Hercules Capital's (HTGC) CEO Manuel Henriquez on Q4 2016 Results - Earnings Call Transcript

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Hercules Capital, Inc. (NASDAQ:HTGC) Q4 2016 Earnings Conference Call February 23, 2017 5:00 PM ET

Executives

Michael Hara - Senior Director of Investor Relations

Manuel Henriquez - Founder, Chairman and Chief Executive Officer

Mark Harris - Chief Financial Officer

Analysts

Jonathan Bock - Wells Fargo Securities

Kyle Joseph - Jefferies

Ryan Lynch - KBW

Chris York - JMP Securities

Aaron Deer - Sandler O'Neill

Robert Dodd - Raymond James

Operator

Good day, ladies and gentlemen, and welcome to Hercules Capital Fourth Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. And later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference maybe recorded.

I would like to introduce your host for today's conference, Mr. Michael Hara, Senior Director of Investor Relations. Sir, please go ahead.

Michael Hara

Thank you, Michelle. Good afternoon, everyone, and welcome to Hercules conference call for the fourth quarter and full year 2016. With us on the call today from Hercules are Manuel Henriquez, Founder, Chairman, and CEO; and Mark Harris, Chief Financial Officer.

Hercules fourth quarter and full year 2016 financial results were released just after today's market closed and could be accessed from Hercules Investor Relations section at www.htgc.com. We have arranged for a replay of the call at Hercules web page or by using the telephone number and passcode provided in today's earnings release.

During this call, we may make forward-looking statements based on current expectations. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein due to timing delays between the date of this release and in the confirmation of the final audit results.

In addition, statements contained in this release that are not purely historical are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements, including, without limitation, the risks and uncertainties, including the uncertainties surrounding the current market turbulence and other factors we identify from time-to-time in our filings with the Securities and Exchange Commission.

Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also can be incorrect.

You should not place undue reliance on these forward-looking statements. The forward-looking statements contained in this release are made as of the date hereof and Hercules assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of related SEC filings, please visit sec.gov or visit our website, htgc.com.

For today's agenda, Manuel will begin with a brief overview of our key highlights and accomplishments for the fourth quarter and full year business highlights, followed by an overview of the venture capital markets, a perspective on potentially new administrative legislation and regulations and conclude with a brief outlook for the first half of 2017.

Mark will follow with a more detailed overview of the results and accomplishments for the fourth quarter 2016. And following the conclusion of our prepared remarks, we will open the call for question and answers.

With that, I'll turn the call over to Manuel Henrique, Hercules Chairman and Chief Executive Officer.

Manuel Henriquez

Thank you, Michael. And good afternoon, everyone, and thank you all for joining us today for Hercules Capital fourth quarter and full year 2016 earnings call.

First and foremost, I am very pleased and proud to announce yet another outstanding and robust fourth quarter activities for Hercules Capital, which culminated in delivering another strong record performance for Q4 and the full year 2016. As Michael said, we'll go through a quick presentation or I should say discussion and then followed by Mark's presentation and a Q&A.

Now, let me get into some of the specifics of our achievements and highlights for the quarter and to the year. We delivered our third consecutive quarter of net investment income exceeding our dividend and distribution of $0.31 and in fact, realized NII for the quarter on a GAAP basis was $0.43 per share.

Excluding the one-time event in the quarter, which I think it's prudent to do of $8 million, our adjusted GAAP was approximately $0.33 from the $0.43, reflecting the adjustment of one-time, once again covering our dividend, truly a great performance for Q4 activities and finishing a very strong year.

In addition, we achieved the following records for 2016. Total debt investment portfolio grew to $1.38 billion at a cost of 20% year-over-year. Total investment assets for the year ended at $1.42 billion at value, up 19% year-over-year. Total investment income at $175 million, up 11% year-over-year, and of course, our net investment income with and without the adjustment, meaning $100 million with the onetime event fee or $1.34, up 37% year-over-year or excluding the onetime $8 million settlement from litigation, we are at $92 million of net investment income, up 26% year-over-year.

We also successfully generated our third consecutive year of projected cumulative dividends and earning spillover of approximately $34.2 million, representing $0.43 per share of undistributed income based on our share count at year-end. This accomplishment of having an earnings spillover is quite important and affords us a great latitude and flexibility and considering multiple options for our benefit of our shareholders with regard to distribution of this growing earnings spillover.

For example, we could actually raise the dividend, our current dividend of $0.31, we can issue a onetime special dividend potentially later in the second half of 2017 or given the new tax rates that are contemplated by the new administration, we could actually pay taxes and retain a portion of those earnings to grow our net asset values further, and as you can see, with the stock trading at $1.50 to book over net asset value, that could also be a very accretive consideration taken in account.

We plan on revisiting our dividend policy at mid-year at the end of the second quarter of 2017. We are evaluating these multiple different options and opportunities to ensure that we enhance continued shareholder - total shareholder return for the benefit of our shareholders.

In addition to having this large earnings spillover, this earnings spillover allows us greater flexibility. This flexibility affords us what you saw us do in 2015 when we invested in our organization and to ensure that we have the infrastructure, the talent, the individuals and the necessary systems to ensure the professional portfolio growth that you witnessed in 2016.

We made this investment in 2015 and looking forward now or seeing the realization of those investments, most would all see that those investors were well founded and end up harvesting great returns for our benefit of our shareholders as manifested in the current stock price and overall total shareholder returns that we've generated for our shareholders. As I said a few minutes ago, we do expect to revisit a dividend policy by the mid-2017 time period.

Finally, and in early 2016, Hercules was also quite busy. We also raised nearly $142 million in two bond offerings of our 6.25 notes due in 2024. This initial period of capitalization in the beginning of 2016 also afford us the capability to continue to grow our portfolio.

We also added two additional banks to our banking syndicate and also began to use more actively our ATM program, which we will discuss later on this call. As you can see, 2016 was a very, very important period of time for us and manifested itself in realizing earnings for our shareholders of significant earnings growth and accumulated earnings distribution.

It is very important for Hercules to continue to maintain a liquid balance sheet. It is also critically important to continue to rely heavily on our ATM programs to which we have an equity program in place.

By relying on just in time capital raises, it allows us to have the greatest flexibility on both origination and managing our leverage and manage multiple different ratios and how we run the business.

It also forces to access to the cap - the equity in the debt capital markets to which most of our direct or indirect competitors are blocked out or unable to access those capital markets.

The ability to access those capital markets and generate higher ROE for the benefit of our shareholders has continued to afford us the ability to also be growing our overall investment portfolio, as we've done.

In addition to our ATM programs, by accessing these multiple different sources of liquidity or growth capital on adjusted time basis, we're also able to manage and not have overly large equity raises on our balance sheet and taking us two or three quarters to deploy that capital.

The use of the ATM programs allows us to have just-in-time and continue to manage our growth as we've done effectively for benefit of our shareholders, while also making those equity issuance highly accretive to net asset value, which Mark will cover later on in the presentation.

As we entered the year, we stated at the beginning of 2016 that our goal was to achieve an investment loan portfolio of $1.3 billion to $1.35 billion on a cost basis. I'm very proud to state that not only did we achieve this goal, but we also surpassed it by the end of the year, ending the year at $1.38 billion on a cost basis.

Reaching this important goal, we find ourselves on a very important and optimal inflection point whereby our portfolio has a potential to generate net investment income earnings at or above our just-in dividend policy by also ensuring that we can continue cover our dividend simply based on NII organic portfolio growth or if the portfolio contracts, centralizing seeing early repayment activity that will compensate for that in, excuse me, will compensate for the decline in the portfolio, driven by prepayment penalties and activities that we pay or receive from our shareholder company.

With that said, let me give an illustration of the benefit of this portfolio at the current optimal level that it's at. Let's assume, for, example that we maintain our effective yield above 13.5%.

Currently, today, we have 14.4%. Let's further assume that we maintain our net investment margins above 52%, and today, we are at 53%, and let's assume further that we maintain the share count relatively same as we had at year-end or slightly increase the share count.

By merely running the assumption of our portfolio at these levels, you will soon see that using these assumptions, our portfolio at the current level would more than adequately generate an earnings that would be add for the same level as our current distribution of our dividends of $0.31 per share. That is precisely what we wanted to achieve in that portfolio.

This is critical on this inflection point because it affords us the ability to look at the market and reanalyze the market and what is going on with the competitive landscape. We also by having this earning spillover affords us greater flexibility to also make investments in our company and infrastructure for additional growth for the future without having to worry about having a dividend not covered and having our investor to see distributions. Again, the dividend spillover offers tremendous flexibility as we embark in continuation of our growth of our overall business.

The Hercules Capital brand and our reputation as a long-term capital partner is widely recognized as the largest BDC venture lender in the marketplace. This is evidenced by our continued and sustained annual new commitment growth to venture capital-backed companies and our total asset growth now exceeding the $1.46 billion.

That said, as we look to enter 2017, I do not expect to abandon our very effective slow and steady growth strategy, which has served us well over the years and certainly not until we have a clear picture directionally which way our new economy is headed and our new administration will be putting regulations in place. Because of continued discipline, we are anticipating flat to modest growth in our loan portfolio during the first quarter. In short, we simply expect to take any repayment activities and amortization and simply reinvest and maintain the same cadence or level in our investment portfolio in Q1.

Said differently, we are intentionally holding back liquidity and purposefully maintaining a highly liquid low leveraged balance sheet until we have clarity as to what market directions we can expect during the early tenure of the new administration and what sectors may be impacted by the new administration due to regulations or changes in regulations before change deploy capital in any meaningful way.

We think prudence is more important now in a first or second quarter of the year and allows administration to gain its footing and provide good directional understanding of which way we're going.

We are very optimistic, we are encouraged by some of the many things that are going on, and we certainly welcome the changes to the tax laws that are being contemplated in new administration, and we think all those are great things for the economy.

Furthermore, we are seeing early signs of some competition entering the market. But as we've done many times in the past, as we see new entrants into the market, we take advantage of that opportunity to rebalance our portfolio and selectively prune and modify our investment loan portfolio in sectors that we believe maybe overheated or sectors that we want to begin cycling out.

With that, you expect to see a modest growth in Q1, and you'll see a slight increase in the portfolio in Q2 2017. Again, this is something that we definitely see and do when we see competition coming into the market that we want to take advantage of.

With that said, we anticipate early loan repayments in Q1 to be approximately $60 million to $80 million of early loan repayments. We expect similar levels in Q2 2017 as we look to continue to rebalance our portfolio.

During the first half of 2017, we are projecting, I mean, a modest overall net portfolio growth in the first half of 2017 of approximately $50 million to $100 million in the first half for a net portfolio growth overall, including the early repayments of between $120 million and $160 million for the first half of 2017.

Again, the important statement is we expect to have net portfolio growth between $50 million to $100 million even after the $120 million to $160 million of early repayments during the first half of 2017.

As a reminder, the benefit of earlier payment activities, especially given the inflection point or pivotal point the portfolio is in, is that as these early payments are harvested, we can expect our effective yields to be elevated.

We are anticipating effective yields during the first half of the year to be approximately in the high 30% levels or the low 40% levels attributing to this early payoff of anywhere between $120 million and $160 million early payout activities.

This gives us further confidence in sustaining and earnings of NII in the portfolio on that $0.31, $0.32 as we look to select and deploy capital in the first half of the year.

That said, and turning my attention to overall administration and the changes that are going on, I am very pleased and encouraged by many factors we are seeing in the market and for the prospects of growth in 2017.

At a time when many of our existing small cap competitors are experiencing growing credit challenges and credit losses, unable to access the debt and equity capital markets, trading our financials trading below net asset value and in some cases unable to fund their large unfunded commitments or even worst potentially unable to comply with the existing SEC 18f-4 requirements, Hercules finds itself with amply liquid and low leverage balance sheet for growth.

Today, Hercules finds itself in a very advantageous positioning entering 2017. Thanks to the wonderful shareholders and our continued faith and recognition of Hercules capital, coupled with our generating strong consistent returns and healthy TSRs, ROAs and ROEs, Hercules capital stock continues to trade at significant premium to net asset value. And in fact, as of February 22, we were trading at approximately 150 to 155 to book to net asset value.

This affords us greater access to the debt and equity capital markets at highly accretive rates in a highly attractive cost of capital fundings for our benefit, for our portfolio companies and of course to that of our shareholders and earnings growth. This particular strong position was evidenced by our recent Q1 2017 issuance of the 4.35% five year convertible note.

We went out with a $150 million offering and found ourselves a highly oversubscribed offering, which we ended up closing at approximately $230 million well oversubscribed. In addition to generating this wonderful capital raise, that capital raise allow us to also add additional liquidity to our balance sheet, providing us net liquidity of an additional $150 million to deploy in the coming quarters.

Embedded in that $230 million was also a statement that we made that we plan on retiring $110 million of our bonds at a 7% note, which would took place effectively tomorrow, February 24.

This will create an additional savings of approximately $0.03 in interest savings on a dollar for dollar basis of $110 million dollar bonds that retired with the new bonds of those replaced. Mark Harris will more than gladly provide greater details into the impact of our Q1 earnings related to the one-time event on net financing.

As I said earlier, the access to the ATM program is invaluable as they're extremely cost effective method of issuing debt equity capital. It also is a very important tool to manage our leverage.

We finished the quarter at a modest leverage of 60% leverage, which is slightly down from the prior quarter. This gives us plenty of headroom for additional access into debt capital markets to continue to grow our balance sheet and drive further our ROEs on the benefit of our investors.

Also early in Q1, we capped the equity capital markets through our ATM program. I'm happy to report that in the first 42 days or so of the quarter, we have successfully raised $50 million that represents accretive to net asset values of anywhere between $0.12 to $0.14 when we finalize the end of the quarter calculations. Those offerings have been very accretive and have been at book value multiples greater than 145 to book, giving us access.

Lastly, I'm happy to report we have finally made a decision to reach out and partner with our SBA partners and have begun the process of filing our third applications for our third SBA license. That process has just begun in January and we do not expect the license and the new SBA staff and administration to settle in until sometime in the early March, late March, early April.

With that, we anticipate our third SBA license to come to fruition sometime in the beginning of the second half of 2017. We may see it earlier, but we want to be conservative, and we think that most likely the license will be granted in the second half of 2017.

We are encouraged by the early signs that we see in the market with recently the SBA granting two additional - two other SBA - two other BDCs, the third SBA licenses, excuse me for that.

Now, let me give a quick update on venture capital marketplace, which was equally robust. As a reminder, most of our data that we used to report the venture capital industry comes from Dow Jones VentureSource. The venture capital fundraising activities ended quite strong at the end of 2016; in fact, at an unexpectedly positive note.

Although investments were slightly down, activities in the Q4 were quite robust and venture capital fundraising was also impressively strong. With a highly anticipated initial debut of a long and awaited Snap IPO, a high profile unicorn, Snap will serve as an important bellwether for many others to follow should the IPO go well, and I believe that the IPO should have a good following, which will serve as a potent proxy for many other potential pre-IPO candidates to consider a follow-through in 2017.

That said, I'm encouraged by the initial interest in the IPO activities going into 2017 to which we currently have six companies in IPO registration. VC investments. VC investments topped our initial expectation in 2016 at $50 billion, which is our forecast and in fact, finished much stronger than that.

I'd like to remind you everybody that we have been anticipating the venture capital activities would be lower in 2016 than 2015 when we had $70 billion of activities take place.

In terms of specific venture investments, $10.4 billion was invested during the fourth quarter and $54.2 billion invested in 2016, up from our anticipated $50 billion. Venture capitals themselves have raised $44 billion of new venture funds to invest in new investments, quite strong.

We also saw a continuation of strong investments by the VCs into our core area of focus of investing, which is later-stage companies, which is where Hercules focuses. We do not do early-stage investments per se, and the vast majority of our investors go later stage where we saw the majority of the venture capital dollars flow.

IPO activities. As we all can see and know, IPO activities remain very nascent and not very impressive. We had 37 IPOs completed in the venture industry itself, not a very strong to view, especially when compared to 69 in the prior year.

We also saw times of liquidity increase to 7.9 years from 6.3 years in 2015, directionally going in a wrong direction. We are hoping that Snap IPO begins to reverse that course. We are encouraged and optimistic and hope to see that the IPO for Snap goes quite well.

M&A event. M&A on the other hand continued quite strong. We saw strong deal activities in the year with $82.4 billion versus $58 billion in 2015. I always remind investors that venture capital actions are by and large driven mostly by M&A events and not so much by IPO events. As much as we all like to see greater IPOs, M&A is still the exit of choice for the industry itself.

Now, turning my attention to the new administration and all the regulations and legislative changes that we are anticipating to occur, we remain encouraged and optimistic that the new administration, the pro-business congress will finally act upon various critical pieces of legislations and regulations for the benefit of the BDC industry.

There are various critical developments moving forward that could have profound and meaningful impact to the BDC industry and specifically Hercules Capital if enacted and or amended.

For example, AFFE, acquired funds, fees and expenses, I remain hopeful and encouraged that the new director of investment management at the SEC and the potentially proactive business congress will address the disparity once and for all between how BDCs and REITS are treated differently as it relates to REITs having an exemption from AFFE.

This has had a profound negative impact on BDCs as it relates to institutional ownership, which ultimately led BDCs being dropped or excluded from the S&P and the Russell index.

I'm encouraged by some of the chatter that I'm hearing on AFFE, and we certainly welcome changes to the AFFE rules and regulations. The second element to bring forward is 18f-4.

In short, 18f-4 is the disclosure that requires the definition of senior securities, specifically unfunded commitments and the calculation and termination of the impact on loan funding commitments when you derive asset coverage ratios.

We remain hopeful and encouraged that the SEC, after many discussions, is moving forward with a potential provision on filing providing clarity on the calculation and description and disclosure regarding 18f-4. We remain hopeful and looking forward to that.

Lastly and one most important provisions that I truly care about is congress taking up the provisions of the 3% limitation rules. Clearly, 3% limitation rule has an unexpected consequences, thereby limiting institutional investors from owning greater than 3% of a registered investment advisor or closed-end funds, which is a BDC.

By removing the 3% ownership rule or amending that to allow a certain institutional investors to own greater than that, but I believe that you will see a dramatic benefit and the realignment of external management fees as well as a consolidation of the BDC industry. It will be a welcome change to the industry itself.

Finally, related to another provision that's quite important. I'm thrilled to report that congress has begun to enact a critical bill regarding BDC leverage. In fact, the bill now has a name, the Financial CHOICE Act 2.0. This bill will allow BDCs to actually increase leverage from one-to-one to two-to-one. This has a meaningful impact in our business and more importantly will offer a great benefit for the benefit of our portfolio companies where we are able to allow and offer our portfolio companies lower cost of funds in order to finance their businesses, and we still generate the necessary leverage in ROE that we require with the two-to-one leverage.

It will also allow us to expand our own product offering by offering ABL-type financing solutions to our companies, which serve the critical function and also expanding our franchise and our franchise capabilities by offering a wider array of new financing products for the benefit of our portfolio companies.

In addition to all these regulatory and legislative changes that are being contemplated, Hercules itself is evaluating a strategic significance and evaluating the various growth options, initiatives and opportunities that may avail itself upon some of the changes in adoptions of these regulatory changes.

These regulatory changes could have profound impact in our business and provide meaningful growth opportunities for our business. For example, it could allow us to expand new potential asset classes, provide a management of outside manage pools of capital and also allows to expand new lending opportunities to the venture industry itself. Opportunities can include, for example, acquiring the entire team investment professionals from an additional asset manager.

The acquisition of the loan portfolio or in fact both, an acquisition of loan portfolio and a team from another adviser that may exist in the marketplace today. It could allow us to form complementary, privately managed pools of capital to expand in new markets with different costs of capitals in funds, allow us to manage potentially SMA accounts as we look to expand our Hercules platform and brand.

By doing these different potential funds, we're also able to spread our SG&A over a wider pool of capital, thereby benefiting our overall investors and lowering our overall cost to capital while increasing the brand and also the debt of financing offerings to our portfolio companies and new markets that we choose to enter.

In closing, 2016 was an excellent year on many fronts, as evidenced by a very strong financial performance and stock performance. I would like to thank all of our highly dedicated outstanding team of employees for their continued hard work and dedication, as well as our venture capital partners for their continued support and trust in helping us achieve this wonderful achievement in 2016 and continue to help us grow as they have done over the years.

We are extremely well positioned entering 2017. We have a low leveraged balance sheet, highly liquid balance sheet, and we're conservatively postured with liquidity to make new investments once and when we have a clear understanding of what the recent cabinet appointments and nominees will be taking action on and their reaction to administrations regarding potential new policies, regulations, legislated changes that are being discussed and proposed.

Many of these regulations and legislations can have profound impact in our business, both in accretive fashion and potentially detrimental fashion depending on which way the regulations go.

The impact ranges from legislative changes include environmental policy in tax credit changes, for example, Solar; impact on pharmaceutical and biotechnology companies regarding drug price and drug price lower pricing pressures. These are some examples of impact from these new policies and regulations that are being contemplated.

However, notwithstanding that comment, we are very optimistic and remain bullish but guardedly optimistic entering 2017. We have purposely increased the liquidity in our balance sheet and moved to a defensive position in our balance sheet as we wait for directional evidence of the new administration policies, the Federal Reserve Monetary policy and the administration fiscal and tax policies that could have profound impact in our business and in the overall market.

We are encouraged by what we're seeing and remain optimistic, and we look forward to make substantive investments as we n turn of the second half of 2017. As a reminder, we anticipate ending 2017 with the new target of $1.5 billion to $1.6 billion. But given the optimism I'm seeing and the expectations of what I expect to see by the end of the year, there is a stretch goal of achieving $1.7 billion in overall investment portfolio growth representing 20%. But I will caution, most of that growth will be second half of the year weighted.

With that said, I will turn the call over now to Mark Harris, our CFO, to run through more specific details. Mark?

Mark Harris

Thank you, Manuel. And good afternoon and evening, ladies and gentlemen. Today, I'm going to make comments on our core numbers, which means that I will not be speaking to, I will be speaking to all numbers and ratios without the benefit of the one-time income of $8 million related to a litigation settlement.

We at Hercules believe strongly in providing accurate view of our performance, then I'll present alternative facts as we want our investors to have a reasonable trend line to judge our performance today and into the next several periods. If you would like to see the full impact of this income, I would direct you to our 10-K and press release filed today after market.

With that in mind, I'm pleased to report another strong quarter and our annual 2016 financial results as our premium eventual lending platform continues to deliver outstanding financial performance on virtually every meaningful metric. When we look at 2016 performance compared to 2015, we see growth on nearly all fronts.

For example, our total investment income grew 11%, our NII grew 26% and our NII per share grew 19% for the year ended December 31, 2016. All of this was possible to the growth of our balance sheet, where we achieved another record high investment portfolio of $1.424 billion at value or growth of 19%.

We did this through raising $92.8 million of net equity at a blended rate of 1.32 price to book under our equity ATM program and issuance of our debt with a weighted average cost of debt dropping from 6% to 5.8%, demonstrating again our full accessibility to the capital markets by erasing $243 million in 2016 alone.

In addition, we're pleased to declare our 46th consecutive dividend since going public in 2005, a $0.31 per share that will be paid on March 13 as approved by our Board of Directors with the record date of March 6.

Today, I'd like to focus on six key financial items that drove our success in the fourth quarter. First is our managed growth. We have strong total investment fundings on $219.2 million in the fourth quarter, the highest performance quarter in 2016, which included the addition of nine new portfolio companies that accounted for 59% of our originations in the quarter.

On a cost basis, we were able to grow our loan book by $109 million in the fourth quarter, even with the headwinds of $100.5 million stemming from $67.2 million from unscheduled early payoffs and $33.3 million from scheduled amortization.

This resulted in our debt investment portfolio increasing to $1.385 billion at the end of the fourth quarter on a cost basis or up approximately 20% from the beginning of 2016.

In our first quarter of 2017, as Manuel has commented, we expect to maintain our existing loan investment portfolio of balance given our decision to rebalance and cycle out of certain investments related to unscheduled early payoffs estimated at approximately $60 million to $80 million.

Second comment was on higher NII and NIMs. Our net investment income closed at $25.1 million in the fourth quarter was $0.33 per share, more than covering our dividend of $0.31. This was driven by an increase in our total investment income by over 5% to $47.5 million in the fourth quarter from $45.1 million in the third quarter.

This increase is attributable to both the growth of our debt investment portfolio where we saw an increase of 7% in our weighted average loan outstanding balances between the third and fourth quarter and an increase of one-time accelerations from early unscheduled payoffs.

While interest and fee expense were flat in the third and the fourth quarter, we do anticipate an increase in interest and fee expense in the first quarter and beyond of approximately $800,000 due to the issuance of the $230 million convertible notes that we used to tender all of our 7% $110 million 2019 notes and add liquidity for future growth.

In conjunction with the redemption of our 7% 2019 notes, we will incur a one-time non-cash expense of approximately $1.6 million or approximately $0.02 per share in the first quarter of 2017.

Further, due to having both notes outstanding for a 30-day period in the first quarter, we further expect to see another $700,000 of additional interest and fee expense in the first quarter only.

Our net interest margin continues to expand to $37.4 million in the fourth quarter, up from $35 million in the third quarter due to strong investment income growth. Further, our net investment margin as a percentage of average yielding assets was 11.8% in the fourth quarter, up from 11.1% in the third quarter as we generated more income over a growing yielding asset base while effectively managing our cost of capital.

As I commented, our NII per share in the fourth quarter was $0.33, which is above our dividend of $0.31 or 106% dividend coverage. This outstanding performance coupled with earnings still lower from 2015 and our net realized gains in 2016 of $4.6 million has now accumulated approximately $34.2 million in spillover income or approximately $0.43 per share at the end of 2016, which will be carried over into 2017 based on our share count at the end of 2016.

Last, we are always keeping our eye on the Federal Reserve Open Market Committee reports as potential rate hikes are always monitored closely. As we have commented in the past, we have a very well positioned portfolio with a highly asset sensitive balance sheet in the event of future interest rate movements.

We do this where 92% of our loans are variable interest rate loans with floors and nearly 100% of our debt outstanding was fixed interest rate debt. That's a 25 basis points increase in the benchmark interest rate at the end of the fourth quarter will be accretive to our income and NII by approximately $1.9 million on an annualized basis or $0.02 NII per share annually. In fact, if the estimated three hikes happened this year, that would generate an additional $6.4 million of income and add approximately $0.08 NII per share annually.

Turning to credit outlook, in the fourth quarter, our weighted average credit rating moved to $2.41 million from $2.32 million in the third quarter. This increase was primarily driven by one movement of the company to a credit rating five in the quarter. Our watch list grades three through five, slightly reduced from 38.5% to 37.6% on a cost basis.

Other movements within the portfolio are consistent with our longstanding policy of generally downgrading credits to a grade 3 as the companies’ approaches the capital raise or clinical milestones.

Traditionally, our portfolio companies will need to raise capital every nine to 14 months. Thus, it's our expectation that our portfolio companies will migrate to a rating 3 at some point in their normal lifecycle with Hercules and in the ordinary course of business.

Our credit 4 and 5 rated companies, which are primarily areas of focus, did increase from 9.3% to 13.8% on a cost basis in the fourth quarter, primarily due to the addition of one portfolio company.

However, we're making significant progress on closing three potential M&As and a handful of companies in the process of completing new capital and future transactions in the first quarter. For example, if everything occurs as we are anticipating, we could see a material reduction in our credit rated 4 and 5s accordingly.

We also saw continued improvement on our non-accrual loans, which decreased by $2.3 million in the quarter on a cost basis due to the removal of one company were Hercules was fully paid off. This reduced our non-accruals to 2.9% of our investments on a cost basis in the fourth quarter.

As discussed previously, if one of the non-accrual companies completes an M&A event in the first quarter of 2017, we anticipate this will further reduce our non-accruals to 2.1%. We had modest net realized activity in the fourth quarter with net realized gains of $1.1 million or $4.6 million for the year ended December 31, 2016.

Our annual realized activity mainly came from the full and partial disposals of a handful of investments. At the end of Q4, we continue to reduce our cumulative of net realized losses since inception to just under $2.3 million on approximately $6.5 billion of commitments, making our realized losses negligible and outstanding achievements of the proactive investment management culture here at Hercules.

We had a net change in unrealized appreciation of approximately $20 million on our investment portfolio during the quarter, consisting of both debt investment portfolio, which had a net change in unrealized appreciation of $4.3 million, and our equity and warrant portfolio, which had a net change in unrealized appreciation of $15.6 million.

The depreciation of our debt investment portfolio primarily consists of one company having an impairment of approximately $15.4 million and another investing company reversing its previous impairment of $10.2 million as it closed an M&A event.

The depreciation in our equity and warrant portfolio was made up of approximately $4 million from our public company portfolio and 11.1 from our private company portfolio. More than half of the private company depreciation came from the write-down of one portfolio company in the period consistent with our policies and procedures here at Hercules. Outside of that one event, the performance of our equity and warrants was consistent with the market.

Turning to our ROE, with our strong fourth quarter performance, we were able to achieve solid returns for our shareholders. Our return on average equity increased from 12.9% to 13.4%, recording one of the highest ROAEs we have had historically at Hercules since our inception, which highlights the strong platform we have built and our strong market leadership of our core business and making these achievements consistently.

Moreover, we achieved as well operating at modest leverage levels with our regulatory leverage at 60.6%, that's not stressing our balance sheet to make this achievement, and providing us plenty of headroom for growth to keep continue driving our key ratios.

Last, I want to turn to our treasury and liquidity management. In the fourth quarter, we continued to demonstrate our access to the capital markets on a just-in-time basis, offering us tremendous flexibility in managing our growth and balance sheet management. Hercules was pleased to begin operations of the first debt ATM program.

This program issues are 6.25, 2024 notes at the market, which are currently trading at our premium. The basis of this program is no different than our equity ATM program where we can issue just-in-time debt in combination with our just-in-time equity ATM program, that's enabling us to control our leverage ratios as we deem fit.

In the fourth quarter, we issued approximately 317,000 notes for net proceeds of approximately $8 million, all of which were issued at a premium over par plus accrued interest.

By using our ATM programs, we were able to effectively manage our liquidity and our leverage. For example, our leverage quarter-on-quarter declined. Our regulatory leverage, excluding SBA to ventures as we have an exemptive relief from the SEC, declined to 60.6% at the end of the fourth quarter versus 62.7% at the end of the third quarter.

Our GAAP leverage, which includes the SBA debentures, also declined to 84.7% in the fourth quarter from 87.9% at the end of Q3 2016. With our cash position at the end of the fourth quarter and our self-imposed one-to-one to 1.1 to 1 gap leverage, this will enable us to grow our debt investments between $1.5 billion and $1.6 billion without raising additional equity at the end of the fourth quarter. Hence, we have plenty of access and room to reach the achievements that Manuel discussed earlier.

Our liquidity is the foundation for our success with very strategic treasury planning. At the end of the fourth quarter, we finished with $203 million of liquidity. Our liquidity consisted of $13 million of unrestricted cash and $190 million of un-drawn availability under our revolving credit facilities, which are subject to borrowing base leverage and other restrictions.

Our liquidity was enhanced in the fourth quarter, primarily through the incredible performance of our equity ATM program where we issued 3.2 million shares generating $42.7 million of net proceeds at an average price to book multiple of 1.38, plus all issuances were accretive to book and contributed to approximately $0.14 per share increase in our NAV in the fourth quarter.

We further enhanced this in the first quarter of 2017, we had two positive liquidity events. First, our equity ATM program issued another approximately 3.3 million shares with net proceeds of approximately $47.1 million at an average price-to-book multiple of 1.45.

We also successfully completed our $230 million four and three eights convertible notes due in 2022, the proceeds of which were used to redeem all of the 7% 2019 notes on February 24 and the remaining proceeds to be used for investments and working capital needs.

This will increase our interest and fee expense by approximately $800,000 per quarter in 2017 and generate pro forma regulatory debt of approximately 71% or net regulatory debt of 57.2%.

Our cash pro forma after closing the 230 convertible note offering and redemption of the 7% 2019 notes will increase some $13 million to approximately $123 million, thus improving our total liquidity from $203 million to approximately $318 million early on in Q1 2017.

This affords us the ability to grow our book further to $1.6 billion to $1.7 billion holding for one-to-one to 1.1 to 1 gap leverage ratios due to the issuance of our equity under the ATM program.

In closing, we're very pleased with our fourth quarter and 2016 performance achievements. We believe we have positioned ourselves nicely for 2017 and beyond with our liquidity position to grow our book prudently.

We believe strongly that our long-term focused approach will enable us to deliver solid results for the receivable future, and this is evident by the performance in our key ratios, our stock currently trading above 1.5 price to book today and our continued access to diverse capital markets.

With that report, I now turn the call over to the operator to begin the Q&A part of our call. Operator, over to you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Jonathan Bock with Wells Fargo Securities. Your line is open. Please go ahead.

Jonathan Bock

Good afternoon or good evening and thank you for taking my questions. Manuel, I just wanted to start to make sure I got it correct, but if you're a bit, let's say, hesitant and would like to see how the administration plays out in a number of your core areas, did I hear it correctly that you're looking to perhaps just lighten the accelerator a bit and perhaps not intend to grow the portfolio significantly over the next several months, is that generally what I'm hearing? I just want to make sure I got that fine point. Then, I've a small follow-up.

Manuel Henriquez

Yeah. Because of all the noise going on in Q1 and refinancing the bonds, the excess interest expense, the one-time non-cash charge, the rebalancing of portfolio that we're doing, ostensibly what I'm saying is we're still going to take the amortization in early payout activities and reinvest it to sustain the cadence of the portfolio at the levels we're at today.

So you may see a modest growth in Q1, but our intent is basically kind of keeping it flat at the same interest earning level that is today. And then, as we get more clarity on various key things that are going on in the market, you'll see a step-up origination activities going into Q2 and I think you can expect to see Q2 to be net up, meaning net portfolio growth considerably $50 million and probably more like $100 million of portfolio growth.

Jonathan Bock

Okay. So then if that's the case, then should we also see the ATM issuance slow meaningfully as well?

Manuel Henriquez

I want to negotiate myself, but the answer is yes. And until such time - look, I want to be very clear here. The administration has done some very positive things, others have not so much.

But I think as the cabinet members finally settle in, I think that you'll see us get more comfortable in certain sectors and if that happens, you'll see us accelerate growth more and tap the ATM. But at this point, reliance in ATM for the first half of 2017 will be light at this point.

Jonathan Bock

Okay. And then maybe one competitive question, and it's just come as a dovetail, So then while your balance sheet now affords you flexibility to do very large offerings, particularly for publicly traded small life sciences companies, right, nonqualified asset from a BDC perspective because your lending to company with, say, perhaps $250 million of market cap - equity market cap or greater, there is interest in that market from some of your competitors, some of whom performed a large JV, $700 million, I guess, in terms of size.

Manuel, can you talk about the competitiveness only because your balance sheet is so large and when it's time to grow, making sizable loans to those types of life sciences companies is fairly beneficial to all, how would you rate the competitive environment in large cap life science fields with more capital entering that marketplace or is it really just you and Oxford, a mid-cap and perhaps a new entrant, that's not bad, there's plenty enough to go around for everyone.

Manuel Henriquez

Well, look, I think there is a couple of critical points in your question. I mean, number one, I think that the construct of the BDC regardless of my large balance sheet in itself places limitations on size of investments.

And as you rightly have pointed out, the good asset, bad asset, 30% bucket, which can include international companies or what have you, so even though there could be a robust opportunity for us to pursue on the public side.

It is certainly probably best done with having a sister fund or join fund, as you referred to, with some of the other players out there. It doesn't mean that Hercules we will not be disenfranchised in that opportunity.

But you can actually rather we distribute more of the capital that we're deploying into a sister fund, for example, to continue to grow the franchise, but also be cognizant of the regulatory 30% bucket role in doing that, which some of my competitors are in fact doing and they have that flexibility that I currently do not have today. So that totally affords it.

As to the more macro question, I think that as most people know, venture capital, life science investing has always been - acquires a public to private franchise, because of the enormous amount of capital that these life sciences companies needs and the amount of capital that's available in the private venture capital marketplace is finite and limited, hence the reason why you have to bridge the private to public world and oftentimes, these life science companies continue have support by the venture capital partners, even as public companies themselves.

So we think that market remains quite attractive. It is a tricky market. Just because we have an outstanding track record of doing it, it is not something as easy replicatable, and we think it adds significant barriers to entry, which others will soon learn, and it takes us quite an expertise to do life science investing.

Jonathan Bock

Okay. Got it. Then just as a follow up on one investment in particular, Sungevity. How big was that post quarter follow-on and more of a detail on that investment, should we expect changes from the 4Q mark, which was at about $0.75 [indiscernible]? Thank you.

Manuel Henriquez

So, I'm not going to disclose the actual amount of the capital because that's something that's private to the company itself. I would tell you that the amount of capital that was raised certainly affords the company the exercise that they're engaged with right now with evaluating the various strategic opportunities they have before them.

They chose to not to pursue the IPO that ended, I think it was January 4, 2017, and as such, the engage investment bankers as advisors to evaluate multiple different opportunities and would be early chatter that we are seeing and hearing, we are quite encouraged with the path that they are evaluating.

We are not on the Board, so we're simply lenders to the company, but I think the company is embarked on a good process. And I think that they're having a higher receptivity to multiple different options they're doing.

And to answer your more macro question, if everything continues to go down the path that I'm seeing, I think that you could have a substantial, if not entire, recovery of the position that was marked if everything comes to fruition that I see things falling into place right now. But again, I need to caution everybody, strategic evaluations are probably different decisions by parties that we do not control or involved with. So at this point, we are along for the ride, and we're encouraged by what we're seeing.

Jonathan Bock

Yes. We'll look at passes prologue to understand that workup situations, you've done them much better than almost everyone. So thank you for taking my question.

Manuel Henriquez

Thank you for that.

Operator

Thank you. And our next question comes from the line of Kyle Joseph with Jefferies. Your line is open. Please go ahead.

Kyle Joseph

Hey. Afternoon, guys. Thanks for taking my questions. Congratulations on a good quarter or actually for that matter, good year overall.

Manuel Henriquez

Thanks, Kyle.

Mark Harris

Thanks, Kyle.

Kyle Joseph

I'd just like to start, I know you talked about your investment philosophy post-election and you nurture sort of cautiously optimistic or whatever right now, and you're not really deploying capital until we get a little more certainty and I fully understand that, but from a longer-term perspective, are there any changes you have to your investment strategy regarding specific industries just based on the election?

Manuel Henriquez

So, Kyle, as much as I'd like to share that with you, the last thing I want to do is share that with you and give my competitors a perspective as to why we do, what we do and why we navigate the historical credit performance that we have is because we have - one of the most before things about Hercules is different from the vast majority of players out there is that we don't have generalist.

We have three industry verticals; a team in renewals, a team and technology and a team in life sciences, and those teams are staffed with highly experienced, highly knowledgeable individuals who share with us their perspectives on what's going on in the industries.

And so I would give this service to our team and our franchise to divulge exactly what we are doing in our strategy, but I would tell you that we will - we are pruning and rebalancing our portfolio, and we will still originate over $100 million just by reinvesting the amortization and the early payoffs.

So we're doing what most people came and do in a year, we're doing it still in a quarter, so we're quite busy. We just chose not to growth it in Q1 and may grow modestly and then grow it in Q2 by probably net $100 million or so.

So you'll still see some growth in the portfolio. We just want to wait and see with all the new cabinet members to exactly if there's an alignment with this insurance policies and alignment with that of the cabinet and also regulatory changes that we want to see occur, which we're encouraged by.

Kyle Joseph

Got it. And then I know you talked about it, you addressed the dividend sort of mid this year, I think you said, can you give us your philosophy, Manuel, on special versus sort of run rate increase of the quarterly dividend, just given where your NOIs trended to and also the spillover you had as of 12/31?

Manuel Henriquez

It's obvious that we have three quarters sequentially of earning NII well and excess of our dividends. So obviously, that is one of the items that allowed us to see the growth in earnings spillover over, but I have to remind everybody that we have a very independent board and the decision on dividend policy is one that is discussed and reached an agreement with perspective with the board, our policy.

However, it would be my preference to consider doing a small one-time dividend sometime in the second half of the year. And once I have a good directional knowledge of where we're going as an economy, also probably increase our normal $0.31 dividend by a $0.01 or $0.03 given the portfolio growth, and that's going to be the function of those two factors.

But there's no question that we intend to distribute those dividends, and there is also an element that I believe strongly that given the potential lower corporate tax that we are potentially seeing coming up in the future is a highly accretive event whereby we actually retain some of those earnings and end up doing a 1099 that grows us up on the cost base for the benefit of shareholders, and we see growth - net book value growth continue, especially when the stock's trading at 150 to book.

Kyle Joseph

Got it. And then earlier this month, I saw a press release that you guys made a pretty large investment in a company called Axovant. I think it was a $55 million investment.

Would you have any intention to syndicate a portion of that? I know that you’re fully capable of taking on and investing that size given where your balance sheet is grown too, but can you discuss your thoughts there?

Manuel Henriquez

Sure. I mean, historically, we have chosen not to syndicate. I don't think in the immediate future I have an interest to syndicate. As of right now, we do have a few BDC partners that we consider to be highly credible and very good investors that we would be happy to partner with if we still choose to do syndications, but it's something that we're evaluating and we've been approached by other BDCs as well in kind of the upper tier BDCs that share the same kind of credit discipline as ourselves.

So it's not on the question, but it's not something that is on the horizon in Q1 or Q2, but we have been approached proactively, and we have approached few of them also proactively on the possibility of entertaining that, especially in light of initial question that was asked in terms of size of investments and concentration issues that may exist, and it may be prudent especially when you're looking at bad asset, this is a particular bad asset, I mean, this is a foreign asset.

When you look at the issues of foreign assets, you have to make sure you are monitoring your bad bucket closely, which we are, but it's an issue of eventual growth that we may have to address.

Kyle Joseph

Got it. Thanks very much for answering my questions.

Operator

Thank you. And our next question comes from the line of Ryan Lynch with KBW. Your line is open. Please go ahead.

Ryan Lynch

Good morning. Following up - sorry, good afternoon. Following up on kind of that question on the administration, obviously, you talked about kind of slowing down or pulling back just a little bit, just be a little more cautious and so you guys get a little more clarity on the administration's new positions.

Are you seeing the same caution, outlook or pullback from some of the venture capital firms in terms of their deployment of capital or M&A in response to the new administration?

Manuel Henriquez

Ryan, you got to understand we're dealing in the world where a tweak can cause volatility in the stock, alternative facts become real facts. We are living in a paradigm that is very difficult to handicap until we have clarity.

I mean, policies seem to ebb and flow, and there are implications that we as risk managers have to be cognizant of and that is the implications on H1 visa program, to that of staffing and our technology companies and getting PhDs in biotechnology companies. The implications of drug prices and the pressure that these companies could face that could alter their business models.

The un-clarity or lack of definition on the affordable care act on reimbursements, especially when it comes to medical devices and other aspects of the business. So prudence we tell you that it's better to go slow and if some competitors want to jump in and the waters warm, I invite them to go swimming.

But I got a 12 year record here of managing this book with my team of being prudent. I think slow and steady is the right thing to do. There is - I don't believe there is threat to my earning power, the way it is, especially for $0.43 still over, I think we have the advantage with a highly flexible liquid balance sheet, low leverage earning spillover that to sustain our earnings for the time being, I think it's the right strategy.

Ryan Lynch

Yeah. I agree with that. Moving to a different point, though, you mentioned that there seems to be some signs of early competition in your space and new competitors may be in the space over the last few months, I have read or a seen a few articles out there that are talking about actually some meaningful players in the space pulling back from technology lending specifically.

So, are you seeing any less competition in the technology lending space and if so, does that mean that that's because of - that's more of a riskier asset class right now or is that maybe present an opportunity for you guys to go in there to take some market share?

Manuel Henriquez

So I say this all-time, I don't understand the concept of the market share when you run a risk business and you do risk investments and risk management. So to me, the opportunities are what they are, and they just have to meet the appropriate screens that reflect a risk award basis that is commensurate with what we deem to be appropriate and also with an eye of long-term capital preservation as a strategy.

I think that you're absolutely correct that we've seen a lot of new entrances rush to originate assets and then find themselves pulling back because of their experiences in significant losses. Not to give an infomercial on behalf of Hercules, but we have one of the best teams in the industry as evidenced with $6.5 billion of commitments we've done over 12 years and culminating in 12 years of cumulative losses net of gains of just $2 million.

We make it look easy, but it's far from that and is evidenced by many who have tried, and so we will continue to do what we do, which is methodically evaluate new opportunities. We're not going to get hung up on market share or simply grabbing market share if it doesn't make sense.

And as I said this many times in the past that of any investors, if investment quality is not there, I'm more than happy to miss earnings and risk the balance sheet. And so I think that discipline is more important than just trying to make earnings.

And I think that's evidence in how we perform and how we manage this business, but we will certainly evaluate all opportunities, all opportunities are welcome that meet our screens, but we're going to be who we are, we're just methodical conservative guys and gals and how we evaluate opportunities.

Ryan Lynch

Okay. And then just one last one, in your press release, you talked about core yields in your portfolio or I guess core yields in new investments maybe coming down just slightly about 25 basis points you expect in 2017. Can you just talk about what are the drivers that's compressing those yields slightly?

And I'll be interested to know that if you guys are pulling back and maybe not being as aggressive and being more selective in deals, at least in the first half of year related the first quarter, is there a chance that your selectivity is going to offset some of the lower yields you guys are seeing in the market today?

Manuel Henriquez

So there is a couple factors there. First of all, on the more macro question, our overall yield, it basically, its pricing equilibrium. Our pricing necessity, excuse me, so we have rising rates, as Mark indicated, from all accounts that Fed anticipates three rising rates in fiscal 2017, that 75 basis points.

You have the rental rate increase in December. So sensibly you could find yourself effectively at 100 basis point increase in your overall weighted yields, which could be obviously $0.10, $0.12 in earnings just for Hercules alone from that. So the conservative nature of that statement on pricing elasticity is primarily attributed, I want to make sure we could pass those rate increases fully to our underlying new perspective companies that we are going to be lending to.

So that is one signaling that until I have a good confidence that those prospected future rate increases can be fully passed through. Hence, what I believe is a more conservative outlook on kind of managing down the core yields that I talk about.

The second element that I will clarify for you that you addressed, which I don't 100% support, is that we're not going to be out of the market if we find competitive price yields, that's not what I'm saying. In fact, what I am saying is that we will be more than happy defend our franchise.

And if we have to go significantly very competitive on certain deals because we think that those deals merit a very, very aggressive pricing, given that I have a $1.3 billion loan book at over 30% plus, I can go do a highly competitive deal at significant lower yields that I'm doing today and the impact on the overall aggregate maybe 5 basis points, 10 basis points in that.

So the comment that you've made is I'm going to put it back into why I made the comment. It's an offensive comment and allows to have greater flexibility with the liquidity in our balance sheet that we have that we want to be very competitive and offer highly competitive rates if we so choose, we can do that without materially impacting our overall weighted yields.

Ryan Lynch

Okay. Make sense. Thanks for taking my questions and congrats on a great quarter.

Manuel Henriquez

Thank you very much.

Operator

Thank you. And our next question comes from the line of Chris York with JMP Securities. Your line is open. Please go ahead.

Chris York

Hey, guys and thanks for taking my questions. Most have been asked and answered, but how are you ranking your seemingly expanding opportunity set for strategic initiatives like ABL venture leasing, maybe your life sciences' JV today and is expanding your reach globally also included in that opportunity set?

Manuel Henriquez

So the answer is yes, all the above. But the answer is also driven a lot by a potential or anticipation of regulatory changes. The two-to-one leverage for example will be critical and embarking more earlier than non-ABL product.

The joint venture and looking at that asset distribution, that also could have an impact in the business and looking at it, because if you have two-to-one, you still have a 30% bucket issue to balance and looking at that.

There is no question that there's opportunities that we're seeing in Europe, as evidenced by the cold question asked earlier regarding our recent exposure to European life sciences company, we're seeing good opportunities in that market.

So what we are seeing is that the Hercules brand is reaching now outside United States, and we're getting very nice interested in deal flow there, but because of our structure, we are limited to 30% of that assets being non-US assets.

So we want to take a very select rifle shots, if you will of what those opportunities are, but we are seeing a growing demand whereby our current regulatory structure significantly impairs our ability to pursue such opportunities, but those are things that we're evaluating.

And these are opportunities that may take place later on in 2017, early in 2018, but I think they're still very early in the exploratory process of evaluating these opportunities and to you initial question, ranking which ones to pursue until we have clarity on the regulatory front.

Chris York

Yeah, that makes a lot of sense, and you did provide a comprehensive outlook for regulatory improvement in BDCs, but do you think may be included in that or not included that is whether the staff could include SEC staff changes to the definition of eligible portfolio companies?

Manuel Henriquez

That is the third rail. I think that the initial two-to-one BDC leverage bill initially included language to clarify exactly that issue. If I remember correctly, I don't have the bill in front to me.

I believe that the bill that's moving forward today, I believe, omitted that clarification in that language. So I think that the financial choice act currently is moot on that issue and I don't think it's being addressed in initial passage of the bill, so no.

Chris York

Okay. And then maybe this one here from Mark, you touched briefly on balance sheet leverage, but with changes in your balance sheet and comments about the pursue of a third SBIC license and then a strong investment track records, are there situations where you wouldn't want to take balance sheet leverage above that one-to-one that you've mentioned?

Mark Harris

Well, look, I think the guidance I would like to give is that we're kind of again self-imposed on that one-to-one, 1.1 to 1. The answer to your question is by adding the SBA third license, remember, it's not an all or not, you can actually scale it as you deem fit, it doesn't all have to come in.

For example, if we did the full 150 license to put all in at the same time, so it would give us the opportunity and still be able to monitor the position of our leverage through both adding debt as well as our equity program when we see it prudently in terms of the deals we're looking at, they are fit within the SBA license as well as other things that we're doing that would also fit onto our balance sheet. So it's very much something that you got to manage very carefully, but none that were too concerned with.

Manuel Henriquez

Yeah, I want to emphasize that - let's assume that the SBA staff acts efficiently and quickly, and let's say you get the license April-June-July, let's call it September to make it easy. By the time we get up and running and making that deployment, the third license will be marginally impactful, if at all, in 2017.

I think that you'll see that really accretive nature of that third license really come into fruition at the beginning of 2018. So I think that we're not anticipating much leverage from the SBA in 2017.

Chris York

Got it. So maybe somewhere maybe near-term one-to-one and potentially above that in 2018, you'd consider potentially going above the one-to-one that might be a situation that provides that.

Manuel Henriquez

If you remember what I said, the Financial Choice Act, if enacted by Congress, increases leverage two-to-one, and that will give us a lot more confidence and level on that flexibility to do that. So that's one of the gating items that we're looking at as well, which is why we're not in a rush.

But I think Mark said absolutely correct that our comfort level is 1.1 and the fact that we are up 0.6 today regulatory leverage and on a GAAP basis, I think we're 0.8 or 0.78, I think that we have quite a nice headroom before that becomes an issue to consider.

And as Mark probably articulated, we don't need any incremental significant growth to simply achieve our goals of $1.6 billion, $1.7 billion loan book by the end of the year without getting that higher leverage point anyway. So to say differently, we're kind of good right now with what we know and what we see.

Chris York

Yes, makes a lot of sense. That’s it for me. Thanks for taking my questions.

Manuel Henriquez

Thanks, Chris.

Operator

Thank you. And our next question comes from the line of Aaron Deer with Sandler O'Neill. Your line is open. Please go ahead.

Aaron Deer

Hey, good afternoon, guys.

Manuel Henriquez

Hi, Aaron.

Aaron Deer

I just want to follow up on the core yield guidance question in your response. Your response led me to believe that you guys are willing to get as competitive as necessary to kind of keep your positioning in the market.

And I realize that there is a decent amount of churn in your portfolio over the course of year. But I'm still just struggling with the idea behind the core yield coming down given your positive sensitivity to rate.

So even if you're - if you've got a fair bit of churn in each subsequent quarter, if rates are going up and the vast majority of your portfolio is tied to primary LIBOR, why wouldn't we see this quarter yield going up, are you seeing that much, do you expect to see that much pricing pressure?

Manuel Henriquez

We don't know. We don't know how much of the overall yield can advance through to our companies and what is their own pricing elasticity, why they say I'm going to refinance or not. I mean, we all know mathematically the simple equation is that the rate you can change to a portfolio can bring greater than 3% in the first year and greater 2% in the second year as a natural trigger point for them to refinance the paper.

To be verbally honest, if you look at our investor presentation on page 23, the historical core yields have navigated between a fairly tight band of 13.8 at the beginning of Q3 2014 and really have been a sustained level between 12.6 and 13.4 pretty consistently.

So we're not really forecasting much change other than 25 basis points from our historical level of 12.5 to 13.5, now guiding down to 12.25 to 13.25, so not a really significant change.

But I want to make sure that we also provide a perspective of that until we test pricing elasticity in a marketplace to your point, rise in rates, I don't know how much of those rates I'll be able to pass through, I don't know what the competitive landscape will be.

And so I want to make sure that we have ample amount of margin and liquidity, which we do have, and if we find ourselves in an unexpectedly higher competitive environment, that we're happy to go out and do $200 million at 9%, $200 million at 10%, whatever that rate maybe.

And so that is what the flexibility that we want to dial into our models, which we take into our own models to make sure that we have a competitive offering for our portfolio companies.

Aaron Deer

Okay. And then relatedly, Mark, in the rate sensitivity table where you kind of demonstrate $0.02 plus an EPS benefit from each 25 bp change from the fed, is that based on a static balance sheet?

Manuel Henriquez

So the rate, yes. So the rate table that we use is basically on the static balance sheet at the end of Q4. So that would be the impact as it would happen if the rate step up 25%, 50% or 75%. The other comment that I do want to make, though I think Manuel answered the question correctly.

But I want to amplify on his answer a little bit also is when we give you our thoughts on where yields are, please remember, we do not embed future rates into that and we do it very easily.

Because in 2016, as you might remember at the beginning, there was supposed to be a three rate increase year and it turned out to be one, and it turned out to be at the very end of 2016.

So we find it prudent when we talk is to not even think about rate increases, we can't predict when it's going to happen and if we could, maybe a little bit differently. But again, it's accretive, that's the most important part is when it happens, fantastic, but we do not build that into any kind of thoughts in our models until it actually comes to fruition and then we do it.

Aaron Deer

Okay. So no rate hikes embedded in your core yield guidance?

Manuel Henriquez

No.

Mark Harris

No. Absolutely, nothing.

Aaron Deer

Okay. Got it. Very good. Thank you, guys. Have a good evening.

Manuel Henriquez

Thank you.

Operator

Thank you. And our next question comes from the line of Robert Dodd with Raymond James. Your line is open. Please go ahead.

Robert Dodd

Hi, guys. If we go back to 2015, a lot of investments, which as you point out, paid off in NII growth, et cetera, et cetera, that showed up at the bottom line to shareholders benefit in 2016. So you're willing, I think, to invest ahead of opportunities that you see coming, and then, obviously, today, you eliminate, talking about potentially managing other pools of capital.

The double leverage and opening up other asset classes, et cetera. So would you say it was prudent for us to think of this year maybe being an investment year again ahead of those opportunities coming later?

Obviously, the double leverage, if it kicks in, there a one year waiting period before you're allowed to actually use it, it was two years before with the new bill is one year, so - but clearly, that could be an investment in personnel systems, et cetera, ahead of some of these opportunities manifesting in income. So what's the timing that we should be thinking about that, and is this year going to be an investment year?

Mark Harris

Robert, thank you, an excellent question and great question for clarification. So the fact of matter is in the first half of the year, there is no real significant investment that we're making other than watchful waiting and getting clarity directional, which way we're going as administration, because, again, we invest in life science, we invest in renewable energy, we invest in tech companies.

So I think it'll be really imprudent to continue to invest on the same hypothesis - some thesis, I should say, without having - without taking into account potential regulatory changes.

However, to the second part of your question, any event that we do see favorable regulatory changes, i.e., the two-to-one bill or other provisions happening, we will obviously signal as we have done in the past that we are embarking on an increase in SG&A and doing that and yes, we will be adding additional staff to seek out these new opportunities and that would add to SG&A, to the process depending on which vehicles we so choose to potentially pursue.

But I think that you would have and our investors would have a clear indication by us as we have did in 2015 that we are now going to go into a purposeful investment period for the benefit of long-term capital appreciation for the benefit of our shareholders.

But the first half of the year, we're not anticipating that investment to take place, and until we have clarity, I don't think we will be doing - we will be signaling that until probably end of Q2 where we have more better directional understanding.

Robert Dodd

Okay. Got it. One more, if I could, Michael, you talked about the potential regulatory volatility and so you're holding back a little bit the foot of the accelerator, as I think Jonathan said, a touch to kind of see how regulations shake out, and obviously, it is easy, quotes around that because it is not, to avoid a potential incremental credit exposure by not making alone.

How does that volatility and concerns you have affect the existing boot, because obviously, you've got an existing portfolio loans, many of which are potentially exposed to the same regulatory issues that you could be worried about changing and causing disruption.

So do you have any contingency plans in place for addressing if those issues do come up and concern you about some verticals making incremental investments? What about the books that you already have that's exposed to potentially the same issues?

Manuel Henriquez

A great insightful questions. So our loans are short term maturities rapidly amortizing loans. The legacy portfolio would benefit dramatically because it looks you know, very ablated [ph] invested for at least 12 to 15 months. So you would see the average duration of our loans is only 18 to 22 months typically.

So if I have a legacy portfolio its already on a weighted basis, invest 15, 18 months, it won't take long for me to re-tack the portfolio, and somewhat I did in 2008, 2009, where we can convert back to cash and go on to a defensive position by bolstering our cash position.

So what we do quite attractive is that I don't have five-year bullet, sever-year bullet. What we do is a short-term amortizing loans. So the ability to change the outlook of our portfolio, better yet the construct of our portfolio.

But as we're doing right now, rebalancing and pruning is exactly what we're doing is positioning the portfolio for factors we may not be fully clear on yet, but have a portfolio as dynamic enough and defensive enough that we can actually re-tack quite easily, and that's exactly what we're doing, similar to what we did in 2008, 2009.

Robert Dodd

Okay. Got it. Thank you.

Manuel Henriquez

Thank you.

Operator

Thank you. And I'm showing no further questions at this time, and I would like to turn the conference back over to Manuel Henriquez for any closing remarks.

Manuel Henriquez

Thank you, operator, and thank you everyone for joining us today on the call. We will be attending the RBC Capital Markets Conference in early March in New York City, and we anticipate continuing to do a selective group of non-deal roadshows throughout the first half of 2017. If you would like to schedule a meeting with Hercules while we are in New York or one of our non-deal roadshows, please contact Michael Hara at Hercules Capital or RBC directly to get yourself on the docket for the RBC Conference. And with that, thank you very much, and thank you, operator.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a great day.

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