Hercules Capital Inc (HTGC) 2012 Q4 法說會逐字稿

Good day, ladies and gentlemen. And welcome to your Hercules Technology Growth Capital Q4 2012 earnings conference call. At this time, all participants will be on in a listen-only mode, but later, we will conduct a question and answer session and instructions will be given at that time.

(Operator Instructions)

As a reminder today's conference is being recorded. Now, I would like to introduce your host for today, Linda Wells.

Thank you, operator. Good afternoon everyone. On the call today we have Manuel Henriquez, Hercules Co-founder, Chairman and CEO and Jessica Baron, Vice President of Finance and Chief Financial Officer. Hercules' fourth quarter of 2012 earnings results were released just after today's markets closed. They can be accessed from the Company's website at www.htgc.com. We have arranged for a replay of the call at Hercules webpage or by using the telephone number provided on today's earnings release.

I would like to call your attention to the Safe Harbor disclosure in our earnings release regarding forward-looking information. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein between the date of this release and in the confirmation of final audit results. In addition, statements contained in this release that are not purely historical are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially than those expressed in the forward-looking statements. Including without limitations, the risks and uncertainties, including the uncertainties surrounding the current market turbulence and other factors we identify from time to time in our filings with the Securities and Exchange Commission.

Although we believe the assumptions on which these forward-looking statements are based on are reasonable, any of those assumptions can prove to be inaccurate, and as a result the forward-looking statements based on those assumptions also can be incorrect. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained in this release are at made as of the date hereof. And Hercules assumes no obligation to update the forward-looking statements for subsequent events. To obtain copies of related SEC filings, please visit sec.gov or visit the website, www.htgc.com. I would now like to turn the call over to Manuel Henriquez, Hercules' Co-founder, Chairman, and CEO. Manuel?

Thank you, Linda. Good afternoon and thank you everyone for joining us on the call today. As usual, I want to do a quick outline for today's call. I want to review the summary of our very strong operating performance and results for Q4 and full-year of 2012, discuss the current market conditions including the venture capital activity during the fourth quarter of 2012, our outlook for Q1 and 2013 with investment activities and pipeline discussions. And then, of course, turn the call over to our CFO to review in more detail our financial achievements and results for our shareholders.

Overall, 2012 was an exceptional year on many fronts. We are pleased to report very strong December quarterly earnings result, capping off a tremendous year for Hercules. During the fourth quarter, we demonstrated our commitment to expand our leverage and continue to access the capital markets, further increasing our financial flexibility, and more importantly, laddering out our debt maturities. With the earliest at debt maturity not being due until April 2016. And this, of course, excludes our short-term securitization instrument, which we recently committed, and I will expand upon.

We're continued to pursue our strategy of slow and steady, an investment philosophy that seems to have been adopted by other BDCs as we have been adhering to for the last few years. In this process of slow and steady, we continue to methodically deploy our excess liquidity into accretive earnings assets for shareholders and continue to drive our investment portfolio, which topped off over $900 million at the end of the year representing over a 40% increase year-over-year, our highest level since our inception.

We enter into 2013 with a significant higher level of earning assets than a year ago. Which we expect translates into higher earnings, net investment income for our shareholders, which in turn will lead to further dividend increases in 2013. As an example, as we continue to convert our existing cash balances on our balance sheet of approximately $180 million into interest earning assets, this process alone will represent a 20% increase in our current portfolio -- investment portfolio, and as those assets become earning assets, and assuming, for example, a 6% net interest margin spread on that $180 million, that alone could represent $0.20 in earnings as we convert that cash liquidity into earning assets and driving EPS growth with that simple process.

However, I want to caution, our intent is not to fully deploy all our cash balances. We historically have maintained a $15 million to $25 million cash buffer, or cash level, for unforeseeable issues that may arise or investment opportunities. We always like to maintain some level of liquidity in the form of cash.

Now, let me turn this call over to discuss some of our financial highlights for the year and the fourth quarter. For the fourth quarter, we delivered a record high total investment income of $27.4 million, representing an increase of 29% year-over-year. We also achieved a 21% year-over-year growth in Q4 in NII, net investment income, of $13.1 million, or representing $0.25 a share. Not to be left behind, our DNOI in Q4 also increased over 20%, to 23.5% on a year-over-year basis to $14.2 million or $0.27 in EPS earnings. Our dividends for the year represented $0.96 and represent an increase of 5% year-over-year. DNOI on an annual basis also increased approximately 7% to $1.07 per share.

As we continue to deploy our capital, as I said a minute ago, we expect to see an increase in dividend as we achieve over the year. As we finished the second part of 2012, we also finished with the probably $1.5 million of dividend spillover, or taxable earnings spillover, representing approximately $0.03 per share with the share count at year end. Now, over the course of the last few months, I have been meeting with investors. And a couple questions have surfaced during this period of time as new investors come into the BDC at the class category. And as a reminder, GAAP earnings don't necessarily translate into taxable earnings. There's a timing differences. So it is not unexpected that our GAAP earnings may show a lesser number than the dividends that we are paying out. This is generally adjusted at the end of the year, when we do the so-called tax top off, when the audited financials and tax files are completed, at which point we have a very good indication of what that taxable dividend or earnings spillovers were to occur. The reason why I say this is, that over the course of the last few weeks and months, many new investors who have been interested in the BDC space have been asking me this question.

So now let me turn the conversation back to our portfolio growth. New commitments during the first quarter -- the fourth quarter, excuse me, were also very strong at $260 million, representing a 50% -- 57% increase year-over-year. Bringing our total annual commitments to over $637 million. Our fundings not left far behind, were also very strong with approximately $200 million in fundings during the fourth quarter and for the year over $469 million of fundings took place during the year. A very strong showing both the commitments and fundings for fiscal 2012.

Net portfolio growth for the fourth quarter was equally as strong. We saw an $121 million increase in the portfolio year-over-year. Many of you may recall during the third quarter earnings call, we remained a bit guarded, waiting for the election results to take place in order to continue to deploy our capital during the fourth quarter. I am happy to report that a lot of anxiety and uncertainty has been removed with the final election and some of the debt ceiling issues have been resolved. However, I want to caution that we still one more hurdle facing us, which is sequestration, that we continue maintain a steady hand on our origination activities, although you will continue to see us continue to originate and grow the portfolio in Q1, we are holding back a little bit in that origination process until we have a bit of visibility on the sequestration outcome.

That said, we continue to set a very high bar for ourselves on our new investor parameters and remain very cautious and selective about our investment portfolio. We're not interested in simply growing a portfolio to grow a portfolio. Unlike many other BDCs, as an internally managed BDC, we do not have much of an incentive to simply grow assets to collect management fees or incentive fees. We are very much aligned with our shareholders, we continue to grow our portfolio in a controlled and deliberate fashion to ensure continued earnings and dividend growth for our shareholders.

It appears, also, that the new norm is that assets will be on-boarded late in the quarter. I have spoken about the subject now for many quarters and have come to the final realization that the new norm is, everything is going to happen near the end of the quarters. What that means is that we will see an earnings lag on quarter-to-quarter as those assets are on-boarded. The real economic benefit of those assets being on-boarded late in the quarter will realized in the subsequent quarter to follow. It is something that we thought was simply an arbitrary -- we simply thought it was an anomaly in the marketplace, and after now seeing this for six or eight quarters, I am convinced that is a new norm. I just want to share that with you as everybody looks our financial modeling, and as we, too, give a little bit of guidance on earnings being back-end weighted for your benefit.

As we look to 2013, we look to continue to expand our portfolio as we convert our excess cash liquidity of $100 million, we expect to see new origination on a net basis for Q1 in the neighborhood of $60 million to $70 million. That number, of course, includes approximately $20 million of early payoffs that we expect to occur some of which has not happened yet, so that number may be impacted up or down, if those early payoffs do not occur as they are expected or scheduled at this point. Again, to repeat, we expect to see approximately $20 million of early payoffs in Q1, and is basically at the end of February and not a lot of those payoffs have, thus far, taken place.

We remain very diligent on monitoring our credit portfolio and continuing to monitor very closely developments in many one of our sectors, and specifically in Q3, we spoke about our life sciences sector. I am very happy to report that our life sciences portfolio had a very strong and very tremendous showing of major achievements during the quarter of many companies that we had on a watch list that had major FDA milestones and major funding milestones that were critical in the fourth quarter. That substantially all of those companies significantly achieved or overachieved on those milestones securing FDA approval or additional capital as part of the capitalizations of their companies. As such, you saw a reversal of some of those concerns and impairments from fair value accounting that we had taken in Q3 that now have been realized or reversed in Q4. A testimony to a continued strength of our life sciences group in identifying the right companies and continuing to build assets for our investors.

Now, moving my overview to yields. In keeping with how other BCD report yields, we decided to first keep in line with how other BCD's are reporting yields, however, we feel very strongly that it is important for shareholders to look beyond the certain yields that BDCs report look at yields when you adjust them for the elimination of one-time events. With that, yields in the fourth quarter came in very strong again at 14.3% for the yields in Q4 for our assets. However, as I said just a second ago, we believe that it is important for shareholders to see through that aggregate yield and have those yields adjusted for one-time events. This is something that Hercules has been doing now for over six quarters.

In the fourth quarter, that same 14.3% yield, when you take into effect the one-time impacts, that yield actually is adjusted to 13.6% on a much more predictable and sustainable level. We think that is important to highlight that point. We also continued to do something that other BDCs don't seem to want to do. And that is we refuse to give up credit quality, and more importantly reach down the capital structure in order to preserve yields. I have said more than once, Hercules is more than happy to give up 30 to 50 basis points in yields to ensure that it maintains a senior secured, first party lien on its assets that it is advancing capital to. We do not believe in trading off yields for going down on capital structure or for credit quality. That said, over 98.4% of our debt investment portfolio is represented by senior secured first lien positions in our companies today.

Moving towards the balance sheet. Our focus in 2012 was diversifying our source funding and laddering out the maturities of our debt while continuing to convert our liquidity to earning assets. We executed on that 100% as expected and I would actually say above our expectations. It was a spectacular year of everyone working diligently in this Company to continue to asset deployment and diversification of our source of funding. A very important part of our continued success story.

As a matter of highlight, in 2012, we completed three unsecured, unrated 7% bond offerings, or as we call our first baby bond capital raises of approximately $170 million. We executed two equity capital raises totaling approximately $81 million. And one of the most important achievements that we have done in 2012 was the completion of our first investment grade securitization, rated A2 by Moody's, for $231 million with net proceeds -- excuse me -- of $129 million, at a cost of capital of approximately 3.2%. A very important achievement in continuing to lower our overall cost of capital.

Not to be left behind, we continued to diligently execute a strategy of refinancing and retiring old SBA debentures. We did approximately $50 million of SBA debentures, which retired at a higher rate, that generally provided net interest savings of approximately 300 basis points while also extending the maturity of the debentures for an additional 10-year duration, highly accretive to benefit our shareholders. In addition to that, working with our strong partner, Wells Fargo, we're also able to lower cost of financing at our capital lines from Wells Fargo by 75 basis points to 4.25% and also adding additional duration on our current credit facilities.

Our philosophy relating to credit facilities in 2013 is that we now view the use of our credit lines, thanks to the securitization market, as the back stop for our unfunded commitments. I will expand on that as I go through this call. As I said, we ended the quarter with over $288 million of liquidity, $183 million of that in pure cash and approximately $105 million of that in bank lines.

Again, an important statement. We expect to now use our bank lines as the back stop for our unfunded commitments as we continue to manage our funded commitments portfolio basically to a level of our bank lines leverage. This is another topic that has come up over the last few months in conversations with investors. It became very obvious to me that many new investors, and some of our existing investors, have forgotten some of the benefits of the Hercules model. And certainly the focus of Hercules in the venture capital industry. Specifically, Hercules has an exemptive order from the SEC which, in essence, allows us to eliminate for the calculation the SBA debentures from the regulatory SEC leverage test of one to one.

Said differently, with the exemptive order from the SEC, Hercules is able to leverage its balance sheet up to the maximum level of 1.44 to 1, versus traditional BDCs one-to-one. I can assure you, our intent is not to go to 1.44 to 1, but our intent is to manage that leverage up to the 1.2 to 1.25 level. As such, today we have additional capacity. When you look at our SBA leverage -- excuse me, when you look at our GAAP leverage today, we have a ratio on a GAAP basis of 1.15 to 1. However, because of the $180 million cash balance on our balance sheet, we actually look at that net adjusted leverage, or what we call net leverage -- that net leverage is really only 80%, when you take into account the cash balances. All of this, by the way, is explained both in our 10K and more in our press releases for your benefit, as well. The take away from all of that, is that we have the capacity to go to $145 million of borrowing capacity if we were to go to the optimal level of 1.44. In other words, plenty of growth to continue to grow our investment assets.

Turning over to liquidity. 2012 was also very strong year. We achieved 12 liquidity events; five M&A events and seven IPO events. We saw very robust activities on two of our portfolio companies completing acquisitions, also in the life sciences sector, where Pfizer purchased one of our companies, NextWave pharmaceuticals, for a transaction value of over $700 million. And also deCODE, in late December, that was being acquired by Amgen for over $450 million. Again, further evidence and testimony of our team continuing to pick the right companies that are either pre-IPO or pre-M&A companies. We finished the year with two companies in IPO registration, which are iWatt and Paratek.

Not being left behind, our warrant portfolio which represents continued hidden value for shareholders if and when the monetization of those companies achieve access events. We finished the year with 116 warrant positions with a GAAP value of approximately $30 million as of the end of December. We always caution everybody, they should always look at our warrant portfolio and we generally only expect to see a 50% monetization in value in that warrant portfolio, to be conservative. Historically, the value of those warrants have ranged from 1X return to as high as 10X returns. We do not think that you should consider a 1X or a 10X to be the normal.

Now, turning my conversation or overview to the venture capital industry. Something that seems to be very important to investors that we like to share with investors, some of our insight into the venture capital marketplace. Yes, the venture capital industry continues to consolidate. And despite what the media would like to see as the sky is falling, we actually welcome and see the consolidation of venture industry as the continued, important process of thinning the herd and strengthening the venture capital industry.

That said, 2012 represented a very strong year for the venture industry. Basically, $29.7 billion was invested by the venture capitalists to over 3,000 companies. Although on an aggregate dollar, it represents a 15% decline in deals, we still think it is a very healthy environment. Of that, $6.6 billion was invested in the fourth quarter to over 733 companies. The IT sector, or information technology, continues to be one of the shining areas of investment activities by the venture capitalists. That sector experienced a 50% increase in investment activities and saw 33% of the capital, or $9.9 billion of the venture capital dollars invested in that sector. With the software industry representing the most strongest representation in the IT category.

Healthcare and information technology continued a moderate decline in saw 19% decline year-over-year in investment activities. Principally to blame for that is the elongated approval cycle from the FDA. However, we are seeing encouraging signs that that process may be thawing and some improvement is happening in that area. Because of that, I expect to see an increase in investment activities in Q1, and at minimally in the first half of 2013 and life sciences categories.

We saw significant traction in the consumer services area and social networking. An area that we basically have shied away from. And that experienced, a 29% decline to $4.4 billion in activities in fiscal 2012. The most dramatic decline, not that we weren't expecting it, was in the energy and clean tech sector, which saw approximately 47% decline year-over-year in investment activity to a mere $1.7 billion. That is because as the whole conversation with government budget cuts and government dependencies, we think that the clean tech industry, until it has a better outlook on becoming a self-sustained industry without government dependencies, we will continue to see some challenges as economic models. That said, because we are debt providers, we are able to take advantage of that disadvantage in the marketplace and make very selective investment decisions in that area to add to our portfolio. But we're taking a very guarded approach as we expand in that asset class.

2012 IPO activities. Very robust. We saw 50 venture capital IPOs complete over $10.6 billion. Most people may not realize, that is the most IPO activities we have seen since 2000. That is 12 years. And finally, we saw some improvement of 50 companies. I'm happy to say. That compares to 46 completed in 2011. Although we are far away from the peaks of '98 and '99, it is, so far, a very encouraging sign. We finished the year as venture industry with 26 companies in IPO registration today. M&A, although off 24%, was still very strong at $37 billion of activities that took place in 2012.

Finally, the venture capital ecosystem. It is an important part to understand the investment activities, the exits realized with the venture capitals, but more importantly, the number of venture capital funds raising capital. In 2012, over $20 billion was raised by the venture industry, basically, five to 2011. That is a good sign and a very healthy sign that gives me very good visibility and continuing venture capital activities in 2013 and beyond. We are not discouraged by the level of venture capital activities, and, in fact, we are encouraged by the continued pace of investment by the venture industry and their selectivity in the venture industry and the asset classes that they are investing in and sub-sectors that they are investing in.

Now, finally, turning my call over to our outlook for 2013, as well as Q1. As I said at the earlier part of the conversation, we believe that we will see net investment activities for Q1 of approximately $60 million to $70 million of net portfolio increase. That is after taking into account approximately $20 million of early payouts the we expect to see in Q1. Our pipeline is one of the strongest I have seen in the last three years. I am happy to say that we're looking at and facing a pipeline that represents over $1.4 billion of investment activities and only getting stronger every day.

We are seeing unprecedented demand for capital, and because of that unprecedented demand, we have gotten more guarded and more jaded as we sort through the investment opportunities. Again, I need to emphasize, we are not interested simply in filling all of the orders that are available out there for demand for capital from the perspective companies of the marketplace but remained very stewart to our commitments to underlying the right companies, the right yields, and if that means missing earnings or taking our time, we will continue to do that and behave in a very disciplined and controlled approach.

So far for the quarter, as we outlined in our press release, we have net fundings, or net portfolio growth of approximately $55 million. Because of the early payoff, that number may go down slightly if the early payoffs are realized or not. We are finishing, as of this call, we have approximately $126 million of signed term sheets giving you visibility for the conversion into the remainder of Q1 and certainly into Q2. We are well-positioned. In summary, 2012 was a tremendous year. I am very proud of the execution at all levels of our team members at Hercules for the benefit of our shareholders and for the continued growth of our dividends to our shareholders. 2013 we are well-positioned to see continued earnings growth -- continued dividend growth, and continue to deploy liquidity in our balance sheet. I will now turn the call over to Jessica, our CFO. After that, Jessica and I will both be happy to answer any questions you may have. Jessica?

Thank you, Manuel. And thank you, everyone for listening today. I'd like to remind everyone that we filed our 10K as well as our earnings press release after the market closed today. And I'll briefly discuss our financial results for the quarter ended December 31, 2012.

Turning to our operating results, we delivered $27.4 million in total investment income or revenues, a quarterly record, an increase of 29% when compared to the fourth quarter of 2011. This year-over-year growth was driven by higher average outstanding balances of yielding assets during the course of 2012. As Manuel mentioned, the GAAP effective yield on our debt investments during the fourth quarter was 14.3%. Excluding the income acceleration impact from early payouts and one-time events, the effective yield for the quarter was 13.6%, down slightly due to the asset mix and timing of the amortizations relative to the previous quarter, down by approximately 30 basis points.

Interest expense and loan fees were approximately $7.5 million during the fourth quarter of '12, as compared to $4.6 million during the fourth quarter of 2011. Our weighted average cost of debt, comprised of interest and fees was approximately 6.29% of the fourth quarter of 2012 versus 6.23% during the fourth quarter of '11. The slight increase was due to 170.4 of 7% senior unsecured notes that we issued in 2012. Offset by lower weighted average cost of SBA debentures -- new SBA debentures of 4.3% versus 5% in the fourth quarter of '11.

Operating expenses for the quarter totaled $6.9 million as compared to $5.8 million in the fourth quarter of 2011. The increase is primarily due to increase in employee headcount since the end of 2011 and the stock compensation expense. Q4 of '12 net investment income was $13.3 million compared to $10.8 million in the fourth quarter of 2011, representing an increase of approximately 21.3%. Net investment income per share was $0.25 for Q4 of '12.

Our net unrealized appreciation from our loans, warrants, and equity investments for the fourth quarter was $10.3 million driven primarily by $9.9 million of reversals of prior period collateral based impairments in our life science companies. Our net realized gains for the fourth quarter was approximately $1.1 million. As a reminder, we have two notable liquidity events this quarter in our life science portfolio. deCODE Genetics was purchased by Amgen in December and we realized a $2.6 million gain on our warrant position. And NextWave Pharmaceuticals was purchased by Pfizer, and we recognized a $300,000 gain attributed to that transaction.

Our net asset value as of December 31st was $516 million or $9.75 per share compared to $9.42 per share as of September 30, 2012. We have seen significant growth in our portfolio over the last year as a result of our debt investment origination activities. We ended 2012 with total investment assets, including warrants and equity at fair value of $906.3 million, an increase of $253.4 million, or 38.8% from a year ago, reflecting continued growth in net new originations and strength in our platforms. Our debt portfolio ended the year of $827.5 million at fair value, an increase of 29% year-over-year.

Moving on to credit quality, our loan portfolio credit quality remains excellent. The weighted average loan rating on our portfolio was 2.06 as of December 31, we had one small debt investment, we had an approximate $350,000 cost basis on nonaccrual at the end of the quarter. That was our only nonaccrual investment.

Now to liquidity, at the end of the year, we had approximately $288 million in available liquidity, including $183 million in cash and $105 million in credit facility availability. Capital raising activities for the quarter included an equity offering of 3.1 million shares resulting in proceeds of approximately $33.6 million, excluding other offering expenses which closed in October. In December, we issued our first Moody's rated A2 securitization for 129 million asset-backed notes backed by 231 million of senior secured loans, which we originated. This securitization provides us with additional liquidity at a very attractive interest rate. We ended the quarter with $225 million of SBA debentures outstanding, which is the maximum amount of debentures allowed under the program. A reminder, we have two SBIC licenses.

At December 31, our debt to equity ratio including SBA leverage was 115%, with a target ratio of 120% to 125%, as Manuel mentioned. We would also like to remind investors that our $125 million of SBA debentures are excluded for regulatory leverage calculations purposes, that the exemption effectively allows us to leverage beyond the 1.1 to equity limit to 1.44 to 1. Which means, at the end of the year, we had a capacity to add incremental debt of approximately $145 million, if we so choose. Our net leverage, which is calculated as total debt, of $596 million, less approximately $180 million of cash divided by total equity of $516 million was 80.1% at the end of December. Finally, we increased the quarterly dividend by $0.01 and declared a dividend of $0.25 per share for the fourth quarter. And added approximately $0.03 dividend, $1.5 million spillover for the year.

In closing, the fourth quarter was a strong end to a great year. We remain focused on diversifying our sources of funding, lowering our overall cost of capital, and bolstering our balance sheet to take advantage of investment opportunities to grow our investment portfolio. Operator, we're now ready to open the call for questions.

(Operator Instructions)

Greg Mason, KBW.

Thank you. Manuel, can you please talk about your new securitization? And in particular, the flexibility of that for the type of assets that you do? Were you able to put existing, down the fairway loans that you do in there, or is that going to have to change a little bit in terms of what you need to do on the lending side to have assets fit in that securitization?

That is a great question, by the way. To the credit of Moody's, the process was anything but easy. It was a very, very methodical -- we basically had to work with the Moody's team and work with them to understand the asset class -- the unique nature of this asset class. So, it's not like there is a lot of folks originating this asset, and therefore with a lot of experience and history here. The Moody's team was very, very methodical and very diligent in really getting their arms around this asset class. To answer the question very succinctly, the answer is what we do today, our bread and butter, our core asset, is what we intend to continue to put in that securitization conduit, if and when we do another one.

Great. The VC market tends to -- can be impacted by government funding. Does the sequestration potential impact have any impact on your portfolio, or the VC industry overall?

The only thing that we can see today that may have some form of impact of sequestration, could be that potentially staffing cuts at the FDA may delay some FDA processes and trials to progress on a sequential basis. Because just lack of budget. But the poor FDA to their defense, has been understaffed and under budgeted for quite some time. Hurting them further could be an issue. IPOs could get delayed with lack of staffing at the SEC. That may happen with some budget cuts that could occur. But there is nothing systemic that we are aware of as of today that could have any material impairment or impact to the VC industry, other than just ongoing government agency delays.

Great. Then one last question and I will hop back in the queue. A lot of the middle market BDC lenders have talked about spread compression, increased leverage points -- just competition flowing in from the liquid markets and this hunt for yield. Are you seeing any of that trickling down into the VC market where you guys lend?

Not to that extreme. The only thing left, is dividend recaps and covenant light, and higher leverage and lower spreads. The lower end of the market, is an area that, as we have said historically, we find difficult to really get excited about because of the things that you just described. The venture industry, on the other hadn, and what we do, it is such a specialty practice that, yes credit knowledge is key and fundamental, but also technology understanding is by all means one of the most significant parts. So, not everybody can do what we do.

So people may want to try to come in the venture industry to chase yields. But it will be very quickly when they start realizing capital losses, because just because you are getting high yields does not mean you're getting high-quality assets. You have to make sure that you underwrite to that -- understand that discipline. Which we are one of the better guys doing that. We're not seeing a disproportionate increase in competition. In fact, we are seeing it the other way around.

We're seeing declining competition, which is continuing to allow us to, in essence, identify the right companies that meet our screens. As I said, we have a very, very strong pipeline right now of over $1.4 billion. But that does not mean that all of those companies will meet our credit criterias and underwriting criterias. We are able to continue to harvest what's the best of the best in that pool.

Great. Thanks, Manuel.

John Stilmar, JMP Securities.

John?

John, your line is open if you would check your mute button.

Okay, why don't we move on, and operate the next call then. Maybe he will come back on.

Robert Dodd, Raymond James.

Yes, hopefully you can hear me. A question on that competitive issue. You've said you would be willing to take a little bit of yield compression, obviously, to maintain quality. That has been a theme you have been on for a better part of a year. It is one thing to be willing to do it. Do you actually expect that compression to continue this year given the comments that you just made about reduction in some of the competitors out there in the space? And kind of tied in with that -- are you seeing changes in other types -- parts of the structure? I'm talking about (inaudible). Because, obviously you are not going to do a covenant light loan, or anything like that. But any more color that you can give us on that?

Sure. As we indicated, in 2012, at the beginning of the year, then, we started off the year indicating that we expected to see 170, 200 basis points expression in yield at the beginning of the year. I can tell you right now, from what I am seeing, and what we have in the marketplace today, I am not seeing that level of spread compression at all. I will tell you that on a quarter-by-quarter basis, having a swing of 30 basis points, up or down, is not necessarily unreasonable or unexpected to do that. But I am not at this point expecting to see a dramatic 100, 200 basis points compression in yields. And one of the things that we will say is, we are not interested in chasing those yields if that is even happening.

We have a very strong portfolio today. We continue to be very selective in what we're doing. There is no question that we're seeing some banks being a bit more aggressive out there. And frankly, we are fine with that. Doing $600 million plus of new origination activity, tells you that we are facing a very strong market, and we continue to do what we do well. There's plenty of transactions and deals that be had out there. Chasing yields is not something we're interested in doing.

Okay. Got it. I appreciate that. Thanks

Jonathan Bush, Wells Fargo.

Thank you for taking my questions. Manuel, you did mention and always have, your focus on credit quality. You also pointed out in earlier calls that sometimes you would be more willing to give up on warrant coverage in an effort to either supplement interest income or vice versa, depending on where warrants stand in the relative valuation scheme. What are you seeing today regarding warrants, and where does that fit in terms of placing down the bets that will pay off three years from now, in terms of equity upside?

I appreciate the vernacular -- the use of the word bets. But I am working with sheltered money, so I would prefer not to use the word bets.

Investments excuse me. (laughter)

It is a very good question, because you will see that appreciation in one area and my concern on another area, of that comment. For example, our legacy warrant portfolio in the technology sector has experienced a pretty handsome increase in valuation in 2012. Which means, I think that some of the technology opportunities are quite well valued. Which means that when I look at new technology opportunities in these companies that are so well valued, I'm more than willing to give up warrants because I have a lack of belief that the warrants will monetize in a significant value.

We are being very controlled in our investment activities in Technology companies, which is why you will see our technology portion of our portfolio slightly be underrepresented in the first half of 2013, as I think that the valuations in the private sector either adjust or catch up to some of the public side. That said, the life sciences side of the equation has experienced some pretty dramatic valuation adjustment. And we think that there are some pretty good opportunities in the life sciences area to make investments and we see some good capital appreciation in that area.

But you're absolutely right. The equation on overall yield is a function of what we believe the expectations on the exit on some of these warrant instruments that we underwrite to, and if we think that those warrants are well valued or over-valued, we will forgo warrants in lieu of, or in turn for fees are additional higher interest income. We continue to do that mindset, which is why you will see a change in yield quarter to quarter 20 to 30 basis points simply attributed to the OID factor, on taking more or less warrants.

Okay. Great. Thank you. That is great color. And then, a question early versus late stage investments, of course. Where do you see additional dollars flowing in, I mean that competitive dynamic the you referred to? And to the extent that we are approaching another M&A cycle -- I'll go from the middle market standpoint, with credit spreads where they are and perhaps private equity firms itching to deploy little bit of capital, as evidenced by some big deals only recently. Where would you see some opportunity in late stage deals that might be approaching liquidity events?

Late stage can be the tricky part because of the valuation issues. Obviously being a credit shop that we are, we first looked to enterprise value and loan to value analysis, more than economic returns on a equity instrument itself. Because if you cannot get your capital back, who gives -- who cares about the economic return of a warrant? We continue to remain very steadfast and look at the fundamentals of credit. And not get hung up on some of these banks we're seeing in the marketplace who are more focused on market share and talk about their prowess.

We still run an investment shop. So I do not don't understand what market share means when you are doing credit underwriting. So we remain very disciplined in that area. That said, there is an interesting growing market in the public orphan and public fallen angel companies that we have historically have not weighed in quite heavily, that we're seeing a disproportionate amount of unlocking of value in some of those public orphan companies that trade out there. We are not very game and very excited about looking at early stage companies right now. We think that those companies more than any other sectors are over-valued and the economics are not as attractive as we like them to be. We are more than happy to see banks continue to fill that void and continue to go after the early stage companies. It is that area that we are not allocating a lot of resources to right now at all.

Okay, great. Thank you. We would agree that slow and steady is the prudent investment strategy. You have demonstrated this past year and we look forward to 2013.

Thank you very much for the acknowledgement.

John Stilmar, JMP securities.

Not again, John.

(laughter) Really quickly. As we start thinking about your Business and the ultimate kind of ROEs, or targeted ROEs for it. And you obviously have not been a company, or designed a company that has been driven by ROEs. But I can't help but think that you guys delivered on a great securitization. Theoretically, this is the first of several that are probably to come over the next several years. You're an internally managed company that can drive operating leverage. Absent sort of changing your perspective of risk, shouldn't we start seeing some moderate ROE expansion over the next two years?

The answer is unequivocally, yes. And to be very clear, I think we saw ROE expansion just in the third quarter to the fourth quarter. I think you'll see additional ROE expansion as we deploy the additional liquidity that we have on our balance sheet. $180 million earning assets, I think that you will see an exponential kick to the ROE as that capital is deployed from basically negative spread cash to accretive earnings toward shareholders -- that that net margin that I spoke about earlier on the call would drop straight down the bottom line and driving the E in the ROE.

Perfect. Just another point of orientation for me. The venture finance business seems to be a relatively underserved segment. It is sufficiently small, given the overall scope of venture finance. In terms of the macro trends you are so good about laying out for us, how did those actually kind of feed back into the venture finance space in and of itself? Is venture finance as a whole, gaining market share, or -- given some of these changes, or is it more of the fact that there are these sort of changes out there and each company needs to position themselves appropriately, as seemingly you are engineering Hercules? I was wondering if you can put both those comments in context for us.

I can't help but to strongly emphasize this issue. What makes Hercules successful is the high caliber of individuals that we have. Those individuals, rightfully so, are highly cognizant individuals because they bring a combination of both commercial banking background, venture capital background, and technology underwriting and life sciences underwriting, knowledge and experience. Inasmuch as you underwrite credit as you underwrite technology trends and risks. Our team has to be intimately familiar with the changes and the technology and life sciences spectrum and world of what is going on out there. In other words, what we call the disruptive technologies.

What we do, is that we invest in tomorrow's companies today. When we make an investment, we have no idea whether or not these companies are going to be ultimately successful in their endeavors or not. These companies typically require a subsequent round of equity capital investments, that typically are done every nine to 14 month intervals. If you tend to underwrite this asset class, purely from a yield point of view, in a naive point of view, you will lose hundreds of millions of dollars. I have seen it happen throughout my entire lifecycle in this asset class.

The asset class is quite large and going -- and getting larger. It is expanding. As the venture capital industry contracts a bit and IPOs get more elongated from a liquidity timeframe, point of view or time horizon point of view, those later stage companies who are waiting to get acquiring or waiting to go public, are less reluctant to do equity capital raises and experience evaluation dilution or of evaluation decline in value, and are much more reticent and more willing to take on venture debt to continue to sustain their operations and continue to preserve value for their shareholders, especially in the early stage or seed shareholders that exist.

Third or fourth, not knowing what is going on on the broader spectrum from a competitive environment point of view. In other words, if you simply have business development officers who don't have a knowledge of the very sectors that they are involved with, which is why we're purposely divided in four segregated, dispersed, operating units, or I should say segments of reporting, clean tech, technology, life sciences, and special situation. Those four groups fundamentally operate autonomous from each other. They have four unique different underwriting characteristics, and they are staffed by individuals who have expertise in those particular verticals.

That is a very, very difficult thing to replicate. Many people can try to venture into the asset class. However, as you see over the years, we have grown in size because of the expertise and our disciplined approach. I do not see any real new threats coming into the asset class. If anything, I am seeing our franchise and our brand only getting stronger and expanding further.

Got it. Thank you for that time. I really appreciate you letting me ask my questions.

Thank you.

Aaron Deer, Sandler O'Neill.

Manuel, you were just talking about the importance of your lending teams. On that subject, how many staff do you have that our are front-line business development officers today versus say a year ago?

This is all obviously at zero. We have origination teams that either credit or technologists in their focus. We have a total headcount at the Company, last check, of 53 or 56 people, of which, I think 27 are forward or outward facing origination team, whether it's associate analyst, managers and directors principles that are all focused on credit and credit monitoring and credit underwriting or new loan originations, if you will. It is almost 50% weighted of the Company in that outward facing origination activities.

How does that compare to where you were a year ago?

One of the issues to your questions that we have to be careful in trying to imply a straight analysis. We have different people in different levels of maturation as investment professionals, or loan officers if you will. And so our more seasoned individuals have a higher expectation on both credit monitoring and portfolio performance and new asset origination, than some of our newer folks.

It typically takes six to nine months, minimum, for somebody to get conditioned to the Hercules underwriting methodologies, and to identify investment opportunities and credits that meet our criteria. So, we invest quite a bit of time in our people in that six to nine month period of time, before they become what we consider productive and accretive on the bottom line. And so on that level, we have probably seven to nine -- yes, seven to nine is probably the right number -- of senior people who have the capability to be highly accretive investment officers identifying new investment opportunities.

And then going back to the discussion on the securitization. I'm curious. How do you view your willingness and ability to do more of those? Obviously, it is a great source of low-cost funding, but it seems a little bit of at odds with some of your recent efforts to extend into longer-term funding sources. So I am curious to get your thoughts on how you view doing more of that type of funding.

I'll be very blunt. If I can originate cost of capital at 3.2%, and I can create a longbook at 13.3, I'm arbitraging at a 1,000 basis point net spread. So, yes. And remember, the important part of the securitization is that it matches the short-term to short-term financing. As you may or may not remember, although we underwrite for a 36-month duration on our credits, the average term,- or the average outstanding is about 22 to 24 months. The matching of short-term to short-term liabilities to asset side is quite good.

Our strong preference still remains to focus on laddering out the maturities. We are not going to be only a short-term dependent securitization shop. I do not think that that's prudent. I like the long-term capital planning that the baby bonds offer. Is really going to be a complementary strategy, not and all -- all strategy at the cost of giving up baby bonds or other sorts of debt financings.

Another final point to remember is that a BDC, is inherently has a limitation of debt to equity leverages. Even us today, once we fully convert our $180 million of liquidity, we only have optimal available if we go to 144% leverage, only $145 million. However, our preferences is, as I have said more than once on these calls, our preference on the GAAP basis is to take $120 million to $125 million on a GAAP basis. Which I talked about, not to confuse everyone on this call, when I talked about a net leverage we are at 80 basis points today -- sorry, yes, 80% today. So I have basically another 40% of leverage to go after before I start running into that self-imposed glass ceiling of $1.2 million to $1.25 million. We're managing our liabilities and source of fundings quite closely.

That is helpful. Then lastly, on the credit. Obviously you had some good trends again this quarter, with the three collateral based impairment reversals. I'm sorry. I think there was three of those, as well. There were three small impairments. I'm just wondering, are those due upcoming funding rounds that are approaching for those borrows, or is there something else that might have driven that?

When you have, I think our active borrowers today are, I want to say 85 or 87 companies. We deal with risk all day long. What we do is probably nail biting for the lower, middle market asset class. Our expertise is understanding the technology trends and the ebbs and flows that happen there. As I said, and to reinforce it again, it is not untypical for 90% of the portfolio companies to be cycling through our next equity round of financing and find themselves near a zero cash balance on their balance sheet and need to raise another equity round of financing.

That is the normal course of business in what we do. As that happens, we will automatically downgrade the credit from a two to a three, and if it warrants a down to a level four, if we do not see much more tangible evidence of a term sheet or an equity round, or an exit event happening to ensure the mitigation of our down side principal risk that we have.

As to your specific question, there is not one of those companies at this point that represents a significant issue, other than one larger credit that we may have, that is something that we are monitoring closely, but the company is actually engaged with a transaction that just like you saw in the third quarter with some of our life sciences companies, in the next 60 days or so, is probably something that may be fully mitigated.

So, at this point, from what we're aware of those small market adjustments or collateral impairments that you're thinking, those are not issues that I am ultimately concerned about and they will normally cycle through. Just like we saw in Q3 to Q4, in these life science companies, these two technology companies in particular, I think that we will start seeing rays of sunshine in that 60 to 90 days.

Okay. That's great. Thanks for taking my questions.

Kyle Joseph, Stevens.

Good afternoon, guys. Thanks for taking my question. And congratulations on a great quarter. Manuel, can you tell us about what drove the accelerated deal activity, accelerated credit demand that you guys saw in 4Q '12. I don't imagine that you guys had as much of that driven by potential tax changes. Was there something else driving it? Or was it just the general recovery of the VC markets? Or can you break that down?

No, I actually -- I loosely think that a lot of it was a sigh of relief that we got this horrific election behind us. Whether you support the President or you do not support the President, at least you have some level of confidence that you are going to see higher taxes or a lack of government or what have you. So I think that there is a bit of relief that we had this issue behind us, and capital was able to continue to be deployed and invested.

Sequestration, still, is a bit of an overhang. It is hard to say how that is going to play out, which is why, again, like we did in third-quarter going into fourth quarter, a little bit. We're holding back some of that liquidity and not going out of the fulfilling all of the opportunities that we see before us. We want to preserve some dry powder going into the sequestration black hole. But I think that the venture industry got a little more confidence when the election issue was resolved. Whether they support Obama or not. It has nothing to do with that, but at least some level of uncertainty was now resolved. And I think that more than anything, that led that.

Got you. Thank you, there. And then, can you give us a little idea of your average investment size and how that has changed as your portfolio has grown so much?

I still think that the average portfolio deal remains pretty static at the $8 million to $10 million level. I do not think that I have seen change in that average number now for probably eight quarters. Maybe longer. We have some outliers, but I think that the granularity still remains in the portfolio.

All right. I think this one is for Jessica. Could you break down the fee income for the quarter a little bit between origination versus repayment fees?

I think you can back into that when you take a look at the effective yield with and without early payoffs, or one-time events. But I don't have the dollar total printed -- I can get to it.

No. I can back into that.

We can certainly follow up for you on that.

Okay. I have not had time to spin through the K yet, did anything change with the nonaccruals in the quarter?

No. We still have that one small investment on nonaccrual.

It is beyond insignificant.

Right. It's $350,000 cost basis.

Yes. And then for the $0.03 spillover, do you guys envision doing something of a special dividend or just contributing that to quarterly dividends this year?

You know, we remain pretty steadfast in our historical response to that. We think it is better to pepper that additional earnings. And subsequent quarterly earnings than just simply distributing it out in one quarter as a special dividend. So our philosophy, or I should say, the Board's philosophy still remains that we would rather create it over economic life of 2013.

I guess that makes sense. And in what was the new coupons on the refinanced SBA that you had done recently?

I think the base interest rate was 2.8%, and when you add in the fee costs, it is around 3.2%.

All right. That is all I've got. Thanks for answering my questions, guys.

You're welcome.

Douglas Harter, Credit Suisse.

Can you talk about the benefits that you might get from the continuing to grow the size of the portfolio? And sort of balance that off with the fact that SBA -- the attractive SBA debt can't grow anymore? And how you think about the prose and cons of those two things?

Sure. As we all know, and to be cynical about this comment, there are two critical bills in front of the Congress. One is increase a BDC leverage from one-to-one to two-to-one, that if passed would be highly accretive. And then the second bill, which is more impactful to your question is raising SBA debt limit from to $225,000 to $350,000. That passed actually passed the House, so it passed the Republican House. And I find it incredibly ironic that it is delayed in the Senate by Democrats. This is baffling to me. Because it doesn't add to the debt and it actually helps the economy.

The SBA debt ceiling of $225,000 going to $350,000, a lot people still believe that actually will happen. That said, the issue on spreads, we think are quite attractive when you are borrowing long on SBA at 3.5% to 4% on a weighted basis and lending long at 13%, 13.5%. And I apologize, what was the first part of your question?

I was recognizing that attractiveness of that financing, and how you balance that with growth -- growing the total portfolio, absent Congress actually doing something.

Sure. The other part of your question is important to note. Is that not necessarily all of our assets are well-suited or fit the SBA underwriting criteria. One of the things that we are constantly cognizant of is making sure that we are not overly liquid on the SBA, SPV, the Special Purpose Vehicle that holds the SBA assets.

And so, today, for example, we have a little bit more weighting in cash with the SBA buckets, which means that we need to make sure in order to optimize, which is why the $180 million I talked about earlier, may not fully be deployable. Some of that $180 million is resident in the SBA, which means that account can't be used for general corporate but it must be used for assets under the SBA program. So there could be a timing delay on optimizing the balance sheet to fully deploy excess cash, some of which may be located in the SBA, causing that little bit of lag effect.

Overall, we see a very robust opportunity to deploy the excess liquidity of the $180 million in cash certainly by the end of the first half of 2013, into earning assets. Which would equate to about 20% growth in the loan book and could equate to $0.20 at earnings on an annual basis.

Great. I appreciate that color, Manuel.

Thank you.

Greg Mason, KBW.

Great. Thanks. Manuel, I wanted to talk a little bit about the securitization again, and you said you had to work a lot with Moody's to educate them. And this first CLO, there is no reinvestment period, I think you said, weighted average life of a little over one year. So two years from today, this debt will be gone. I assume that you want to this securitization again. Do you think as Moody's gets more comfortable with this, there can be any potential changes for securitization number two or three? With regards to reinvestment periods and length of the securitization debt?

So, most of you know, me, I'm going to ask for everything as much as I can, on day one. But to Moody's credit, they said unequivocally no to me on various occasions on some of these requests. That said, to Moody's defense, there comment was, let's crawl before we run. And there's no question that our intent, working with Moody's, is to continue to work with them in developing their models and their better understanding of asset class to, in fact, ask for a reinvestment period and a longer duration of the next securitization.

Whether that securitization is number two or number three, I don't know. That is fully subject to Moody's and Moody's solely. There's no question that we're going to ask again and try to seek that out in some of the subsequent securitizations that we do. It is a pivotal part of the equation, just like you recognize it to be.

Great. Thanks, Manuel. Good quarter.

Thank you very much.

Jonathan Bush, Wells Fargo.

Bush? Jonathan Bock. Thank you. Just one quick follow-up, Manuel.

You're French.

Oui. Je suis français. We could talk really briefly, you said the use of cash by 2013. But Manuel, you have also been very opportunistic in terms of equity capital. That can accrue to the benefit of the investors because you choose to protect the balance sheet, and we do understand that. In light of valuation, can you maybe talk about where you sit on that front? Only because, while portfolio growth would occur, also the underlying share base, and splitting that benefits of additional leverage with new shareholders does dilute earnings. Maybe just a few comments on what you see on the equity capital front in light of the high cash balance.

My first comment is, that I think there is a timing on equity earnings dilution as you have the equity capital raise and then at what the capital raises is deployed and earning assets. If you look at our discipline for the last seven plus years of our history, a little longer than that, I remain very steadfast, whether this philosophy is embraced by others or not. And that is that I believe that you raise capital, whether it is debt or equity, when the market affords you that opportunity; however, only if and when you can deploy that capital in the preceding one to two quarters out.

One of the things that makes the internal managed BDC very important, is that it has no economic incentives to raise capital just to raise capital. And since we are incentivized and in-line our stakeholders -- our shareholders, we are hyperly cognizant of having significant drag on earnings unnecessarily simply for a capital raise.

That said, when you look at our balance sheet today, it's not a secret that sometime in the next duration of time -- I do not know what that is -- it all depends on when we end up deploying our cash investments, that because they're approaching the magical ceiling of 1.2 to 1 debt to equity ratio, that if we so choose to continue to grow because there's attractive opportunities in the marketplace, then a small equity capital raise maybe imminent.

But that is all entirely contingent upon sequestration, the pipeline, where are we on our capital deployment, and a lot of different characteristics. But the fact of the matter is that we are approaching that GAAP mythical cap of 1.2 that we placed on ourselves that may indicate a propensity to look at doing a small equity raise, if that is something that we could deploy in a very short order.

Great. Thank you.

Thank you. That does conclude our Q&A portion for today. I would like to turn it back to Manuel for any concluding remarks.

Thank you, operator. And thank you, everyone for continuing your interest and support in Hercules Technology Growth Capital. Very, very happy to report a very, very strong quarter for our shareholders. And, more importantly, also an increase in dividends to our shareholders as we promised we will be doing. And I expect to continue to do it throughout 2013. So to the market not falling out or some unforeseen event. As always, I want to sure that our shareholders are aware that we're more than happy to entertain discussions with you. And anybody who would like to engage in additional conversation with us, you're welcome to contact our investor relations department or contact Hercules directly to schedule a follow-up conversation or a meeting. Thank you much for your time and thank you for being one of the Hercules shareholders. Operator?

Thank you, ladies and gentlemen. This does conclude your conference. You may now disconnect and have a great day.