Hercules Capital Inc (HTGC) 2006 Q3 法說會逐字稿

Good afternoon and welcome to the Hercules Technology Growth Capital Inc. Third Quarter Conference Call. At this time, all participants are in a listen-only mode. Later, we will open the call to your questions. Instructions for asking questions will be explained at that time. I will now turn the call over to [Thomas Rozicky] with Hercules' Investor Relations Group to introduce today's speakers. You may go ahead Mr. Rozicky.

Thank you, operator, and good afternoon to all of you joining us today. Joining us on the call are Manuel Henriquez, our Chairman and CEO and David Lund, our CFO. Our third quarter 2006 financial results were released just after today's market closed. They can be accessed from our Web site at www.herculestech.com.

I would like to remind everyone that today's call is being recorded. Please note that this call is the property of Hercules Technology Growth Capital and that any unauthorized broadcast of this call in any form is strictly prohibited. An audio replay of the call will be available through our Web site or by using the telephone numbers and passcode provided in our press release. An audio replay of this call will also be available through our Web site or by using the telephone numbers and passcode provided in our press release.

I would like to call your attention to the Safe Harbor disclosure in our press release regarding forward-looking information. Today's conference call may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake any obligation to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit www.sec.gov or visit our Web site at www.herculestech.com.

I will now turn the call over to Manuel Henriquez, Hercules' Chairman and CEO. Please go ahead, Manuel.

Thank you, Tom, and thank you everyone for joining us today. I'll spend a few minutes discussing our third quarter highlights and investment activities, provide a perspective as well as our views on the general state of the venture capital marketplace, and finally provide some additional color on our existing warrant portfolio and then David will take you through the third quarter operating results. After that, we will be more than happy to take your questions.

Let me first start by saying that it's always a pleasure to speak to our shareholders and members of investment community and provide insight into Hercules' activities, and I am excited to talk about our third quarter record results that we reported.

We had a number of important highlights in the third quarter. We achieved the highest level of commitments and funding in the Company's history. This is significant for many reasons, but perhaps is most gratifying as the third quarter characteristically our slowest, by the way, quarter generally -- excuse me, our slowest quarter as well as generally slowest quarter in the venture capital industry. I will elaborate more on this later and during the call.

In the third quarter, our new debt commitment increased by a record $81.5 million to approximately ten companies. Our debt commitments since inception now exceeds over $425 million to $428.7 million to 59 companies. Fundings for the third quarter totaled $65.4 million to 14 companies, which also represents a record for the quarter and for Hercules' history. In addition to that, on September 27, we also became licensed by the United States Small Business Administration to operate as a small business investment company or SBIC. Many of you are aware that this has taken a long process and I am happy to finally report that we achieved that milestone.

There are significant other accomplishments that occurred during the quarter. We have seen an increase in our business model in traction and awareness on Hercules in the marketplace. We are continuing to provide additional value to our shareholders as we continue to expand the team and expand our market awareness in the venture capital industry. We continue to leverage the success to enhance our financial strength as we look to expand our portfolio and our portfolio fundings with additional increase in financing that you see and we will report here with our Citibank and our capital raise we recently completed -- more on that as I go through the call.

In addition, we also recently declared a third quarter dividend of $0.30 per share, our fifth dividend declared since our IPO and that dividend will be payable to our shareholders on December 1 with shareholders of record as of November 6, 2006, bringing our total cumulative declared dividend to $1.225 since our IPO. Now, let me turn over to some of our accomplishments that we have done in the quarter or achieved in the quarter, I should say.

We announced that we also renewed our existing credit facility with Citibank which stands at $125 million, which continues to represent a great partnership we have with Citibank. In addition to that, as I said a minute ago, on December 27, we successfully secured a license from the United States Small Business Administration to operate as an SBIC, with the opportunity to access additional capital from the SBA for approximately $124 million in future financing to continue to fund our growth.

The license will provide an additional source of capital to the Company as we continue to expand and to provide additional growth capital to venture capital private equity-backed technology and life sciences companies. We have recently or will be recently submitting our first application to draw upon the leverage under the SBIC program from the SBA shortly.

Finally, last week, we had our shelf filing declared effective by the SEC and we subsequently completed the sale of 2.5 million share of the Company's common stock, resulting in gross proceeds of $32.5 million to Hercules. We will use these proceeds to enhance our portfolio, pay down our debt and fund general working capital purposes.

Now, let me give you a little overview of the venture capital activities as we have seen occurred and reported by various different sources of the venture capital industry today. The US venture capital investment activity continued to outpace 2005 with approximately $6.4 billion invested in Q3 alone. On a year-to-date basis, the investment activity by venture capitalists is now trending at $19.5 billion for the first three quarters of 2006, representing approximately 1,800 different transactions to technology and life sciences companies. This is the first time, by the way, since 2001 that we have seen three consecutive quarters in which over $6 billion was invested by venture capitalists to technology companies.

In addition to that, we continued to see a robust merger and acquisition marketplace as well as positive reaction to IPOs, specifically in the last two or three weeks of the third quarter. Another positive sign is the increase in investment activity in early-stage companies. This is important because investors in early-stage companies represent future opportunities for us to invest in companies as they continue to mature.

Venture capital activity in the third quarter alone was 38% of the capital or $6 billion that was invested towards or to early-stage companies. Again, this is a positive sign of the future of the venture capital marketplace to see a solid pipeline of early-stage companies being funded, which will be eventually turning to prospects for Hercules as it continues to mature down the road.

By region, we saw venture capital activity remain fairly robust in the San Francisco Bay Area, which remained the dominant venture capital marketplace investment activity with approximately 207 deals of receiving capital for approximately $2.5 billion of new investment activity during the third quarter alone. Another indication of the health of venture capital industry that we track and monitor is the fund formation or new capital being raised by the venture capitalists themselves, as we known -- better known as the general partners of these venture capital firms.

In the third quarter alone, we saw approximately 52 different venture capital firms raise approximately $4.9 billion for a cumulative three-year total raise now approaching $75 billion of new capital in-flowing into the venture capital industry. This is a dramatic recovery from what we have seen post the 2000 bubble of venture capital activity now regaining some strength and growing again.

As you may know, venture capitalists typically take anywhere between three to seven years to invest this capital. So, we expect to see the $75 billion invested over a three to five-year period of time. This is important because this capital is a critical capital need for our portfolio companies to continue to service their debt obligations as they continue to grow and seek additional forms of capital in the form of equity by the venture capitalists out there.

Lastly, in terms of liquidity, as I said a minute ago, in the third quarter, we saw eight IPOs in the third quarter alone for 2006 and 37 IPOs for 2006, for the three quarters ending September 30. The 37 IPOs raised approximately $2.5 billion. In addition to that, we have seen 97 M&A activities take place through the year, representing $23 billion of capital or transactions I should say, of which $6.8 billion alone occurred in the third quarter.

In addition to that, we saw a very robust activity in the last few weeks of the third quarter in the technology, information technology IPOs, which was the first time that we have seen an increase in technology IPOs from the previous three to four quarters, which historically has been more in the life sciences and biotechnology sectors to date. All this information that I have been quoting is a source of data from both Dow Jones VentureOne, the NVCA, the National Venture Capital Association, and of course E&Y in connection with the Dow Jones VentureOne.

With all that said, we experienced a robust third quarter in deal flow and traditionally our third quarter is the slowest quarter and is historically the slowest quarter as we said in the venture capital industry as well. Looking forward, however, we should not expect to see that continued robust third quarter activity that's dependent upon the overall venture capital marketplace as well.

Lastly, you will see that our pipeline continues to expand as the venture -- the venture capital industry itself continues to expand with new capital in-flows to technology companies and life sciences companies.

We are constantly evaluating the market opportunities across the US especially with our presence in our various different offices in Boston, Chicago, Boulder and Palo Alto. We will continue to distinguish ourselves as a leading publicly-traded multi-stage venture debt investor, providing growth capital to venture capital-backed life science and technology companies, as evidenced by the very strong quarter we had that the Hercules brand name and awareness in the marketplace continues to expand and grow as we continue to progress as a company and mature as a company.

Now, let me turn to another subject which is constantly and frequently being asked by many of our investors and our research analysts, and that is our warrant portfolio and warrant participation and future equity participation rights. I would like to take a few moments to discuss the topic of the venture -- excuse me, of the warrants and how the warrants are treated and how we actually look at the warrant portfolio to kind of give you some additional insight and help clarify some of the potential confusion on the warrant portfolio from an accounting point of view and from a face value point of value that we may take for granted, since we live in this world everyday, and sometimes we may accidentally not be as expansive in discussing the warrants as we should because we are so close to the details. But notwithstanding that, more than happy to respond to additional questions on that in our Q&A session of course.

Now, what does all this mean? In the third quarter, we acquired warrants that would grant us the right to invest approximately $6.2 million of capital in various venture-backed technology companies. On an accumulated unexercised basis, that one portfolio on a face value, that is the exercise value of a totality of those warrant positions would represent or exceed, excuse me, $27 million in value. And again, it is important to note that the face value of the warrant does not represent any additional future value we may or may not realize with those warrants. It requires those companies over time to continue to build on their business model and increase in value over time, at which point we have the ability to exercise that warrant in` sometime in the future and realize some value in that warrant that has been accreted as the company develops the business model further and receives additional rounds of equity capital in the future, at higher valuations.

And again, I'd like you to note, do not assume that although warrants will monetize in value, we don't necessarily know what their value will be, but some percent of that may monetize in time and that duration of time may be anywhere between three to five to seven years. It is directly tied to obviously the IPO market and the M&A market, which I described earlier in my discussion.

Notwithstanding that comment, to help clarify somewhat of a confusing topic, the $27 million in warrant face value that we have represent on a book or accounting basis approximately $9.2 million end value from a carrying basis on our income statement and balance sheet today -- excuse me, our balance sheet today.

To illustrate how this actually works, in the last 12 months, we have made -- we have converted or exercised, excuse me, two warrants of which we realized approximately $2.7 million in gross value from the exercise of those warrants. And again, I would like to caution everybody that although we have a very growing portfolio on warrant values, we will expect some portion of that to monetize over time, but again, it is unknown what portion of that will monetize and what multiples if any will that realize over time.

In addition to that, I would like to discuss our future equity rights. In addition to our warrants, we also secure contractually, as part of the loan and security agreement into our companies, the right to invest in the next or subsequent round of capital in that respective portfolio companies. I will caution you again, although we have these equity rights in our companies, the majority of our transactions, we oftentimes do not exercise that right for many reasons as we underwrite either the valuation of the particular company or different changes in the capital flows or marketplace where we feel that having a warrant position and debt position are sufficient from an exposure to that particular company. Again, it changes over time, but we have a growing portfolio of future equity rights that is entirely in our option that we may choose to exercise over time.

In summary, I am extremely pleased with the results of the organization, the commitment and execution by our origination team and frankly, on the entire organization of Hercules. I assure you that -- to our shareholders, everyone is Hercules is working extremely hard and is evidenced by the performance of the third quarter. I would like to thank the whole team again and thank our shareholders for continuing to be supportive and believers in Hercules. And at this point, I would like to turn over the call to David Lund to review our third quarter and operating results. David?

Thank you, Manuel. Let me start by saying that we are proud of the results we achieved in the third quarter. We continued to grow our investment portfolio quarter-over-quarter, our revenues increased for the eight consecutive quarter and we grew net investment income by 26% over the second quarter. I will begin by discussing our third quarter portfolio and investment activity, followed by our operating results.

We continue to grow originations with third quarter debt commitments of $81.5 million to nine new companies and one existing company, bringing gross originations from inception to date to $428.7 million in 59 companies. Our third quarter debt fundings totaled $65.4 million, of which $49.6 million was invested in nine new companies and we provided an additional $15.8 million to five existing companies.

Our third quarter equity investments totaled 2.8 million to three companies. These investments consisted of $1 million of debt conversion to an existing portfolio company, in conjunction with its new equity round of financing and approximately $1.8 million in two new equity investments. As of the end of the third quarter, our total equity investment at value was $8.3 million in 13 companies.

As of September 30, 2006, our unfunded debt commitments approximated $95.7 million to 19 portfolio companies. In addition, we executed non-binding term sheets, which are subject to further negotiation and due diligence, with six prospective portfolio companies representing approximately $58.5 million. We continue to see a robust pipeline of quality companies as we head into the last quarter of the year.

The fair value of our debt portfolio including warrants at September 30, 2006 was approximately $229.2 million, representing investments in 53 portfolio companies compared with approximately $130 million at September 30, 2005 with investments in 24 portfolio companies.

Hercules' proceeds from principal repayments approximated $19.4 million in the quarter. These payments were comprised of normal amortization of principal of approximately $9.5 million, repayments of approximately $1.8 million from one well-performing company who prepaid its loan in full, $1 million repaid upon a loan restructuring agreement, and finally, $7.1 million paid down on a working capital line.

The fair value of our equity portfolio at September 30, 2006 was $8.3 million with investments in 13 portfolio companies compared with approximately $3.3 million at September 30, 2005, with investments in five portfolio companies. We continue to manage the portfolio by investing our capital in high-yielding assets. At September 30, at fair value, we had invested approximately 93% of our portfolio in debt investments, 4% in warrants, and 3% in equity investments. At September 30, 2006, the overall weighted average yield to maturity on our loan portfolio was approximately 12.75%.

Moving on to our operating results for the third quarter, revenue continued to grow and reached a new high of $7.5 million compared with $3.7 million in the third quarter of 2005, representing an increase of 106%. Interest expense and loan fees were approximately $1.6 million in the third quarter, up from $840,000 in the comparable quarter of 2005. The increase of approximately $731,000 was primarily due to borrowings under the Citi credit facility that were not outstanding during the third quarter of 2005. In addition, total debt outstanding at September 30, 2006 was $91 million as compared to $25 million at the end of the third quarter of 2005.

Total operating expenses, excluding interest expense and loan fees, were $2.9 million, an increase of $1 million from the third quarter of 2005. This increase was primarily due to increased growth, additional headcount, opening of new offices, higher expenses related to being a public company including expenses related to the implementation of the requirements under the Sarbanes-Oxley Act. In addition, the Company incurred approximately $160,000 of expenses related to a consultant used for a loan workout.

Net investment income before provision for income taxes was $3.1 million, up 252% over the third quarter of 2005. During the third quarter, our net realized and unrealized loss -- gains and losses was $1.9 million. During the quarter, we recognized a realized loss of approximately $2.5 million due to the assets disposition of one portfolio company. This was offset by the net increase in unrealized depreciation on investments of approximately $593,000 in third quarter. Our third quarter taxable income was approximately $1.3 million or $0.09 per share based on 13.7 million weighted average basic shares outstanding.

In terms of liquidity and capital resources, during the third quarter, our net assets were approximately $151.3 million or $11.06 per share. As of September 30, 2006, we had an outstanding balance of $91 million under our $125 million Citigroup credit facility, leaving approximately $34 million available subject to existing terms and advance rates. Currently, we have approximately [$53.1] million of variable loans in our portfolio with interest rates pegged to the prime rate. We had $7.1 million in cash and cash equivalents at the end of the third quarter.

The quality of our loan portfolio remains strong. At September 30, 2006, the weighted average was 2.17 on a scale of 1 to 5, with 1 being the highest quality compared to 2.21 at the end of the second quarter. Our policy is to adjust the grading on our portfolio companies as they approach the point in time when they will require additional equity capital.

In today's earnings release, we provided a breakdown of our portfolio at fair value as of September 31, 2006. 56% of our portfolio is in technology and technology-related companies, while 35% is biopharmaceutical companies and 9% is in medical device companies. With that, I will now turn the call back to the operator and we can open the call for questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Don Destino of JMP Securities. Please go ahead.

Hey guys, congrats on the nice quarter.

Hey Don.

Couple of questions, both kind of housekeeping. Manuel, can you remind me, I know that you needed to get some kind of SEC release in terms of the SBIC license and the ability to lever beyond one to one? Can you kind of just remind us exactly what has to happen, what the timeframe is -- of that and whether or not you think it's just a foregone conclusion or something that we need to keep our eye out for?

Clearly, anything to do with our government is rarely a foregone conclusion. I don't mean that in disrespect, it is just that it takes time. However, many BDCs are out there who have gone the same process have received the license. I am happy to say that as of last night, which I just received an update on the progress of the license, that we believe that it's fairly imminent that it will be granted here in short order. We have recently did a modified amendment to our regional application and as of last night, we actually had a dialog or exchange with the SEC getting an update on the progress and I think it's fairly imminent that,- not to handicap it, I would say between probably 60 to120 days, maybe less. I don't purport to be able to imply when the government will finally issue it, but I think it's progressing quite nicely and I think it's a matter of just when, not if.

Okay. Just to be clear, you are referring to the actual SBIC license or --

Let me clarify. Sorry, Don. I apologize. What happens is twofold. We have received the SBA license as an SBIC from the SBA. That allows us -- as a separate entity that will allow us to then leverage or access about $124 million of capital from the US government on a ten-year fixed cost basis from the US government SBA program. However, as a BDC, before I can exceed my one-to-one debt-to-equity ratios, I have to then apply for an exemptive order as an SBIC BDC. Now, that does not mean that today, if I apply for leverage from the SBA, I cannot use that leverage. I just have to cognizant, now my overall leverage position as a Company cannot exceed one-to-one until an exemptive order is issued by the SEC.

And that's what you are referring to as you got the update on and you think it's 90 to 120 days?

That's right. We received the update -- like I said, last night, we received the update and we believe that [we'll] probably again within 90 days or 120 days. I would hope and expect it to be less but, frankly, I want to be more conservative here and say that it is certainly forthcoming, but we should expect to receive that here shortly.

But with your new capital, that's not really a binding constraint for a while anyway, right? I would assume you are in pretty good shape for a while.

Well, certainly. We are certainly in good shape for a period of time. That's why we end up doing the deal that we just completed on $32 million of gross proceeds raised for exactly that issue, to give us that additional buffer. And just to remind everybody, as part of the SBA program, SBIC, we will have to also downstream into our SBIC, the required equity capital in order to receive the leverage from the government. And you may recall that I had spoken to this subject a few calls ago, whereby we have to basically downstream approximately $60 million of equity capital to receive $124 million of SBA leverage.

Got it. And then, next question is probably for Dave. Dave, can you walk me through or remind me the difference or the delta between your taxable fees -- the fee income you recognize on a tax basis that you use to pay the dividends and the fee income that I guess you're amortizing for investment income purposes? How big of a difference is that at this point in the company's lifecycle?

Right now, it's roughly about $100,000 on a quarter to $150,000 because we are amortizing the fees partially for the tax basis as well. Some of it we're amortizing -- were recognized immediately and then a portion of it is being amortized.

That's what you do for investment income purposes and then you recognize the entire fee for tax purposes?

For tax purposes, again, a portion of it is immediately recognized related to the commitment fee that is paid and then the facility and the portion of the commitment fee is amortized as well, on a somewhat accelerated basis compared to the book basis.

I got it. Okay, thank you very much.

Thank you. [OPERATOR INSTRUCTIONS] Thank you. Our next question is coming from Jordan Hymowitz of Philadelphia Financial. Please go ahead.

Hey guys. Congratulations on a good quarter.

Thanks, Jordan.

Three quick questions. On the operating expense, the loan fees were much less than I thought they would be. This is what you amortize I understand on a quarterly basis. Is there a reason why it would be so much less this quarter than last quarter or the quarter before, since I thought you amortize them pretty straight line?

The fee is because -- the first tranche of the fees that we paid last year were based on the fees and we amortized it over the period of time that the loan was outstanding. And then, we renegotiated it in August and we paid a certain fee again for the renewal, but all those prior fees had been amortized in the prior year. The fee that we paid for this year going forward, for this year's loan outstanding balance, was significantly lower.

And also, Jordan, just to remind you, we no longer have the Farallon debt outstanding as well, which was -- when you look at it on a trailing basis, would have made it seem higher because that's the way -- we paid back that loan.

That's correct.

Now, this would be the number closer to the run rate going forward?

That should be the run rate going forward.

Okay. Second question, what was the net deferred fees in the quarter? In other words, the origination fee less what was amortized so the [technical difficulty] taxable earnings?

So, I believe we took in approximately $1.4 million in fees and we amortized approximately $600,000 of that during the quarter. I can get back with the specifics on that, but that's an approximation.

About 800k?

Yes.

You will see on our balance sheet on a cumulative basis approximately about 3.5 of deferred revenues, which basically are composed of these loan fees that we are talking about.

Yes, the net effect was that we added approximately $800,000 to the deferred balance during the quarter.

Okay. And last question, the stock-based compensation was up. Was there a new round of grants or something like that in the quarter?

We had some grants -- we have some annual grants that took place in the very latter part of June and so we had the full effect of the amortization of those expenses, plus we also had a couple of new employees that we did hire during the quarter that were granted options as well, as part of their hiring package.

Thank you very much. Congratulations on a good quarter.

Thanks.

Thanks, Jordan.

Thank you. Our next question is coming from Joe Jolson of JMP. Please go ahead.

Hey guys, I am on a cell phone, so if I lose you, let me go this question in first, but the -- how many loan positions did you have at the end of September and how many warrant positions, and are those two numbers starting to diverge now at this point in your development? And then, a follow-up is, what was the normal amortization of principal in that, as well as maybe the month of the September? Thanks guys. Good quarter.

Thank you. We had approximately 50 companies with loan balances outstanding and then on top of that, we had additionally approximately three -- four companies that we had additional warrant positions in, where the loans have been repaid.

On an active warrant basis, the number we actually [inaudible] disclose it, but it averages around 45ish companies or so. And as you may or may not know, that goes up and down if we decide to exercise and convert some of the warrants. But, right now, on an active basis, we consider to have warrants that we consider active approximately 45 companies right now that are active. Total portfolio companies, I think David just said -- what was it, David?

Approximately 50. Let me just pull my numbers up here real quick. It's approximately 50 companies.

And what about the amortization, before I lose you here?

The amortization of normal principal during the quarter?

Yes.

It was about 9.5 million.

And Joe, just to clarify, to make that number a little more complicated, we also have various working capital type revolver loans that also will revolve during a particular quarter, and if you add to that, approximately there was $7 million of revolving facility that took place, we saw, in a normal course of business, close to $16 million of principal repaid in that quarter. Again, 9 of which contributed to normal amortization. And in this particular quarter, 7 million of that attributed to the revolving nature of the borrowing base at the respective portfolio companies.

Yes. And the total was approximately 19 in total. We also had a loan that repaid early because they were doing so well and decided to repay the loan for almost $2 million.

Thank you. Our next question comes from [Stan Kane] of [EPI]. Please go ahead.

Great quarter guys. I have a question related to the SBIC loan. I noticed that it's owned by Hercules Technology II LP. And I was wondering how the principals will benefit from owning that independently of also being employees of the Company?

Sure. That's an easy question in the sense that the employees do not own anything of the HTGC management with the exception of myself and Scott. For regulatory purposes, I believe that we invested $5,000, I think the number was, in order to conform -- sorry, for tax purpose, excuse me, my attorney just clarified that. For tax purposes, we each invested approximately $5,000 each and Hercules corporate or Hercules public entity owns 99.9 something of the entity itself. So, the employees have no direct participation in the economics other than at the parent company level through the stock option compensation we have as an [aggregate] at thecompany.

Thank you.

[OPERATOR INSTRUCTIONS] Thank you. And I will now turn the floor back to Mr. Henriquez.

Thank you, operator and thank you all for your continued interest and support in Hercules Technology Growth Capital. We plan on being on the road here shortly and we will have the opportunity to meet with most of our investors, if not as majority of investors as we can, time limiting of course, in the coming quarter. If you would like to arrange a meeting or have additional questions, please contact David Lund or myself at 650-289-3060. And again, thank you very much for being our shareholders and thank you for being part of Hercules.

Thank you. This concludes today's Hercules Technology Growth Capital Inc. third quarter conference call. You may now disconnect your lines and have a wonderful day.