Hercules Capital, Inc. (NYSE:HTGC) Q2 2023 Earnings Call Transcript August 3, 2023

Hercules Capital, Inc. beats earnings expectations. Reported EPS is $0.53, expectations were $0.5.

Operator: Good day, and thank you for standing by. Welcome to the Hercules Capital Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a 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 first speaker today, Michael Hara, Managing Director of Investor Relations. Michael, you have the floor.

Michael Hara: Thank you, Stacey. Good afternoon, everyone, and welcome to Hercules conference call for the second quarter 2023. 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 guarantees 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’ll turn the call over to Scott.

Scott Bluestein: Thank you, Michael, and thank you, all for joining the Hercules Capital Q2 2023 earnings call. Our best-in-class venture and growth stage lending platform continued to deliver record earnings and operating performance in Q2, while maintaining the historical strong credit standards that we have come to expect. Our record Q2 results were highlighted by many of the key themes that we have discussed over the last few quarters. M&A exit activity in our portfolio remained robust, which drove increased prepayments. Capital raising across our portfolio accelerated, doubling from the strong activity that we saw in Q1. Rising rates combined with higher onboarding yields and an increased weighted average portfolio balance drove total investment income, core investment income, and net investment income to record levels.

Credit remains strong and stable. Deal activities combined with pipeline activity continue to show increasing quality and quantity. As a result, we continue to be very optimistic about our positioning relative to others in the asset class and our ability to capture further market share over the coming quarters. Our differentiated business model that is predicated on diversification, fundamental credit underwriting, and longstanding relationships with over a 1,000 venture capital and private equity investors has continued to serve us well and allows us to outperform in a variety of macro environments. During the second half of 2023, our focus will remain on prudent underwriting, asset and liability diversification, maintaining an abundance of liquidity, and an unwavering commitment to the venture and growth stage ecosystem that we service.

Our decision in Q2 to once again raise our quarterly-based distribution to our shareholders is reflective of our strong outlook for the business over the coming quarters. Let me recap some of the key highlights of our performance for Q2. In Q2, we generated record total investment income of $116.2 million, up 61% year-over-year, and record net investment income of $75.7 million, up over 88% year-over-year or $0.53 per share and providing 132% coverage of our newly increased base distribution of $0.40 per share. This is our third consecutive quarter of delivering record net investment income. We also generated record return on equity in Q2 of over 20% for the first time in our long operating history. Our portfolio generated a GAAP effective yield of 16% in Q2 and a core yield of 14.1%, which is indicative of the recent rate increases and higher onboarding yields for certain new loans.

With net regulatory leverage at a very conservative 86.4% and continued robust liquidity across our platform, our balance sheet remains very well positioned. As the market environment for new deals in our asset class continues to improve over the coming quarters, we believe that having a strong and diversified balance sheet with maximum liquidity will be a key differentiator for our platform and best positions Hercules to capitalize on the market opportunity that we believe is in front of us. The focus for our origination efforts in Q2 was on diversification with an emphasis on later stage and scaled opportunities. Our Q2 originations activity was once again driven by both our life sciences and technology teams delivering healthy funding performance during the quarter.

Our funding activity demonstrated balance between our two core verticals, which we believe helps drive consistent outperformance relative to our peer group. We funded debt capital to 19 different companies in Q2 of which six were new borrower relationships. Consistent with what we saw in Q1, we were again able to expand our funding relationship with numerous portfolio companies that continued to show strength and achieve performance milestones during the second quarter. In addition, the strong level of fundings to existing companies also helped to lower our available unfunded commitments to $381 million, which was markedly down from $562 million in Q1. Approximately 50% of our available unfunded commitments will expire by the end of the year, driving higher expected follow-on fundings in the second half of 2023.

As we guided to on our Q1 earnings call, our funding activity in Q2 was backend weighted towards the end of the quarter with over $300 million of our quarterly fundings coming in the month of June. Although Q3 is typically a seasonally slow quarter across the venture and growth stage lending markets, we expect our origination activity in Q3 to be robust. Operating at scale, being able to consistently deliver for our borrowers and their equity holders despite market conditions and not having to worry about being constrained by high leverage or low liquidity is driving a strong start to Q3 for our business. Since the close of Q2 and as of August 2, 2023, our deal team has already closed $209.6 million of new commitments and funded $142.9 million.

We have pending commitments of an additional $305.5 million in signed non-binding term sheets. We continue to expect deal quality to remain high and continue to get better as the year plays out. Although portfolio company exits and liquidity events for the industry continue to be slow, activity across our portfolio continues to be strong. After having eight M&A transactions closed in Q1 across our portfolio, we had another two M&A transactions closed in Q2 and we had another one closed shortly after the end of Q2. In addition, we have two additional M&A events that have been recently announced that have not yet closed, and in July, our portfolio company enGene announced a business combination agreement with Forbian Acquisition to go public.

We now have three portfolio companies in the pipeline looking to go public. Our portfolio activity continues to validate the great work and selective underwriting that our investment teams do. As we anticipated early loan repayments increased further in Q2 to approximately $297 million within our guidance of $225 million to $325 million and an increase from $202 million in Q1 2023. For Q3 2023, we expect prepayments to remain healthy, but to decrease to $175 million to $250 million. Although this could change as we progress in the quarter. The higher levels of prepayments over the last several quarters, despite the market volatility, reflects the quality of our loan portfolio as well as our team’s ability to continue to identify and target the most promising growth stage companies in the market.

Credit quality of the debt investment portfolio remains strong and stable. Our weighted average internal credit rating of 2.24 improved from the 2.26 rating in Q1 and remains at the lower end of our normal historical range. Our Grade 1 and 2 credits remained relatively flat at 59.4% compared to 59.8% in Q1. Grade 3 credits were slightly higher at 38.3% in Q2 versus 37.1% in Q1. Our rated four credits decreased slightly to 2.3% and rated five credits were once again 0% in Q2. As of the end of Q2, we had one debt investment on non-accrual with an investment cost and fair value of approximately $13.3 million and $0 million respectively, or 0.4% and 0.0% as a percentage of the company’s total investment portfolio at cost and value respectively.

As of our most recent reporting, 100% of our debt portfolio companies are current on contractual payments to Hercules. Despite increased selectivity and valuation sensitivity from venture capital investors, capital raising across our portfolio remains strong in Q2 with 21 companies raising nearly $1.9 billion in new capital in Q2. This was up over 100% from Q1 and was the strongest quarter of new capital raising in our portfolio over the last year and a half. During Q2, Hercules had net realized gains of $0.2 million. This was comprised of net realized gains of $6 million due to the sale of equity and warrant investments and gains on foreign exchange, offset by approximately $5.8 million due to the loss on two smaller debt investments. Through Q2, we have generated $8.2 million of realized gains year-to-date.

Our net asset value per share in Q2 was $10.96, an increase of 1.3% from Q1 2023. This was our fourth consecutive quarter of reporting an increased net asset value per share. We ended Q2 with strong liquidity of over $670 million. Inclusive of available liquidity in our private funds, we have approximately $1 billion of liquidity as of the end of Q2. Venture capital ecosystem fundraising and investment activity continued to stay at muted levels relative to the historical highs that we witnessed in 2021 and 2022, with fundraising activity at $33 billion and investment activity at $86 billion for the first half of 2023 respectively according to data gathered by PitchBook-NVCA. In terms of VC investment activity, Q2 was slightly lower than Q1 with $40 billion of investments relative to the $46 billion that was invested in Q1.

This pace puts the industry on track to meet or exceed pre-pandemic VC equity investment levels for 2023. We expect fundraising to stay at much lower levels than prior years and investment activity to continue to pick up as the year goes on. With our record operating performance year-to-date, we exited Q2 with increased undistributed earnings spillover of over $148 million, or $1.02 per ending shares outstanding. For Q2, we increased our base distribution to $0.40 and declared a supplemental distribution of $0.08 for a total of $0.48 of shareholder distribution. This represents the third base distribution increase in the last 12 months and is the 12th consecutive quarter of being able to pay out a supplemental distribution to our shareholders.

In closing, our scale institutionalized lending platform and our ability to capitalize on a rapidly changing competitive environment continues to drive our business forward and our operating performance to record levels. In Q2, for the first time in our long operating history, Hercules delivered over $100 million of quarterly core income, which excludes the benefit of prepayment fees or fee accelerations from early repayments. This is another significant milestone for our business. Our success is attributable to the tremendous dedication, efforts and capabilities of our 100 plus employees and the trust that our venture capital and private equity partners place with us every day. We remain optimistic about our business opportunities, given how well we are positioned to take advantage of market conditions and grow our core income generating assets, and as a result, the earnings power of the business.

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. I’ll now add some emphasis to some of the points that Scott has made. Q2 marked another quarter of solid execution, record financial performance, and conservative balance sheet management for Hercules Capital. We are continuing to see the benefits from operating with a healthy spread between our lending and borrowing rates and a strong balance sheet with no near-term material maturities. In Q2, we had record investment total investment income of $116 million, record net investment income of $75.7 million, record net investment income per share of $0.53 per share, and a record return on equity of more than 20%. The investments that we’ve made in our platform and the scale at which we are now operating are helping to drive our record financial performance.

Our strong and defensive balance sheet positions us incredibly well to be able to take advantage of the attractive market opportunity for new investments that our team believes will continue to get better over the coming quarters. With these points in mind, let’s review the following areas: the income statement performance and highlights, NAV unrealized and realized activity, leverage and liquidity and then finally, the financial outlook. Turning to income statement performance and highlights. This was the third quarter in a row that total investment income exceeded $100 million at $116.2 million, driven by the prior quarter growth in the debt portfolio on solid new business underwriting and an increase in benchmark rates. It was also the first quarter that core income and non-GAAP measure exceeded $100 million at $102.5 million.

Core investment income excludes the benefit of income recognized as a result of loan prepayments. This is a true testament to the size of the portfolio now managed by the team. Net investment income was another record at $75.7 million of 15.6% quarter-over-quarter increase, or a record $0.53 per share in Q2. NII margin has now been above 60% for three quarters in a row. Our effective and core yields in the second quarter were 16% and 14.1%, respectively compared to 15.1% and 14% in the prior quarter. The increase in the core yield was due to an increase in coupon interest as a result of benchmark rate interest increases. We continue to forecast a leveling of core yield hereafter due to minimal movement from the Fed in the coming quarters after the most recent rate increase.

Turning to expenses. Our gross operating expenses for the quarter increased to $42.9 million compared to $42.3 million in the prior quarter. Net of costs recharged to the RIA, our operating expenses were $40.5 million. Interest expense and fees increased modestly to $19.6 million from $19 million in the prior quarter due to the growth of the investment portfolio in the first half of the year and slightly higher weighted average cost of debt. Strong funding activity to start Q3 will likely continue these trends. SG&A expenses remain flat at $23.3 million, slightly above my guidance of $23 million. Net of cost recharge to the RIA, the SG&A expenses were $20.9 million. Our weighted average cost of debt was a mere 4.8%, a tiny increase compared to the prior quarter, reflecting greater utilization of the credit facilities due to growth of the investment portfolio in the first half of the year.

Our ROAE or NII over average equity increased to 20.8% for the first quarter, and our ROAA or NII over average total assets was 10%. Switching to NAV unrealized and realized activity. During the quarter, our NAV increased for the fourth consecutive quarter by $0.14 per share to $10.96 per share. This represents an NAV per share increase of 1.3% quarter-over-quarter. The main drivers for the increase were the net change in unrealized depreciation of $18.9 million, net of reversal of prior unrealized depreciation of $8.4 million, mainly due to investments disposals disposed off or written-off. Net investment income and accretion due to ATM sales offset by dividends paid in the quarter, including the supplemental distribution and the dilution from stock compensation.

Our $18.9 million of unrealized appreciation was primarily driven by $16 million of appreciation to the public equity and warrant portfolio, an additional $8.8 million of unrealized appreciation was related to the loan portfolio. The reversal of prior unrealized appreciation resulted in a net realized gain of $200,000 comprised of net realized gains of $6 million due to the sale of equity and warrant investments and gains on foreign exchange offset by $5.8 million due to the loss on two debt investments. Moving to leverage and liquidity. Our GAAP and regulatory leverage were 101.3% and 90.3%, respectively, which decreased compared to the prior quarter due to maintaining a more normal cash balance over the quarter end and reduction of the credit facility borrowings based on the high prepayments collected in the quarter.

Netting out leverage with cash on the balance sheet, our net GAAP and regulatory leverage decreased to 97.4% and 86.4%, respectively. We ended the quarter with $671 million of available liquidity. As a reminder, this excludes capital raised by the funds managed by our wholly-owned RIA subsidiary. Inclusive of these amounts, the Hercules platform has over $1 billion of available liquidity. The strong liquidity positions us very well to support our existing portfolio companies and source new opportunities. We continue to have no near-term debt maturities giving us the ability to be opportunistic should we decide to raise additional capital to support the business growth that we anticipate. In Q2, we opportunistically access the ATM market and raised $65 million, resulting in a $0.07 per share accretion to NAV.

On the outlook points. For the remainder of 2023, we expect our core yield range to be at 13.8% to 14.2%. As a reminder, approximately 95% of our debt portfolio is floating with a floor, so the recent interest rate hike and any additional in 2023 will benefit our core yield going forward. Although very difficult to predict, as communicated by Scott, we expect $175 million to $250 million in prepayment activity for the third quarter. We expect our third quarter interest expense to remain stable compared to the prior quarter. For the third quarter, we expect SG&A expenses of $23 million to $24 million and RIA expense allocation of approximately $2.5 million. In closing, our balance sheet remains strong to support our existing portfolio as well as opportunistically invest in the best opportunities.

I will now turn the call over to Stacy to begin the Q&A portion of the call. Stacy, over to you.

Operator: Thank you. We will now conduct a question-and-answer session. [Operator Instructions] Our first call is from John Hecht with Jefferies. John, go ahead with your question.

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Q&A Session

John Hecht: Hey guys. Thanks very much. Congratulations on another great quarter. Making our lives easier here. Maybe Scott, the first question is, obviously, that’s changed in the world since the U.S. reported and one of the major financing entities in your market SVB, had issues and then it was obviously sold to the First Citizens. So I’m just wondering, can you describe any – are you seeing any kind of changes in the overall framework of the industry that are worth noting?

Scott Bluestein: Yes. So I think, John, in addition to what we talked about on our last call, which was post the SVB failure, I think we’ve seen sort of a little bit of normalization across the market. First Citizens, I think, has done a great job at stabilizing that business. We’ve seen them in the market on a handful of deals. We’re actually working with them on a number of deals as well. Outside of First Citizens, there are some commercial banks that have pulled back from the venture lending ecosystem, which I think is a net benefit for our business. On the non-bank side, I think the two key themes that we’re certainly seeing in the market is that a lot of our competitors are hamstrung by either high leverage or low liquidity and that really puts them in a position where they’re having to operate deal by deal, whereas we’re sitting here with low leverage and abundance of liquidity, and it allows our team to be consistently in the market essentially going after any and all of the deals that we think fit our tight underwriting and pricing parameters.

John Hecht: Okay. And then, I mean, like it sounds like it’s obviously moving net-net favorable to you guys from a competitive perspective. But anything like either venture capitalist behaviors changing in terms of their – either the way they process funding? Or is that pretty stable?

Scott Bluestein: Yes. So look, I think the VC ecosystem continues to be somewhat volatile and in flux. But I would caveat that by saying when we look at the year-to-date data, we’ve now had two consecutive quarters where U.S. venture capital investors have invested $40 billion or more of equity capital. And that gets us to roughly the $86 billion that we mentioned through the first half of the year. That is down materially from what we were seeing on a quarterly basis throughout the pandemic. So if you look at the 2021 numbers and the 2022 numbers, VC investors were averaging almost $80 billion to $90 billion per quarter. That $40 billion, while down from the pandemic levels is still up from where it was on a pre-pandemic basis.

So when we look at what we’ve seen year-to-date, it’s down, but it’s still healthy and it’s still robust. What we have noticed, and we think this is a positive, the venture capital investors are being much more selective in terms of the companies that they are investing to. So if you look at it on a numbers basis, approximately 17,000, 18,000 individual investments were done by the VC firms in 2021, 2022. That’s down to about 6,000 year-to-date. So we’re seeing less deals get done and we’re seeing much more of a focus on valuation. But we would be of the view that the venture capital ecosystem continues to be healthy, continues to be robust and that it’s actually on pace to exceed pre-pandemic levels.

John Hecht: Okay. All right. That’s helpful. And then final question is, I mean, you talked about obviously, spreads have been pretty healthy, and I think that’s just a reflection of maybe your opportunity and market leadership, but like what about other things like warrant coverage and things like that, anything worth note there in terms of changing trends when it comes to the deal structures?

Scott Bluestein: In terms of pricing, we’re focused on increased yields that can come through a variety of different triggers that we have. It can come from coupon. It can come from facility fee. It can come from warrants. It can come from end of term fees. So outside of just the general emphasis on higher onboarding yields, nothing specific that I can mention. And then on the structuring side, what I would tell you is that we’re playing a long game here, and we continue to run this business with an emphasis on how do we continue to outperform over the long-term. And so our deals continue to be very tightly structured. Our deals continue to be underwritten by what I believe is the best team in the business, and we view that, that is something that will serve us incredibly well going forward.

John Hecht: All right. Thanks very much guys.

Scott Bluestein: Thanks, John.

Operator: [Operator Instructions] Our next question comes from Crispin Love with Piper Sandler. Crispin, go ahead with your question.