Hercules Capital, Inc. (NYSE:HTGC) Q1 2024 Earnings Call Transcript

Hercules Capital, Inc. (NYSE:HTGC) Q1 2024 Earnings Call Transcript May 2, 2024

Hercules Capital, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and thank you for standing by. Welcome to the Hercules Capital First Quarter 2024 Earnings Call. At this time, all participants are in listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Michael Hara, Director of Investor Relations. Please go ahead.

Michael Hara : Thank you, Gerald. Good afternoon, everyone, and welcome to Hercules Conference Call for the First Quarter of 2024. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer, and Seth Meyer, CFO. Hercules financial results were released just after today’s market close and can be accessed from Hercules investor relations section at investor.htgc.com. An archived webcast replay will be available on the Investor Relations webpage for at least 30 days following the conference call. During this call, we may make forward-looking statements based on our own assumptions and current expectations. These forward-looking statements are not guaranteed of future performance and should not be relied upon in making any investment decision.

Actual financial results may differ from the forward-looking statements made during this call for a number of reasons, including but not limited to the risks identified in our Annual Report on Form 10-K and other filings that are publicly available on the SEC’s website. Any forward-looking statements made during this call are made only as of today’s date, and Hercules assumes no obligation to update any such statements in the future. And With that, I will turn the call over to Scott.

Scott Bluestein : Thank you, Michael, and thank you all for joining the Hercules Capital Q1 2024 earnings call. Following our record operating performance in 2023, Hercules Capital is off to a tremendous start to 2024. Our record origination and funding performance in Q1 continues to reflect the benefits of being able to operate an institutional venture and growth stage-lending platform at scale. Our ability to consistently deliver strong results for our shareholders and provide custom-tailored solutions for our growth stage borrowers in a variety of market environments speaks to the quality of our employees, the strength of the platform, and team-first culture that we have built, and our 20-plus year history of operating with an emphasis on prudent underwriting, asset and liability diversification, and an unwavering commitment to the venture and growth stage ecosystem that we serve.

As of the end of Q1, Hercules Capital is managing more than 4.5 billion of assets, an increase of 14.7% from where we were a year ago. We continue to expect 2024 to be another year with higher than normal market and macro volatility and a higher for longer rate environment. But as we discussed on our last call, we expected the market environment for new originations to improve throughout 2024. We have already witnessed this in Q1, and we are now benefiting from the balance sheet decisions that we made throughout 2023, where we went long liquidity and low leverage. We continue to manage our business and balance sheet defensively while maintaining maximum flexibility to shift to offense quickly and aggressively if deal quality warrants it, as we did in Q1.

This includes continuing to enhance our liquidity position, maintaining low leverage, tightening our credit screens for new underwritings, and maintaining our higher than normal first-lien exposure, which remained relatively flat at 88.4% in Q1. Let me now recap some of the key highlights of our performance for Q1. Many of the quality later stage companies that put off debt decisions in 2023 were back at the table, and that drove our very strong start to the year on originations. In Q1, we originated an historic record for any Q1 for both gross debt and equity commitments and gross fundings of $956 million and $605.2 million respectively. The $605.2 million of gross fundings in Q1 is the strongest funding quarter that we have ever delivered.

For Q1, we generated total investment income of $121.6 million, up nearly 16% year-over-year, and net investment income of $79.2 million, up nearly 21% year-over-year, or $0.50 per share, and providing 125% coverage of our base distribution of $0.40 per share. We were able to achieve 125% coverage of our base distribution despite ending the quarter with very conservative GAAP leverage of 93.6%. This is our fourth consecutive quarter of over $100 million of quarterly core income which excludes the benefit of prepayment fees or fee accelerations from early repayments. We also generated return on equity in Q1 of 18.8%. Our portfolio generated a GAAP effective yield of 14.9% in Q1 and a core yield of 14%. Our balance sheet remains very well positioned to support our continued growth objectives and serves as a key differentiator of our business.

The focus of our origination efforts in Q1 was once again on quality and diversification. Our Q1 originations activity was driven by both our technology and life sciences teams, delivering record funding performance during the quarter. Although new business activity was again intentionally weighted slightly more towards the life sciences side. In Q1, approximately 65% of our fundings were to life sciences companies, while approximately 57% of our commitments during the quarter were to life sciences companies. Our new commitments in Q1 reflect our slightly more optimistic view on the technology sector as we start the year. We funded debt capital to 24 different companies in Q1, of which nine were new borrower relationships. Consistent with what we saw throughout 2023, we expanded our funding relationship with numerous portfolio companies that continued to show strength and achieve performance milestones during the first quarter.

In addition, the record level of new commitment activity and continued strong performance of the current portfolio led to an increase of our available unfunded commitments to approximately $483.4 million, which increased from $335 million in Q4. Since the close of Q1 and as of April 30, 2024, our deal team has closed $117.3 million of new commitments and funded $52.3 million. We have pending commitments of an additional $308.5 million in signed non-binding term sheets, and we expect this number to continue to grow as we progress in Q2. Consistent with our historical approach to underwriting credit, we will remain disciplined on new originations and we will prioritize asset quality over chasing higher risk transactions with a yield premium. Given the market backdrop throughout 2023, which carried into 2024, we remain pleased with the exit activity that we saw in our portfolio during the first quarter.

In Q1, we had four portfolio companies announce acquisitions, of which one was recently completed in March. We also have two portfolio companies that have filed registration statements for an IPO. As we anticipated, early loan repayments decreased in Q1 to approximately $161 million, which was in-line with our guidance of $125 million to $225 million. For Q2 2024, we expect prepayments to accelerate from Q1 levels and be in the range of $200 million to $300 million, although this could change as we progress in the quarter. Credit quality of the debt investment portfolio improved quarter-over-quarter. Our weighted average internal credit rating of 2.16 improved from the 2.24 rating in Q4 and remains at the low-end of our normal historical range.

Our Grade 1 and 2 credits improved to 68% compared to 62.6% in Q4. Grade 3 credits decreased 29.2% in Q1 versus 34% in Q4. Our rated 4 credits decreased moderately to 2.6% from 3.4% in Q4 and rated 5 credits were 0.2%. In Q1, the number of loans on non-accrual increased by 1. We had two debt investments on non-accrual with an investment cost and fair value of approximately $42.2 million and $5.2 million respectively, or 1.2% and 0.1% as a percentage of the company’s total investment portfolio at cost and value respectively. With respect to our broader credit book and outlook, we generally remain pleased by what we are seeing on a portfolio level, and our monitoring remains enhanced given continued market volatility. Our focus on credit underwriting and a diversified asset base is continuing to serve us well.

We are continuing to see general outperformance and positive momentum in terms of capital raising, M&A activity, and milestone achievement throughout our Life Sciences book, while things continue to remain slightly more muted on the technology side with respect to the same. During Q1, capital raising across our portfolio was very strong, with 31 companies raising approximately $2.6 billion in new capital, which was again weighted towards our life sciences portfolio. During Q1 2024, Hercules had net realized gains of $8.2 million, comprised of net realized gains of $9.2 million, primarily due to the gain on warrant and equity investments offset by $1 million, due to the loss on warrant and equity investments. Our net asset value per share in Q1 was $11.63, an increase of 1.7% from Q4 2023.

We ended Q1 with strong liquidity of $498.1 million. Our balance sheet is both strong and stable and it puts us in a very strong position to be able to benefit from a new business environment that we believe is as strong as we have seen in several years now. Venture capital ecosystem fundraising and investment activity started 2024 with fundraising activity at approximately $9.3 billion and investment activity at approximately $36.6 billion, according to data gathered by PitchBook and VCA. We expect investment activity to remain at these levels, driven by more selectivity in terms of the profile of the companies that are receiving equity funding. Given our strong operating performance in Q1, we exited the quarter with undistributed earnings spillover increasing to approximately $143 million or $0.88 per ending share outstanding.

For Q1, we are maintaining our base distribution of $0.40 and a supplemental distribution of $0.08 per share. This represents our 15th consecutive quarter of being able to provide our shareholders with a supplemental distribution on top of our regular quarterly based distribution. In closing, subsequent to Q1, we marked our 20th year investing in the venture and growth stage asset class, reaching the $20 billion milestone in cumulative debt commitments for our company. By focusing on our team, culture, and always trying to do things that are in the best interest of our shareholders and stakeholders, our platform has been able to reach incredible highs. Our scale, institutionalized lending platform, and our ability to capitalize on a rapidly changing competitive and macro environment continues to drive our business forward and our operating performance to record levels.

Our success since inception over 20 years ago is attributable to the tremendous dedication, efforts, and capabilities of our employees and the trust that our venture capital and private equity partners place with us every day. Having a team and platform that is able to consistently deliver for our borrowers in a variety of markets is something that we are all incredibly proud of. We are thankful to the many companies, management teams, and investors that continue to make Hercules their partner of choice. I will now turn the call over to Seth.

Seth Meyer : Thank you, Scott, and good afternoon, ladies and gentlemen. Hercules’ record first quarter origination’s performance was a testament to the amazing team and the relationships we have in the venture and sponsor-backed space in which we operate. The portfolio growth was supported by our low leverage and cost of debt, as well as strong liquidity entering the quarter, a position we maintained strategically throughout 2023. To further support our current and anticipated growth, in the first quarter we took advantage of the ATM by raising $66 million of very accretive capital, helping us to maintain a strong leverage position below one-to-one on both a GAAP and regulatory basis. We continue to maintain strong available liquidity of approximately $0.5 billion as of quarter end and more than $850 million across the platform, including the advisor funds managed by our wholly-owned subsidiary, Hercules Adviser LLC.

Speaking of Hercules Adviser, the performance for the quarter enabled us to increase our second quarterly dividend to $1.6 million, which when combined with the expense reimbursement of approximately $2.9 million, resulted in $4.5 million of cash delivered to the BDC in Q1. With that in mind, let’s review the areas of the income statement performance and highlights, NAV, unrealized and realized activity, leverage and liquidity, and the financial output. Turning our attention to the income statement performance and highlights, total investment income was on par with the record prior quarter at $121.6 million driven by the prior year and year-to-date growth in the debt portfolio. Core investment income, a non-GAAP measure, remains stable at $114.2 million.

Core investment income excludes the benefit of income recognized as a result of loan prepayments. Net investment income decreased to $79.2 million or $0.50 per share in Q1, an 8% quarter-over-quarter decrease driven by an increase in variable compensation due to the record funding volume and peaking of benefit expenses and payroll taxes in Q1. Our effective and core yields changed modestly in the first quarter to 14.9% and 14% respectively, compared to 15.3% and 14.3% in the prior quarter. The decrease in the core yield was due to a lower yield on new originations and lower expired commitment revenue. First quarter gross operating expenses were $45.3 million compared to $38.2 million in the prior quarter. Net of costs recharged to the RIA, our net operating expenses were $42.4 million.

Interest expense and fees remained stable at $20 million. SG&A increased to $25.2 million at the low end of my guidance. Net of cost recharged to the RIA, the SG&A expenses were $22.4 million. Our weighted average cost of debt remains stable at 4.9%. Our ROAE or NII over average equity was 18.8% for the first quarter. And our ROAA or NII over average total assets was 9.2%. Switching the focus to the NAV unrealized and realized activity, during the quarter our NAV per share increased $0.20 to $11.63 per share. This represents an NAV per share increase of 1.7% quarter-over-quarter. The main drivers were the net investment income of $79.2 million, accretion due to the use of the ATM, net realized gains mainly on the realization events on equity and warrant positions of $8.2 million, and unrealized appreciation of $3.6 million, all of which exceeded the dividends paid in the quarter.

Our $3.6 million of unrealized appreciation was the result of $0.7 million of net unrealized appreciation on the loan portfolio and $5.7 million of appreciation on the public equity and warrant portfolio. $2.4 million of unrealized appreciation was attributable to the valuation movements in the privately held equity warrant and investment funds and $0.2 million of the net unrealized depreciation attributable to net foreign exchange movements in addition to $7.3 million of net unrealized depreciation attributable to the escrow and other investment-related receivables. These were partially offset by the reversal of prior unrealized appreciation of $7.5 million. For leverage and liquidity, our GAAP and regulatory leverage increased to [93.6%] (ph) and 84.4% respectively compared to the prior quarter due to the greater utilization of our leverage facilities on the higher volume of business.

Netting out leverage with cash on the balance sheet, our net GAAP and regulatory leverage was 91% and 81.7% respectively. We ended the quarter with nearly $500 million of available liquidity. As a reminder, this excludes the capital raised by the funds managed by our wholly owned RIA subsidiary. Inclusive of these amounts, the Hercules platform had more than $850 million of available liquidity. The strong liquidity positions us very well to support our existing portfolio companies and source new opportunities. As a final point, we continued to opportunistically access the ATM market during the quarter and as I mentioned raised approximately $66 million resulting in a $0.13 per share accretion to NAV. Finally, on the outlook points, for the second quarter, we are updating our core yield guidance range at 13.7% to 13.9%, excluding any future benchmark interest changes.

As a reminder, more than 97% of our portfolio is floating with the floor, so Fed decreases in interest rate may not have an equal reduction to our core yield. Although very difficult to predict as communicated by Scott, we expect $200 million to $300 million in prepayment activity in the second quarter. We expect our second quarter interest expense to increase slightly on the growth of the balance sheet compared to the prior quarter. For the second quarter, we expect SG&A expenses of $23 million to $24 million and an RIA expense allocation of approximately $2.5 million. As previously guided, the adviser business began paying dividends in the fourth quarter to Hercules Capital. Going forward, we expect a quarterly dividend from the RIA of approximately $1 million to $1.5 million per quarter.

In closing, the business is positioned well for 2024. After delivering record first quarter commitments and fundings. We’re excited to see how the rest of 2024 develops. I will now turn the call over to the operator to begin the Q&A part of our call. Carol, over to you.

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Q&A Session

Operator: Thank you. At this time, we will conduct the question-and-answer portion of the call. [Operator Instructions] Our first question comes from the line of Crispin Love with Piper Sandler. The floor is yours.

Crispin Love: Thanks, Good afternoon. First on first quarter fundings, very strong here with net Hercules fundings at nearly $500 million. And Scott, you mentioned the pent-up demand of companies that put off debt decisions in 2023 coming back to the table early in the year. Do you view the first quarter here as somewhat of an anomaly, or could this pent-up demand just remain a tailwind through the next few quarters to continue to drive elevated funding to elevated levels or even levels similar to the first quarter.

Scott Bluestein: Thanks, Crispin. The funding activity in Q1 was exceptionally strong. As you pointed out $605 million of gross fundings, nearly $500 million net in the BDC, that led to net debt investment portfolio growth of over $325 million. If you look at our pending and closed pipeline, you can see continued momentum. So I would say, that we are very optimistic about a continuation of a strong funding environment over the next couple of quarters. Do we expect it to reach the level that we saw in Q1? Most likely not, but we certainly don’t expect to see a reversion back to the level that we saw a year or so ago.

Crispin Love: Great. Thanks, Scott. That all makes sense. And then a little bit of a bigger picture question just on the competitive environment. Can you just talk a little bit about how the competitive environment has shifted just over the last year or year and a few months since the bank turmoil of March last year? Are you seeing any recent activity from banks coming back or increasing exposure and then just separately are you seeing more of a pickup from private lenders or others in the space or any retrenchment just curious the competitive environment as a whole?

Scott Bluestein: Sure, yeah I think for us it’s still status quo on the competitive side. As I’ve pointed out in the last few calls, there are still venture banks that are active in the market. We continue to see First Citizens, SVB, from time-to-time on transactions. We’ve seen HSBC on a handful of transactions and we’ve seen a couple of other Venture banks that have been in and out of the market. The reality is we are not primarily competing with venture banks on transactions, when you think about sort of the non-bank side of the market, there are a handful of competitors that we compete with on a deal-by-deal basis, but there really is no consistent source of competition that we see on a deal-by-deal basis. The changes that we’ve made to our business in terms of being able to strengthen our balance sheet, due deals that on the low end are 10 million, on the high end are 300 million due deals that are both expansion and established stage, go after companies that are looking for that last round of financing, have really put us in a unique position where we can play on both ends of the market and we can really dominate everywhere in between.

And so not much has changed on the competitive side for us, and we continue to focus on the things that we can control and obviously that’s leading to tremendous results both on the operating side and on the funding side as well.

Crispin Love: Thanks, Scott. Very good. I appreciate you taking my questions.

Scott Bluestein: Sure. Thanks, Crispin.

Operator: Thank you for your question. One moment please. Our next question comes from the line of Brian McKenna with Citizens. The floor is yours.

Brian McKenna: Thanks, good evening guys. I appreciate all the commentary on new funding activity and the outlook there, but I guess what I’m trying to figure out is the trajectory of the portfolio from here just in terms of growth. So if you’re 10% in the quarter sequentially, I appreciate it likely doesn’t increase that much moving forward every quarter, but, you know if there’s a way how should we think about the cadence of portfolio growth in the coming quarters, and then what might that mean for the trajectory of NII assuming kind of no material shift in the rate backdrop.

Scott Bluestein: Yeah, thanks, Brian. We don’t on a quarterly basis provide funding guidance and we certainly don’t provide our expectations in terms of net debt portfolio growth. We did provide, as we always do, updated prepayment guidance for Q2, and we expect prepayments to increase pretty substantially in the second quarter. The guidance that we gave was $200 million to $300 million. Based on what we’re seeing right now. I would expect it to be on the high end of that number. So that’s almost double what we saw in Q1 where we had $160 million of prepayments. So in Q2, we’re certainly not expecting to deliver another 300 plus million dollars of net debt portfolio growth. I think if you think about sort of the basic cadence of the business, we are generally going to do somewhere between $300 million and $400 million, $450 million of gross fundings on a quarterly basis.

You can obviously pull out the normal course amortization and then you can pull out the prepayment guidance that we give. Knowing that the prepayment guidance is just our best-guess based on what we know as of the day to this call.

Brian McKenna: All right, great, helpful Scott. And then just maybe a question on credit. So you added one company to non-accrual status. Can you just talk about that one investment a little bit? And then just more broadly, non-accruals are still low in the absolute, but are there any areas across the portfolio you’re watching closely today or any situations you’re maybe looking to get out in front of?

Scott Bluestein: Sure. So we’re always watching the totality of the portfolio very closely. That’s our DNA, that’s what we do. We run this firm as if it’s a credit shop, which is the way a venture lending firm really should be run. The overall credit book continues to perform very well. If you look at the numbers that we just reported, less than 3% of the entirety of our book is in Grade 4 and Grade 5 credits. It’s about $89 million in Grade 4 and about $8 million in Grade 5, so it’s very small on a relative basis. We did add one small loan to our non-accrual list in Q1. That loan has about a $12 million cost basis, has a fair value of approximately $5 million, and our expectation is that we’ll have that situation resolved before our next earnings call.

Brian McKenna: All right I’ll leave it there thank you.

Operator: Thank you for your question. Our next question comes from the line of Finian O’Shea from WFS. The line is yours.

Finian O’Shea: Hey everyone. Good afternoon. Scott, going back to some of your introductory remarks on positioning the company with liquidity to take advantage of this market? That — looks like it worked out pretty well. Are you able to update us on what you’re thinking today and how much growth at Hercules, the overall BDC, you sort of hope for or plan for this year, next year?