Hercules Capital Inc (HTGC) 2008 Q1 法說會逐字稿

Good day, everyone, and welcome to today's Hercules Technology Growth Capital Q1 '08 conference call. As a reminder, we are recording today's call. I would now like to turn today's call over to Mr. Jason Gold. Please go ahead, sir.

Thanks, Andrea. Good afternoon, everyone. On the call today are Manuel Henriquez, Hercules' co-founder, Chairman and CEO, and David Lund, the company's CFO. Our first quarter 2008 financial results released just after today's market closed. They can be accessed from the company's website at www.HerculesTech.com, or HTGC.com. We have arranged for a taped replay of today's call, which will be available through our website or by using the telephone number and pass code provided in today's earnings release.

I would now like to call your attention to the Safe Harbor disclosure in our earnings release regarding forward-looking information. Today's conference call may include forward-looking statements and projections. We ask you that refer to our most recent filings with the SEC for important risk factors that could cause actual results to differ materially from those projections. We do not take any obligations to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit SEC.gov, or visit our website at HerculesTech.com. I would now like to turn the call over to Manuel Henriquez, Hercules Co-founder, Chairman and CEO. Manuel?

Thank you, Jason and good afternoon and thank everyone for joining on the call today. I would start by reminding everyone that Hercules is a highly specialized business development company, which focuses on high growth venture capital backed technology in life sciences companies. This focus has allowed us to pursue a thematic investment strategy, which allows us to focus and target investment opportunities in the sectors that we have a bias towards for or a better understanding of. For those who may have attended our New York and Boston Investor Day conference, we expanded upon that thematic investment strategy and how we expect to pursue that investment strategy throughout calendar '08. I would also like to remind you that we have no exposure to subprime real estate, consumer debt, or highly leveraged middle market buyout type investments.

On today's call, I would like to discuss the following. Our first quarter results and highlights, our current liquidity position, our credit performance and credit quality of our portfolio, an update on the competitive landscape, an update on the current venture capital environment and the investment activities by venture capital including [Etrix] and a summary of the Hercules platform. I will then turn the call over to David Lund, our CFO, who will discuss our financial results in more details. After that, we'll be happy to answer questions from our investors and our research analyst community.

First, on our quarterly results and investment highlights, to summarize results from the quarter, we reported revenues of $15.6 million EPS of $0.28 per share. We achieved these results in spite of the current economic conditions, due to the combined credit and capital markets turmoil that currently exist in the marketplace today. The venture capital activity during the quarter remains strong, with new capital being invested to venture capital backed companies, providing us a pipeline of new investment opportunities. Our team continued to work very diligently during the quarter, in identifying and closing new investment activities. We also realized net gains in the quarter of $3 million from our warrants, with the sale of or liquidity of three portfolio companies and I'm also happy to report that as of last night, another one of our portfolio companies, Gomez, has filed for initial public offering. I'm also happy to announce that our Board of Directors declared an increase to the dividend to our shareholders by 13% to $0.34 per share, which we expect to pay out from net investment income and our 2007 earnings spillover.

We also achieved a solid level of commitments and funding during the quarter, while maintaining our historical solid credit performance. We continue to build upon a diversity and strength of our investment portfolio, despite the current economic environment. We finished the quarter with approximately $531 million in investments on our balance sheet, and we completed the quarter with $128 million of unfunded commitments, giving us future visibility for fundings for the next one to two quarters in the future. David will expand upon that further during his presentation. We achieved this while maintaining a weighted average yield of approximately 12.6%. This, despite short term LIBOR rates and prime rates declining during the same period of time. We continue to focus our portfolio growth and diversifying our portfolio holdings within a technology and life sciences companies and sectors, with a shift in emphasis more towards later stage investment opportunities.

We're also on our way to achieving on liquidity of 8 to 10 portfolio companies realizations which we talked about back in the fourth quarter of 2007, and I'm happy to report that thus far in 2008, we've had three liquidity events and we now have a fourth liquidity event that occurred post the end of the first quarter with Sertris being acquired by Glaxo. The expected realized gain on our investment in the transaction, assuming it's completed, will generate approximately 2 to $2.2 million in additional realized gains above and beyond the $3 million gain that we disclosed for our holdings in the first quarter of gains. As I said just a moment ago, I'm happy to report that even as of last evening, Gomez, another one of our portfolio companies, has filed for initial public offering.

Now turning to liquidity. We are confident that our current liquidity position will allow us to continue to grow our portfolio. I would like to remind our investors that we are only 36% leveraged as of the end of the first quarter. We continue to manage our liquidity position very diligently, and as I will continue to expand upon, we managed our investment activities very closely as well. I'm very happy to report that we have successfully and recently amended and renewed our existing credit facilities with both Citibank and Deutsche Bank which David will expand upon during his section. Given the continued venture capital marketplace activities with investments into technology and life sciences sectors, we believe it is important that we maintain flexibility in our capital structure in order to capitalize on the opportunities our team has identified as we continue to see very attractive investment opportunities in this current market today.

Now turning to credit quality. I'm happy to report that since inception date, Hercules has now originated approximately $1.1 billion in new investment activities to technology life sciences companies. We continue to maintain a high standard of credit, underwriting and credit quality monitoring in our portfolio, and we maintained a very disciplined approach of selecting the appropriate and proper investments despite the current economic environment that we find ourselves. Credit quality remains very strong, and we continue to identify, track and quickly identify problems in our portfolio, and address those problems expeditiously to ensure that we maintain the highest credit quality in our portfolio. To that end, we finished the first quarter on a weighted average loan grade of approximately 2.2 or even to that of the fourth quarter of 2007.

Turning to the competitor landscape, our unique position has one of, if not the most highly specialized BDC, focused exclusively on the technology and life sciences sectors, our venture capital backed companies has afforded us the continued growth in our brand and awareness within the venture capital community, that has afforded us to continue to see a stronger source of deal flow and a broader source of deal flow investment opportunities for Hercules to pursue. We've also expanded into later stage venture capital backed companies as well as lower middle market technology companies during the fourth quarter, and now pursuing it further in the first quarter of 2008. Within our sectors, we're seeing lesser or fewer, I should say, competitors, and we are one of only a handful that have the bench strength that we have within our origination team, the broadest of the Hercules footprint throughout the United States with offices in the major venture capital centers, such as Boston, Southern California, Palo Alto, Chicago and Boulder, Colorado. We believe that by having a presence in these key venture capital marketplace, affords us the ability to source better investment opportunities than simply being a passive provider of capital to venture backed companies.

Given the current environment, we have become increasingly more selective in our investment. This means we've made strategic decisions to de-emphasize early stage investments, and turn our attention more towards later stage, expansion stage venture capital and private equity backed technology and life sciences companies. In addition, we have also moderated our pace of fundings and new investment originations during the quarter, and we have adopted a much more controlled, or what we call internally, a slow and steady pace of origination on investment activities throughout 2008. We've adopted this policy of slow and steady to allow the market to catch up to the current yield spreads that we're seeing in the underlying cost of capital that we've recently experienced with our renewals of our credit line, and I'm happy to report that as we've done this, we've implemented numerous different strategies to help mitigate the increase in our spreads from a cost of financing by implementing through the first quarter interest rate floors and all new investments originating in the first quarter of 2008, and we've now moved towards all floating rate loans in the first quarter of 2008 as a further mitigant to the increase in spreads that we've seen as we renewed our credit facilities. This has allowed us to maintain, or more importantly, to pass through the increasing amount of spreads that we've seen on the cost of leverage to our underlying companies, however, we believe that it will take us one to two quarters to fully successfully pass through a significant portion of those increase in spreads that we've experienced in our credit line renewals to our underlying companies.

Moving along, we continue to see very attractive investment opportunities. However, I would like to caution that although we're seeing a very robust pipeline of new investment opportunities, it does not mean that all of those investment opportunities necessarily fit our new underlying criteria of terms and conditions by which we would underwrite. Bringing it all together, Hercules has chosen to shift strategies in the first quarter to moving away from early stage investment activities to more later stage investment activities targeting more mature venture capital and private equity backed technology and life sciences companies. We have moderated purposely our pace of investments to allow the market to catch up to the new yield spreads that we're seeing in the marketplace today, in order to mitigate any yield compression that we may have been experiencing in the marketplace which as David will discuss during his section, we have managed quite effectively so far in the first quarter.

Now turning to the current venture capital marketplace and excess realized by portfolio companies in the venture community. Clearly, we all are aware of what the media has written that IPOs and M&A activities are significantly down in the venture capital marketplace. That is certainly a statement that is factually correct. However, I would like to point out that despite this decline in IPO activities as well as M&A activities, the Hercules portfolio continues to perform quite well. As we indicated earlier, we have seen liquidities being realized in M&A activities in our portfolio, Sirtris being acquired most recently in May, and we've had had both Compete and Ageia be acquired in the first quarter and now I'm happy to report that Gomez filing an IPO, all this despite the broader media comments on the venture capital marketplace activities. Conversely, the venture capitalists continue to invest very diligently in venture backed companies, investing $7 billion during the first quarter or said differently, at a run rate not dissimilar to what we've seen in 2005 and 2006. I would like to emphasize that venture capitalists are long-term investors and have deep experience working through many economic cycles and they invest for the long-term horizon, not for the near term economic cycle that we may be experiencing today.

It is certainly true that venture backed companies typically are averaging approximately eight years from initial investment of the venture capitalist to achieve a liquidity event. This is why the prevailing market in M&A and IPOs are somewhat lesser of an impact to Hercules, since we invest in companies throughout all stages of their life cycles, and our portfolio has companies in various different stages of life cycles which allows us to harvest realized gains in different economic cycles such as the one we're in right now. Again, during the first quarter, we had three liquidity events being achieved in our portfolio, generating realized gains of $3 million. Sirtris, which was acquired during the second quarter, or announced to be acquired in the second quarter, will produce when the transaction ultimately closes, approximately $2.2 million gain and as I said earlier, again, Gomez filing an S1, all despite the current economic environment that we're in. While IPO activity is down, the extended time it takes to achieve liquidity for a venture backed company is now approaching what I've never seen in my experience, over eight years from the level of maturities. This (inaudible) affords us a very attractive investment opportunity for Hercules by offering these maturing pre-IPO companies an alternative source of growth capital such as debt that is minimally dilutive, as they wait to achieve liquidity event from and M&A or IPO activity.

Now I'd like to address our warrant portfolio and future potential liquidity opportunities from this portfolio for the benefit of our shareholders. Today we have approximately 83 portfolio companies or I should say 83 warrant positions in our portfolio companies representing an aggregate fair value of approximately $24 million, and an exercise value, had we exercised a full face value of these warrants, of approximately $52 million. As we've indicated in numerous calls in the past, you should not extrapolate from that comment that all these warrant positions will ever monetize. We've indicated that you should model anywhere between a 50% monetization of that warrant position and never assume that 100% of warrant position will monetize. That said, the increase in warrant portfolio year-over-year represents 131% increase over the same period last year. This is significantly important, because this warrant portfolio represents future opportunities to generate long-term capital gains for our shareholders or provide investment vehicle by which Hercules would retain those capital gains and become self funding as we continue to grow our portfolio.

Lastly, and turning to our platform, I would like to reaffirm our investment focus and elaborate on why I am so enthusiastic about our platform. Hercules is focused and primarily invests in the activities of the venture capital marketplace. It is not subject to broader economic impacts from lower middle market or excuse me middle market companies that are much more prone to recessionary impact that are somewhat dampened in the venture capital marketplace. The venture capital marketplace investment activity continues. We've seen $7 billion invested in the first quarter. And we estimate that number to be similar in the second quarter. The increased time to liquidity on achieving liquidity for the venture backed companies represent opportunities for Hercules to offer alternative source of growth capital and to these pre IPO or pre M&A companies as an alternative source.

We believe that Hercules brand is quite significant and a very growing brand within the venture capital marketplace, and that brand has been achieved by our growing field and team of investment originators that currently stands at 15 investment professionals targeting the venture capital community, giving us access to deal flow in the marketplace. In conclusion, I believe that we're well-positioned to deliver long-term value to our shareholders and that our business model and strategy will allow us to sustain growth throughout this economic cycle. Overall, I am extremely pleased with the continued performance of our individuals, our investment professionals, our portfolio, and the organization as a whole, given the current economic environment that we are in. We remain very focused on credit quality and capital preservation as well as maintaining adequate liquidity positions to continue to grow and fuel our portfolio.

To that end, I'd turn the call over to David Lund, our CFO. David?

Thank you, Manuel. Today I will provide more details on our commitments and fundings, income statement, key portfolio metrics, and balance sheet. Commitments totaled $65.3 million in the quarter, comprised of $55 million in debt commitments and $300,000 of equity commitments. Fundings for the quarter totaled approximately $49.8 million. This brings our commitments since inception to over $1 billion, and our fundings to over $800 million. I would like to point out that the average funding level during the quarter was $25 million, and the average outstanding balance of our loan portfolio was $480 million.

Turning to the income statement, total investment income which is comprised of interest and fee income was $15.6 million, which was an increase of 61% over the first quarter of 2007 investment income of $9.7 million. As we've stated in the past, the level of our one-time fees is hard to predict quarter-to-quarter. As an example, one-time fees were lower during the current quarter by approximately $0.01 per share as compared to the fourth quarter. The effective yield on our debt investments during the quarter was 12.6%. The decrease in the effective yield in the current quarter as compared to the previous quarter of 13.9% was attributable to lower LIBOR and prime rates and lower fees related to early repayments. Interest expense and loan fees on borrowings were $2.2 million for the first quarter of 2008 as compared to $952,000 in the first quarter of 2007. The change was attributed to higher average loan balances outstanding and fees related to the SBA drawdowns.

During the quarter, our average loan balance outstanding was $139.3 million, of which $77.3 million was attributed to our credit facility and $62 million was attributed to our SBA facility. The effective cost of debt during the quarter was approximately 6.4%. During March 2008, Hercules secured its borrowing rate on $58 million of borrowings under the SBA program at a rate of 6.377%, which is comprised of the interest rate of 5.471% and an annual fee of 0.906%. Subsequent SBA borrowings will bear interest at a minimum rate of LIBOR plus a spread of approximately 30 basis points until fixed at the semiannual meeting of the SBA. As a reminder, the rate becomes fixed at the time of the SBA pooling, which generally occurs in September and March each year, and is set at the ten year treasury rate at that time plus a spread an an annual SBA charge.

Operating expenses for the quarter excluding interest expense and loan fees were $4.4 million, as compared to $3.5 million during the same period last year. The increase, as compared to the first quarter of 2007, was primarily attributable to the expansion of our office locations and an increase in the number of employees to 45 from 29 in the same quarter a year ago. Net investment income for the quarter was $9 million, or $0.28 per share, based on 32.6 million basic shares outstanding. This is compared to $5.2 million or $0.23 per share in the first quarter of 2007, based on 22.9 million shares outstanding. Representing an increase of 22% on a per share basis. Taxable income for the quarter was $0.29 per share, excluding realized gains.

During the first quarter, we also recognized net realized gains of $3 million, these gains were primarily attributed to the gain on sale of our warrant and Rubicon technology and our gain on our warrant through the sale of Compete. Net unrealized appreciation on investments in the first quarter was $921,000, compared to an unrealized gain of $816,000 in the first quarter of 2007. I would like now to briefly discuss credit quality. We continued our high credit quality standard and discipline of loan monitoring through the quarter. The weighted average loan rating of our portfolio was 2.2. As a reminder, most of our portfolio companies are dependent on future events of venture capital investments and we downgrade our companies as they approach a period when they will need to close additional rounds of financing. I would like to note that the makeup of the companies in the various gradings categories will change period to period, based on operating results and funding activities. Also as we had identified in our earnings release today, we continue to diversify our investment portfolio which mitigates investment risk in any single industry subsector.

Turning to our liquidity, as I just mentioned, we ended the quarter with $13.8 million in cash. As we disclosed in our press release, we amended and renewed our credit facility yesterday for $135 million. Under the terms of the agreement, we will pay 1 percentage point renewal fee, our borrowing rate will be LIBOR plus 500 basis points, and the unused fee will be 250 basis points. As also noted in the release, we had an excess capacity of $177 million on our $250 million line of credit as of March 31st. As such, we made the decision to right-size the amount of our credit facility to mitigate the adverse impact on EPS for the costs related to renewal and unused fees. We believe our relationships with our existing partners and other providers will allow us flexibility to expand our credit facilities as needed between now and year-end. I would like to point out that based on our existing stockholder's equities the company has the potential to leverage its balance sheet.

Now turning to the balance sheet. The leveraged balance sheet makes up the $500 million. The company had $143 million in debt outstanding as of March 31, 2008, representing a leveraged ratio of approximately 36% or 29% taking into account the exemptive relief for the SBA. Now turning to the balance sheet, as of March 31st, 2008, we ended the quarter with $548.9 million in total assets of which $13.8 million was in cash and cash equivalents. Effective January 1, 2008, the company adopted FAS 157. There was no material effect on the investment valuation as a result of adoption of this accounting principle. With them and based on their review they have concurred the valuation procedures we are applying are reasonable for our investments. During March we placed one of our loans on non accrual as the company was placed in receivership and is currently being sold. The company was fully performing on its debt obligation through March 1st of this year. During the quarter, we paid down $6.3 million under our warehouse credit facility, the debt balance under the facility was $72.9 million at March 31, 2008. We also drew down an additional $15 million from the SBA, bringing the SBA debenture total to $70.1 million at the end of the quarter.

Finally, our Board of Directors has declared a dividend of $0.34 per share. The dividend will be payable on June 16th 2008 to shareholders of record as of May 16th, 2008. This is our 11th consecutive quarterly dividend declaration since our initial public offering, and will bring the total cumulative dividend declared to $3.07 per share. Operator, we are now ready to open the call for questions.

(OPERATOR INSTRUCTIONS). We'll now take our first question from John Hecht with JMP Securities.

Good afternoon, guys. Thanks for taking my questions. Just focusing on spreads a little bit, can you give us the current mix, I guess as of March 31s,t mix of fixed versus floating rate assets in your portfolio?

Approximately 54% is floating rate at the end of the quarter and the balance being fixed rate, 46%.

At that point, were any of them through their floors or is the floor concept a new layer of a term in the loan.

John, it's Manuel. Good afternoon. The concept of the floors, we had -- I would describe as peppered through the portfolio in the last half of '07, it has now become a policy of ours on a go-forward basis, calendar '08, to have an interest rate floor placed on our deals, meaning that we will always have a minimum return, despite what happens to the indexed rates and the LIBOR or prime and then it will float upward as those increases but we maintain our spreads.

The floors pretty close to where LIBOR is right now or relative index?

No, the floors are very tight. The floors can range anywhere between 25 bps decline to maximum 50 bps decline but after that, no more than that.

And then last question is you guys have clearly been focused on more late stage and even into public companies and larger deals. Do you forfeit any yield on that or are you able where credit spreads have gone, are you able to pass that on, even later stage companies?

We are -- you hit the nail on the head. We have purposely targeted, moved upstream, because we're able to see and garner much more attractive yield spreads in that area, primarily given the lack of competition in that segment in the market right now, so that's consciously our effort to maintain yields, rather than trying to maintain yields and going down the cap structure, we're maintaining yields, remaining at the fee level of the cap structure but going to more mature companies.

Okay. Now moving on to liquidity, you guys still have close to 30 million remaining in your SBA; Correct?

We actually had more than that. At the end of the quarter we had $58 million that was available to us.

Excuse me. That's what I meant. 58. And given where -- did you say your spread to LIBOR went up to LIBOR plus 500 in your renewed warehouse facility?

Unfortunately that was not an error. It unfortunately has gone to that height, which is why we have taken the slow and steady approach of origination that until we had greater visibility of what that new spread would be, we didn't want to risk underwriting new transactions that may have been below that spread increase. So by taking the slow and steady approach that we've taken, we now have that spread increase that we now fully know and we're passing as much of that as we can to our underlying portfolio companies, expect to expand upon that and proceed the next few quarters. You're absolutely correct, it is a rate spread that was frankly surprising to us ,and primarily precipitated by the now infamous Bear Stearns weekend.

Yes. So with that, I mean, would you focus on using the SBA more on the short term? I mean, I think that's lower cost in permanent financing relative to your borrowing line, the renewed borrowing line is that correct?

That is absolutely correct. We are actively managing our cost of capital and constantly looking at the multiple source of financing or capital that we have. Just to remind you and ever, that as we showed in our first quarter results that we have approximately $48 million of amortization, both of prepayment and normal amortization that came back to us. This may turn as a very unique BDC, because unlike most other BDCs since we do not invest in or primarily invest in a large percentage of our portfolio in five year or seven year term loans, the vast majority, if not significantly the entire portfolio is rapidly amortizing debt instruments which means that Hercules receives anywhere between 25 to $35 million in a normal course of principal repayment every quarter and then of course it is augmented by early prepayments that are realized or liquidity gains realized from warrants or repayment of loans in our portfolio. So that's all very accretive to us which is why we have not fully tapped into the Citibank and Deutsche Bank credit facilities of 250 because we have this recycling of capital that's very efficient for us to use and mitigate our costs.

Okay. The last question, I appreciate you guys taking my long laundry list of questions, is are you looking at other sources of capital, other bank deals to either augment or replace this to some degree in the near future?

Yes, we are in discussions right now with a couple of very large national or international banks so yes we have.

Our credit performance has not gone unnoticed. Citibank and Deutsche Bank continue to be very good partners. It's unfortunate they got into their own little pickles that they got into. Their cost of capital shot up and we're unfortunately, the beneficiaries of that increased cost of capital in their marketplace but we're also targeting or I should say in discussions with other nationally recognized and internationally recognized financial institutions as well.

All right. I appreciate the color. Thanks very much, guys.

Thanks, John.

And we'll take our next question from Douglas Harter with Credit Suisse.

Thanks. If you could just remind us -- remind me what the cost of funds on the credit facility was prior?

It was previously LIBOR plus 120.

Great. And then just back on the liquidity side, how should we think about it? Right now sort of with the smaller Citi and Deutsche Bank facility, your unfunded commitments and term sheet exceed your available liquidity right now. How do you get comfortable with that and help us get comfortable with that.

Sure. As we said since the inception of Hercules and there's numerous data to support this throughout our earnings calls, is, we never, ever expect that all unfunded commitments will ever fund. That is a rare circumstance. In fact, the range that we have provided historically has been anywhere between 70 and 75% of the unfunded commitments will actually draw down capital for the preceding two quarters and it is often the case that a lot of those unfunded commitments are subject to performance milestones of the underlying company. So said differently, they must qualify for certain events in order to be able to get access to that capital as well. As to the signed term sheets, the waterfall of the unsigned term sheet works as follows. Of the $90 million that we disclosed, generally speaking, 75 to 80% of those will actually convert into closed permanent committed capital amount to us. Of that, 75 or 80% that closes, another 75% of that will actually fund of the proceeding next three quarters. So there's not this torrent of capital being displaced right away to the marketplace.

So as David just said, we have $58 million available capital under our SBA line. We have ample capacity under the $135 million Deutsche Bank and Citibank line and we are experiencing above normal repayment of principal and amortization in the higher end of the scale, probably the 35 to $40 million run rate per quarter, giving us very good visibility to fund the activity. That said, we're also very much in discussions with these other banks as well as Deutsche Bank and Citibank, that come sometime in the third quarter when we start needing additional capital, we can increase those lines accordingly with either them or other providers that we're speaking to right now. But it's very important to denote that the reason why, and we could have renewed a higher credit line, we have chosen not to do that because of the unused fees are so expensive right now. When from 20 to 250 basis points for the unused portion. Meaning that unused capital from our commercial bank today is a very, very precious capital to them and in their defense, their whole philosophy is we want to see our capital deployed and working for us as soon as possible and since we do not need to tap into that much excess capital, we felt that the cost of carrying that for next, I don't know, one or one and-a-half quarters, was much more expensive than what our shareholders should be burdened with.

Thanks for that answer, Manuel. Just sort of a follow-up. Can you talk about the profitability of the loans that will be funded off of the previously unfunded commitments, given the higher cost of funds, especially on the floating rate piece?

Sure. We anticipated a higher spread on renewals of our credit lines back in the fourth quarter and certainly the beginning of the first quarter. Unfortunately, I did not anticipate the Bear Stearns phenomena and watching the exacerbation of the dislocation in the credit markets and seeing our credit spreads increase so broadly, pardon me. So we have been so far originating new investment activities, I'll give you a range, competitors in this case, anywhere between 11.5 to 12.5% originations on new deals. Said differently, we've so far been maintaining, despite the decline in LIBOR, and prime, we've been thus far been able to preserve better than I expected and pass through more of that higher cost to our companies by maintaining 11.5 to 12.5 underwriting yields to begin with and I think that's going to be creeping up ever so slightly in the first and certainly the second quarter as we migrate to more mature stage companies.

And I guess just one other follow-up. What is the -- is it a one year maturity on this new facility?

Right now has an October 31 date and then it rolls out so it's a one year for final payout.

Great. Thank you.

We'll take our next question from Robert Napoli with Piper Jaffray.

Thank you. Pretty crazy pricing there. Pretty wild times. Not only you guys, obviously, on the -- but it does seem with the low -- extremely low leverage that you have, it just -- it does seem out of line, the pricing seems out of line with the risk.

Well, as a recipient of that, I can assure you it does seem out of line.

And so you said you're able to hold your pricing at 11.5 to 12.5. Should you be able to bring that up to like 15% yields? I mean, what's going on -- your competitor's cost of funds, many of them have to be going up and what are you seeing out of the competitive front? It seems to me like you should be able to pass on all of that increase.

Well, I think we need to kind of make sure we bifurcate the competitive landscape into the different tiers of stages of companies we're talking about. Despite that viewpoint, I will tell you that the early stage series A to series C stage companies, it is ferociously competitive, to a level I have never seen before in my history. The venture banks are literally killing themselves to provide prime based loans to early stage companies in order to garner the deposits. There's basically no margin in that business right now. And some of the venture banks and the most recent earnings call also indicated that they are fighting out very aggressively to maintain any kind of market position there because of the competitive nature of early, early stage venture backed companies. It is unprecedented the amount of thin, thin margin business that's being written in that stage of companies. Conversely, on the later stage side of the equation, we are certainly seeing an abatement of competition that's going on, primarily because a lot of our competitors have either died, are dying or are unable to garner additional liquidity or capital and are underwriting businesses that we feel are ridiculous in price, what they're doing to keep any kind of presence in the portfolio to try and secure a next round of equity capital to try and capitalize themselves.

We have decided to let that competitive environment somewhat pass and preserve our capital and do selective underwriting so when a lot of that competition ends up going away even further, we should be able to see higher underwriting yields but I don't believe we'll see 15% yields. I think that is excessive. I think that we'll probably see stabilization somewhere in the neighborhood of 13.5. Even that is probably on the high side. Venture backed companies are still very well sought out, investment opportunities because many providers out there are more interested in getting their hands on the equity and the warrants and lesser extent on the current cash yield. We're much more focused on credit quality and current cash yields, and some extent lesser on the warrants themselves, because we care about preservation of capital first.

Okay. Now let me ask a question about the dividend and maybe the growth of the portfolio over the next couple of quarters as this environment shakes out. And maybe on the growth of the portfolio first. Are you anticipating, then, kind of holding your leverage at below 0.5 to 1 and needing to do so over the next few quarters until you get some of these additional bank deals done? Or, I mean, is that a reasonable expectation?

Well, I think that on a leverage basis I think that's probably on the low end of the range. I think that you'll see leverage creep up, probably into the high 70s to mid-80s over the course of calendar '08.

Without getting additional -- without getting new funding deals done or would you -- ?

Well, I think that you'll see that we have the SBA, we'll fully draw down $127 million of the SBA in calendar '08 and I think that you'll probably see our credit lines, this can change dramatically if we see the yields going up to the 15% level that we like or as you said you would like to see, obviously we'll exploit that. But I think you'll see the credit lines probably will creep up to the 175, maybe $200 million range with the outside providers.

Okay.

That should be sufficient. Let's say you go to the full extreme of $200 million plus SBA. You're looking at potential leverage at 327 or $400 million of equity capital.

Okay.

And sorry to interrupt you. You should not assume. If I came across that way, I apologize. That's not the case. It is certainly a slow and steady but we'll be growing the portfolio in '08.

Okay. The dividend, I mean, you -- the full year guidance for the dividend, if you divide it by -- this is -- because of the higher realized gains you've had, you kind of gave a $0.34 dividend is not intended to be the ongoing dividend. I'm sorry if I missed that at the beginning of the call when you talked about that. Is the dividend next quarter, what is your anticipation of a second quarter dividend?

I think that there's a lot of factors here that are very important to take into account. The Board of Directors took into account many, many positive factors in determining the -- this recent dividend. The first and foremost is our NII earnings throughout the year. That's clearly a major factor in that decision. Secondly, it is the spillover of approximately $4.2 million or $0.12 from calendar '07 earnings to calendar '08. Above and beyond that, we have two other events so far that are quite critical in that decision as well, and that is we have the Rubicon gain of approximately $3 million, that actually -- that gain is in reality an ordinary income gain and it's not one year. So that may be paid out in '08 or may spill over to '09 with a 4% excise tax. That will be determined at the end of the year but that earnings is fully ordinary income. Above and beyond that, we then have another $2.2 million as of right now assuming no credit losses throughout '08 that will become long-term gains for us at which point the Board may determine to either increase the dividend further, do a special dividend and/or do an excise tax spillover or lastly, do corporate tax and retain those earnings. So we feel pretty confident that all the $1.32 of dividend that we've discussed will come out of earnings, ordinary income earnings in calendar '08.

Okay. Last question, what percentage of the portfolio did they look at?

They actually went through and were reviewing the policies and procedures with us. They had not done -- they didn't do any specific account valuations or investment valuations, but it was the policies and procedures that we're applying and looked at the underlying documentation that we have.

Are they going to do valuation work? Is that kind of a -- ?

Yes, we're in discussions with them to actually do that. We'll be meeting with them about a go-forward approach and looking at some of the specific companies.

I think they'll do a random sampling of the portfolio, continue to test it throughout the year. That's the intent of what we expect to happen with.

Okay. Great. Thank you.

We'll take our next question from Jon Arfstrom with RBC Capital Markets.

Hi, guys.

Hey, Jon.

Few questions here. Manuel, you talked about industry deal flow at just under $7 billion for the quarter. Where do you think that's likely to go on a quarterly basis? Do you feel like that's an achievable quarterly pace?

If you look at the venture capital industry, and there's data I can kind of share with you, that right now, assume an annualized rate of the $7 billion will give you a run rate of $28 billion for calendar '08. That is down slightly from $30 billion in 2007 and up from 2006. If you want my -- this is Manuel's own forecast. I believe the venture industry will probably end up doing between$ 26 billion to $28 billion in calendar '08. I don't see any real structural changes in the venture marketplace investment activities. In fact, I will tell you that we're seeing a very bullish investment activities by the venture capitalists into the IT, information technology area, and more specifically information services, which ironically is where we've been bolstering our portfolio as part of our investment strategy.

And what the information sector means it's for example Glam Media, it is Rock U, it is Blurb these are really exciting companies in our portfolio that are performing quite, quite well, that we have exposure to and we're seeing a very strong keen interest by the venture capital community into the information services sector which received approximately 41% of the capital being invested during the -- I'm sorry, say it differently. Of the 62% -- sorry, of the $7 billion invested, 62% went into IT, of that 62% of that, 41% went to information services. So a very, very strong growth sector for the venture capital community of which we have very good exposure to within our portfolio. And again examples of those are High Five, Blurb, Glam Media, Waterfront Media and of course most recently Rock U. Examples of portfolio exposure that Hercules has in that segment of the market.

In terms of your preference or your transition to later stage companies, does that change the financial model at all in terms of longer term expected gains? Does it result in potentially higher yields in the near term and less gains in the long-term?

It's a combination of both. The really solid EBITDA performing companies generally tend of to have no warrants associated but a very high current cash yield and may include a portion of that as interest. The later stage venture backed companies that may not be sustained EBITDA positive yet or may have lumpy EBITDA but certainly approaching EBITDA positive in 12 months or so, those tend to have warrants associated with them for long-term cap appreciation. So we are still at a very strong bias towards later stage venture with warrants on them.

Okay. Couple more questions. This may seem like a crazy question, but I'll ask it anyway. Was the dividend decision made in connection or did you have full knowledge of did the Board have full knowledge of the fact that your spreads would widen out so much on your cost of debt? You mentioned that you signed it yesterday, I believe. I'm just wondering if these two decisions are related, if you had that type of knowledge when you decided to take the dividend out?

No, in all fairness, we've known about the potential spread expansion now for probably I would tell you almost three or four weeks. This is not nothing new. And it's been a very protracted, long-term discussions with our providers out there. The Board is fully reticent of that information and knowledge of that. I think that the Board and management is -- we strive on the knowledge and the confidence in our ability to generate NII income in calendar '08 coupled with the spillover of the $0.12 from '07 to '08, you may or may not recall that the $0.12 spillover and earnings from '07 to '08 must be distributed or must be declared and distributed in calendar '08, regardless. And has 90% test, said differently, we would have had to pay it down anyways.

Okay. And then just one more question. The grade one assets in terms of the portfolio, what is in grade one? Is that a couple of credits? One credit?

You're going the wrong way. Grade one, is in our scale, Hercules, grade one is the best. So we have actually, if I remember correctly, I think we have six grade one deals in that portfolio.

Yep.

You can -- here's a couple telltales. When somebody becomes a grade one, it is almost but certain that in the course of the next 12 months or so, a liquidity event will be achieved in that position, resulting in a form of realized gain. Conversely, a grade five, you can actually assume there will be some capital loss attributed to a grade five. So I'm happy to report that we're heavily weighted in the right direction.

Yes, I was just looking at -- there was down 10 million I was just wondering if that was a specific credit that came out of there that resulted in a gain. I guess that's --

it's probably more attributed unfortunately to Mark to market as relates to some of our public securities, such as Memory, Lava Farm and various other investments that we've had. It's no secret to anybody that in the public markets volatility has been somewhat volatile.

Okay. One more, if I can. David.

Yes.

Just back of the envelope calculation, the increase in the unused fee and also the 380 basis points in incremental costs, I penciled out to about $0.02 a quarter after tax. Is that a -- ?

The unused fee, again, this is back of the envelope, we were looking at it being $0.025 to $0.03 on the year. Is probably a reasonable estimate.

I don't have an answer to that yes because that can get compressed by us as we continue to originate higher spreads. I think as of right now, I would rather defer to a more conservative position which I think that's probably a fair comment but management and our team is certainly looking to make that up as much as we can.

Yes. No, fair. I'm looking at one side of it. That's entirely fair. Okay. Thanks.

We'll take our next question from Henry Coffey with Ferris Baker Watts.

Hey, good afternoon. Probably going over some of this stuff once again, I'm sorry. But the sort of gains pool, you've got $3 million that you just booked. You've got $2.2 million coming, tied to the potential sale of a company and what is the spillover on distributed income?

Approximately 4.2 million from 2007.

Or $0.12, Henry.

So it's 4.2, $3 million booked and $2 million maybe?

Correct.

And that's all obviously going into your dividend decision, so this $0.34 that you put out there is obviously sustainable into the future?

Henry, absolutely right. I mean, if anything I learned in running a publicly traded BDC is don't overshoot your dividend so you can't earn.

And then in terms of originations, obviously things are going to slow down somewhat by choice, which seems like a very smart move, given where the market is. Can we look at the current quarter and use that as our going forward benchmark or should we expect to see more aggressive or less aggressive originations?

Well, I'm not a big fan of the word aggressive. I think that --

More robust.

Thank you. I think that the first quarter is not indicative of what we expect the activities to be. I think it's on the lower end of the scale and as I said at the beginning of our my opening comments, we consciously and purposefully took our foot off the gas a little bit here to allow the market spread to catch up to what we're anticipating to be the yield or the spreads from our credit facilities. Those credit spreads ended up being broader than we anticipated so we're going to go a little bit slow and steady but start creeping up our spreads on our underwriting of our new deals. But I want to caution you and everybody else, remind everybody that the third quarter is historically our lowest period of time by which only 15% of our assets are usually placed on the books at that point. So I think that you're looking at the typical Hercules curve here that the fourth quarter is a very robust quarter but we're having a very good second quarter so far.

And in terms of your usage of the SBA facility, can you sort of access that at will or does that have to come in chunks?

No, we can access it. We just put in our leverage request and draw on it as we need to and we support our draws with the SBA. So we have pretty good accessibility to it.

Henry, you should know as an important feature of the SBA line that we should make more publicly known, we have of course but we don't talk about it as much, and we should, which is the SBA launches in two periods of time, March and September. However, the interim borrowings between that period of time are only priced at LIBOR and a small spread ranging between 30 to, say, 45 basis points. So depending on where in the continuum you are in that interperiod of time, you're actually garnering fairly significant margin to your benefit for that six months, three months or four months period of time until the rates lock in.

That's why I was asking. Because it seems like a very attractive facility to have right now.

This is exactly why we chose to lower the Citibank, Deutsche Bank line from 250 to 135 because we don't -- we didn't feel it made any sense for us to burden our balance sheet and P&L with the unused charges because we can't absorb that credit facility anyways.

And of course your interest yield was I think if I read everything right, 1264 this quarter?

That's correct.

And should we look for that -- I know that there is some noise in there, but should we look for that to move higher or stay in the kind of low 12 range or -- ?

Certainly we're looking to move that up higher. I have $470 million loan base, so to kind of start moving that up, meaningfully, it will take some quarters to do that. So the interesting thing is we have 50% of our portfolio is fixed rate loans, 50% of it is floating rate loans. Of that existing floating rate loans, a portion of those are one year facilities that are coming off and as those facilities come off we're renewing those at a higher rate. I think you'll see that ultimate spread increase, yield increase, but I think that you need to give us a couple quarters to get there.

Great. Well, given what you're doing with your balance sheet and where you're going, all this looks surprisingly absorbable.

Well, we try to be as transparent out there and really work for our shareholders to make sure we manage our overall cost of capital effectively.

Great. Well, thanks again. Good quarter.

Thank you.

We'll take our last question from Greg Mason with Stifel Nicolaus.

Good afternoon. This is Troy Ward. Greg will follow up. You said you had one loan on nonaccrual. Can you tell us the size of that.

Approximately $4 million. And it's a company that's gone into receivership. They're looking to sell the assets and NOLs and so on.

Troy, should look at that transaction, similar to how we handled the transaction where we worked very diligently with management to move the company into a receivership or chapter 11 process and then we effectively offered the company dip financing on the transaction. We did the same thing on the transaction and we actually provided dip financing for that company and we are having a date certain auction on May 28th. This whole event will be reconciled and packaged up and completed by May 28th.

Any thoughts on recovery rates on something like that?

You know, right now I will tell you that we have many, many interested buyers on that property. And we are receiving -- I've got to be careful. We've got other bidder. I don't want to cap myself here. So far the bids are all higher than our debt by a good portion and the others who want the assets and other intangibles of the company that may bid even higher than that.

Is that why -- I'm assuming there's nothing in grade five. Is that the reason it's not in grade five is that you're not expecting a loss?

In all fairness, under the FAS 157 rules, when we closed the quarter we did not have the visibility that we have today on the value of the assets and the prospective interested buyers of those assets so we actually impaired that loan by $1.5 million at the end of the first quarter, primarily because we didn't have the visibility and the confidence at that point from a fair value to believe that was worth more than $2.5 million. I will tell you that if things progress the way seem to be going right now, I don't believe at this point, that we may experience any loss in that transaction.

I guess at March 31st, if you thought you had an impairment and you thought you likely or potentially were going to take a loss, why wouldn't that have been included in the grade five bucket where you have zero.

We had written that down to what we believe was the market value of it so as a grade four it's what we had expected to have a loss but not a total loss.

Let me expand further. Grade five is you will have a loss. Grade four is you may have a loss. So let's take the example I just gave you. May 29th comes and goes and we have bids that are materially less, that loan would move into grade five in Q2.

Okay. I understand. I understand the gradation. I think Greg has follow-up here.

Okay.

Can you talk about with your slow and steady, what your thoughts are for kind of a range of origination volumes on a quarterly basis?

I got to tell you, this market providing kind of quarterly visibilities, I don't want to do, it is -- I've got to tell you, it's much too difficult in this current environment to do that. I feel that although we've never done this on an annual basis, I believe that on an annual basis the numbers are probably more easier to talk about and that is that you'll probably see a range in the order of probably -- I'll give you a broad range, $400 million to $500 million on a committed basis range. I don't want to give guidance in this market. I want to put context around. I will reserve to make those adjustments each quarter hereafter. Certainly it's 400 to $500 million range of gross originations and probably 350 to 375 in fundings. It's probably a right range for you to look into 2008. I will tell you that if we see a substantively dramatic improvement in lowering our credit spreads from a cost of leverage, that number will go up quite dramatically.

Great. One last thing. The SEC proposal yesterday that would allowed BDCs to hold public stock of companies that were previously qualified assets and those stocks will not -- will continue to count as qualified assets, does that impact you in any way and how you look at this business?

I think that the SEC and Congress are working in the absolutely right direction to create a stimulus package for small market cap publicly traded companies. The answer to the statement is yes it will. As you know, the way the legislation was written it would actually affect Hercules adversely because had a company that we made an investment in as a private entity gone public, that classification at that point would have deemed those assets to be bad assets. Under the new amendment that Congress is or I should say the SEC is looking to do, that asset looks back to original date of investment and doesn't change the characteristics if it goes public in the future. So that will be very beneficial to us.

Does it also allow you to provide debt to public small cap public companies? Am I understanding the proposal correctly there?

That's correct. The intent, the ambiguity of the rules were primarily precipitated by the Fed's changes in margin. What happened was that in 1980 and throughout the '90s, marginal securities historically were securities that were over $5 price per share and that rule has kind of changed a little bit overtime. In essence, was non marginable. That ruling was modified by the Fed to allow all securities to be marginable subject to any brokerage house rules. What happened was the natural bar of using margin as the differentiation went away and we in the BDC industry were left with this ambiguity as to what's an eligible asset in the public side and I think the SEC deserves a lot of credit for moving diligently here to help clarify that for many publicly traded companies who don't have access to capital.

That would imply you'll have a whole new area that's opened up to you to make originations.

Which is why you're extrapolating the right logic, which is why we're moving towards later stage publicly traded technology companies that we know well that we historically could not pursue as investment opportunities. That is correct.

Have you heard anything about the timing of when Congress could actually approve this?

Troy, I will -- Greg, sorry. I will tell you this in all honestly. Our government is working very hard but no longer try to handicap any time frame when our government will react or not react.

Thanks, guys.

And with no further questions, I would like to turn the call back over to Mr. Manuel Henriquez for any closing remarks.

Thank you operate her and thank you everyone for your continued interest in support of Hercules Technology Growth Capital. If you would like to arrange a meeting or have additional questions please contact David Lund or myself at 650-289-3060. Again, thank you very much for being our shareholders. And thank you for being part of Hercules. Thank you, operator.

This does conclude today's conference. We thank you for your participation, and ask that you have a wonderful day.