seen something as far-reaching and affecting so many individuals, institutions and government agencies that we're experiencing today. It is simply unprecedented and requires a steady hand at the tiller.

Given the current state of the markets, coupled with our clear liquidity horizon in concern with our liquidity position, we have opted to navigate waters quite cautiously, and we continue to focus on managing credit very, very aggressively, as well as maintaining a strong liquidity position on our balance sheet. In fact, we will be delevering our balance sheet as we continue to navigate these difficult times ahead of us today.

In our corner of the world, however, I am very proud of our achievements during the third quarter and more importantly, the achievement of our investment professionals in our team here at Hercules.

We reported another strong, solid quarter to our shareholders on all fronts, including portfolio growth, net investment income, dividend growth and sustained, high credit quality within our portfolio.

As I indicated to you in our previous two earnings calls, we remain very focused and deliberately pursuing a slow and steady investment strategy as we continue to navigate these difficult times. We expect these times to remain through the remainder of '08 and certainly into the better half of 2009.

Regarding our third quarter performance and achievements, we attribute our success in our strong quarterly performance to many factors, including, but not limited to the experience of our investment professionals, our growing brand and reputation within the venture capital industry, and our focus within the venture capital industry.

As I indicated just a minute ago, the venture capital industry continues to support and invest in our portfolio of companies, investing just a little bit over $7 billion, or $7.4 billion in new investments during the third quarter.

We remain sedately committed in tracking our credit in our portfolio to ensure that we address any near-term credit concerns that may arise. Like many companies today, we are too affected by this global economic downturn, which has also affected the venture capital industry, as I said earlier, by allowing the venture capitalists to focus on and managing the portfolio of companies very, very closely.

No one has been spared. However, our business model and our focus has helped to insulate Hercules from this broader market contraction, while also allowing us to maintain our strong credit quality.

Given the importance of our business model and focus, I would like to remind you how our business model is able to achieve these objectives while also preserving our capital and liquidity position.

First and foremost, we continue to focus on, and primarily invest in the venture capital marketplace. The venture capitalists invest in tomorrow's technologies companies today, meaning that these companies are less susceptible to near-term economic conditions and are much more concerned about long-term economic impact on the technology offering today.

We also have continued to migrate our portfolio more towards later stage, more mature companies. We commenced this strategy back in 2007, and we've continued to remain disciplined in expanding our portfolio to more mature, later stage companies, migrating further and further away from early stage Series A or Series B preferred stage companies, which we believe have the highest risk. And in fact, our portfolio today has less than 5% of our investment assets currently located in early stage, concept stage, venture capital-based companies.

We continue to build our portfolio in more revenue generating companies, most of which are also EBITDA positive companies that provide and offer innovative technologies that we believe have tremendous growth potential and will be the first companies to experience a liquidity event upon the exiting of these current economic times that we're in today. These companies are generally funded by top-tier venture capital firms and private equity firms. Therefore, they are not early stage startup companies.

However, I would like to remind everyone that the majority of our portfolio companies are generally require additional rounds of equity capital. That equity capital represents the primary source of repayment of our loans and the vast majority of our companies will still require one or two additional rounds of equity financing from our venture capital sponsors, as they continue to build their own business models, build upon the revenue growth, and ultimately seek a liquidity event in the form of an IPO or an acquisition, as we've seen occurred again in the third quarter in our portfolio.

Despite the current economic times, we're seeing unprecedented demand for our financing. And I would assure you that the demand now is higher than it's ever been since we started Hercules for our form of financing today. However, that demand does not mean that we are interested in fulfilling all that demand.

We continue to remain very cautious in our investment approach and as I said earlier, remain focused in our strategy on a slow and steady investment manner in order to ensure minimizing our risk exposure as well as maintaining a very solid liquidity position and low leverage position on our balance sheet, given these uncertain times we find ourselves in today.

Secondly, our investment professionals, which have over 15 years experience in this asset class most of which have also experienced these difficult times in the past. This team has been committed to extensively performing due diligence and actively monitoring our portfolio in order to ensure to the best of our abilities, we continue to maintain our credit performance that we have had historically throughout Hercules since inception.

Let me go back and talk about the third aspect of our portfolio and our business model, which is quite important. And that is the ability to maintain liquidity. Our liquidity is maintained, if not enhanced by the sheer fact that we invest in short-term 36-month credit facilities.

Unlike the rest of the VDC or the majority of the VDC industry, Hercules primarily focuses on investing in 36-month amortizing credit facilities, which means that Hercules generates between $50 million to $70 million a quarter in gross cash flows coming back on the normal amortization and early payoff of our investment portfolios. This allows us to maintain a very solid liquidity position while also maintaining a very strong balance sheet by mitigating risk at the same time.

This is a unique aspect of our business model, and certainly one that's very unique to Hercules compared to the other VDCs, who primarily invest in and rely upon five-year, seven-year, non-amortizing credit facilities. Said differently, those other VDCs find themselves with a disproportionate amount of credit risk in these uncertain economic times, as their current debt investments are not amortizing out. This amortization certainly helps us maintain a strong liquidity position, as I said earlier.

Now, let me take a moment to discuss and share with you our views and some of the facts surround the venture capital community, a lot of which has been written about in the media most recently.

I'm happy to report that despite the overall climate that we're seeing in the overall marketplace, the venture capital industry continues to invest solidly within the venture capital marketplace. They invested approximately $7.4 billion in new investments during the quarter.

Now, I'd like to remind everybody that back in December of 2007 as well as remind everybody that in Q1 and in Q2 2008, we have indicated to our investors and to our shareholders that we, Hercules, expected the venture industry to only invest between $26 billion and $28 billion in 2008, which is down from the $30 billion in 2007. So we had already purposely managed the business to see decline of approximately 10% or so in the venture industry, which is what led us to our slow and steady policy of investment activities.

Now, we certainly expect and are looking to see a dramatic adjustment further in the fourth quarter by the venture capitalist marketplace to investing approximately $6 billion to $7 billion only in the fourth quarter of 2008, giving a total investment activity in the $26 billion to $28 billion I said earlier. This is not a surprise to us, as we actually saw the same activity adjusting during the dot.com adjustment that we talked about earlier today.

Year-to-date, the venture capitalists have invested $22.3 billion through the third quarter of 2008. So they're on a very solid pace of continuing investment activities.

Now, let me be a little more specific about the venture capital dollars and the industries of which the venture capitalists invested in. $2.7 billion of the third quarter was invested in information technology companies, representing 39% of the venture capital activities were invested in information technology companies, of which Hercules portfolio represents approximately 70% of that.

Healthcare received the second largest amount of capital by the venture capitalists, or $2.2 billion into the healthcare industry, which represents about 30% of all venture capital activities, and coincidentally, represents about 30% of the Hercules portfolio. So we tend to emulate pretty closely the venture capital flows of the venture capital activity in our portfolio itself.

That said, on the other hand, clean tech, which is the third largest sector of investment activity by the venture capitalists, received $1.2 billion of activities. However, it's a sector that we have chosen to deemphasize as an investment activity because we believe it has a little bit of the earmarks similar to what we saw in the dot.com era.

Now, specifically about the stage of investment by the venture capitalists. Again, similar to the Hercules portfolio, the venture capitalists invested the vast majority of their dollars, $5.9 billion into later stage, more mature venture capital company. We have – the Hercules portfolio represents a bit over 55% or so of our portfolio is in later stage investment as well. The venture capitalists, in turn, invested $1.3 billion into early stage companies, of which we have less than 5% of our exposure in that area.

Again, we believe that early stage investing in this current market environment represents the highest risk of principal loss in this environment and we continue to deemphasize early stage investment for the time being.

Let's talk about geographic distribution and geographic capital deployed by the venture capital industry. I want to remind everybody that Hercules has offices in all the major venture capital centers in the country. San Diego, Boston, Palo Alto, or Silicon Valley as its better known as well as in Chicago and in our Boulder office, giving us reach to all the major centers across the country.

That said, the venture capitalists invested 45% of all the venture capital dollars went towards California, representing $4.1 billion of capital deployed in the California area, of which $3.2 billion was invested here alone in the Bay Area or Silicon Valley itself.

Our second largest investment activity occurred in San Diego, where we have our next office located, which received $867 million of venture capital activity. New England, our second largest office for Hercules, received the third amount highest capital by the venture capital, approximately $800 million of capital itself.

Notwithstanding that, let's talk about the remainder part of the ecosystem in the venture capital community, and that is dollars committed by limited partners or investors to venture capital firms. And as I've said historically on these calls, it is a very important part to understand the ecosystem of the venture capitalists raising money, which then they in turn invest in portfolio of companies.

The venture capitalists raised $8.1 billion in commitments during the third quarter, for a total of $24.4 billion of commitment through year-to-date third quarter 2008, a very healthy pace of investments or I should say, pardon me commitment from limited partners to the venture capital industry. That is an important indication to us on the health and vibrancy of the venture industry.

Lastly, but not least, is the private equity. As our portfolio migrates more and more towards mature later stage companies, we now track and monitor the investment activities by the private equity industry itself. According to Dow Jones private equity analysts, the private equity industry has raised a total of $222 billion through the third quarter of 2008, that is compared to $313 billion through all of 2007. So they're on a very healthy pace. And in fact, it was a record fundraising quarter for the private equity industry.

Now, in conclusion, we continue to believe Hercules growth capital strategy is sustainable and defendable in this current economic time to deliver long-term value to our shareholders. Our long-term growth strategy and timely conservative nature of investing in later stage companies, as well as continuing to manage a slow and steady pace of investments, we believe will contribute to Hercules strength in our balance sheet on liquidity, and allow us to manage through this more challenging economic environment, while others seem to be struggling.

Overall, despite the formidable challenges, I am extremely pleased to the performance of our financial results during the third quarter and of our investment professionals. Our success is clearly attributed to their hard work and dedication, the performance of which is translated into realized performance at our shareholders.

At this point, I would like to turn over the call to David Lund, our CFO, to elaborate more specifically of the achievements during third quarter earnings.

David Lund

Thank you, Manuel. As Manuel mentioned, given the recent market turbulence, we are very pleased with the results we achieved for the third quarter. With our low leverage liquidity, cash proceeds from our loan amortization and strong credit quality, we believe we are well-positioned to weather the current credit quagmire and will remain a strong lender to the technology and life science sectors.

With that, I will now provide more details on our commitments and fundings, third quarter results and highlights, credit performance, credit quality and liquidity.

We are increasingly cautious with this quarter with our commitment and funding. While there are many financing opportunities for us, we have chosen to invest at a more measured pace to ensure we maintain our high credit quality and support our existing portfolio of companies.

During the quarter, we entered into commitments for approximately $54.2 million and funded approximately $99.7 million to new and existing portfolio of companies. This quarter, investment activities bring our commitments since inception to over $1.3 billion and our fundings to approximately $1.1 billion.

Turning to the income statement, total investment income, which is comprised of interest and fee income was $19.2 million, which was an increase of 27.1% over the third quarter of 2007 investment income of $15.1 million. The effective yield on our debt investments during the quarter was 13.1%. The decrease from the effective yield of 14.3% in the last quarter was due to higher one-time fees in the second quarter as compared to current quarter. The weighted average yield of our portfolio as of the time of loan origination was consistent with the prior quarter, at approximately 12.67%.

Interest expense and loan fees on borrowings were $4.5 million for the third quarter of 2008 as compared to $1 million in the third quarter of 2007. The change was attributed to higher average loan balances outstanding, increased expense related to the amortization of fees related to the SBA facility, and higher average interest rates on our borrowings.

During the quarter, our average loan balance outstanding was approximately $221 million. The effective cost of debt during the quarter was approximately 8.2% as compared to 7.7% in the previous quarter.

The increase in the cost of debt was primarily due to the rate change under the Citibank and Deutsche Bank facility impacting the full quarter as compared to only half of the second quarter. As a reminder, our borrowings in the SBA facility are locked in for 10 years and at a cost of debt of approximately 6.6%. Even with the increased cost of borrowing we experienced this quarter, our net interest margin remains steady at 10.16%.

Operating expenses for the quarter, excluding interest expense and loan fees were $4.7 million as compared to $4.1 million during the same period last year. The increase as compared to the third quarter of 2007 was primarily attributable to higher salary expense, due to an increase from 39 employees at September 2007 to 46 employees at September 30, 2008, higher legal and work out related expenses and recruiting expenses, offset by lower accrued bonus and slightly lower stock-based compensation expense.

I'm pleased to report that the net investment income for the quarter was $10 million or $0.31 per share, based on 32.6 million basic shares outstanding. This is compared to $10 million or $0.31 per share in the third quarter of 2007, based on 32.4 million shares outstanding.

Taxable income for the quarter was $0.33 per share including realized gains. During the quarter, we also recognized net realized gains of $126,000. Hercules recognized $430,000 of realized gains primarily from the sale of warrants in EpiCept Corporation, offset by realized losses of approximately $304,000 on the sale of one loan and the write-off of warrants in two companies that were recently acquired.

I'd like to point out that Hercules had full recovery of principal, interest and fees on the sale of the two companies with positive IRRs of approximately 60% and 13% on these two debt investments. Net unrealized depreciation on investments in the third quarter was $2.4 million compared with an unrealized loss of $2.9 million in the third quarter of 2007.

We continued our high credit quality standards and discipline of loan monitoring during the quarter. Our diligent monitoring of our portfolio companies, combined with our focus on later stage venture capital and private equity-backed companies, have helped to maintain our credit quality. We continued to build upon diversity and strength of our investment portfolio by adhering to our slow and steady approach and maintaining our high investment standard and seeking out leading companies in life sciences and technology.

The weighted average loan rating of our portfolio was 2.25 compared to 2.10 in the prior quarter. As a reminder, most of our portfolio companies are dependent on future events of venture capital investment, and we downgrade our portfolio of companies as they approach a period in which they will need to close additional rounds of financing.

I would also like to note that the makeup of our companies in the various grading categories will change period-to-period based on the operating results and their funding activities.

Now turning to the balance sheet, at September 30, 2008, our investment portfolio grew to a record $637 million, representing a 53% growth in our investment year-over-year, while maintaining credit quality. We finished quarter with a backlog of unfunded commitment of $95.5 million.

However, of these nonbinding term sheets, we decided to continue negotiations on approximately $17 million and postponed the remaining term sheets until the credit markets stabilize. We also ended the quarter with approximately $20.5 million in cash, as we continued to manage our liquidity position.

During the quarter, we drew down $9 million under our warehouse credit facility, resulting in debt balance under the credit facility of $127.9 million at September 30, 2008. We also drew down an additional $32.15 million from the SBA, bringing the SBA debenture total to $127.2 million at the end of the quarter.

I would also like to once again remind our shareholders that borrowings under the SBA program are available to us for 10 years. In addition, we drew $10 million from our new Wells facility.

Turning to our liquidity, on August 25, 2008, Hercules secured a new credit facility for up to $300 million in capital. This facility contains an accordion feature, in which we can increase the credit line from the $50 million, which has already been provided by Wells Fargo Foothill, to up to $300 million funded by additional lenders if and when they join the syndicate.

Under the terms of the agreement, our borrowing rate under this facility will be LIBOR plus 325 basis points, or prime plus 200 basis points. And the unused fee will be 0.5% in the first year, decreasing to 0.3% in the second year of this facility. Depending on market conditions, we hope to add additional lenders to this facility in the coming months.

Our facility with Citibank and Deutsche Bank expired under the normal terms of the agreement on October 31, 2008, and we will be – and will be amortized for the period for the six months through April 30, 2009, at which time any remaining outstanding principal and interest are due.

The borrowing rate under the amortization period will be increased by 100 basis points to LIBOR plus 650 basis points. But we will cease being charged the nonuse fee of 250 basis points.

We continued to maintain an outstanding relationship with Citibank and will be discussing various financing options with Citibank over the course of the next six months.

I would like to point out that based on our existing shareholders equity and our SEC exemptive relief for borrowing available under the SBA debenture program, Company has the potential to leverage its balance sheet in excess of $500 million. The Company has $265 million in debt outstanding as of September 30, 2008, representing leverage ratio of approximately 66% or 34% taking into account the exemptive relief for the SBA.

Finally, our Board of Directors declared a dividend of $0.34 per share. The dividend will be payable on December 15, 2008 to shareholders of record as of November 14, 2008. This is our 13th consecutive declaration since our initial public offering and will bring the total and cumulative dividend declared to-date to $3.75 per share.

We are pleased that we're able to pay 100% of our dividend from ordinary income and spillover of the prior year earnings, meaning, we don't rely on extraordinary gains to pay our dividends.

I'd like to reiterate that we're pleased with our financial performance this quarter and would like to acknowledge the hard work and dedication of our team here at Hercules as well as the support of our shareholders.

Operator, we are now ready to open the call for questions.

Question-and-Answer Session


(Operator instructions) Our first question comes from Troy Ward with Stifel Nicolaus.

Troy Ward – Stifel Nicolaus

Good afternoon, guys.

Manuel Henriquez

Hey, Troy.

Troy Ward – Stifel Nicolaus

Hey. Just real quickly, we'll start kind of towards the end of your comments. Based on the higher cost of the Citi up to L plus 650, I assume you've already moved $40 million from the Wells line to pay down the Citi line. Is that probably a fair assumption?

David Lund

No, at this point, we've not. We still have – actually, as we indicated in our release, paid down $10 million of the Wells Fargo line and have the full availability of the credit facility of the $50 million to us.

Manuel Henriquez

And Troy, the answer is very simply, we want to maintain a very strong liquid position. We don't want to necessarily overuse our available liquidity to pay down a Citibank line or the Deutsche Bank line. So that will be managing itself down anyway, naturally. And the higher cost of rate of interest, we think is prudent to pay, and not overshoot our liquidity position.

Troy Ward – Stifel Nicolaus

Okay. And can you briefly talk about what is – what are the steps you would go through to add new participants to the facility – to the Wells facility?

Manuel Henriquez

Sure. Well, I can honestly tell you that we've been actively engaged with probably no less than 10 banks or 12 banks during the course of last four months or five months. And as we all now are very evidently aware, with the whole federal government stepping in and begin to bail out some banks via the lack of liquidity, lot of the banks we've been engaged with and discussing with, are all now participating in one form or another of the TARP program and then still trying to figure out what and how much of the TARP program they will be participating in. So we are still actively engaged with one bank or two additional banks who are continuing to do due diligence on the Wells Fargo line – that we believe that should come together between now and year-end. But I can't handicap this any more, other than say that when we have clear visibility on what's going on in the broader capital markets, I think that we'll have lenders falling into the fold and joining the Wells Fargo facility right now.

Troy Ward – Stifel Nicolaus

Is there any compromise or any negotiations around that L plus 325? Clearly, the market moves every day. And I'd like to think at some point it's going to come in. But if couple lenders wanted to join, but they wanted L plus 350 or 375, is that doable?

Manuel Henriquez

The answer – it certainly is doable, but we're a little bit somewhat reluctant to step into higher funding costs when we don't necessarily need all that extra liquidity right now. We're very fortunate to be in a position where we can control liquidity the way we are, and we can add lenders to that if we decide to potentially take a higher spread over LIBOR. So that option is always available to us. But we feel that because we don't have any outstandings under Wells Fargo today, it would be somewhat imprudent to merely add more capacity and pay a higher rate when you don't need it.

Troy Ward – Stifel Nicolaus

Right. Understand. And then, talking about the marketplace a little bit, you had the term sheets, the nonbinding term sheets, and you pulled back on that. And clearly, that's something that can be done. But does that impact – how often does that happen in your industry, in your space? And then what about the relationships with your VC funds?

Manuel Henriquez

I think, as I said in the beginning of my comments, I think the VC themselves are doing an extremely prudent job of managing their own portfolio of companies. And we've been working with many venture capital firms and their portfolio of companies to encourage them to both cut their burn rates meaning allow cash to last longer throughout 2009. And we have been fairly vocal on working with venture capitalists that this is not a time to be over-levering your portfolio of companies’ balance sheets. And when we approach that in a very pragmatic way with the venture capitalists and the portfolio of companies, I think that they see it as well as we see it, which is it's better to be cautious right now than overleveraging their underlying companies.

Troy Ward – Stifel Nicolaus

Can you comment just quickly along that same theme of what is the other competition stepping in, in place of those term sheets, or is there any right now?

Manuel Henriquez

I will say something that's going to be shocking to most people out here – there is no more competition. Term sheets right now in the marketplace are achieving yield spreads that are unprecedented in my entire history of doing this. We're seeing deals in the marketplace today that can be done at 15% to 16% term catch yields right now. It is an unprecedented lack of liquidity in the marketplace. And because of the high interest rates that these term sheets would garner, we feel, as partners with the venture capitalists and our portfolio of companies, it's not the right time to overburden your own balance sheet by extremely high cost of leverage. Unless you as a portfolio company really need that money, we're encouraging our companies to defer any financing for at least a quarter or two, to allow the liquidity to return to the marketplace.

Troy Ward – Stifel Nicolaus

Based on your industry knowledge, when do you think – what's going to be the telltale sign to let you say, okay, I'm going to step in, and now really going to start to take advantage of these wide spreads that are available?

Manuel Henriquez

The first and foremost is a strong visibility of liquidity. I need to see a very tangible evidence that LIBOR which I'm happy to say today, I think closed down to 2.4%. So we're seeing LIBOR dropping. The problem with that is that bank to bank lending is just now beginning to occur. Bank to financial institution or bank to companies is not yet really occurring. I don't expect that to happen until, frankly, mid-to-late December, and really not come into true lending activity until the early part of '09. I don't really expect to see a lot of lending going on in the marketplace.

Troy Ward – Stifel Nicolaus

And then one final one, and I'll hop off. Can you speak to any – how you're looking at your overall platform with an eye towards expense savings? I know the employees have come up, and you've – headcounts come up, and you've opened in some key offices. I heard in the commentary that there was lower accrual bonuses and a couple other lower areas. How much leverage do you have there on the expense side?

Manuel Henriquez

Look, clearly, any company that is not reviewing itself internally in these tough economic times is doing a disservice to its shareholders. We have clearly looked at, we've discussed it internally, our employees are aware that if we find ourselves in a very long, protracted economic environment that we find ourselves today, lasting throughout all 2009, I think that it would be prudent of us, like most people are doing, to be forced into rightsizing our company. However, I am very, very cognizant that I am unwilling to cut muscle, merely cut muscle, if I feel that we're in an environment that will be improving at the end of the first quarter or sometime in the second quarter. The savings of doing in reduction of force are not worth it with the degree of investment professionals we have here. So I will only do a cut if we find ourselves in a very long, protracted economic environment.

Troy Ward – Stifel Nicolaus

Great. Thanks, guys.


And next we will hear from John Hecht with JMP Securities.

John Hecht – JMP Securities

Afternoon. Thanks for taking my questions. I wonder if you guys can break out of the principal payments, how much of it was investments that lie within the Citi facility and then without – outside of the Citi facility? What I'm trying to figure out is how much you guys can amortize that just naturally over the course of the next six months? And then, Manuel, if you can maybe kind of address what – how you perceive options in that time frame – obviously, the banks you're addressing as well as other options you have, to replace that in the near-term?

Manuel Henriquez

Sure, John. What I'll do, I'll let Dave answer that. And I can assure you we've run numerous, numerous models on the scenarios of the Citibank and Deutsche Bank facility. I want to be clear on this statement. Citibank has been an outstanding partner in this process. They've been very open to us and clear to us on how much they would like to continue working with us and extend credit to us. They are going through their own difficult times and figuring out their own liquidity positions. But I feel very confident that in the course of the next six months, with our long-term steady relation with Citibank, that we will have the ability to either renew or extend this facility. But let me let David answer the question on the cash flows and other aspect of your question.

David Lund

John, obviously, we've looked at the amortization. And just on normal amortization, not assuming any other early repayments or the types of cash flow, we would be down to between $50 million to $60 million by the time we got to April 30th. In addition, we know there probably be additional payments that come in. We also have ability to access our credits through Wells Fargo to potentially use that as capital to pay down the facilities. We also, if we needed to, can go to the capital markets. It's not something we would do, we would be very prudent and cautious with doing that. But that's an access to capital pay down this facility as well. And as Manuel indicated, we are in continual dialogue with Citibank, who is very interested in continuing to work with us through the course of the spring, to get an answer that works for all of us.

John Hecht – JMP Securities

Okay. Thanks. And then, Manuel, could you talk about – I know historically, there's been a lot more exits of liquidity events from the M&A side of your business, rather than the IPO side. I'm wondering your perspective on your various categories of technology, and what you hear out there in terms of potential consolidation. I guess, maybe given pricing out there, there may be some more opportunistic consolidation even in the segments here. I'm wondering if you can give us color on that, maybe your expectations for the next several quarters.

Manuel Henriquez

Sure. Again, correcting a myth or a misconception that exists within the venture capital industry, from an outsider peering in, the venture capital industry has historically continue – historically has always been more dependent upon M&A than necessarily IPO. Even during the most heated period of time, '99 and 2000, IPOs barely represented 45% of the exits. So it's always been M&A.

Now, to quote a most recent article that occurred in Fortune magazine, that was republished recently by CNN Money, where it was quoting Larry Ellison, HP, Google, Microsoft and others, this is probably one of the best time for technology companies, and by the way, life sciences companies to go on a shopping spree. And the reason why I say that is, if companies that were technology – or innovative technology companies were being – looking to raise capital at $100 million and $200 million valuations, or are looking to go public at $200 million and $300 million valuations, today, technology partners, such as IBM, Google, HP, Microsoft, SmithKline, Glaxo, what have you, those companies now are buying potential venture-backed companies on sale, meaning that they're buying them at 30%, 40%, 50% off of the original asking price. So there is a very strong and I would argue, a growing M&A market, from a technology-driven point of view. And we believe firmly, as we saw evidenced in our portfolio in the third quarter, we saw NetEffect being purchased by Intel for strategic value, and Agami also purchased for strategic value in the intellectual property that the company has.

So I'm – only way I can answer your question is that clearly, we've been so far picking the right companies. These are our credit performance remains outstanding, and we continue to see exits on M&A through technology acquisitions by the larger companies. On the foreseeable future, I'm no different than anybody else. I do not expect to see an IPO market opening up any time soon. However, I do believe the technology IPO market will start showing itself sometime in the June timeframe. And probably by September '09, we should start seeing some remnants of IPO liquidity taking place from a technology point of view.

John Hecht – JMP Securities

Okay. Thank you, guys, very much.


Our next question comes from Douglas Harter with Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. I was hoping you could talk about the unfunded commitments you have – what amount of those you expect actually have to fund and over what time period those commitments are for?

David Lund

We have – at the end of the quarter, we had just about $142 million of commitments. And we know, of that, quite frankly, a significant amount of those commitments will not be drawn upon. We think that, that number will probably be somewhere less than 50% of that would actually be drawn over the course of the commitment period, which in some cases extends out to 2010, most of them within the next nine months though.

Manuel Henriquez

And Doug, I'd like to also side note that – or side that, that a lot of these commitments also have what's called performance or contingency requirements that a company either must execute a Phase III clinical trial or Phase II clinical trial, or it must achieve a certain number of customer ships or bookings. So they're often times attributed to or tied to performance by the underlying company itself that triggers a release of additional commitment.

Douglas Harter – Credit Suisse

Would that sort of hitting those triggers, would that be in the 50% number that Dave just talked about?

Manuel Henriquez

That's correct. But as our models have indicated and our discussions with a lot of our companies, we think that, that 50% number is really over the next three quarters. And in the cash flow models that we have run, we don't see any near-term liquidity pinch that will take place. And in fact, this is why the Wells Fargo line is entirely undrawn today. With $50 million available to us, we think that we have more than ample amount of liquidity to achieve those funding objectives.

Douglas Harter – Credit Suisse

With sort of keeping that Wells Fargo line for those unfunded commitments, are you going to – are you in the market originating new loans today?

Manuel Henriquez

We – as we did in the third quarter, we remained – we're incredibly committed and remain supportive of all of our portfolio companies, which you saw invest close to $100 million in the third quarter. $99 million was invested in the third quarter. Big chunk of that, approximately $70 plus million of that, was to our existing companies and $25 million or so was to new companies. I don't think that's going to change much materially in the fourth quarter. Despite the fact that the fourth quarter has historically been our busiest quarter, I would certainly say and encourage all the analysts that they need to revisit the fourth quarter projections out there. Because we are materially pulling back on originations in the fourth quarter until we see greater visibility on liquidity out there.

Douglas Harter – Credit Suisse

And can you talk about – when you're making new loans to existing companies, are you able to get significantly wider spread?

Manuel Henriquez

Yes, we are. And we want to – we approach that very cautiously, because we want to remain a good partner both to the venture capital industry and to our portfolio of companies. But clearly, we have a fiduciary obligation to look at that opportunity cost of that capital, in making sure that it's now being invested of what the prevailing normalized rates are in the marketplace, given its current dislocation in the marketplace today. But yes, we are seeing a dramatic increase in rate spreads.

Douglas Harter – Credit Suisse

And then sort of related to that, if you could talk about – given, obviously, the dislocation in market spread, why the sort of fair value of the loan portfolio wouldn't be marked down, just given general spread widening?

David Lund

Sure. When you look at FAS 157, and you address the market participants, our market participants are technology and life science companies. If you look at the exits that we've had from our portfolio, they've been a result of acquisitions by these companies. And so it's the underlying collateral that has value. And we've looked at the underlying collateral of our portfolio of companies. When we have an assessment that says that we need to mark it down because there is a risk, we will write it down. But if the underlying collateral supports the value of the loan, then we carry the loan at value.

Manuel Henriquez

And Doug –

Douglas Harter – Credit Suisse

Just beyond you see look through the actual loan, and you're looking at the collateral, not at the loan as the instrument itself?

Manuel Henriquez

That's correct. But let me footnote before we go any further. There has never been, nor will there ever be a secondary market for venture capital-based loans, primarily because these are non-cash flowing-positive loans, which means that you have to look to and understand the underlying intellectual property of these companies as your liquidity and marketability of the loans. It has nothing to do with the yield spread, and all to do with the underlying intellectual property or the collateral that makes up these loans. That is why the so-called leverage market – leverage index is less relevant, which is down 10%. Because there is no secondary markets, we could not tender one of our loans to be sold in the market. There is no viable market for venture-backed loans.

David Lund

And I'll point, as an example of that, in the course of the last three months, we've had two companies acquired, four in excess of our loan value, one acquired by a CEO who understood the technology and wanted to control the technology, and bought our loan for full face value and fees and everything, and the other one was acquired by Intel, in something of a distress situation, where we got full recovery.

Manuel Henriquez

But it's extremely important to note, we go through a very meticulous FASB 157 exercise, along with our auditors as well as our valuation committee, where each quarter we look at the underlying value of the loans based on the collateral to ensure that any loan require to be impaired, it is impaired on a fair value basis.

Douglas Harter – Credit Suisse

Great. Thanks for the explanation.


We will move on to Sean Jackson from Avondale Partners.

Sean Jackson – Avondale Partners

Yes. I wanted to follow-up on that aspect of valuation. The – again, the weighted average loan grade of the portfolio, 2.25, little up from 2.1 – compare that with again the idea that the valuation of the portfolio as a whole, demonstrated by the unrealized gain losses is somewhat steady. Again, I'm trying to – is there different valuation metrics associated with that internal loan grade versus the valuation metrics related to the accounting?

Manuel Henriquez

Well, let's make sure we address some statement of facts here. I appreciate the comment on steady, which in fact is, specifically speaking, correct. But in reality – I'm going to put some meat on the bone here, and be specific. During the third quarter, we had approximately $149 million of loans that we classify as Grade III. I want to remind everybody again that we automatically would downgrade a loan to a Grade III merely because it's approaching a round of financing, or the round of financing is coming – a term sheet has not been tendered to the underlying companies. So we're putting out what we call a more closely watch list. At the end of the third quarter, we had approximately 21 companies making up the $149 million of Grade III credits. That compares, however, to 11 companies at the end of the second quarter representing $55 million. Of those 11 companies – of those 11 companies, we had approximately nine or so of those companies spill over from Q2 to Q3 timeframe. And these companies are doing fine. However, we want to watch them a little more closely. Some of these companies are actually properly capitalized, but they may be behind plan or we have other concerns that are milestone issues that we're monitoring. So a Grade III does not necessarily translate into impairment of value in our companies.

Sean Jackson – Avondale Partners

Okay. Appreciate it. And also, just within your IT portfolio, I think you've had a trend of looking at more software-related companies recently. I think you backed away from that couple of years ago. Is that still the case that you're going back to the more software-related companies? Or is that still not the case?

Manuel Henriquez

Well, I think that your point, on a very broad portfolio, we have for the last, I think, 16 – I believe it's actually 16 quarters, to be honest with you. For the last 16 quarters, we have materially deemphasized software investing. It wasn't until Q1 '08 where we signaled to the marketplace that we believe that software investing now is actually a good time to start doing that. And we've recently made a software investment, a very mature software investment in a company called HighJump, for example. So we are slowly reemphasizing software, but it's not to the point that it's going to – it's making up 25% of our portfolio. So we're a long way away from that being the case.

Sean Jackson – Avondale Partners

Okay. And just last question, when you went through all the statistics on the VC community, and what they're doing and so forth, you mentioned that still it looks like most of the VC money now is with later stage companies. And I think you mentioned some stats to that. Is that a trend that is going to increase in your view for the next couple of quarters, not only the VC community, but also your own investment decisions?

Manuel Henriquez

The answer is yes, on both. And the reason is quite simple. A more mature, more stable company is often times a more accretive acquisition to an Oracle, an IBM, an HP, a Google, because now their net cash flow is neutral. So they can buy those products, or those technology solutions, and run it through their distribution system, and find a Google, Oracle, or IBM. So it's a lot more accretive. The venture capitalists in turn are fully cognizant of that fact. And they realize, in order to get IRRs or return on their capital, they're better circling the wagons and protecting their more mature companies that will give them return of principal back, which allows them to give capital back to the limited partners and generate returns for those LPs. So yes, I think the trend will continue for the next couple of quarters out.

Sean Jackson – Avondale Partners

Okay. Thanks. That's helpful.


And with no further questions in the queue, I'd like to turn the call back to our speakers for any closing comments.

Manuel Henriquez

Thank you very much, everybody. Most of you realize that we historically have gone out after the earnings call for investor meetings. We will be doing the same thing after this investor meeting. But given the schedule of Thanksgiving and some other logistics and conferences that we've heard investors, we will be holding some conference calls to investors next week, but also meeting with many investors in person during the first week and second week of December. So if you would like to participate in a conference call with ourselves and/or in-person meeting in the first week or second week of December, please feel free to contact David Lund, our CFO, or myself at 650-289-3060.

Again, thank you very much for being our shareholders, and thank you for being part of the Hercules Earnings Call.


Once again, that does conclude today's conference call. We thank you for your participation. Have a great day.

Manuel Henriquez

Thank you.

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