Hercules Capital Inc (HTGC) 2009 Q2 法說會逐字稿

Good day, and welcome to the Hercules Technology Growth Capital Q2 2009 Conference. Today's call is being recorded.

At this time for opening remarks and introductions, I'd like to turn the call over to Dede Sheel. Please go ahead.

Thank you, Operator, and good afternoon, everyone. On the call today are Manuel Henriquez, Hercules' Co-founder, Chairman and CEO, and David Lund, CFO.

Our second quarter 2009 financial results were released just after today's market close. 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 numbers and passcode provided in today's earnings release.

I would 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 that you refer to our most recent filings with the SEC for important risk factors that could cause actual results to differ materially from these 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.

I would now like to turn the call over to Manuel Henriquez, Hercules' Co-Founder, Chairman, and CEO. Manuel?

Thank you, Dede, and good afternoon, and thank you, everybody, for joining us today. As you most realize, after the market close, we released our Q2 2009 earnings release and financial performance for the second quarter of 2009.

I am proud to say that, once again, we, Hercules, produced another strong quarter in an otherwise difficult and challenging credit environment, as most of you are fully aware of, as listening to the many earnings calls over the last few weeks.

I'd like to start off by giving you a quick overview of the quarter, then some specific on the venture capital industry, some specifics on the balance sheet and outlook that we have for the second half of 2009, and then have David Lund, our CFO, provide you more detail and thorough overview of the financial performance in the quarter, and of course, finish off with a question/answer session for our investors to ask questions and get better orientated in our performance.

In terms of the quarter, we once again produced record net investment income of $11.8 million and producing earnings on an NII basis that are $0.04 above Street consensus of $0.30. We reported $0.34 in net investment income earnings for the quarter.

On top of that, we also reported record net interest margin of 14.35%.

We also experienced a 2.4% income growth year-over-year, as compared to the same period for 2008.

We also improved and dramatically increased our liquidity position and further solidifying our cash position and our balance sheet by de-levering our balance sheet further and increasing our cash position, which David will elaborate further. This is part of our ongoing strategy of maintaining high liquidity position as we position Hercules for the fourth quarter and beyond for new originations.

During the quarter, we also saw the beginning and improvement of the venture capital industry by seeing an increase in investment activities compared to Q1, but I like to caution everybody, although the data is certainly encouraging, one quarter does not make a trend yet, and I will expand upon that as I go through more details on the venture capital industry.

Another important achievement during the quarter was our ability to secure a $20 million credit facility by Union Bank California that we expect to close in the third quarter, providing us even more liquidity to continue to make investments in the fourth quarter and beyond.

As to the asset quality, as many of you have seen today, we experienced a $4.2 million realized loss in the quarter primarily attributed to two investments.

However, I remain optimistic, and in keeping with Hercules' credit position, that I expect to see over the proceeding few quarters some recovery of those realized losses that we experienced as we look to monetize or liquidate some of the fixed assets and intangible assets that we may have received as part of the liquidation of those companies.

We've opted to take a more controlled sale of those intellectual properties and look to monetize some portion of those for some recovery of that 4.2 realized loss in the quarter.

A testimony to Hercules' continued credit performance is out of our investor professionals. Hercules' credit performance would not have been and would not sustain itself without the incredible dedication and hard work of our employees at the Company. To that end, we remain extremely vigilant, tenacious, and aggressive in ensuring that we attack and address the first signs of credit concerns in our portfolio.

During the quarter, we've also experienced a 12 -- excuse me -- $20.7 million of unrealized depreciation, and in keeping with Hercules' historical credit performance in underwriting and fair value standards, a significant portion of that is attributed to companies that are either in the process of closing a next round of financing or expect to close a round of financing in the near term.

And to that end, we have fair [value of the] investments in the event that those companies do not successfully secure a next round of equity capital.

Said differently, we expect to see in future quarters some reversal of that unrealized depreciation subject to those companies successfully either raising additional rounds of equity capital or continuing to achieve developmental milestones when it comes to specifically the life sciences companies, which I spoke to during the first quarter's earnings call, where some of our companies are in the process of completing critical FDA milestones to transition from a phase II to a phase III clinical trial process, and more on that as we go through the process in today's call.

To date, I'd like to point out another important fact that differentiates Hercules from a significant part of the financial services industry and certainly that of other specialty finance companies.

I'm extremely proud to say that Hercules' inception to date -- that is, from our founding and first origination back in October 2004 to the present quarter of 2009 -- we've experienced a loan loss of only 1% of total committed capital -- excuse me, of less than 1% of total committed capital since inception.

That has been achieved because of our ability to also harvest realized gains from our warrant portfolio that, since inception, we've now realized approximately $15.8 million of realized warrant gains to help offset some of the realized losses in our loan and equity portfolios since inception. Frankly, I found that statistic to be outstanding in the wake of this very difficult and challenging environment.

However, in keeping with our conservative stature, I'd also like to point out, as we disclosed in our earnings release, that we expect to see two additional realized losses that should materialize in the third quarter that represent approximately $14 million of realized losses. However, I'd even like to caution, of that $14 million in realized losses that we disclosed, as a subsequent event for the third quarter, we certainly expect that some portion of that should go down as we also look to monetize some of the intellectual property and other assets of those companies.

Now, in keeping with the venture capital marketplace, it is certainly encouraging to see the venture capitalists invest $5.2 million -- billion in the second quarter. It is certainly in keeping with our expectations of a $5 billion investment activity in the second quarter; however, we will continue to remain cautious as we ensure that this is not what is more commonly called a "dead cat bounce." We want to make sure that the venture capitalists are, in fact, continuing to support and sustain their investment activities. We are encouraged, and we're certainly optimistic and remain optimistic as we look to Q3 and, more importantly, Q4 investment activities.

To that end, we saw 595 transactions completed by venture capitalists in the second quarter, according to Dow Jones [Venture Source].

On the capital-raising activities, that is, venture capitalists or more commonly known as general partners raising capital from their limited investors, limited partners, we also see some mixed but encouraging news, as well.

In the second quarter, we saw 25 venture capital funds raise approximately $1.7 billion. Although the number is quite low and the lowest as it's been since the first quarter 2003, it is nonetheless encouraging that the venture capitalists are still able to raise and continue to raise capital.

But more importantly, during the first half of 2009, the venture capitalists in the first two quarters have raised approximately $6.3 billion of additional capital to invest in technology and life sciences companies. Frankly, I view that to be a very encouraging sign and an indication that the tide may be turning and we're certainly coming off the bottom.

In terms of liquidity, again, although the numbers are dramatically lower, they're still nonetheless positive. What I mean by that, the venture capitalists realized approximately $2.6 billion in M&A activities completed during the second quarter of 67 companies being acquired.

We also saw extremely encouraging, although anemic at that, IPO activities of three companies successfully completing IPOs and approximately 45 companies currently in registration that are venture capital backed.

This, by the way, breaks a 13-month drought in IPO activity. The reason why I'm so encouraged by that is that even Hercules' portfolio saw one of its portfolio companies also file for a public offering, and that company is Ancestry.com, who just recently filed for an IPO, and we currently have another company, Gomez, also in registration today for IPOs.

The other source of data on the venture capital industry is the National Venture Capital Association, and they report five IPOs that have been completed versus the Dow Jones of three.

The activities show strong liquidity in the information technology sector and the consumer-related sector, well positioning the Hercules portfolio as they're currently sitting on over 50 warm positions in various technology and life sciences companies, which David will elaborate during his presentation, as well.

Now, let me speak to the overall landscape. The current credit environment has further reduced, if not almost all but eliminated, our competitors in the marketplace. We are seeing a dramatic shift in the competitive landscape as this credit cycle continues, as many of our competitors are either unable to secure additional follow-on capital or are experiencing extreme difficulties and credit challenges in their portfolio.

We continue to remain disciplined, focused, and extremely hawkish in monitoring and pursuing our credit portfolio to ensure that we manage through the successful challenging current credit environments, something, unfortunately, I cannot say a lot of our competitors.

This bodes well for Hercules as we position ourselves for Q4 and beyond investment activities given our increased liquidating position. This will allow us to continue to harvest broader spreads in our underwriting, allow us to continue to sustain high effective yields and net interest margins in our portfolio as we continue to pursue our business model for the remainder of 2009.

Strategic direction --

Given our high liquidity position, we remain actively interested and have evaluated other BDC portfolio assets to buy, other portfolios to invest in, and other strategic initiatives that we're constantly and continuously looking at to ensure our ability to continue to unlock value for our shareholders. The landscape is loaded with opportunities, but we're also hyperly cognizant that opportunities don't necessarily translate into monetization for our shareholders.

With that end, we remain cautiously interested in evaluating portfolios, making acquisitions, or other strategic initiatives that will unlock value for our shareholders, but we remain very cautious in pursuing those opportunities unless we see the appropriate returns for our shareholders.

We expect to see improvements in both the broader capital credit and venture capital marketplace, which is why we have chosen to continue our slow and steady strategy of investment activities to ensure that we have ample liquidity to harvest new investment opportunities leading into the fourth quarter.

There's no question that we're positioning ourselves for much more heavily orientated fourth quarter origination activities, assuming that all the leading and [inaudible] indicators that we look to in the marketplace point to and continue to support the direction that we expect to see for the fourth quarter.

Until then, you can expect us to maintain a high cash level position, low leverage on our balance sheet, and extremely aggressive monitoring of our credit situation to ensure the continued long-term viability of Hercules in these recently challenging times.

With that, I'll turn the call over to David Lund to provide you more detail over your financial performance, and then, of course, we'll open it up for questions. David?

Thank you, Manuel.

Despite the current challenging market, we believe our results from operations for the quarter were outstanding. Today, I'd like to focus on a couple of things -- continued strong NII achievements and liquidity and capital resources.

During Q&A, Manuel and I will be more than happy to respond to questions you have on other operating results that I do not specifically address during my discussion.

First, I will touch on Q2 operating results.

Year over year, we had growth in net investment income, NII, and net interest margin. We achieved approximately $19.5 million of investment income for the quarter and 14.35% net interest margin.

The effective yield on our debt investments during the quarter was 16.1%, compared to 15.6% in the preceding quarter, primarily due to higher income from acceleration of fees and interest from early loan repayments and loan amendments as our team continues to renegotiate higher terms.

We'd like to note that fee income is often composed of one-time event-driven fees, and we currently anticipate that our Q3 fee income will not be as high as Q2.

Compared to the same quarter last year, we were able to reduce our cost of debt from $3.5 million to $2.4 million by decreasing our average debt balance outstanding from $180.9 million to $135.8 million, primarily due to the repayment of the Citibank credit facility in March of this year.

All of these factors -- improving effective yield, reducing our cost of debt, and managing operating expenses -- contributed to our record Q2 net investment income of $11.8 million, or $0.34 per share, and taxable distributable income of $10.6 million, or $0.30 per share.

Turning to credit performance, we continue to be vigilant in monitoring our portfolio and mitigating losses by identifying trouble credits early. The weighted average loan rating of our portfolio moved up slightly to 2.70 compared to 2.43 at the end of last quarter.

This change in grading was primarily attributable to the increase in companies rated 4 and 5 from approximately 6.5% to 21.7% of the total debt portfolio on a cost basis. We downgraded a select group of companies based on their need to raise additional capital and, accordingly, posted unrealized depreciation for the quarter of approximately $20.7 million. We anticipate that some of these companies may secure financing in the remainder of 2009, and as a result, we will reverse the unrealized depreciation.

As of the end of the quarter, we had four companies that are on nonaccrual with the combined carrying value of approximately $6 million, or less than 1.5% of the fair value of our loan portfolio and less than 6.2% on a cost basis.

We and our portfolio are not impervious to the vagaries of the current financial markets. In the quarter, we had two portfolio companies cease operation, and consequently, we took realized losses of $4.2 million.

Since inception, net realized losses total approximately $1 million. This represents less than one-tenth of 1% of total commitments since inception of greater than $1.5 billion.

As the economy is showing signs of improvement but by no means is what we consider healthy, we anticipate that we will have additional realized losses, as disclosed in the press release today.

As we have indicated before, liquidity remains one of our top priorities. On that note, I'd like to discuss Hercules' liquidity and capital resources.

Our strategy for the last few quarters has been, and is, to remain as liquid as possible until we are comfortable that the VC investment activities have normalized. We anticipate that this will begin to occur in the fourth quarter of this year.

With our cash leverage and steady cash loads from loan repayments, we believe we will be in a strong position to increase the pace of our investing when the market improves.

I'm pleased to announce that on July 31 in this tight credit market, we received a commitment letter from Union Bank of California for a $20 million credit facility, further showing confidence in our operating performance. This commitment is subject to due diligence completion and legal documentation.

As of June 30, we had $37.4 million in cash, and our only debt was $130.6 million on our SBA loan and less than $0.5 million on our credit facility. We have since paid down the amount, outstanding balance with Wells Fargo, allowing us access to a $50 million of borrowings under the facility. The $150 million maximum available under the SBA program provides us with additional borrowing capacity of $19.4 million, subject to regulatory limitations.

The combined access to capital from these potential sources and our cash on hand as of quarter-end totaled approximately $127 million. Combined with future principal collections, this access to capital places us in an advantageous position to invest as we enter the fourth quarter.

In addition, I'd like to note that we have been invited to meet with the SBA to continue the application process for our second license that would allow us to borrow up to a combined total of $225 million.

Finally, we are pleased to announce that our board of directors has authorized a cash dividend of $0.30 per share payable on September 14 for shareholders of record on August 14.

At the end of the year, we may also pay a fifth dividend, such that we may distribute approximately 98% of our annual taxable income in the year it was earned instead of spilling over our excess taxable income.

In closing, we believe we are in a strong financial position, and we'll be ready to increase the pace of our new investments as the market turns.

Operator, we are now ready to open the call for questions.

Thank you. (Operator instructions)

Our first question comes from John Hecht with JMP Securities.

Afternoon, guys. Thanks for taking my questions, and congratulations on another good quarter.

My first question's related to really your position of excess liquidity, strong position of cash right now. And with that, one is you announced a potential buyback program last quarter so you could apply some of the capital using that. And then the second is, Manuel, how do you see the venture capital [mark] ramping up in the second part of the year? In both of those factors, I'm wondering is when do you expect to ramp up the investment activity, and when might you pursue some of the buyback?

Well, let me take the latter first, and then I'll expand on the former.

Clearly, signaling on what our criteria would be to commence a buyback program, it would be silly for me to get into the specifics of that program.

We have ample liquidity to, in fact, do a buyback, as you rightfully point out. I think that the -- to temper that statement, I think you have to look at what the dividend yield of Hercules is today versus its ability to originate new assets and new activities and look at that spread and make a determination.

Clearly today, with a 16% or so effective yield, 14% net interest margin, our ability to originate new assets far exceeds that of the dividend yield of our stock. So that's a criteria there that we look to.

Obviously, maintaining ample liquidity is also being done for strategic purposes as we look at different opportunities to potentially buy other portfolios, some of which we've looked at, some of which we've passed, but liquidity remains a very important issue for us.

As to the first part of your question on the venture capital marketplace, liquidity is the reason why we're doing what we're doing.

Clearly, the first quarter of almost $4 billion of venture activity extrapolating to a $16 billion investment activity of venture capitalists was of concern. We have always said that we expected the venture capital industry to be about 20 to $22 billion in 2009, and then we subsequently lowered that threshold of what Hercules expected it to be to between 18 to $20 billion.

Clearly, right now, we're at an $18 billion run rate or so. However, I want to caution and remind everybody, just like Hercules, the third quarter for the venture capital marketplace is traditionally the slowest, and it certainly has been and always will be the slowest for Hercules. The fourth quarter always represents the strongest quarter.

I'm expecting to see the venture capital marketplace invest between 6 to $7.5 billion in the fourth quarter, with probably $4 billion or so invested in the third quarter.

If for whatever reason we see the third quarter venture capital activity throughout fall off below $3 billion, it's highly likely that we're going to continue to take a slow and steady strategy in our investment processes, and the reason being, I want to ensure that the venture capitalists in the private equity and, more importantly, the limited partners for the venture capital community are continuing there to support their venture capital sponsors, who, in turn, support the underlying portfolio companies that we invest in.

This goes further into our continuing shifting that we've now been doing for almost eight quarters away from early, early-stage investing to more established-stage companies, and that process will continue as we remain in this credit cycle.

Okay. So it sounds like a little bit of a wait-and-see program in that endeavor.

The second question is can you refresh us where your dividend carryover is from last year and what the status of that might be and the strategy for payment there might be?

You know, so we've had the $0.18 carryover from the end of last year. We will -- obviously, we're monitoring those, the performance of the company as we go through each one of the quarters, but we would anticipate, like I had mentioned earlier, that we were going to try to pay out about 98% or better of our taxable income within the year by doing a special or fifth dividend in the fourth quarter. So we really want to return the capital to our shareholders during the quarter -- or during the year.

Hey, John, to expand upon that, we're clearly one of the few BDCs that are certainly more than amply earning its dividend or covering its dividend from both taxable income and GAAP NII.

And you're absolutely correct; our continued profitability, in fact, is positioning us, subject to the Board of Directors' final approval and vote on this, for clearly a fifth dividend based on our continued profitability throughout 2009 and clearly with the spillover of 2008 to 2009 of $0.18 or so of the dividend.

So we're well positioned at this point for highly likely a fifth dividend to be paid out, as David said, but that's something that we'll revisit by the fourth quarter and make that determination or our Board will make that determination. But we are clearly on that track.

Great. Thanks very much. And last question is related to the expected realized losses that she talked about in Q3. Were those already booked? I guess what level of that was already booked in an unrealized loss thus far?

All of it, yes.

Okay.

Yes, it is -- again, I strongly believe in having transparency for our shareholders, and I think it's important in subsequent events that if you have something that is so well known and so well defined that I believe, and maybe we're a minority in this view, that it's prudent for our shareholders to have that understanding as they look at the company.

But, yes, the good news is that all that realized loss that will happen in the third quarter has been booked as unrealized in the second quarter. But, again, I want to caution everybody that I remain fairly optimistic that some portion of those anticipated realized losses in the third quarter will be reversed as we continue to engage in discussions with prospective buyers for some of the intellectual property of some of these companies that we are actively engaged in right now.

However, because of the uncertainty of seeing an acquisition fully be consummated under fair value accounting, we had to book the unrealized depreciation to its fullest.

Great. Thanks very much for that color, and thanks a lot for answering my questions.

You're very welcome.

Our next question will come from Troy Ward with Stifel Nicolaus.

Good afternoon. Thanks, guys. Quickly, on -- well, let's start with the taxable income with respect to the dividend. Manuel, we've seen several other BDCs in the last six to nine months; when they take a loss on a debt piece that they originated, they offset that against taxable income. So the loss you took in the current quarter and expected losses in Q3 should lower your taxable income by quite a bit.

Well, I'll let David expand on that, but let me tell you that we have spent an inordinate amount of time with both our accountants and our attorneys on this subject, and that application is not correct.

Yes, what happens, Troy, with regards to taxable distributions is that capital gains cannot be offset against ordinary income. Losses of these nature can only be offset against future capital gains. As a result, while we may show a taxable loss for a -- a loan loss or something or even on a piece of equity investment, that will be offset in future periods against gains, so that's why you're seeing the taxable gain that we've got.

Well, I guess I understand that, but you're being advised that you can't use -- even if it's a self-originated debt piece, you cannot use the loss to offset taxable income?

We have gone through -- and let me tell you, I have been materially involved in these discussions on getting that potential confusion within the BDC landscape corrected. And according to our tax accountants and our attorneys' tax experts, it's very important to make sure we all understand what we're saying.

Investment capital, loan capital or equity capital that translated to realized losses, cannot be used to offset income. And it's an interesting thing because our profitability continues to be so profitable that we're not able to offset ordinary income against capital losses. It's no different than we, as individual taxpayers, that if you have a capital loss, whether short-term or long-term, you cannot offset your W-2 income against that. You're limited to $3,000, for example.

Right. Well, Manuel, I know you watch the space fairly closely. Would you characterize what a few of the other BDCs have done your advisors would not tell you to do? Is it apples to apples?

You know, let me put it to you this way, not to dodge your question. I cannot purport to understand what other BDCs do. I have been often surprised on fair value on some BDCs and how they hold investments, and I'm always surprised on the confusion that surrounds taxable income, which in itself, a fairly complex calculation is derived on taxable income, which, as you probably well know, differs substantially from that of GAAP NII income.

And so I cannot venture as to what other BDCs are doing with their advisors. I can only tell you that what we have done and clearly spent a fairly significant amount of time with our advisors and, once again, maybe we are confused and are doing it right. I'm not opining as to whether they're doing it wrong or not, but I feel now fairly strongly after spending so much time with our accountants and lawyers that offsetting capital losses or ordinary income cannot be done.

Okay, well, that's good. And nine months ago, we'd never seen anybody do it, so that's fine.

And let me clarify one more thing it's important for you to know as a footnote to that.

Now, believe it or not, there's actually -- taking a bad situation, you could actually help make it good over time. What does that mean?

It means that a BDC who's a RIC -- and it's more of a RIC, and I misspoke a minute ago. It's a RIC issue, not a BDC issue, so it's my error on that one. It's an IRS RIC issue, not a BDC issue.

A RIC, as we all know, cannot take net operating losses and spill it over year over year as a RIC. You lose -- you have to decide to either lose your RIC status or maintain your net operating losses.

However -- this is an important footnote -- however, a BDC RIC is, in fact, able to carry over its capital loss to offset against future realized gains.

Now, why I say that is important because Hercules more so than not, compared to other BDCs, has a significant warrant position in over 70-plus companies that has a face value, if we were to exercise all the warrants of $50 million.

I said at the beginning of this conversation that Hercules had so far, inception to date, realized over $15.8 million in realized gains of those type of securities.

So it is our expectation over the proceeding one to four years, whatever that may be, especially if the IPO market opens up, that some monetization of that one pool will clearly offset any capital loss that we have, rendering those gains that we have, in essence, tax-free be applied to offsetting those capital losses that we have.

Yes, that makes sense. And how many years can you carry those forward?

Those carry forward for eight years.

Okay, great. Real quickly, on the SBIC, Manuel, the way I read it, and I think this is correct, you're at 1.30 now. You can go to 1.50 without any new -- without anything. You just draw down the capital, correct?

The answer is almost correct. Because of the remaining last tranche, we have to do is basically file a submission letter or a funding request, and then the SBA has its normal course. It can be one to four weeks on simply saying, "Okay, you're approved to draw the final capital. We now have the capital available for you." So it's fairly perfunctory, but we technically have to file the drawdown request.

Okay, and then the second license would enable you to get $75 million in additional debt. Do I assume you need to have $37.5 million of equity to fund that?

That's correct [inaudible], and that's why we're keeping a high liquidity position because unlike some of the other BDCs out there, because we have ample liquidity, because we continue to be a well-managed SBIC, and we have been invited by the SBA to move fairly expeditiously by our second license, which David and I will be flying out to the SBA to meet with their panel either end of this month or early next month, that process is moving about fairly quickly, in fact, even more faster than I was anticipating, which I'm encouraged by the SBA inviting us to come in.

Okay. And with the $37.5 million of equity, would it have to be funded first before you draw down the additional 75?

No, we can drop down in increments and then borrow against on essentially a 2:1 ratio against what we invest as capital.

Okay, great. And then just one final topic on credit quality, and we don't have to have these conversations very often, Manuel, but clearly, Active Response Group, with being marked 98% of par on the Q1 10Q and now apparently when we see the next 10Q, it's going to be marked down substantially, can you just give us a little color on kind of what happened there and why we shouldn't expect something like that again?

Yes. And the answer is that that situation is quite unique. The situation is not entirely over. They are some practices that transpired at the Company level that has caused us significant concerns on corporate governance that may have existed at the Company level, that we are looking further into it and expect to pursue to mitigate the capital loss.

In a situation that is precipitated by a decline in their business segment of the market, customers that they had moved away from them, and the nature of the business is such that it has a fairly high fixed operating cost that as the revenue contribution margins that they expect to have materialized either did not materialize or materialized in a materially lower margin than management had expected, coupled with management did not rapidly and adequately adjust its business model to take into account the changing environment that they were faced in.

Okay. Like I said, it doesn't happen very often in this portfolio, so just wanted a little color. Thanks, guys.

Thanks, Troy.

Our next question will come from Jason Deleeuw with Piper Jaffray.

Good afternoon, everyone. Just wondering on the competitive front, a lot of your competition fell off the map with the credit crisis. Now that the world's looking a little bit better, are you guys seeing any of the animal spirits in your competitors be revived at all?

No, I think the spirits live on in the skies. I think that the competitive landscape has materially and dramatically changed. I do not expect any material change in the competitive landscape for probably a year or more out.

Although the overall pool opportunities on the venture capital side may have shrunk, the competitors that existed have all but gone. That means that although the pool is smaller, the opportunities remain no different than they were a year or two years ago.

I think it would be extremely hard for a lot of our competitors to successfully show that their portfolios remain as resilient as ours and as profitable as ours have been.

We are making a very strong statement to the marketplace with our balance sheet position by showing a strength in the balance sheet and our continued willingness and support of our portfolio companies to ensure that they, along with the venture capital sponsors, work through the difficult environment and survive.

A lot of our competitors do not have any excess liquidity and are unable to work with their companies, let alone support the companies, through these challenging times. I think that Hercules' liquidity position, the investment professionals that we have here to work through difficult and challenging times is a testimony to the Hercules' credit performance and our ability to identify the right investments to begin with and also work through those challenging times with our companies.

A lot of our competitors do not have that expertise and do not have that access to additional capital, and their portfolios are dramatically impaired in this current environment.

Great, and appreciate the color. And I'm just wondering on the investment portfolio growth, you know, the third quarter's seasonally slow, so you guys are still targeting the fourth quarter. So I'm wondering if the VC activity, if it's healthy enough, if you guys expect to ramp up the growth rather quickly, or is it still going to be rather controlled and then you're just going to build the growth as we get into 2010?

As I said earlier, there are -- the third quarter is the leading indicator. It's quite an important one for us in the venture capital marketplace. Clearly, public investors are now clamoring for and seeking growth capital-type investments.

I remain fairly optimistic that we'll see some good liquidity events through IPOs, and certainly, I've seen very good liquidity so far in the third quarter through M&A. So I'm expecting a fairly robust M&A and probably three to five IPOs in the third quarter.

As to venture capital activity, I think that the venture capital is probably investing 4 to 5 billion only in the fourth quarter -- in the third quarter, excuse me, which will be very good for what we're looking for. If that is the case, you'll probably see Hercules originate between 50 to $80 million in the fourth quarter, assuming all those indications continue to support and point to that direction.

If for whatever reason we don't see that activity going that direction, you'll probably see us sustain a 20, $30 million investment space in the fourth quarter or so. But I wanted to caution everybody, this is not intended to be giving guidance; it's more speaking of what we think the market may, in fact, translate into.

We are more interested in not chasing necessarily yields on investments; we're more interested in sustaining credit performance and not sacrifice credit performance for yield. I think there's a confusion in the marketplace that just because you get high yields, you should originate a transaction. We prefer to see strong credit qualities and strong collateral coverage as much as we possibly can expect to see with intellectual property as we originate new loans and transactions.

Great. And, also, I'm just wondering on that growth, are you thinking of doing it more organically, or would you -- I mean would there -- or maybe possibly acquire some of these portfolios that you guys have looked at? I mean what's going to -- what can we think of in terms of the components of your growth?

I think it's safe to assume that we're going to continue to stick to our [wheelhouse] and do what we know how to do. I think that we spent some time looking at some portfolios out there and quickly realized what we don't know or what we don't like is probably a better description.

Not all middle market or low-middle market companies are created equal. Some are more susceptible to recessionary periods, some of which makes us extremely uncomfortable.

We will originate the numbers that I spoke to you on organic self-origination, as opposed to looking for growth by buying a portfolio under those numbers. It will be self-originated because we feel more comfortable handling a credit process cradle to grave, from when we first involved a credit, and making that investment decision on our own as opposed to doing it on a secondary market, buying an asset within three or four weeks of a due diligence process.

Thanks. I appreciate that color. And just, lastly, on the SBA, looking to upsize it, what would be the timing on that? It sounds like the end of third quarter. I mean could that be in place by the fourth quarter?

You know, we're waiting to see exactly what the application process is going to look like from the SBA. We will be going in and presenting the merits of Hercules and getting the second license here in the third quarter. And we've been indicated it could be a three to five-month process, so we're kind of laying out that timeline.

I think that, Jason, from a modeling point of view, we're not modeling the [access] to the $75 million from the SBA in the fourth quarter; we're looking at more of a Q1 event.

I think that our government is quite busy these days, and I think that prudence will really govern here, that -- I think that expecting it to occur in the first quarter is probably the safe assumption, and if we get lucky in the fourth quarter, that's accretive, clearly. But we're treating it as a Q1 event to be conservative.

Thanks, guys.

Our next question will come from Jon Arfstrom with RBC Capital Markets.

Thanks. Good afternoon, guys.

Hey, John.

Manuel, a question for you on the warrant portfolio. Sounds like you have one potential gain assuming that IPO occurs, but how many other potential IPO candidates do you think you have in that portfolio?

Well, Jon, not to be dismissive, if I had that knowledge, the overall expectation on liquidity, everybody would like to know that. I mean it's extremely hard. Public investors, as you know, are extremely demanding right now in terms of, rightfully so, of what to expect the company's registration to look like from a revenue composition and EBITDA performance to cash flow performance.

The market -- Rosetta Stone was a clear example of a successful IPO. OpenTable has been a very good successful IPO so far. [Inaudible] cash flow negative company at the time.

I've got to be cautious here because Ancestry is in registration, so I do not want to do anything to compromise that. So other than saying that they are filed and people should look at the S-1, that's all I could say. I can't opine as to the likely outcome of that company or others in our portfolio.

I think that, however, it's safe to say that you could expect for the near term, probably the next 18 months or so, that the majority of the liquidity in the warrant portfolio will still be driven mostly by M&A, as opposed to IPO activity. I think that's a safe assumption.

As to what that means in specific numbers, I'm not dodging the question. I have no idea. There are so many factors that go into a company's registration process and/or M&A activity that it's very, very hard to handicap.

Yes, what I'm trying to get at is it's the handful, and I think that's what you're saying. It's a handful of companies that are potential standalone IPO candidates. But I know you drive the bulk of your gains from M&A.

I think over the next 12 months, a handful is probably the right number from an IPO point of view. I think, on the other hand, in the next 12 months, M&A is probably more of two handfuls that's there.

I am very much aware that we have certain companies that are in the middle of completing material milestones that would automatically trigger an M&A activity, for example, but those milestones, some of which are contingent upon successful FDA events, some which are contingent upon continued execution of the revenue models to further get the company to a cash flow neutral or cash flow breakeven were some of the potential targets, larger targets, we look to acquire that company for either its technology or its customer base.

So what I'm trying to say is in no uncertain words here, the M&A events are more event-driven by the company's successful achievements of milestones, which is entirely out of our control.

Another question here, maybe a little bigger question. Can you give us some more comfort on how we can get comfortable that the loan grading will improve in the second half? And I just -- let me set this up a little bit. You say that there will be some reversal of the unrealized depreciation, and then maybe I'm thinking too much into this, but you talk a little bit about the capital loss carry-forward discussion, and you're saying that eventual warrant gains will offset losses. And I just -- you know, I want to make sure I'm understanding this correctly. Are you saying that some will reverse and we're going to see higher and more realized losses that will eventually be offset, or am I reading that the wrong way?

No, I think you're being too literal and going the wrong way on the comment. Let me -- I apologize for my lack of clarity here. So let me take another shot at it.

Of the approximate $21 million in unrealized depreciation in the second quarter, we have stated in our earnings release under Subsequent Event the narrative or descriptive explanation on two of that large credit, representing approximately $14 or so million.

We are engaged right now in meaningful negotiations with one of those companies' intellectual property that has a high probability of seeing a deal consummated here in the third quarter.

Now, here's where I'm an old dog at this business. I've been doing this for 20-plus years, and until a deal is done, a deal is never done, and fair value accounting trumps whatever Manuel or investment [candidate] process seems to believe.

Fair value accounting mandates that we mark down those assets to what the liquidation or value of those assets can be in an orderly sale, for example. And because we're in the midst of that and discussions can move away, and they have and they start over again, until that uncertainty is fully reconciled, we've opted to be more conservative and fully write off the remaining residual value of that asset that we foreclosed upon until we have a sale that's fully been consummated, or completed, I should say.

If that were the case, you would certainly see a recovery of that $20 million anywhere between 1 to $10 million in possibility, and the reason why that is is that the other component of that unrealized depreciation, and in keeping with Hercules' historical credit performance and grading, is that we will always downgrade and eventually depreciate on a fair value impairment if and when one of our venture-stage companies expects to close around an equity capital and for whatever reason, that equity round of capital is delayed or does not close as expected.

We will then reevaluate the fair value of the loan to value and take an impairment on our loan on an unrealized basis of what we believe would be the recovery of that asset in the event of a distressed or controlled sale of that company's asset to recover our loan.

A big component of the $20 billion of unrealized depreciation in the second quarter is also attributed to merely impairment on pending closing of new equity round of financing.

So it's both credit related, as well as speculation on our part, as to whether or not that company successfully closes its pending round of equity capital. In the event that that would happen, that company will be reevaluated on a fair value basis and potentially either reverse any impairment that we've taken or maintain the impairment as to reasonable fair value for the loan to value at that point.

We evaluate each and all our credits, our investments every quarter on that level of specificity on determining the collectibility and recoverability of our principal to loan value.

Okay, that helps. Thank you.

Our next question will come from Douglas Harter with Credit Suisse.

Thank you. I was wondering if you could talk about the amount of your portfolio that's coming up for equity -- the next round of equity in the back half of the year?

Yes, we're looking at about a third of the portfolio, you know, somewhere in the neighborhood of anywhere from 19 to 23 companies that were -- are in the process or will be looking to raise capital.

And just for comparison's sake, how did that compare to sort of the first half of the year?

It has been running probably --

About the same.

It's about the same. We were looking about 15, I think, at the end of the first quarter, knowing that we were going to see a higher amount coming into the back half of this year, so it's pretty comparable.

Yes, Doug, a crib sheet to kind of get you there quickly is this. Because the venture-stage companies, all of which require subsequent equity rounds of financing to sustain their business models, they traditionally raise capital every 9 to 14-month intervals.

With the contraction of the venture capital industry and the shrinking of the venture capital industry we saw in Q1, we suddenly saw an elongation of that process taking longer to secure the next round of equity capital than has been historically expected, meaning that historically, companies would start capital raising three to four months prior to the capital need coming to the surface. Now, we're seeing the process taking easily six months, and in some cases, up to eight months of a process.

So, ironically, just when they completed raising a round of equity capital, they're already positioning themselves to start embarking on understanding what the milestones of what the venture capitalists are expecting from that company for its next round of financing.

Now, the good news is that in the second quarter, we start seeing that timeframe starting to compress a little bit, so rather than taking five or seven months to raise capital, we're seeing some companies now successfully getting multiple different term sheets coming in and still taking a five -- four to five months, for example.

So we saw about a month, maybe two months, being shaved off a process, but it's still too early to say that we're still not facing a six to eight-month process for our Company to raise money.

Great. Thank you.

Our next question will come from Vernon Plack with BB&T Capital Markets.

Thanks very much. Hey, Dave, could you give those non-accrual numbers again, please?

Yes, we had four companies. Non-accrual was about $6 million in the value, and it represented about 1.5% of the portfolio, the loan portfolio, on a value basis and about 6.2% on a cross basis.

And how did that compare to the previous quarter?

It's up a little bit. We had three companies. At the end of the first quarter, it was about $1.4 million. They were smaller credits.

All right. And fees, of course, are higher this quarter. Could you give me an idea why those fees were higher?

Yes, you know, we had some restructure fees that came through in this quarter, and for about three or four companies, in particular, that pushed up the amount of fees that we gathered in the quarter.

Vern, the best way of looking at it is I would say that the Q2 had probably 1.5 to 1.7 million of non-reoccurring one-time fees, meaning that I think that the second quarter probably had that much of fees that I don't expect to see happen again in Q3 or beyond.

Okay. Just to give a sense for at least the next quarter, I'm assuming that we should see your cash position build again, correct?

Yes.

Okay. All right. Thank you.

You're welcome.

At this point, that is all the time we have for questions. Mr. Henriquez, I'd like to turn the conference back over to you for any closing remarks.

Thank you, Operator, and thank you, everyone, for your continued interest and support of Hercules Technology Growth Capital.

If you are interested in arranging a meeting or have additional questions, please contact David Lund, our CFO, or myself at 650-289-3060.

Dave and I will be meeting with investors throughout the country over the course of the next two to four weeks. We'll be doing a Midwest tour sometime next week, and we expect to be on the East Coast either late August or early September, and we'll be more than happy to meet with investors who are interested in arranging for meetings if our calendar can accommodate those requests.

So, again, thank you very much. Thank you for being our shareholders and being part of the Hercules story. Thank you.

This does conclude today's conference call. We thank you for your participation.