Hercules Capital Inc (HTGC) 2010 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Hercules Technology's fourth-quarter 2010 growth capital earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (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. Scott Gable. Mr. Gable, 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, our CFO.

Our fourth-quarter and full-year 2010 financial results were just released after today's market-close. They can be accessed from the Company's website at www.htgc.com. We arranged for a replay of today's call as well, which will be available through our website, or by using the telephone numbers and pass code provided in today's earnings release.

I would also like to call your attention to the Safe Harbor disclosure in our earnings release regarding forward-looking information. Today's conference 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. And to obtain copies of our latest SEC filings, please visit SEC.gov or visit our website at www.htgc.com.

Now I would like to turn the call over to Manuel Henriquez, Hercules' co-founder, Chairman and CEO. Manuel?

Thank you, Scott, and good afternoon, everybody, and thank you for joining us in today's call. Let me kind of provide what I typically do, a quick agenda of what the topics I will be speaking to. And then, of course, David Lund would provide more specifics on the financials. In turn, we'll conclude with a question-and-answer session from our investors.

Back to my agenda. I'll provide a quick summary of the operating performance and results of the Company achievements in Q4 2010, and of course, in all 2010; and a few observations and discussion points on the environment and the greater venture capital activity in the marketplace today, as well as competitive landscape summary; as well as opportunities that Hercules is seeing for 2011. And as I said, David will provide more details on the financial performance of the Company and our achievements.

So, on the fourth quarter -- we grew our investment portfolio quite handsomely at 26% growth and we saw a record number of new commitments finishing up for the year at over $500 million in new commitments. In fact, there was about $523 million, making it a record level of new commitments in the history of Hercules since our founding over six years ago.

We saw credit performance improve quite dramatically, especially with this final sale of InfoLogix that took place in the first quarter of 2011. And you'll see that demonstrating credit performance when David Lund goes into the whole discussion on the credit side.

In addition to that, we saw liquidity increase on our balance sheet, with the successful capital raise of over $70 million done in November. That was accretive above book to our shareholders. And we also expect to be announcing here shortly additional secured lines of credit, to provide additional access to capital, to continue to fuel our portfolio growth that we expect to announce here next week or two.

Beyond that, we also spent a lot of time in 2010 focusing on capital preservation and asset protection. And you saw that our portfolio continued to perform quite well from a credit point of view. And now that we're turning away from a credit-defensive positioning to all of growth, you'll see 2011 be spawned with quite a significant growth in the portfolio that we expect to see on a go-forward basis. That, of course, assumes that we don't have any macroeconomic events that are taking place in the world today, continuing to persist throughout 2011 as we look to portfolio growth.

With that said, let me turn just specifically to discuss some of our achievements for financial performance in the fourth quarter. We saw that net investment income, or NII, was $9.5 million or $0.24 per share for the quarter. And you saw the DNOI was $0.26 a share over $10.2 million in DNOI for the quarter. On the year, we saw net investment income, or NII, at $30.1 million or $0.82 a share, and the DNOI number was $32.8 million or $0.91 a share, quite a significant achievement, as you saw or started to see our loan growth start kicking in from an asset origination point of view and contribution point of view.

As I said, new commitments for the year were $523 million. That's up, by the way, 179% from that of the same time in 2009, a fairly substantial increase year-over-year and just indicative of the hard work that our team has been putting in. On a quarter-to-quarter basis, the fourth quarter saw $123 million of new commitments, representing 242% growth on the same period last year -- again, demonstrating the achievements of our origination team hard work at building assets and deploying our liquidity.

Fundings, which are an integral part of our growth strategy, which is the conversion of commitments to that of funded assets, saw an equally dramatic increase, seeing fundings increased to $322 million for the year or up over 240% over the same period last year of 2009. These are very significant numbers, and shows you our strategy of maintaining a high level of liquidity throughout 2010, and then focusing on investment activities as we turn into the later part of 2010 and 2011 on a go-forward basis.

Principal repayments for the year saw approximately $196 million of principal repayment that took place during the calendar 2010. And we saw the investment portfolio finish the year at approximately $472 million, of which $402 million of that was interest-earning loans. The dividend -- I am proud to say that, as we've been advocating, we saw now a first dividend growth of a 10% increase in the dividend from our Board of Directors, representing a $0.22 dividend. We expect that dividend to continue to grow throughout 2011, as new assets are brought on board, and our net investment income and taxable income continue to increase. You will see us continuing to increase the dividend as those metrics continue to show growth.

Our effective yield -- I want to be careful here. Although the effective yield is extremely strong in the quarter, it was supplemented by one key event, an early payoff of a clean tech portfolio company. Notwithstanding that, the effective yield was 17.7%. When you normalize it to remove the one-time early payoff, the effective yield equates to about 15.8%, which is in contrast to 16.2% in the prior quarter.

We do not encourage our analysts to be forecasting the dividend -- excuse me, the effective yield to maintain that level, and we'll expand on that during the Q&A session. We expect effective yield to start drifting down lower between 100 basis points to 125 basis points throughout the year. We'll speak to that in the question-and-answer session of the call.

Overall credit -- as I said, overall credit performance continues to show strong signs of improvement, and we're seeing a solid stabilization on a credit book, with only two companies on nonaccrual representing less than 1% on a fair value basis on a nonaccrual basis -- basically, immaterial.

InfoLogix -- after extremely hard work and hard effort, we were successfully able to report the sale and eventual repayment of the entire investment of InfoLogix to Hercules, representing a gain of approximately $8 million to $8.5 million; we finally get all the accounting settled on all the escrow accounts that exist. In terms of our portfolio gain on the IRR for the InfoLogix transaction, it represents approximately a 30% IRR. Enclosed in the loop, the transaction was valued at $61.2 million for the sale of Stanley Works purchasing InfoLogix itself.

Liquidity event -- as we've said at the beginning of 2010, we expect to see eight to 10 liquidity events take place in 2010. And I'm happy to report that we actually finished the year with eight liquidity events that occurred in 2010. And we had -- embedded in that, we had IPO activities that took place in various M&A activities that includes the PSS Systems [Sabion], [Intelligent Roulette], GameLogic, and Gomez, to name a few on the M&A side and, of course, the completion of the IPOs of [Avail] and Asurion also took place in 2010.

As I turn to 2011, I expect that number to improve, and we're looking for liquidity events probably in the neighborhood of anywhere between 10 to 12 [exits] that we expect to see in the portfolio in 2011 from liquidity in our portfolio today. So far we've had one event be completed in 2011 -- we had the Pacira IPO that was completed in early January. And, of course, we have the close of the InfoLogix M&A transaction in mid-February. So of that 10 to 12, two events have already taken place.

Now, no call is complete on a Hercules portfolio without spending some time talking about our award portfolio, which is probably what I would consider the greatest hidden assets inside of Hercules. Today, we're sitting on approximately 91 warrant positions into various technology and life sciences companies that we have in our history since the founding Hercules. If you were to take the full face value of the entire warrant portfolio and exercise that, it would represent about [$65 million] (corrected by company after the call) on a cost basis, to exercise the entire warrant portfolio, in doing so.

We also have, currently, of the 91 warrant positions that we have today, we have approximately three companies and IPO registration as of today -- we have Horizon, Nexx System, and Reply that represent existing companies in IPO registration. Pacira, of course, completed its IPO in early January.

Now let me turn my attention to the venture capital marketplace because, as we've said all along and we continue to talk about Hercules, investing in Hercules requires a good understanding and knowledge of what goes on in venture activity. So we tend to take time in our earnings call to spend some moments to provide you some color and some perspective of what activities are going on in the venture capital marketplace.

Let me first start off with exits. I'm happy to report that in 2010, the venture capital industry realized 46 IPOs that took place during 2010. 14 of those IPOs occurred in the fourth quarter. Beyond that, we're seeing a very strong and a very high investor demand in appetite for some high-profile IPO activity that is currently being contemplated in 2011 or 2012. Names like Facebook, Twitter, Zynga, Groupon, and LinkedIn, all helped serve to create a strong investor demand for high-quality investment opportunities that exist. And as I said earlier, we're sitting on 91 warrant positions in our portfolio -- four of those companies -- or now three, excuse me -- are IPO candidates in our own portfolio in the early part of 2011.

Currently today, there's 44 IPO companies -- excuse me -- there's 44 venture stage companies in IPO registration today, three of which are existing Hercules portfolio companies that expect to achieve a liquidity event, if they are declared effective -- Horizon, Nexx, and Reply are those three names in our portfolio.

In addition to that, the venture initially experienced 514 exit events that took place, netting over $39 billion in liquidity from the combination of M&A and IPO activities. This represents a 72% increase in terms of dollar values on exits as compared to 2009. In the fourth quarter, the venture industry experienced 126 exits, representing $12 billion in exit activities compared to $11 billion in 2009 through the same period.

M&A, albeit a bit flat, we saw 109 transactions and M&A activity take place in the fourth quarter, representing $10.5 billion, and a total of 445 companies had M&A events from a venture stage point of view, representing $34 billion in capital or a 17% increase over the same period last year.

Now investing activity, what we care an inordinate amount about. The venture capitalists invested $26 billion in new investment activities. If you may recall at the beginning of 2010, we estimated that number to be between $22 billion to $24 billion at the beginning of 2010 of venture capital activity. And I am happily to say that that number has been exceeded by over $2 billion. On a year-over-year growth, we saw an 11% increase in venture capital investment activities, all of which help to repay our loans and continue to fuel the growth of our portfolio of companies, with added new venture capital dollars flowing into those transactions -- a critical part.

Q4, we saw $7.6 billion of investment activities take place, representing a modest increase over the same period last year, representing $7.2 billion in activities. What is interesting, however, is a shift in the capital that we're seeing in the areas of focus on the venture community. We saw a shifting, albeit gradual, away from the traditional sweet spots of IT investment in healthcare, which are traditionally the mainstays of the venture capital industry investment activities. We saw the healthcare, as we've been advocating for some quarters now, has drifted down 7% in new investment activities.

We have made a conscious effort throughout 2010 to maintain a portfolio concentration in healthcare, what we call life sciences, in the mid-30% range and we expect to maintain that for the foreseeable future. IT, on the other hand, saw a modest increase of approximately 6% in investment activities in 2010, representing $7.3 billion of investment activities, which is a large part of the Hercules portfolio.

I'd also like to introduce a concept that we have been investing in that you will hear speak more about in the coming quarters. And that is our expansion into business services, consumer services, and of course, clean tech or renewable technologies. Ironically, those three segments that Hercules has been focusing on represented the highest three growth segments for the venture capital activities.

Consumer services, more commonly referred to like a Zynga or a Facebook, or even one of our own portfolio of companies called box.net, saw the highest increase of venture capital activity at 23% or $4.5 billion of capital invested by the venture capitalists in 2010. We expect that segment of the market to continue to exhibit a high degree of growth.

Not being left far behind is clean tech. Clean tech is an effort that we've been studying and working with for the last 3.5 years, and we made a conscious effort in 2010 to make a meaningful investment into that activities. You saw that clean tech represented [19%] of all venture capital flows in 2010, representing $2.5 billion of all the capital that was invested by the venture capitalists in 2010. You will see that same reflection of the venture capital activities in our portfolio, and I can give you assurances that we will continue to invest actively in the renewables and clean tech industries in the foreseeable future.

Stage of development -- we are seeing a slight shift in stage of development, where the venture capitalists invested 61% of their capital in later-stage activities and 18% in seed and first-round capital. You may have realized that we recently put out a press release where we actually discussed exactly this barbell affect, where we're investing in on more later-stage companies, and conversely investing in and bolstering our efforts on the earlier-stage efforts, with the addition -- and I'm happy to have him back, my cofounder and partner, Glen Howard, who was leading up to charge in our early-stage investment activities, which I'm happy to have him back in the organization to focus on the same activities that he and I worked on in 2006 and 2007.

Glen will be heading up and working on the early-stage effort, along with Andy Laszlo and other members of our team, as we focus on growing our early-stage initiative. I want to caution, however, that early-stage investment activities do, in fact, garner and realize lower yields, and the time to liquidity of those investments are much more further out than that of traditional later-stage investment activities.

The early-stage investment efforts for us is strategic in nature, and you expect us to see that we will remain very competitive in offering good financial solutions to early-stage companies a segment of the market that we purposely have vacated back in the early part of '07, that we're now making very much aware that we intend to reinvigorate our efforts into early-stage investment activities.

Lastly, nothing is complete without fully understanding the ecosystem of the venture capital activities. We talked about exits realized by the venture capitalists. We talked about capital investment activities by the venture capitalists. Now, of course, we must talk about investments received by these venture capitalists as they start new funds.

In 2010, the venture capital community raised approximately $12 billion in new funds. $2.4 billion of that was raised in the fourth quarter. That compares to $13.5 billion in 2009. Now, most people would be taken back by my following comment. We actually think that the contraction in the venture industry is quite good for the industry. It allows earlier-stage companies and earlier-stage investors not to be so competitive with each other; as the number of venture capital firms have shrunk, the competitive environment has also reduced the need to see higher and higher increase in value in early-stage companies -- meaning investing in an early-stage company -- it's quite an attractive thing to be doing currently today.

This by the way, the $12 billion investment, is the seven-year lowest point that it's been in the venture industry. And I actually think it's a very good thing because it allows you to see that the venture industry has contracted in kind. And now the venture firms that survived are more stronger, and the portfolio companies more resilient to withstand an eventual liquidity event through an M&A or an IPO activity.

Overall, we saw $86 billion invested in US private equities, which includes private equity venture capitalists. This represents a [16%] decline year-over-year to 336 new investment companies that were created.

With that, we'll be happy to answer more questions from you in the Q&A. I'll now turn the call over to David Lund to give you more specifics on our operating performance. David?

Thank you, Manuel. Today, I'd like to focus on a few key areas -- summary of fourth-quarter and full-year 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.

First, I will touch on our fourth-quarter and full-year operating results. Overall, we delivered solid operating performance for Q4. We achieved approximately $17.5 million of investment income for the quarter, having grown it each quarter during 2010 from a low of $12.5 million in the first quarter. The higher investment income in the fourth quarter compared with Q3 was primarily attributed to interest and fees collected from the early repayment on our outstanding loan with Trilliant.

For the full year of 2010, total investment income was $60.2 million compared to $74.3 million in 2009. This decrease year-over-year was due to a lower average portfolio balance during 2010, which we began growing the portfolio again during this year. Our net interest margin continued to improve quarter-to-quarter to 12.63% for the fourth quarter of 2010 from a low in the first quarter of 9.34%, as we grew our investment portfolio.

We continued to generate a solid effective yield on our debt investments during the quarter at 17.7% compared to 16.2%. This increase in the fourth quarter was primarily attributed to the pre-payment of our debt outstanding with Trilliant. And as Manuel indicated earlier, on a normalized basis, the effective yield would have been approximately 15.8% in the fourth quarter.

Our fee income during the fourth quarter and the year was down as we recognized fewer one-time event-driven fees. We see this metric, the reduction in one-time fees, as an additional indicator that our portfolio is stabilizing and we are entering into new high-quality originations.

Our cost of debt increased quarter-over-quarter as we increased our borrowings during the year under our SBA facility. The cost of debt year-over-year decreased primarily due to a lower average debt balance outstanding in 2010, as we repaid the Citibank credit facility in March of 2009.

Operating expenses for the quarter, excluding interest expense and loan fees, were $5.4 million as compared to $5 million in the third quarter of 2010. This increase is primarily attributed to higher compensation-related expenses. The operating expenses for 2010 were $20.3 million compared to $19.9 million in 2009, primarily due to higher stock-based compensation expense.

All of these factors -- an increased portfolio balance, increasing effective yield, and management of our operating expenses, contributed to our Q4 net investment income of $9.5 million or $0.24 per share, which steadily improved quarter-to-quarter during 2010. Our distributable net operating income, or DNOI, was $10.2 million, or $0.26 per share as compared to $8.9 million or $0.25 per share in the preceding quarter.

The net realized losses of $11.2 million recognized during the fourth quarter were primarily attributed to net losses on loans and warrants and three portfolio companies, which were previously recognized as unrealized losses in the prior periods. Our unrealized gains of $13.6 million during the quarter are primarily due to the reclassification of the unrealized losses on these three companies to realized losses, and net market valuation adjustments to our investment portfolio.

Since inception, net realized losses total approximately $54.5 million. This represents less than approximately [$2.6 million] of total commitment since inception of greater than $2.1 billion or approximately 41 basis points on an annualized basis.

As Manuel indicated, we closed approximately $123 million in commitments to new and existing companies in the fourth quarter, including restructures, representing an increase of 242% compared to the comparable period in 2009. For 2010, we closed approximately $523 million in commitments, including restructures, representing year-over-year growth of 179%.

During the fourth quarter and the entire year of 2010, we funded approximately $97 million and $401 million, respectively, including restructures. This investment activity resulted in a 26% growth in our investment portfolio from 2009 to 2010. Additionally, since quarter end, we have closed an additional $42 million of commitments and have over $128 million of pending commitments. We believe these pipeline figures signal a continued growth to our portfolio in 2011.

I would like to note that we have two loans on nonaccrual at the end of the quarter, representing less than 1% of our debt portfolio value, relatively consistent with prior periods.

Overall credit quality improved during the year. In fact, the weighted average credit rating to the portfolio this quarter was 2.2, a nice improvement from the 2.7 weighted rating at the end of last year. I would also like to remind our investors that are warrant portfolio in approximately 91 portfolio companies will allow us to invest approximately $65 million that we believe will provide capital returns to the Company in the future, as we continue to see improvements in the IPO and M&A markets.

Turning to liquidity, we have maintained solid liquidity and capital resources, which positions us to meet the capital requirements of the pipeline statistics I just reported to you. As of December 31, we have over 232 million of liquidity comprised of $175 million -- $107 million in cash; access to $50 million of borrowing under the facility with Wells Fargo; and $20 million of borrowing capacity with Union Bank, subject to advance rates; and approximately $55 million of the capacity under our SBA license, subject to regulatory limitations. In addition, our only debt outstanding was approximately $170 million under the SBA program.

Our liquidity position was bolstered during the fourth quarter of 2010, as we completed an accretive, follow-on offering for approximately $72 million that contributed $0.02 to our NAV. I would like to remind investors also that 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.

In January, we repaid $25 million of SBA debentures with the SBA that had a cost of debt of approximately 6.63%. We have submitted a commitment request to re-borrow the $25 million, and based on the pricing of the debentures sold in September of 2010, we expect to reduce our cost of debt for these borrowings by approximately 2.5% to 3.0%. We believe our liquidity position places us in a very advantageous position to invest and grow our portfolio in 2011.

As to our dividends, we distributed a dividend of $0.20 per share during the third quarter and, as Manuel indicated, announced that we have declared a $0.22 dividend payable on March 24 for the fourth quarter, an increase of 10% from the prior quarter. As I have indicated, we expect to see earnings growth during 2011, as we continue to grow our investment portfolio, and should result in higher dividend growth for our shareholders.

In conclusion, our solid operating performance in Q4 provides a very solid foundation for continued growth. We believe our pipeline, solid credit quality, and strong liquidity, place us in a strong position to grow our portfolio and earnings during 2011.

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

(Operator Instructions). John Hecht, JMP Securities.

Thanks for taking my questions, guys, and congratulations on a great quarter.

Manuel, I just wondered if you could give us some commentary on maybe the right term to use would be conversion rates of commitments to fundings and what you're seeing there. It seems like this was a pretty solid quarter in terms of fundings, but it might have been people pulling down their commitments later than they normally would. And what are you seeing in terms of trends there?

I think that's a fantastic question. Some investors have been asking me this question now for a couple of quarters. And I will tell you that from a normalized basis, what existed in the past is currently in a bit of a state of a flux.

We are seeing drawdowns not being drawn down as quickly as we have seen normally. So for example, as everybody probably remembers on this call, if we make a $10 million commitment to a company, we only expect to see $7.5 million to $8 million of that ever get funded. And historically, you would have seen approximately 50% of that get funded at close. We're seeing that number continue to be drifting a bit lower. So we're seeing about 25% to 30% of initial capital getting funded at closing, and much more of that funding taking place near the end of the expiration of the availability period.

And what that means from an earnings accretion point of view, it means that a lot of our earnings are going to be back-end loaded in the quarter. And although fundings may look high in any particular quarter, the earning assets won't really take effect until the preceding quarter is happening.

Now I don't know if that it is a sustainable trend or a Teutonic shift that is taking place in the venture industry. We're still observing it to determine whether or not it's a trend that we need to make some changes to, to our business model to accommodate. But at this juncture, I still think it's too early to call it a trend other than a very lumpy credit environment, with now a heating IPO environment, that we may be regressing back to normal.

But I don't have any definitive color yet as to where it's going to end up. But I do know unequivocally, everything is beginning to shift from a back-end loaded point of view from an asset funding point of view.

Okay. Thanks for that color. Second, you talked about briefly about that you feel pretty comfortable that you'll have access to a new line of credit sometime in the near future. Can you give us a little bit more color of where you are in the discussions there? And maybe whether -- is this a pricing discussion at this point and that's where maybe the differences lie? Or is it a terms? Or is it some combination thereof?

You know, I'm happy to report it's neither of that. It is as benign as certain individuals who were required to sign off on a final credit commitments from these respective banks, were on vacation -- it's as benign as that. So my level of confidence is extremely high. But I will also preface by saying, I don't believe anything until it's done.

But I have a high degree of assurances from the senior members of these various banks that it is as benign as getting final signature pages. And I'm hoping to report in the next week or two these credit announcements that would bolster our portfolio liquidity even further, to fuel continued loan growth that we're expecting in 2011.

And you feel pretty good about the pricing and terms?

I don't think that we saw much deviation in pricing. You probably have close to minus 25 to 30 BIPS either way movement, but nothing material at all.

Okay. Great. And then the last question is, just based on the NOI versus the DNOI for the year, there's -- the simple calculation is around $0.09, $0.10 of spillover. Is that accurate? And if so, might that be distributed in a special some time in 2011 and how are you thinking about the dividend?

Well, make sure we -- the difference between DNOI and NII is basically non-cash items especially attributed to stock option -- stock compensation expense. I mean, there's other small components, but that's really the disparity of the difference between the two. Many people would argue the DNOI seems to emulate more tax. I'm still not convinced about that argument. They are similar in nature. But the spillover --

Yes, I actually meant the DNOI versus the dividend paid, I'm sorry.

Oh, okay. So, DNOI is a good indication of earnings growth on a go-forward basis, is one way of looking at it. There's no question that we expect to see significant earnings growth which translates to dividend growth in 2011. But again, I need to caution now because I started off the year very aggressive with that belief, and my crystal ball did not have Tunisia, and did not have Egypt, and of course, it doesn't have Libya.

So I have to deal with the context of global crisis that are going on, that may or may not, unfortunately, serve to dampen any kind of growth coming out of the US and in the world. Assuming that situation gets ameliorated here very shortly, I'm very bullish on growth for 2011 that we're seeing. A lot of our competitors are -- aside from the commercial banks -- a lot of our competitors are capital-constrained and struggling. And we're seeing disproportionate opportunities out there.

Now, I will say one thing. I am seeing yield compression that's taking place on the earlier-stage side with banks being incredibly hungry for assets. And that yield compression is being seen in the low to middle market in the earlier-stage companies out there.

So we expect to see some yield compression that will take place throughout calendar 2011 of anywhere between 100 to 200 basis points of existing yield compression on our effective yield, which I talked about earlier at 15.8. It's probably going to drift down between 100 and 150 basis points on an average, that I expect to see happen.

Okay. Thanks very much.

Steven Kwok, Keefe, Bruyette & Woods.

Thanks for taking my question. I guess first question was with regards to the lines of credit that you talked about, what would the terms be and how long of a length would it be, if you'd provide any color on that?

You know, we expect to see the lines of credit to be pretty much the same as we saw in the past. What that means is, typically, two-year deals with a one-year extension. You're seeing now deals with tails coming back now, we have the ability to go from a revolver period to a term period. So I don't think you'll see much material differences in the structure of our credit facilities upon the announcement of renewals of our two facilities.

Okay. And then I guess looking at the balance sheet, I mean, you guys had about $107 million of cash along with your SBIC. And then if -- once you guys have the line of credit, how should we think about, once you start deploying capital, which bucket would it flow from?

Well, we've got to be careful on making bucket allocation issues, because each credit facility, including the SBA, have certain parameters by which the characteristics of certain credits fit into one versus the other. There's single credit obligor concentration issues; there are industry SIC code balances -- we try to make a very broad, diversified pool of capital in each one of the credit facilities, to ensure that no one credit facility is being disproportionately weighted in one industry or stage of development.

So we try to maximize our credit availability by ensuring that the loan mix that's in those SPEs, those Special Purpose Entities, is fully optimized to the best ability of availability that exists. So it's not -- it's a much more benign of a problem than you think it is. It's just simply making sure that as we fill those credit buckets, that we are able to take advantage of the full availability under those credit facilities, and not essentially end up over-collateralizing them by putting in, say, for example, a $20 million loan and only getting $3 million advance against that loan. So that's really the real balance that we focus on, on the treasury function.

Right. And then if you could provide just a little bit more color on the competition in the industry. I know you mentioned about the banks and stuff like that, but I would have guessed like contrary to the other BDCs that operate in a broader market, I thought you guys would be in a much better position, given the niche market that you guys play in.

The competition we're seeing, by the way, is [all] driven by equity. We're seeing a lot more equity -- we're seeing some portfolio companies that are quite attractive and have an incredible amount of promise, going out to seek debt financing only to get -- only to stop at the last minute and say, you know, we're doing equity round because we're getting a lot more equity interest in or the valuations are going up.

Please do not misunderstand that comment. When you're seeing the Facebook, the Zynga, the LinkedIn, the Groupon's of the world seeing these multi-billion dollar valuations, that is helping to help lift valuations in all these private stage venture companies. And so you're seeing a much more increase in activities on preparing these companies for an IPO. And some will actually choose to have debt and equity combinations. Some prefer to have equity if they can get it at even higher valuations.

So from a competition, from a capital point of view, we're not seeing a lot of competition from private venture debt providers out there. We're just not seeing that.

Okay. Great. Thanks for taking my questions.

Jasper Burch, Macquarie.

Just starting off with, could you give some clarity on what exactly happened with the subsequent to quarter-end $25 million repayment of SBA debentures? And then just trying to re-issue them?

Sure.

(multiple speakers) My understanding -- okay. Yes, just go ahead.

Well, as typically is the case of Hercules, we are the first -- I mean, we were surprised by this as much as, I guess, the SBA was. We were the first entity in the history of the SBA to actually pay back a 10-year debenture that was a fixed cost of capital. As you may recall, SBA debenture is a 10-year fixed cost instrument, at an effective interest rate and yield, I should say, about 6.6%. And our most recent SBA debenture that we locked in was approximately 3.75%.

So we said, why are we going to have a disparity of over 300 basis points on a 10-year instrument? So we went to the SBA proactively and said, we would like to refinance our old SBA debentures and replace it with more attractive, lower-cost 10-year debentures. And, to our surprise, the answer was yes. But it's never been done before. So the SBA working in tandem with our partners at the SBA, we worked together to mechanically work out the first SBA debenture payoff.

Now, let me tell you what's important about that from a financial modeling point of view that people need to understand. Because we have an SBA debenture that's a 10-year life, we pay a commitment fee at the beginning of the SBA debenture. That commitment fee is amortized over the 10-year life of the loan. When that SBA debenture is paid off early -- which you'll see happen in Q1 -- you'll see approximately a $550,000 accelerated expense of realized expense in Q1 attributed to the refinancing of that SBA debenture. That SBA debenture [initially at $25 billion] will then translate into a 3% per annual savings over the next 10 years or whatever the finite lifecycle of that new debenture may be.

So we're trading off $550,000 of pre-payment penalty, if you will, early payoff on that SBA debenture to save 300% -- or 3%, excuse me -- 300 basis points, of that [$25 million] over the next five to 10 years of that new debenture's life. So it's highly accretive. But it's a good question, Jasper, because I fail to tell people that there will be an interest charge or interest expense on the acceleration of that payoff, but it will be accretive thereafter.

Yes. We will take the hit in the first quarter, but we expect to recover that cost really over even the first year, based on the lower borrowing costs.

Great. That's very hopeful. Did you guys provide a number for what your undistributed taxable earnings is -- carryforward?

The undistributed taxable is basically de minimis. It was primarily de minimis because of the November capital raised on a share count basis basically [ate] through that. So there was no real significant spillover dividend from fiscal 2010 to 2011.

Okay. And then I appreciate the commentary that you do expect the dividend to rise as earnings rise over the course of the year, but just looking at where your dividend is compared to your earnings, I mean, it still looks a little bit low. I mean, you're paying $0.22, earning $0.24 -- well, $0.26 is DNOI. Do you expect that spread to contract at all?

No. I mean, Jasper, call me too conservative of a CEO -- I firmly, firmly believe, despite some of my brethren BDCs out there, that I like to show dividend growth when I see solid earnings growth.

And you're right, there's probably a little more room in Q1 for dividend increase. But I want to make sure that the Middle East crisis and all the other things that are manifesting themselves in the marketplace end up going away. And assuming that does happen, you'd definitely see an increase in dividend in the second quarter, as we -- I'm sorry, in the first quarter, as we report our first quarter earnings -- start developing higher dividend quarter-over-quarter growth in 2011.

It is my anticipation to actually see a [fifth] dividend being accumulated in 2011. But I have to caution by saying, I need to see continued earning asset growth, which I believe will happen and the dividend will follow suit right behind that.

Okay. And then just lastly, the write-ups -- on the unrealized appreciation of equity and warrants, was that all just due to taking the realized loss? Or do you have any other movement in there, due to market conditions or Company performance?

Well, look, we have 91 warrant positions. We have over 57 loans. It is a potpourri of everything. I mean, there's reversals, there's appreciations, there's depreciation. I mean, there's no one significant factor. But yes, the flipping of the unrealized loss to realized loss is certainly a contributor to that, but there's also up-and-down activities that happen in a normal course.

Remember, one of the things I said, I expect to see throughout 2011, probably some meaningful portfolio appreciation as mark-to-market and venture capital exit activities continue to grow. I suspect you'll see some probably meaningful growth in net asset value on a realized basis as all these venture capital activities continue to take shape. And more confidence in the IPO market in M&A activity continue, you'll see that translate into higher mark-to-markets in the private portfolio companies.

Well, great. Thank you very much for answering my questions.

Greg Mason, Stifel Nicolaus.

Manuel, can you talk about your hiring of a new middle-market team? If I remember last quarter, I think you guys were saying you weren't going to do any lower end of the middle-market deals, and in fact, talked about how you thought the risk-adjusted returns there weren't very good. And then we see you hire a new middle-market team. So can you talk about your strategy there?

Absolutely. Let's make sure we have a good recollection of history. In June of 2010, we shut down the lower middle-market group for failure to perform as we expected, from a cost point of view and SG&A point of view. So we basically got rid of the vast majority of the lower middle-market team.

And your recollection is exactly correct. We have dedicated the last six to seven months on restudying and analyzing the lower middle-market initiative under which Hercules would only consider doing lower middle-market initiatives.

And I mean by that is that the words that you should probably take away from this conversation is that we are rebuilding by testing the hypothesis as to how the lower middle-market should work. And what that means is that we are highly selective on what we consider lower middle-market in the industries.

We're only interested at looking at technology-related assets and healthcare-related assets. We're not going to do a distribution company. We're not going to do a metal bending shop. We're not going to do the traditional lower middle-market. Because we think strongly as being active in looking at that market, that is a race on who has the lowest cost of capital and who is willing to take the lowest yield. There's not much of a defensible business model there, and we think that the traditional lower middle-market paradigm is broken.

And so what we're doing is, we went out and aggressively sought out two very strong candidates who have a very strong industry background and knowledge in the technology-related industries that we're looking for. And so we're going to go out and retest the lower middle-market under this very tight parameter. And I will say this to you, that we're highly yield-sensitive. If we do not see the yields that we're looking for, we're going to pass. We're not going to do those deals.

We're seeing dramatic, and I repeat, dramatic yield compression going on in the broader lower middle-market initiative. If that continues, you will see us completely step away and not focus any resources into lower middle-market. So you'll see us test our lower middle-market focus onto technology-related and healthcare-related companies over the preceding first half of the year, and then I'll report back to you and our shareholders as to how that venture is proving out.

We like this space, but we're highly selective on what we will consider qualified eligible lower middle-market companies. But do not assume that I'm interested in doing generically lower middle-market deals. That is a commodity business that we have no interest in being involved with.

Great. And then can you talk about -- you've got all of these unfunded (technical difficulty) but you need to keep available capital on hand to fund those. So how much of the significant liquidity that you highlighted previously is actually available for deployment versus you have to keep dry for future commitments?

So let me use a perspective as you'll see in the subsequent event disclosure in our earnings release. Q1 is looking to be a very strong and very solid quarter with what we reported so far. I think we reported approximately $42 million of close commitment so far in the quarter.

I can tell you that as we begin this call already, we've already closed new commitments already that turn into unfunded commitments -- sorry, pending commitments to actually closed commitment. And that continues as we speak. But if see in the subsequent section, we talked about $42 million of closed commitments so far; $128 million of signed (inaudible) in-house; and $117 million of unfunded commitments.

If you add those two together, you're looking at over $200 million-plus of [asset] visibility. Now, specifically to your question -- clearly, not all closed commitments fund. Approximately 75% to 80% of the commitment actually fund. So if you look at the closed commitments that we reported, the $42 million that we're talking about here, you'll see that we expect to see approximately $31 million to $32 million of that will end up becoming funded assets over the proceeding one or two quarters. Of the $128 million that we disclosed today, we expect to see about 90% of those will actually close. And of that, you'll see another $86 million of those assets get funded as well.

So you're seeing us on a nice growth pattern to see Q1 to come in somewhere in the neighborhood of anywhere between $110 million to $140 million of closed commitments and a factor below that in terms of funded assets point of view. So real good growth there.

Now, asset growth is important, but you also need to manage the right-hand side of your balance sheet. And the right-hand side of the balance sheet is our credit facilities. As I indicated, I feel very confident with what I know today and the insurance I've received that those credit facility renewals should end up being announced in the next week or two. And you'll see also our ability to continue to enhance and then grow our liquidity side of the balance sheet, with the due commitments we expect to report here very shortly, and continue to fund our growth.

Great. Thanks, Manuel.

Jason Arnold, RBC Capital Markets.

Nice job this quarter. Just a quick question on the current and pending closed commitments you've seen so far in 1Q 2011. Curious if there's any specific technology subsectors you're seeing particular focus or growth opportunities in?

Good question, Jason. Thank you. The fact of the matter is, we're seeing, as I said earlier at the beginning of my remarks, [notice similar] to the venture capital activity, business technology and business services, consumer services, and renewable energies, and our clean tech is where we're seeing the big growth of that.

Now, notwithstanding that, we're also seeing some of our life sciences assets coming online to maintain that 30% to 35% of life sciences assets, which we want to try to manage the portfolio there. But we're seeing a pretty significant demand across all subverticals -- or subsectors, I should say, for the portfolio itself. So we're seeing a very good distribution of interest.

The biggest challenge we have right now is that we're also finding ourselves being very harsh on credit and yield. We're turning down a disproportionate amount of transactions. I always say we're turning down more deals higher than we probably have in a long time. And a lot of those deals are getting funded, ironically, by our competitors, which we're fine with, because we're passing on them for a reason.

We have credit concerns, we think the yields are too tight, and we're passing on those. We have enough deal flow to address what we're looking for from a yield point of view. However, as in terms of second half of 2011, I do see our own yields drifting down a little bit as the market gets a little more sharper out there -- which is fine.

And I think that I said earlier, I'll probably see anywhere between 100 and 200 basis points drift and yields, leading to an average of about 150 basis points in drift that I expect to see throughout 2011. And that's driven by, of course, early-stage investing activities that we'll be focusing on, that will help drive that down a bit.

Excellent. Thanks a lot for the color.

Douglas Harter, Credit Suisse.

Just a point of clarification on that comment about the drift down in yield. Are you talking about the yield on incremental investments or the yield for the entire portfolio?

Well, the entire portfolio -- it's just a law of averages. I mean, that's a big base -- you know, 400-and-plus-million-dollars of earning asset base at a probably a 13%, 14% overall blended yield. So that will take a little bit of time.

New assets, certainly are going to be probably 100, 150 basis points lower as you look to do that. So you'll see the overall effective yield of the portfolio whittle down a little bit. By the end of the year, you probably see maybe 100 basis points on that effective yield to 150 basis points on the overall portfolio drift down by the fourth quarter. But they won't be immediate. But new assets are definitely coming onboard at probably 50 basis points, 100 basis points lower than we historically have been doing most recently.

And then -- thanks for that clarification, Manuel. And then, I guess, on the pre-payment fee that you guys received this quarter, can you just put that in perspective as to -- because I know you have prepayment fees every quarter. How does this compare to prior quarters? And how should we think about the level of pre-payment fees going forward, as like a normalized level?

Well, I can only tell you because we already made this release anyway, so already in the first quarter, you have an early payoff of approximately $18 million on one particular credit. So I think that in Q1, a lot like we said in Q4, we think we said it was about $30 million or so in Q4 and it ended up be a little higher than that. I think that in Q1, you're probably going to see $20 million to $25 million of unanticipated early payoff, $18 million of which has already occurred. That's the InfoLogix, on or about, already has developed already. So you'll see a little bit of that.

I'm sorry -- I just forgot the first part of your question.

No, I guess, just sort of on that, I mean, are the prepayment penalties generally comparable across the deals? So if we were to look at that type of $20 million versus $35 million, and assume that pre-pays are down a comparable amount?

Yes, I mean, look it -- the fees are always tricky. Because, as you may realize, fees have to be discriminated into two different buckets. You have fees that are deemed to be one-time fees, basically easy to look at a covenant cure fee is recognized upon a covenant cure. And then loan modification or loan amendment fees are generally recognized over the remaining term of a loan.

And then, of course, you have the acceleration of deferred revenues, deferred fees on the balance sheet, that if a loan pays off early, that will make it classified as either acceleration of fees or income, depending on the particular attribute of that initial deferred revenue on how it's booked. And then, of course, you have what you're asking for, is the specificity on prepayment penalties that exist.

We -- the best way to look at Hercules is our prepayment schedule is generally 3/2/1 -- 3% in the first year; 2% in the second year; and 1% in the third year. Now there is some variability to that, but that's the best way of looking at it, based on the principal outstanding. On certain cases, we may waive a prepayment penalty if another exit event is being achieved at the same time. For example, a warrant realization may be tied to it. As an inducement to get an early payoff, we may actually choose to do that.

I think that the fee portion of our business is probably one of the most difficult things to forecast because it remains a bit lumpy. And so I apologize -- I don't -- it's very difficult for me to quantify how best to look at it, because it just -- in 16 quarters I've been doing this, it just -- it remains lumpy.

I appreciate the color there. And then just one final one on expenses. How should we think about expense growth going forward into 2011, given that the middle-market testing -- lower middle-market testing that you're doing right now?

I think it's a great question. I think if you look at our run rate right now, I think the G&A expense is probably in the neighborhood of -- $20 million is probably the G&A run rate today. I think with a little bit of market initiative, as we test out that hypothesis, if it takes root, I think that number will probably stabilize around the $22 million range, if it stabilizes. But we're pretty open about that.

We are simply testing it, and we need to see traction and affirmation that our particular emphasis on the lower middle-market business model, meaning tax and healthcare, actually works and those yields that we're looking for are there; if not, you'll see that SG&A kind of average out for the year around $21 million or slightly less than that, if we decide not to continue that lower middle-market after testing it.

Great. Thank you.

I am showing no further questions at this time. I would now like to turn the conference back to Mr. Henriquez for closing remarks. Sir?

All right. Thank you, Operator, and thank you, investors. I'm very happy to have everybody that participated on this call and continue to be part of the Hercules family.

We are maniacally focused on growth for 2011. We want to deliver what we said we've been doing, and now it's a question of building our balance sheet from a liquidity point of view and an asset point of view.

With that, we just put a release out earlier this week, and David and myself will be attending two investor conferences at Sandler O'Neill as well as the Citibank conference in New York the next week. And we'll also be having investor meetings in Boston. If you would like to schedule an investor meeting, please contact Hercules at 650-289-3060, and we're happy to arrange an investor meeting.

With that, Operator, thank you very much and thank you, everybody.

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