Hercules Capital Inc (HTGC) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your Hercules Technology Q2 2010 Growth Capital earnings call. (Operator instructions.) As a reminder, today's call is being recorded.

At this time, I would now like to turn the conference over to your host, Mr. Jason Golz. Sir, you may begin.

Thank you, Joe. And good afternoon, everyone.

On the call today are Manuel Henriquez, Hercules Co-Founder, Chairman and CEO, and David Lund, the Company's, CFO.

Our second quarter 2010 financial results were released just after today's market closed. They can be accessed from the Company's website at 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 pass code provided in today's earnings release.

I'd 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 to do so by law.

To obtain copies of our latest SEC filings please visit sec.gov or visit our website at htgc.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 you, everyone, for joining us today. I'd like to start off the call by providing a brief summary of our operating performance and results for the second quarter 2010, as well as my customary observations on both the venture capital environment, the overall landscape, and competitive landscape, and then turn the call over to David Lund, our CFO, to run through the more specific performance numbers for Hercules in the second quarter.

To that, let me first begin by saying that as we indicated to you in the first quarter we have continued and remain focused on building our investment portfolio and continued with our desire to build our earnings growth to start increasing our dividend. Thanks to the hard work of our employees you saw this manifest itself with over $217 million of commitments close during the second quarter alone.

When taking into account what we did in the first quarter in terms of commitments, we are now at a run rate not seen since the second quarter of 2008, a very impressive loan origination effort, while the rest of the economy continues to grow out of the recession period that we were in at a very slow pace.

To that end, because of this asset growth that we've seen we recorded $6.9 million of net interest income, or NII, for GAAP earnings of approximately $0.19 per share. Total investment assets at the end of the quarter were $435 million, and we are well positioned for growth for the second half of the year with both a very robust pipeline of over $1 billion in opportunity. This, by the way, after harvesting over $217 million of transactions in the second quarter. This should give you some indication of Hercules' continued dominance, or I should say continued growing position within the venture capital landscape as one of the largest venture debt providers in the marketplace.

This growth was also helped, fueled by our recent and final approval for our second SBA license for $75 million, a process by which we had anticipated to have fully completed by the first quarter of 2010 and it ended up spilling over to May of 2010. That said, we are very grateful with our continued relationship with the SBA and, more importantly, a very long-term, stable source of growth capital to fuel the Hercules business as we look to the future for continued growth.

On the credit side, given the continued softness that we're seeing in consumer spending and given the anemic economic recovery that we're still seeing in the marketplace, we felt very strongly that our investment in Spa Chakra, an investment that we had worked very diligent through the bankruptcy process to help the company emerge out of bankruptcy, continues to show signs of languishing or inability to be able to get itself into a cash flow positive growth business.

Because of that, we were forced to make a very difficult business decision and investor decision as to weigh the differences of continuing to support the company or evaluate strategic alternatives. Given our concern about long-term consumer spending we felt that it was prudent to put the Spa Chakra investment behind us, and we took measures in the second quarter of fully running down that investment to cause no further distraction for Hercules and its Team on a go-forward basis, since its performance out of bankruptcy has been anything but stellar. I'll be happy to answer more questions on that in the Q&A.

On the nonaccrual side, our nonaccrual status remains flat to insignificant on a fair market value basis on assets. It's basically 0.01% or insignificant in terms of nonaccruals which further validates our continued credit performance.

Overall, I am extremely happy to see the overall credit performance of the portfolio. I think that many of the credit issues that we had concerns about are now behind us. That does not mean that we're not working through some of the credit issues that we have in some of our companies. Mostly in transactions that were written down, including Spa Chakra, may in fact come-up as recoveries as we decide on different strategic options to take for those companies as we go through a more in-depth analysis of which directions the Company may or may not go in, and if they are able to close additional rounds of equity capital.

In terms of our investment efforts, I am happy to say that as we announced to our shareholders, we have now completed $3.5 million of stock repurchase at an average price of $9.16 a share, which is significantly above today's closing price of approximately $10.40 a share, making those investments, making those open market purchases accretive to our shareholders and turning out to be a very effective use of invested capital that we have available to ourselves.

Our Board of Directors declared an additional dividend, excuse me, another dividend of $0.20 per share in the second quarter, further showing strong indications and belief that dividend growth should and will continue throughout the remainder of 2010.

Now, no conversation regarding Hercules' performance is complete unless we speak to that of the venture capital performance, which is a critical part of the Hercules business model and should be understood by all our investors because it's an integral part of what we do.

Now, there are many good news in the venture capital community, many of which I am extremely happy about and encouraged to see as the market continues to gel and seeing technology companies, in particular, leading the charge of IPO and M&A activity.

More specific terms, the venture capital has invested $7.7 billion into 744 transactions in the second quarter of 2010. This, by the way, represents a 26% increase over the same period last year.

Further to that, capital deployed by sectors and stages is another area that we spend and focus quite a bit of time on. Very much emulating the same performance of Hercules portfolio, we saw the venture capital community deploy approximately 66% of its capital into later stage deals, which is up 56% from the prior quarter. This is very similar to the Hercules investment criteria.

Seed in first round financings by venture capitalists was up to 15% of total capital deployed, excuse me, was down to 15% of total capital deployed, while second round financings were basically flat quarter over quarter. No surprise and no different than our portfolio, technology and life sciences continued to glean the lion's share of all the capital invested by the venture capital community, with a third category in an area which I'm happy to report that we're now moving more attention towards, clean technology, which in turn received approximately $1.1 billion of those venture capital dollars financed in the second quarter.

Now, liquidity. Liquidity is an integral part of the ecosystem of the venture capital community. The venture capitalists, themselves, require liquidity to be able to return back to limited partners, and those limited partners in turn return that to the venture capital community in the form of commitments.

So liquidity in the second quarter. During the second quarter we saw, or I should say the industry experienced 15 IPOs, which is up from 3 at the same period last year. Those 15 IPOs raised approximately $900 million in IPO proceeds, making it the highest level that we've seen since 2007, a highly encouraging sign. This sign is very encouraging because Hercules in turn has four companies currently in IPO registration and holds warrant positions in over 80 venture stage technology and life sciences companies, making it a high candidate for liquidity and harvesting realized gains for those warrant portfolios in the coming quarters or years subject to market conditions.

I am proud to say that even this week we had one of our portfolio companies, Horizon Pharma, formerly known as Horizon Therapeutics, filed for its IPO yesterday, as well as we have currently in registration Everyday Health, Nexx Systems, and Reply!com, all of which have filed active S-1 registrations, awaiting to go public. This is a very encouraging sign and continues to provide optimism as we look to harvest capital gains from our portfolio and continue to organically grow our book values by some of those gains.

However, we have to be cautious because the IPO market is fairly skittish, although it is certainly looking promising we must be cognizant that the IPO market may change and clearly the passage of Fin Reg and the ongoing challenges of venture stage companies related to [SOX] continues to pose a challenging environment for many of those companies to continue to pursue IPO liquidity.

On the M&A front, despite some of the media concerns out there, M&A activities are quite healthy, and M&A activity continues to remain very, very robust in the marketplace. There are approximately 79 M&A transactions that took place in the first half, excuse me, in the first -- second quarter of 2010 obtaining liquidities of approximately $4.3 billion, which is up by the way from $2.9 billion on the second quarter of 2009. It is a very encouraging number but clearly not what it is from an historical rate on a run rate that years have shown close to [$40] and [$50 billion] in M&A activities. However, any M&A activity is encouraging in itself.

Asset quality related to our portfolio. Basically, our risk rated credit rating in our portfolio is flat quarter over quarter. Q2 was 2.33 while Q1 was 2.35, a diminimous change in the credit performance of the portfolio, which is further indicative of our confidence in the direction of our credit performance and our expectations for our own book.

As I spoke to earlier, we have written down Spa Chakra, a decision which I think is prudent because it simply required us to believe that consumer spending will materially improve which will help lift the performance of Spa Chakra. At this point our confidence in consumer spending is not so rosy, and we have concerns of a consumer recovery is much more anemic and much more longer to take shape than most analysts may expect in the marketplace.

Given those statements, we felt that as investors it made sense to reevaluate our investor strategy in Spa Chakra and get the investment behind us as we evaluate multiple strategic options for the Company. I will be more happy to report on this further in Q3 as we conclude our strategic analysis of which direction to take the company in. That said, the remaining credit performance of the Company is quite strong and very, very good.

Liquidity position, despite our efforts on trying to put capital to work we find ourselves still in a very solid and high liquidity position with over $210 million of liquidity, making us well positioned for a continued asset growth in the second half of the year.

Our investment pace continues to be quite strong. Our pipeline remains quite strong, and we're looking to leverage our balance sheet further as we turn to the second half of the year and continue to make investments for earnings growth.

On portfolio acquisitions, many of you may recall that in Q1 we made it aware that we were actively looking at buying a portfolio of one of the other BDCs in the marketplace. I am happy to say after an extensive amount of due diligence and conducting significant valuation analysis it is unfortunate to say that our valuation methodologies did not coincide with the expectations of the valuation of the target that we're evaluating.

As such, we have concluded that pursuing any additional acquisitions with this particular target did not make sense for us to pursue, and we could not come to terms on valuations that we felt that were reasonable and reflected the expectations of risk which Hercules felt was the underlying challenge of that portfolio. With that said, we have concluded the acquisition analysis that we did on that specific target, but we remain open on evaluating other opportunities that may come to fruition over time.

Growth initiatives, I have to once again reiterate our strong interest in continuing to build our portfolio and our desire to continue to control yet growth of our new originations. Again, we have finished the second quarter with over $1 billion of investment opportunities. This in itself speaks to the leadership position and the brand awareness that the marketplace has with Hercules Technology as a source of deal flow.

We are very grateful to our venture capital sponsors who continue to refer transactions to us, and we continue to evaluate those investment decisions to ensure that we find a match between our risk/reward desires and return for what we believe the capital at risk should translate into returns for our shareholders.

That said, diversity remains a critical tenet of our strategy. I like to remind everybody that we spend an inordinate amount of time looking for diversification in our portfolio by geographic region, venture capital sponsors, stage of development of our companies, and of course sectors which include life sciences, clean tech, technology, and of course lower middle market. All of those help serve and have a very balanced, well diversified portfolio to help mitigate risk in different economic cycles. And we will continue to consciously look at the balance within those diversifications to ensure a well balanced portfolio.

With that end, I would like to turn the call over to David Lund to discuss our financial performance, our liquidity position, and then in turn David and I will be happy to answer any questions you may have. David?

Thank you, Manuel.

Between our new loan pipeline, credit quality, and liquidity position we believe we remain in a strong position to grow our portfolio during the remainder of 2010. Today I'd like to focus on a few key areas, in particular, a summary of our current quarter results and operating metrics, 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.

Again, I will touch on second quarter results. We closed over $217 million in new commitments, up 128% from approximately $95 million in the first quarter, and as a result we have increased the total investment portfolio during the second quarter by approximately $52 million or 13.6% to $431.5 million.

Our diligence in adding high quality assets has resulted in the growth of our total investment income by 15.8% to $14.5 million for the second quarter of 2010.

Our net interest margin increased to 11.3% in the quarter from 9.3% in the last quarter due to the conversion of our cash assets into higher yielding debt investments. We anticipate that we will maintain a NIM between 10% to 11% as we build the portfolio in the coming months and quarters and grow our investment income.

Our effective yield on our debt investments during the quarter was 16.7% compared to 14.5% in the first quarter of 2010. This improvement was driven by onetime fees and net growth in the portfolio.

Turning to operating expenses, during the quarter excluding interest expense and loan fees our expenses were $5.3 million as compared to $4.6 million for the first quarter of 2010. This increase was primarily attributable to new hires and increases in the bonus accrual and stock based compensation.

Our Q2 net investment income was $6.9 million or $0.19 per share for the quarter as compared to $0.16 in the prior quarter, a 19% increase quarter over quarter.

I would like to note that we have three loans on nonaccrual at the end of the first quarter, representing less than one-tenth of 1% of our debt portfolio at value, which was flat with the first quarter.

Turning to liquidity, we believe our solid liquidity and capital resources positions us for portfolio growth. I am pleased to confirm that we were approved in May by the SBA for our second SBIC license that would allow us to borrow up to an additional $75 million in a debenture program.

As of June 30th we have over $210 million of liquidity, comprised of approximately $53 million in cash, access to $50 million of borrowings under the facility with Wells Fargo, and approximately $20 million of borrowing capacity with Union Bank subject to advance rates, and approximately $88 million of capacity under our two SBA licenses subject to regulatory limitations. In addition, our only debt outstanding was approximately $137 million under the SBA first license that we have.

I would like to remind our investors about the amortization of our portfolio. Our normal principal collections are approximately $20 million to $25 million a quarter. However, we are unable to forecast with clarity what early repayments may occur during future periods.

For example, we had unanticipated early payoffs of $30 million in the second quarter. Potentially, based on preliminary notifications from our portfolio companies, we could receive $25 million to $30 million in early payoffs in the third quarter, but these repayments are at the discretion of our portfolio companies.

We believe our liquidity position based on available capital and principal repayments, as I have just discussed, places us in a very advantageous position to invest for the remainder of 2010.

Turning to our dividend, we distributed a dividend of $0.20 per share during the second quarter, and as announced today we have declared a $0.20 dividend payable in the third quarter. As Manuel indicated earlier, we expect to continue to see earnings growth over the next several quarters as we grow our investment portfolio which should result in higher dividend growth for our shareholders.

Turning to our share repurchase program, because of our sizable liquidity position we felt it was prudent to use our capital to repurchase our common stock when the price was below NAV, which was accretive to our shareholders. During the quarter we repurchased approximately 377,000 common shares at an average cost of approximately $9.17 a share.

In conclusion, we believe we have laid a very solid foundation for continued growth. We have a robust pipeline and an enviable liquidity position, which we will continue to leverage at a competitive advantage.

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

Thank you, sir. (Operator instructions.)

Our first question comes from Jason Hecht.

I assume that's me, unless one of my long lost cousins is on the phone. This is John Hecht. The question --

John, how are you?

Good. How are you guys doing?

Good.

The question, on Spa Chakra, you've written it down to zero but it sounds like you're still operating it and you may get a recovery. Might that require another line of credit just to fund the deficit or how will you guys -- how does that business fund itself at this point?

Sure. The real issue with Spa Chakra was when you look at the continued lack of consumer spending and given that it's a retail play with consumer points, we just feel that the traffic on discretionary consumer spending is just not there. The company is performing okay. It requires a continuous support of capital.

The problem that we have with the investment is that unless I see a tangible turn on achieving significant cash flow breakeven on its own in a short period of time, it's an investment we'll probably look to divest ourselves from. We have strategic, very strategic options we're evaluating right now. And I just felt that the continued distraction on a business that is not in our core wheelhouse is just not worth the continued support and distraction, and as such we're looking for options. But, yes. And in the interim we will continue to support the company as we evaluate different strategic directions for the company to take.

Okay, and then the -- you referred to the potential acquisition that you evaluated. Was this a strategic acquisition or was this more of just a portfolio purchase? And I guess a distantly related question would be how is the competitive market now for new loans?

Well, that's exactly one of the key drivers that we felt very strongly about when we were evaluating the underlying target. It became, when we (inaudible) the liquidity that we had, and there's no way that I would ever go out and do $400 million of origination in one quarter, if you will. So the best way of achieving continued conversion of that liquidity into earning assets for our shareholders was, in fact, looking at buying a potential portfolio to accelerate that.

However, the continued strong portfolio, excuse me, strong pipeline that we have and the yield of those new assets that we're looking to be able to onboard clearly made the investor decision to continue to pursue a portfolio acquisition that wasn't priced to yield what we felt was a risk/reward with what we'd get in the marketplace didn't really continue to make sense for us.

Not only that, that the strategic synergies that were initially perceived to be able to be had with that acquisition upon further due diligence quickly began to unravel, making the whole investor decision on the acquisition questionable in my mind given the pipeline of opportunities that we have without the headaches and baggage that you usually get with an acquisition.

So, with that, we decided that the strategic advantages of the acquisition no longer outweighed the cost of doing it, and the pipeline was so robust that we felt our capital could be deployed at a much more accretive rate for our shareholders by continuing to originate our own credit quality that we're confident, we're more confident in.

Okay, and a final question, and this is just me trying to understand the semantics of the business, what's the difference between an unfunded debt commitment versus a closed debt commitment? There's two different figures you list for each of those in the press release.

Sure. As we used to do in 2007 and 2008, and I'll reiterate this for every quarter for awhile to reorientate investors on the subtleties of our business model, which is materially different from that of traditional BDCs.

For example, a traditional mainstream BDC that invested in lower middle market or middle market companies, when they pledge capital to a company it is oftentimes that that capital is fully drawn down at close. In our situation our capital is committed to the companies and historically will only be drawn down to around 75% to 80% of that commitment. And that commitment will be drawn down into earning assets generally over a period of three to six months. So you'll have the spillover that we now, for transparency purposes we believe is quite important and, frankly, I think investors should focus on it, is what we would call unfunded commitments.

Unfunded commitments serve to give you or give our investors a gauge of essentially what would be equivalent to call it backlog of fundings that will happen over the preceding three to six-month period of time. So the $99 million or so in backlog, excuse me, unfunded commitments gives you high visibility to assets that will come on the books in Q3 and in early part of Q4 already they're in-house.

Commitments, on the other hand, is a pledge by which Hercules will give you capital so long as the due diligence process holds up and the legal documentation process holds up and the rest of the warranties by which the Company indicated that they were giving us the rest of the warranties will hold-up, and you get to a final agreement called a loan and secured agreement, which then comes into a fully committed funding obligation on our part.

So there's a very big distinction between commitments, which are basically signed term sheets pending due diligence, to what's called closed commitments that are funded and they have a tail called unfunded, excuse me, the unfunded commitments of $99 million that we have today. I don't (inaudible) or not but it's a little --

I understand it now, yes.

Okay.

I think it's clear, and I appreciate the answers.

Sorry for losing my voice there on that one.

Our next question comes from Troy Ward.

Hi, Manuel.

Hi, Troy.

Just go back to Spa Chakra for a minute. You made the comment that it's not in your core wheelhouse and that's why you're going to move away, so that obviously begs the question of why is it in your portfolio? Can you just explain the history behind that investment and, quite honestly, why you made it?

Sure. Well, first of all, the investment was made in 2008, so it's by no stretch of the imagination something that's brand-new. It's been in the portfolio since 2008. The investment thesis in 2008 and the investment thesis today given the change in the economic spending and the emergence out of this recession, that I would have told you in April or May looked a little more encouraging than it did in the probably, excuse me, March to April than it did in May and June to July, when we had then of course the sovereign debt debacle in Europe, you had the continued soft spending on consumers.

And I just felt very strongly that the likelihood of that company continuing to fully recover on a cash sustained basis that we would require it to be is basically something that's better served by maybe another private equity house who wants to buy and own a consumer asset, and it's just not what we do.

As to why we did it, at the time in 2008 it was one of our thesis that prior to the economic recession that took place it was something that we were looking to put capital to work in the consumer spending side. I have made and historically many investments in consumer spending, including Dick's Sporting Goods, and various other retail box plays and retail companies that made sense.

But at the end of the day Spa Chakra was also a (inaudible) play, not just necessarily a retail play. And it turns out that the change in the economic environment, the investment didn't make sense. And what we do professionally is that we have to make evaluation decisions as to whether or not to continue to support a company unfettered or to make a conscious decision to move on. And I think this one is one that we're evaluating strategic options for it. There are potential interested parties in buying the assets of the company. And we will make determinations on what to do with that company over the next 30 to 60 days.

Okay, and looking at the March 31 carrying costs on that, it had a revolver and a senior piece, I believe it was, did both of those get taken down to zero?

Yes, right now, effectively today the carrying cost of Spa Chakra is zero on our books. I felt very strongly that I wanted to get this issue behind us and if, in fact, we end up selling the company, if we in fact end up restructuring it or reaching a joint venture agreement or what have you, there's a lot of things we're looking at in the company right now. That would translate into accretive recovery for our shareholders, but given what I know today and until we get our arms around the strategic direction of the company and its total capital needs that it will require to pursue these different options, I felt that it was better to just get it behind us, have it on the books as zero, and anything that's recovered from that will be gain for our investors.

Okay, thanks. And then on, you know, if we just look at kind of your history of strong performance, it's definitely been in the technology and biotech and the BDC community, how should we look at you going forward? Continuing to hear more talk about middle market and even looking at a BDC portfolio, how should we think about your strategy going forward from a lending perspective?

I think that's a fantastic question. And let me be straight up on my response. I have an inordinate amount of concerns of what I'm seeing in lower middle market and middle market companies. Maybe we just don't get it. I don't understand where we're seeing ridiculous increase in leverage in the lower middle market, a loosening up of financial covenants, and tighter spreads.

Maybe we just are not disciplined enough to understand those sellthroughs, but to me I don't understand why I would underwrite greater risk at a lower yield with little to no covenant protection. Call me silly, but I don't get lower middle market. On some of the deals that we've had we've just simply walked away from them. We've walked away now from $40 million of signed term sheets in lower middle market transactions that I just don't understand. And I'm more than happy to let other BDCs take them.

We're very yield sensitive, and we're very credit sensitive, and we're not big fans of five-year bullets and seven-year bullets. So that in itself it's probably going to make our lower middle market effort maybe not as competitive, which is fine with me, but I think that you'd see us gravitating even more toward strength, which is staying into life sciences, healthcare, and technology is what we're going to look for.

What is -- why do you feel an urge to even do this? I mean, quite honestly, you have the strong history, do you feel like you need to expand to diversify your model? Why are you looking in other places?

No, the biggest thing is we're almost being pulled in that direction by a lot of private equity sponsors, looking for us to provide capital or help fill the void. With some of the other BDCs, which have their own financial challenges, I should say. We look at it. We're probably not -- for nontechnology, lower middle market, middle market play is looking for a five-year bullet loan or a seven-year bullet loan, we're not the candidate for that company. That's the -- it's just not what we're going to do, and we don't like that business.

Great, that's actually comforting. And then just one last follow-up to John's question earlier about the portfolio and the other BDC, we just want to know what was the name of the other BDC, we missed that?

No, you didn't miss it, I didn't -- for their own benefit we won't disclose that. For their own protection, they're an ongoing BDC and it'll be a disservice to them for me to speak out of school on their own credit and their own valuation issues. I've learned in this process of looking at multiple different portfolios out there, people valuation, discipline is not as rigorous I guess I would say as Hercules. Just like evident on our being very transparent and talking about Spa Chakra and talking about our write-down, I'm very much a believer in transparency and dealing with credit as it comes up and just addressing it.

Okay, great. Well, we tried. Thanks.

Our next question comes from Vernon Plack.

Thanks very much. And, Manuel, just interested in, you know, we've talked around this issue, but I wanted to know how you feel about the quality of investments that you're committing to right now? And I'll put it this way, one BDC executive has basically told me this is the best environment that he's ever seen, and this is over a 30-year plus period. How does it feel for you just in terms of what you're seeing on a risk/reward basis? And how does this environment compare to perhaps some other environments?

It's certainly an environment, to use a military term, it's a highly rich target environment that we're operating in. Like all targets or all opportunities you need to weigh in the changes in the technology marketplace that are happening. And although it's an extremely rich environment, I remain cautious in ensuring that although an underlying target may be attractive its fundamental underlying technology shelf life may be limited. Or said differently it is a factor of obsolescence of the underlying technology is quickly diminishing, making it obsolete in the next 24 months or so.

So what makes it challenging and what we do is even though there's a lot of opportunities out there, doesn't mean those opportunities make sense. Now the benefit that we have is that so long as the technology obsolescence doesn't implode or become reality in the 36-month or 48-month window since our investment, from a debt point of view it makes it a great return because it has ample time to amortize and payoff our debt. But what it does is it places pressure on the warrants that we have in those companies, if you will.

So even though we have a very robust pipeline, in all candor that billion dollar pipeline will probably translate into conservatively $200 million to $250 million of flows transactions, meaning three-quarters of those companies will probably go away because we have concerns about the technology lifecycle that they're in or the public competitive landscape on technologies that are emerging from those public companies.

The problem is, that exist in this marketplace, by lack of liquidity in the IPO window it allows established technology companies to catch-up with their R&D, whereby in a very robust IPO environment that technology company, that venture technology company can continue to accelerate its growth and receive large amounts of venture capital dollars because it can move faster and secure that strategic position with this disrupted technology that in a slow-growing economy favors that of larger companies.

Okay, that's great insight. That's great. Thank you. A few other quick questions, just so that I understand it, it looks like do you need to push another $12.5 million down into your SBIC sub to have full access to your available SBA debt?

That's correct. We've got $25 million invested at this point, and we need to downstream another $12.5 million to fully leverage the $75 million that's available under the programs.

Okay, and have you thought about maybe going to the SBA and asking them for a waiver?

You know, certainly putting another $12.5 million down into this particular entity, while we would reinvest it anyway is not an issue for us. I think that we would easily do that and be able to leverage the full $75 million.

Yes, well, let me -- there seems to be some confusion on the SBA. The downstream of what's called contributed equity capital, we don't lose at all any kind of power in that capital.

Right.

That capital is easily deployed. In fact, by putting $12.5 million in, as you rightly know, we (inaudible) $24 million of additional leverage.

Sure.

And we anticipate that will happen probably in Q3, certainly by early Q4.

Okay, all right. And just one final question as it relates to -- you've talked here recently about building infrastructure, I'm just curious in terms of where you are? And are you still looking to build staff and grow the Company?

I think it's safe to say that as we had built some staff earlier on the lower middle market bench, I think that one fact is coming very true as who Hercules is versus other BDCs and other cultures. And that's a very simple comment, which is Hercules is a credit shop. And if you don't have a hard core credit background in underwriting, just like five-year, seven-year bullet loans don't make sense for us, candidates that don't have a strong credit bench are probably not candidates that will thrive and grow at Hercules.

With that said, we continuously are looking to add skillful talent, but our screens on hiring people is equally as rigid as it is in our originations, efforts. You must have a very strong credit bench or it's not a shop that you are probably going to thrive in.

Right, but you're still looking for people?

We are, but the pace of growth has probably slowed. I have significant capacity in-house with our highly experienced origination teams.

Okay.

I have very, very strong quality people in this organization, as shown in their credit performance. These people know this asset class very, very well.

Okay, that's great. Thanks very much.

Thank you.

Our next question comes from Jason Arnold.

Hi, guys. Good afternoon. Nice job this quarter. I was just wondering if you could share with us where you're seeing lending demand concentrated? Is it more in the life sciences end of the equation, or tech? And maybe just some broader thoughts here on loan demand?

Well, probably the greatest demand right now that we're seeing is clearly in the clean tech sector is probably by far the greatest demand. But we're going to foray into the clean tech in a very controlled way.

Clean tech, just a side bar, clean tech is ostensibly all in definition of project finance, of enabling technology platforms. I mean it means a lot of things to a lot of people, and this veneer called clean tech it really requires a lot more scrutiny underneath the hood of exactly what it means. But clean tech is definitely a large driver of demand.

We're seeing unprecedented demand for healthcare, but I've got to say that we have purposely pulled back a little bit on healthcare, or I should say life sciences. It's not that we don't like it. we think that a lot of life sciences companies I think are well valued, and I think that their aspirations for capital that's being requested by them compared to the equity capital underlying the companies we think is a bit of a disconnect, and we think that they're approaching a bit of over leverage.

So we're kind of taking a hold on life sciences, active life science investing over the next remaining quarter or two. It's not that we're not going to continue life science investing, but I think we're going to manage the portfolio somewhere to the tune around 30% to 35% of total exposure as opposed to maybe letting it creep-up to 45%, 50% right now.

And we see other guys, other firms out there really trying to backfill what demand we're not filling. We're fine with that. We're not bothered that some of these life sciences orders are being filled at what we call, we consider the extremely sharp and low yields. We're fine letting those go.

Makes sense. So just the difference between the fill in the 45% to 50% versus the 30% to 35%, is it safe to assume that fill in there may be on clean tech?

No, we still have some portfolio exposure, and we'll continue to have some portfolio exposure in lower middle market. We are -- there's no question that we're consciously looking to divest ourselves from pure lower middle market, consumer type loans in the portfolio. You'll see that happen over the next quarter or two further. And I think that we're going to focus on much more in our comfort zone, in our knowledge wheelhouse, which is technology, healthcare, and life sciences. That's where I think you'll see us concentrate more efforts on. But just the pure play, consumer type play, it's going to be hard to really get us excited about it.

Okay, and then not to beat a dead horse, but looking back to the Spa Chakra, looking back to the investment decision making process is there anything that you would point to that you might do differently next time or is this just simply a case where, hey, the business was in the wrong place at the wrong time, and wound-up being a loss?

Look it, I've been doing this for 25 years, and history is a student for all of us to learn what to do better and how to further calibrate your investment acumen. And the answer to that is it's a perfect storm. In 2008 we didn't anticipate that the consumer spending in 2010 would be as severe as it is and languishing the way it is. A double recession risk continues to be a problem.

Look it, the fundamentals of the company are still very interesting. The real issue for us with Spa Chakra is how much more time do you want to give it? and that's more a private equity investment decision, not what we do in terms of our decision. We supported the company through bankruptcy because we felt that the economy was improving and we were able to bring it out of bankruptcy, refinance our debt out of private equity and move on.

The fact of the matter is the economy sputtered on us further, the company required a little more capital than we wanted to, and it's not in our core wheelhouse. This is not -- we don't make investments to own 100% of these companies, it's not our business model. As such, we felt that seeking a strategic partner or a private equity partnership or divesting of it entirely is probably best done.

And rather than continue to have distractions in our earnings call, charging it off to a zero carrying value, and if we have recovery from that fantastic. It's accretive to our shareholders, but we no longer have any credit distractions or concerns related to that investment.

Okay, perfect, makes sense. Thank you very much.

Our next question comes from [Jason Deleeuw].

Good afternoon. The portfolio growth was pretty solid again this quarter. I'm just wondering now that we're at the midway point and we'll pass that for the year, has there been any material change in how you're viewing portfolio growth for this year versus what you were seeing a quarter ago?

Well, the question has two parts to it, that I'm going to expand on that I think are quite helpful. Had you asked me in the beginning of January where did I expect to see the majority of our loan growth in the first half of the year, I would have responded back in January saying, lower middle market. And the second half of the year I would have said venture stage companies.

Clearly, today primarily driven by our own desire to refocus back into our wheelhouse, is venture is the leading charge of our growth. Venture capitalists are deploying capital. Our brand and our market positioning allows us to have the ability to cherry pick and continue to look at good investments out there.

So as I turn to the second half of the year, the discipline that I must be cognizant of for loan growth is liquidity. And clearly our preference would be to leverage the balance sheet first. We essentially have no leverage on our balance sheet when you exclude the existing SBA debt. We have not tapped Wells Fargo. We have not tapped Union Bank California. I can assure you both of those lines will be drawn in the proceeding third and fourth quarter.

So I look to, first, continue to secure additional lines of credit to grow our portfolio and leverage our balance sheet further, but as I continue to evaluate a very strong pipeline there's no question that equity capital raise over the proceeding one to two, to two-and-a-half quarters is highly probable, but it's entirely contingent upon leveraging the balance sheet, the overall equity capital markets, and the most important of all, a very rich yield to price pipeline that we convert to good earning assets.

Today I have $210 million of liquidity. There's no immediate rush to do anything, which is a great place to be. And a very, very good pipeline of opportunities. And I feel and continue to remain confident that securing new lenders to join our credit syndicate is -- continues to be more probable than not. It is certainly taking a hell of a lot longer than I'd like it to be, but I remain pretty optimistic because two of those lenders are actively engaged, two new lenders are actually engaged in due diligence on completing their processes to provide a firm commitment to Hercules for a line of credit.

Okay, I mean is it -- are these lenders seeking you guys out, or vice-versa? I mean can you give us a little color on how that process went?

David Lund and my knuckles are bloody from knocking on doors. I think that to purport you have the arrogance that lenders are going to come to me would be delusional on my part. It is a continued effort that David and are actively and aggressively pursuing lenders. I can only wish that, to quote Field of Dreams, I will build it, they will come -- no, I have to go out, and Dave and I had to go out and pitch Hercules to these lenders day in and day out.

Okay, and then what's the cost of funds on the second SBA license?

It's the same as under the current license, you know, it's 10-year Treasury with a spread on it.

Well, let me phrase that differently, it's the same formula as the first license. It will no stretch of the imagination be priced as we have the first draw-downs. It is typically expected to see that the first SBA, excuse me, the second SBA license borrowing cost will probably range from 4% to 5% range, while the first license ranges from 6% to 6.5%.

Thanks, that's very helpful.

Our next question comes from Henry Coffey.

Yes, good afternoon, everyone, and congratulations on a good quarter.

Thanks, Henry.

The obvious question that's come-up here a couple of times, as you look around the horizon are there any sources of leverage, whether they're conventional or not, or maybe it's an even different model where you get into an outsourcing mode or something, is there a creative solution out there?

I mean your experience with the bank group back in the Citibank, Deutsche Bank days was pretty rough. Obviously, banks are the least predictable of funding providers. Are there chances that the SBA programs could be extended beyond their current size? Is there a joint venture model you could come-up with? I was just wondering as you look around for more permanent funding if you've come across anything that might really fit the bill?

Sure. I can assure you of one thing, we are more than willing and actively discussing sources of capital beyond equity capital raises, for example, away from traditional commercial banks.

The -- well, to quote another BDC that recently did one, [Golum Capital] is probably a good example, which just completed a $300 million securitized loan package, but what's the difference between Golum and ourselves are they're a traditional lower middle market, middle market credits, so they're able to get a bid, if you will, in the secondary market of what the composition of their asset portfolios are, so they're able to get rate those assets quite quickly. And those assets become ostensibly under the new banking Fin Reg reform basically class two or class one assets, while our assets are more deemed to be class three assets, meaning that we're financing not cash flow positive companies. As such, the reserve requirements or I should say advanced rates to get those loans becomes a little more challenging to educate a credit syndicate.

Now, I will tell you that I have been pleasantly surprised with my continued dialogue with tapping those sources of financing for Hercules as much more three-year, five-year source of permanent financings that we are continuing to engage in. I will tell you that my gleaning off of that requirements in that marketplace are a portfolio that's in the probably the $400 million to $500 million range, having a broad portfolio coming to distribution, where no single five credits make up of 20% of the portfolio.

So it's one of diversity. As we get larger there's no question that we will continue and will continue to pursue those avenues, but as we break-through now the $500 million portfolio mark and beyond I think that those channels become much more attractive for us, which makes probably a Q1 and Q2 event for us if those -- if the market continues to evolve the way I think it is.

So you think you might be able to do a stretch financing then?

Well, I'm optimistic that it looks like we might be able to do that. I have not been shown a door yet, which I think is encouraging in itself. So I remain optimistically hopeful that some sort of structured financing credit arrangement, a lot like we were contemplating with Citibank at the time where we actually had a credit facility as a warehouse facility, that it gets filled up, and then we throw it out to a term, and it pays itself off in the proceeding three to five years. I think that we're back to those days, but that market is still slowly emerging out of its hibernation.

Yes, something with a defined exit point, not a gun to the head is what you're talking about.

Yes, to use your words, I don't like the gun to the head, the loan matures, pay me off scenarios.

Well, thank you very much.

Our next question comes from Jasper Birch.

Hey, good afternoon, everyone. Looking at the venture capital market and deal flow, do you see any impact from maybe possible changes in tax laws, especially regarding capital gains? And can you just give some commentary on what you see in the market in 3 and 4Q, and then 2011?

Jason, Jasper, my comment to you is probably going to surprise the hell out of you. Unlike traditional lower middle market and middle market BDCs that are just out there, our deal flow is not one iota contingent upon change in the tax laws for 2010 to 2011, and it's not attributed at all to change in controls where you have generational passing of companies from one generation to another that they do is change the controls to recapitalize the company, as you see in much more traditional and lower middle market.

The incredible phenomena on venture capital is that these founders have stocks that are as diminimous in value, ostensibly penny shares, if you will, and they're grappling with an IPO at $15 a share or $20 a share. I can absolutely unequivocally assure you that the concept of capital gains does not even factor into the equation and then you get liquidity for the penny stock holdings.

Excellent, that's very helpful. Looking at, I think your equity portfolio declined by about $7.5 million, was that mark-to-market changes or was -- or did you have some divestiture in there?

I'm sorry, I didn't hear the first part of the question on what?

Your equity portfolio, I saw it went down quarter over quarter by about $7.5 million, was that fair value changes or is that due to some divestiture in the book?

No, our equity portfolio today --

It's a combination of the write-down that we had with Spa Chakra, offset by some additional adjustments on a fair value basis.

So the preferred equity was included in that bucket?

Yes.

That is correct.

Okay.

Harvesting, just to be clear, also harvesting gains on the InfoLogix and Ancestry.com also allowed us to do that. I mean we kind of lost on the call here that we actively have sold $3.5 million of realized gains, $3.4 million of realized gains in the portfolio attributed to investments, InfoLogix, as well as in Ancestry.com.

Okay, that's helpful. And then, lastly, I found that your commentary that you just gave on a possible securitization quite interesting. And I was wondering in terms of the structure of that and how your loans fit into it, specifically fully amortizing loans, I mean how would the structure have to vary? Would you need a longer reinvestment period? Have you gotten to the point where you've thought about things like that and looked at what portion of your portfolio you might want to securitize?

So let me -- I run a public company so let me first give some disclaimers. We are actively involved in those discussions. There is nothing yet that has been solidified from an LOI point of view.

But to answer your question just for a second, this way, some of the indications are exactly -- some of the items that need to get reconciled between the various parties that we're in dialogue with are clearly attributed to exactly your question, which is because Hercules does not do five-year, seven-year bullets and because our loans are rapidly amortizing, the discussions with some of these structured players is which period of time will the revolving period be open to? Would it be a one-year revolving period, would it be a two-year revolving period?

What that means is in layman's terms is as amortization is paid back to Hercules and a portfolio is delevered, is Hercules able to tender new loans to ostensibly keep the balance of the loan pool at $300 million or $400 million or $500 million? So, yes, there will be a revolving period of time where as loans pay us off we're able to re-originate and put new loans in that conduit, and then it terms out over a three to five-year period of time.

Okay, that's very helpful. That's all I have for now.

Thank you.

Our next question comes from Douglas Harter.

Thanks. I was hoping you could remind us of the seasonality that you see in investing and whether you think we'll see that in the back half of this year?

Well, Doug, thank you for asking that. It's a very, very important question given this bizarre economic environment that we're in, but on a historical basis, the metrics for everyone to remember are our lowest period of origination on a historical basis and the lowest period by venture capitalists historical norms is the third quarter. And the reason being is venture capitalists who are on the boards are generally on vacation with their children and, therefore, holding board meetings is a very difficult thing to do. So capital deployment decisions are rarely made in any significant size in the third quarter.

That said, the third quarter for Hercules traditionally represents about 15, 1-5 of our total originations are done in the third quarter. Conversely, the fourth quarter is generally 35% of the origination activities, with Q1 and 2 being the balance, around 25%.

And do you expect that to hold this year?

Right now, no. Right now what I'm seeing is that Q3 will probably be a little uptick. I think there's probably going to be in the 20% range probably. We have a $1 billion pipeline. I have a good visibility on what's going on already in Q3. Do I think it'll be disproportionately larger than historical norms, no, but I do think it'll be an uptick from the 15%.

Thanks. And just touching on your comment about a possible capital raise, I mean I guess is the timing of that dependent upon how successful you are at adding other lending partners or is that something that would likely happen regardless?

No, well, the real driver in that is quite simple. It's continued to be visibility to high quality loan growth, new assets being put on the books, and then clearly tempered by the access to additional leverage in our balance sheet.

It is our preference to first consume our existing leverage and tap new sources of leverage for the balance sheet, but the timing of that may not be as congruent as I would like it to be to afford us the ability to say, well, we're not going to do nothing until Q1. I think that that is a very fluid time schedule between now and Q1. If the credit lines, for example, would fall into place next week, well, I think the answer for a capital raise will be significantly lower than that.

I wish I could tell you, like the SBA process, that our access to new availability of credit will happen in two weeks. I remain encouraged but it won't happen in two weeks, but it should happen certainly between now and the middle of the Q4, if not sooner.

And just following up, I mean obviously your regulatory capital leverage at zero today gives you plenty of capital to grow. I guess how do you think about how to sort of optimize and sort of get Hercules into sort of a more levered position to be able to increase returns?

I think that everything that you and I and the rest of the general public reads about the United States banking community is 100% accurate. They're not lending. Here we are a highly profitable company, and outstanding credit performance, and getting a multi $100 billion, trillion dollar bank to give a $25 million line of credit or even a $50 million line of credit it is outrageously difficult, if not almost impossible to be had.

I can only imagine how difficult it is for main street small business or even a middle market business to get credit facilities from commercial banking in today's day and age. I've got to tell you, we saw in Q2 earnings, you saw in Q2 earnings releases, loan growth in commercial banks in this country it's just not happening. And I am just dumbfounded on how difficult it is to get commercial banks to extend credit, even to extremely profitable companies, like we are and have been.

So I don't know what to say, but I agree with your premise of your question. It is certainly our desire to leverage our balance sheet first.

Thank you.

Go ahead, Operator?

I'm sorry, no further questions on the phone. I'd like to turn it back over to you, sir.

Thank you. Thank you, Operator, and thank you, everyone, for continuing your interest and support of Hercules Technology Growth Capital. I can assure you that me and my Team continue to work very, very aggressively but judiciously on looking to continue to build assets and continuing to accelerate earnings growth and eventually dividend growth.

If you would like to arrange a meeting or have additional questions please feel free to call David Lund, our CFO, or myself at 650-289-3060. In addition, if you would like to arrange a meeting with David or I over the course of the next two to four weeks as we traditionally do our visit to investors around the country, please feel free to let us know and we'll be happy to meet with you if the schedule will afford it.

With that, thank you very much for being our shareholders and for your continued interest in Hercules Technology Growth Capital.

Thank you, Operator.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone have a great day.