Hercules Capital Inc (HTGC) 2013 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Hercules Technology Growth Capital Q4 2013 earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions). As a reminder, today's conference is being recorded. I would like to [introduce your host for the conference call], Ms. Jessica Baron. You may begin, ma'am.

Thank you, operator, and good afternoon, everyone. On the call today or Manuel Henriquez, Hercules' Co-Founder, Chairman and CEO; and myself, VP of Finance and Chief Financial Officer.

Hercules' fourth quarter and full year 2013 financial results were released just after today's market close. They can be accessed from the Company's website at www.htgc.com. We have arranged for a replay of the call at Hercules' web page or by using the telephone number and pass code provided in today's earnings release.

I also 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 due to timing delays between the date of this release and in the confirmation and final audit results.

In addition, the 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 from those expressed in the forward-looking statements, including without limitations the risks and uncertainties including the uncertainty surrounding the current market turbulence and other factors we've identified from time to time in our filings with the Securities and Exchange Commission.

Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate, and as a result the forward-looking statements based on those assumptions [could also be incorrect]. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained in this release are made as of the date hereof, and Hercules assumes no obligation to update the forward-looking statement or subsequent event.

To obtain copies of related SEC filings, please visit sec.gov or visit the website www.htgc.com.

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

Thank you, Jessica, and good afternoon, everybody, and thank you all for joining us today. We're going to try something a little different in the call. We're going to try the make the call a little shorter, try a little -- slightly different format, and also I would like to get folks feedback as we try this new format of the call and to allow a greater time for Q&A. So let's see how this tries and works out.

I'm encouraged to share with you the feedback of our performance -- excuse me, I'm encouraged to share with you our reporting on our performance for 2013 and Q4 2013. With that said, we had an exceptional year, and a fantastic quarter, and ending up a tremendous year for Hercules in 2013.

We delivered record new originations of over $700 million and delivered an impressive year-over-year total investment income of $140 million, representing a 43% increase over 2012. In addition and equally as impressive was our growth our net investment income, or NII, of $73 million or 52% over 2012.

As for the agenda today, I plan on doing a brief overview of our operating performance for Q4 2013; a quick overview of the current market conditions, including venture capital investment activities, IPO and M&As, as I usually do; and a prospective on our outlook for Q1 2014, and the entire period of 2014, including the potential realized gains for $[260] million that are of course conditioned upon market conditions remaining in place as they are today. And then of course I'll turn the call over to Jessica to provide a lot more details on our financial performance.

Now let me start by talking about 2013. As I said earlier, it was an excellent year for Hercules. Our strong performance was driven by our continued focus on maintaining high asset quality and strong balance sheet position and liquidity.

We are also not simply interested in originating -- to originate earnings for earnings growth purpose and not willing to sacrifice our balance sheet, which is why you'll see an increase in cash balances today. We remain very selective in our investment approaches, and we'll continue that discipline for at least the first half of 2014.

I would like to remind everybody in early December Hercules celebrated its tenth year anniversary. It is a proud achievement that during that ten year period of time we've now originated over $4 billion of commitments to 260 innovating venture capital backed companies since our inception. We've established ourselves as a strong market leader, and good relationships and strong deal flow from the venture capital community as well as from the entrepreneur community in allowing us to build the success in this portfolio.

We also have done this with a very strong and impressive credit performance. As of 2013, I am proud to say our total credit losses since our inception net of realized gains are approximately $32 million. This equates to approximately 9 basis points on an annualized basis over a ten year period of time. Simply astounding and a great achievement on our team and our ability to select and pick the right credits.

As I said a minute ago, 2013 was also a record year for us on originations, with over $700 million of new commitments achieved during 2013. We continue to work diligently to increase net investment income, and as I said, we achieved a $73 million net investment income, representing an increase of 52% over the same period 2012, and a 27% increase on an EPS basis to $1.22 per share.

After spending ten years of making investments, we have finally begun to see the fruits of our labor. 27 liquidity events were completed in 2013, five of which were IPOs, 22 of which were announced or completed M&A events. This begins to show our ability to continue to identify the most promising companies and achieving a solid credit performance and exit of our investment decisions -- investment choices that we made.

I would also like to share with you that 2014 -- in the short two months of 2014 the robust exits in our portfolio continue. We already have four completed IPOs in the first two months of the new year, and we still have another five companies in IPO registration today, most of which have filed under the JOBS Act. That is a testament to our team's continued perseverance in identifying the most promising companies to invest in.

Now turning my attention to operating highlights for 2013 and Q4. Q4 NII of $18.9 million, representing $0.31 per share, an increase of 44% year-over-year. DNOI for the quarter up 44%, representing $20.5 million or $0.34 per share.

Because of these financial achievements, our Board of Directors declared a dividend of $0.31 per share. We continue to see a very robust it market and continue to be encouraged by the continual liquidity events in our portfolio that we expect to see in 2014.

Turning my attention to portfolio growth. New commitments during the quarter were approximately $126 million, while fundings were equally strong at $79 million for the quarter. Our activity and principal repayment, albeit high, and although we discussed in Q1 -- sorry, Q3 was approximately $141 million, driven in no small part by very robust M&A market that drove a lot of these early payoffs as well.

Of the early payoffs, $104 million of that was anticipated to occur and attributed to anticipated early payoffs, and then we had another approximately $35 million or so in normal amortization that took place during the quarter. Overall, the portfolio declined $77 million, well within the range that we guided, between 50 -- sorry, $60 million to $80 million in Q3.

We finished the quarter in the year 2013 with a very strong unfunded commitment. Our unfunded commitment balance was approximately $151 million. This number becomes important because it gives us visibility to potential portfolio growth embedded in-house with transactions that are waiting to be funded. I would also like to remind everybody not all $151 million is expected to be funded. A big portion of that is tied to demonstrated milestone achievements by the underlying company itself.

Credit. Once again a very important tenet of Hercules is our credit and our credit history and performance. Our historical strong credit performance continues, as we took advantage of a very frothy market,we took advantage of divesting many marginal credits and improving the credit outlook for 2014. Credit remains at stable to very -- to strong, with only one major credit on our watch list. We remain steadfast and diligent in monitoring credit and continuing to take all necessary steps to preemptively and proactively address early signs of credit trouble.

Yields. Despite many of our [BDC] peer groups, Hercules continues to experience increase in yields [in its] overall portfolio. We experienced a 40 basis points increase in yields from Q3 to Q4 at 14.7%. This is achieved in part by rebalancing the portfolio, divesting of marginal credits, and focusing on underwriting strong credit quality investments, and being very tenacious on how we deploy cash if transactions do not make sense or yields are too low.

Because this focus on credit and yield, we finished the year with approximately $268 million of capital, which allows us to continue to make new investments when we see the appropriate time to do more aggressive originations in the marketplace today.

Moving towards the balance sheet. Starting in 2011, we worked on diligently diversifying our source of funding and broadening our source of liquidity on our balance sheet. That was culminated with the issuance of a [first convertible bond instrument]. In 2012 we worked diligently to expand that by offering both [baby] bonds and completing our first securitization.

We have worked diligently throughout that period of time to ensure [that we have] a strategically positioned balance sheet, wide access to multiple sources of liquidity, while also focusing on lowering our [over] cost of capital and positioning [us] Hercules to be the lender of choice by offering the most attractive financial solutions to our companies. Today Hercules is one of the best positioned BDCs.

In the event of rising interest rate in the [lapsing] of QE3, over 99% of our current investment portfolio is priced at floating rate interest rates, either a prime or LIBOR based rates, with floors as well. Equally important is managing our right-hand side of the balance sheet, our liabilities. We have worked diligently to ensure that entire liabilities that are currently outstanding are fixed rate in interest rates and have no principal amortization, with the exception of securitization, until April 2016, allowing us to have a well positioned and well prepared balance sheet to execute on the originations while benefiting from any increase in rates that may occur in the market for the benefit of our shoulders and to our EPS.

As of 2013 year end, we had a very strong balance sheet, with over $370 million of liquidity, $260 million of that in cash. I would also like to remind our listeners, for every $100 million of cash that we convert into earning assets, the impact on annual basis to NII is approximately $0.15 to $0.17. With over $260 million of cash, that would equate to approximately $0.40 to $0.50 in earnings if and when we choose to make those investments and convert the cash balances.

Now turning to exit and liquidity events in our portfolio. As I said, 2013 was an outstanding year. It was remarkable with 27 announced and completed liquidity events [generating] some healthy realized and unrealized gains in our warrant and equity portfolio for the benefit of our shareholders and improving our net asset values. We finished the year with over 110 warrant positions and over 37 equity positions in our portfolio.

Q4, we had one IPO event completed with ADMA Biologics, and we finished the year with approximately five companies [that had] IPO registration. At the beginning of the year, as I said earlier, four of those five companies completed IPOs in the first two months of 2014.

Because of this continued visibility into our IPO pipeline and our warrant monetization of our portfolio, I believe that 2014 could be a tremendous year for Hercules. We can see realized warrant gains in the range of $20 million to $60 million with a handful of companies that are currently in IPO registration or have recently completed IPO registration. That ignores the over 110 positions we held in our warrant and equity position today.

2014 could represent even more outside if the market continues the way they have been in the first part of 2014. 2014 is off to a great start, and we're very, very encouraged by the IPO liquidity event. And in fact two of our companies that recently went public have been tagged as one of the fastest growing IPO companies that we've had. Dicerna and Revance are the names of the companies.

M&A was equally strong, both in the 2013 year as well as Q4. Western Digital completed the acquisition of Virident Systems, netting a $7.5 million gain for Hercules. Biomet acquired Lanx, generating a $1.9 million realized gain for Hercules. And in Q4 -- excuse me, and in Q1 2014 Teva Pharmaceutical acquires NuPathe. [Seeing] this level of activity helps to reinforce the belief that we are finding some of the best and brightest innovative venture capital backed companies in the marketplace and doing the top quality job of underwriting.

I'm very encouraged by the [upside] and potential from our warrant portfolio. With over 113 warrant positions valued at approximately $36 million as of year end, with historical range of exits [monetization] of that warrant pool of one to 14X multiple. As attractive as that may sound, I feel compelled to once again share with our investors that you should not assume a 14X return on our warrant pool.

We think that the more moderate return to be anywhere between 3X to 5X, and also in keeping with our conservative position we do not expect 50% of our warrant portfolio to [ever] monetize into any value whatsoever. It is important for you to keep track of that.

As I indicated earlier, we expect this monetize of 60 -- $20 million to $60 million to be achieved by simply a handful of companies. I want to be cautious as well. We invest in disruptive technology companies that are -- require future rounds of equity capital, and that equity capital is not certain at all times. I feel it's important to remind people that ventured lending is a risky asset class, and it requires a strong understanding of the asset class and years of experience in underwriting the asset class.

Venture capital marketplace activities. The story of Hercules would never be complete without fully understanding the ecosystem of venture capital. Fundraising activity in Q4 by the venture capital industry was quite strong, with $4.5 billion, up 9% year over year. On annual basis the venture capitalists rate $19.7 billion, albeit slightly down from the $21.9 billion raised in 2012. Nonetheless, quite encouraging sign of nearly $20 billion of capital raised by the venture capitals to invest in new companies.

More impressive however was investment activity. In Q4 the venture capitalists invested $8.9 billion in new investments. For the year the venture capitalists invested $33 billion in 2013, up from $32.8 billion. Clearly, this growth in venture capital activity was fueled by a very strong IPO market and M&A market, with nearly 3,500 companies [completing] financing events.

In terms of stages of development, once again Hercules sweet spot and focus area, 59% of the capital was invested in later stage company, while early stage and seed investments received a mere 19% of the capital. Second stage received 21% of the capital.

In terms of business segments, we also seemed to match what Hercules has been focusing on. Business services received a large component of the capital in the first quarter, at $4.5 billion. IT continues to see a decline, at 20 -- at $1.7 billion, down from $2.4 billion in the prior quarter and also reflective of Hercules' own portfolio as we continue to decline our technology investments for many reasons.

That said, IT received 28% of all the capital invested by VCs in 2013, while business services received 24% and life sciences yet again equaled the same investment activities as IT at 28% of the capital being deployed. Northern California remains the highest category or sector in the country receiving venture capital. And interestingly enough, where Hercules has regional offices in Mid-Atlantic and New England, Northern California received 36% of the venture capital dollars, while the Mid-Atlantic region, our most recently new office, received [18]% of the capital and New England received 14% of the capital itself.

Now, IPO exits, something that we all care about as we see and continue [the] monetization of our portfolio. 2013 by all accounts was a very impressive showing of venture capital exits, with 74 companies achieved IPO events, raising $8.2 billion. A level of IPO activity not seen since 2007, and I'm quite encouraged by that activity.

M&A remains robust, with 122 companies completing M&A events, raising $12.5 billion for the Q4. For the year the M&A market was a strong presence at $39 billion of M&A activity in the marketplace today.

Finally, turning my attention to our performance. Because we're building our cash balances right now and because we continue to underinvest in technology, [you will] -- I expect to see Q1 earnings to be down between $0.02 to $0.04simply because we're sitting on a higher cash balance than we had initially anticipated, because we do not like some of the underwriting parameters or pricing that we're seeing in the marketplace today.

However, I believe that over 2014, we will more than make up that amount over the year as we continue to deploy our cash balances. We continue to see very frothiness in the market. We're seeing banks being overly aggressive on transactions, and we're beginning to see some signs of yield compression in the marketplace.

We're seeing weaker underwriting standards being applied in the market, and with that we have chosen to wait out this current frothiness and not follow suit and doing marginal quality underwriting transactions. We expect our portfolio in Q1 to once again [light] down by about $50 million; however, I like to caution that that number has a $20 million plus or minus swing attributed to early investment or investments that we choose to close earlier. But as of this point we're expecting to see a $50 million step down in portfolio from Q4 to Q1.

As we continue to reduce our exposure in certain sectors, we will continue to rebalance our portfolio, which is also contributing to the portfolio step down of $50 million. There are certain industry sectors that we are divesting ourselves from and certain stages of the companies that we're purposely avoiding for the time being.

That said, as of February 24, our pipeline remains extremely strong, with over $1.4 billion of companies seeking financing and capital from Hercules. We remain extremely judicious in our underwriting standard and maintaining credit quality the way we have, and we refuse to play the yield game by reaching down to buy transactions or giving up yield, at least for the time being.

Signed term sheets are approximately $112 million. We expect to see nearly all that $112 million converted by end of Q1, and so far in Q1 we've already closed $46 million of closed commits for the year -- for the first quarter, excuse me.

Now in summary. 2013 was a heroic -- a historic record year for Hercules. We worked diligently to ensure that our shareholders realized total shareholder return, or TSR, exceeding 55%, making us one of the top performing BDCs in the marketplace. We know what that means from a responsibility point of view, and we're very focused on maintaining high credit quality and high investor return for our shareholders.

As the venture capital marketplace continues to pick up both in capital raising and capital deployment and exits, we expect to see continued monetization of our portfolio. As I indicated, $20 million to $60 million of potential realized gains could be realized in 2014, assuming the market conditions remain as strong as they've been.

We continue to focus on expanding our strategic direction. In 2014 we expect to make some major announcements on strategic initiatives that we're working on. We are working on expanding our product offering, our strategic partnerships, and including potential acquisitions of certain portfolios. We remain very judicious in those underwritings, and we're also very, very aware that we need to expand our product offering and service the needs of our portfolio companies, especially in the event -- [advent] that we're seeing bank competition.

With that said, I am very encouraged about 2014. I think that we will see a tremendous portfolio performance in 2014 as we convert our earning assets, most likely in the second half of 2014.

We had another interesting development occur recently that's encouraging, and that is two of our competitors have now shuttered their operations and have shut down and are in liquidation mode. As we maintain our discipline, we think that the venture debt category will continue to consolidate further and affording greater yield expansions in the second half of 2014.

With that I'll turn the call over to Jessica.

Thanks, Manuel, and thanks everyone for listening today. I would like to remind everyone that we filed our 10-K as well as our earnings press release after the market closed. And I'll briefly discuss our financial results for the fourth quarter of 2013.

Turning to operating results, we delivered total investment income or revenues of $33.2 million, an increase of 21.2% when compared to the fourth quarter of 2012. This year-over-year growth was driven by increased interest income from higher average outstanding balances of yielding assets year-over-year.

We had also increased the income attributable to early pay-offs of debt investments, which totaled $105 million during the fourth quarter. Note that our period end debt investment balance on a cost basis is $835.9 million, a decline of $74.5 million during the fourth quarter of 2013.

The [all in] GAAP effective yield on our debt investments during the fourth quarter was 15.1%. Excluding the income acceleration impact from early pay-outs and one-time events, the effective yield for the quarter was 14.7%, up approximately 40 basis points relative to the previous quarter. We don't expect yields to trend much higher beyond Q4 based upon what we're seeing in the marketplace today.

Interest expense and loan fees were approximately $9 million during the fourth quarter of 2013, as compared to $7.5 million during the fourth quarter of 2012. Though quarterly increases primarilyrelated to interest and fee expense related to the asset-backed notes we originated in December of 2012, these notes resulted in a year-over-year increase of approximately $90 million in weighted average outstanding debts during the quarter.

Our weighted average cost of debt comprised of interest and fees was approximately 6.4% during the fourth quarter of 2013, versus 6.3% during the fourth quarter of 2012. This slightly higher weighted average cost to debt is primarily attributable to an increase in fee amortization due to early pay off [in the full outer] pool of the asset-back notes, which is partially offset by a decrease in interest expense, also attributed to the same notes.

Operating expenses for the quarter was $5.3 million as, compared to $6.9 million in the fourth quarter of 2012, and this decrease was largely driven due to [decrease] in variable compensation accrued during the quarter year-over-year. Q4 of 2013 net investment income was $18.9 million, compared to $13.1 million in the fourth quarter of 2012, representing an increase of approximately 44%.

Net investment income per share was $0.31 for the fourth quarter of 2013, as compared to $0.25 for the same quarter [ended] 2012. We recorded approximately $3.6 million of net unrealized appreciation from our investments during the quarter. Of this total, $13.9 million of appreciation was due to market or yield adjustments in [fair] value determinations.

Approximately $600,000 in [that] appreciation was related to the reversals due to loan pay-offs and liquidations and sales of warrant and equity investments. And approximately 10.9 million of depreciation was primarily attributed to collateral based impairment on a debt investment with an Internet and business services portfolio company.

Our net realized gains for the third -- for the fourth quarter was approximately $3.5 million. We recorded $15.1 million of gross gains, primarily from the sale of warrant and equity investments in six portfolio companies, and this was offset by the liquidation of investments in 11 portfolio companies for gross realized losses of about $11.6 million.

We ended Q4 of 2013 with total investment assets, including warrants and equity, at a cost basis of approximately $906.3 million. Andas mentioned before, this was [net] down by $77 million from our investment portfolio balance of $982 million as of September 30, 2013.

The current quarter decline was a result of principle payments of $141 million, $7.8 million of reductions due to the sale of investments, and $10.7 million due to the write-off of investments. And this was offset by approximately $80 million of new debt, equity and warrant additions to the portfolio as well as $3.1 million of net fee accretions. In addition, Hercules recorded approximately $3.6 million of the net unrealized [accretion] which I just described.

I'll remind everyone that amortization typically commences nine to 12 months after an interest only period we have on our term loans, and then the amortization is scheduled to occur over a 42 -- 36 to 42 month time frame. Apart from early repayments, we currently have scheduled amortization of $35 million to $40 million on our portfolio on a quarterly basis.

Moving on to credit quality, our loan portfolio credit quality remains very solid. The weighted average loan rating on our portfolio was 2.20 as of December 30, 2013, reflecting a slight increase from 2.13 reported at the end of Q3. We had two investments on non-accrual at the end of the quarter, with a cost basis of 30 -- $23.2 million and total fair value of $12.6 million, representing less than 1.4% of the total investment portfolio at fair value.

On to liquidity. As Manuel mentioned, at the end of the third quarter we had approximately $370 million in available liquidity, which includes $268.4 million in cash and $105 million of credit facility availability. As of December 31 our debt-to-equity leverage ratio, including our SBA debentures, was 85.8%, lower than 88.6% as of September 30, 2013, due to our net asset [value group] and approximately $13 million of pay-downs on our asset-backed notes.

A reminder our $225 million of SBA debentures are excluded for regulatory leverage calculation purposes. The exemption effectively allows us to leverage beyond a one-to-one debt-to-equity ratio to 1.34 to one, which means that approximately at the end of the year we had additional capacity to add $317 million of leverage to our balance sheet. Our net leverage, which is calculated based on total debt minus cash, is approximately 44.5% at the end of December.

Our net asset value at December 31 was $650 million or $10.51 per share compared to approximately $643.4 million or $10.42 per share as of September 30, 2013. Finally, consistent with prior quarters, we'll be distributing a dividend of $0.31 to our shareholders, and this payment is scheduled for March.

To note on our debentures, we're currently strongly considering repaying approximately $35 million of SBA debentures this quarter, and these have a stated interest rate of around 6.4%. The Q1 impact, should we choose to do this, will be about $0.01 in the first quarter. That will be a drag on earnings as a result of accelerating unamortized fees on these debentures. And going forward, should we decide to do this pay-down, starting in the second quarter, the quarterly benefit will be about $0.01 to earnings as a result of interest expense savings.

So in closing, as Manuel mentioned we continue to take a cautious and steady approach to onboarding new assets in the first quarter and the first half of 2014. And as he mentioned we expect our weighted average portfolio balance outstanding for the debt portfolio to be about -- down by about $50 million in the first quarter. But we do remain committed to our strategy of controlled growth, and we intend to continue to apply our stringent underwriting standards, which have resulted in our stellar first ten year performance and historically low historical loss rate as we enter this new year.

So wit that, operator, we're now ready to open the call for questions.

(Operator Instructions). Our first question comes from Greg Mason with KBW.

Manuel, I wanted to touch on your last topic there about competition. You mentioned banks and other things, and obviously you got some new entrants, like [Aries, The Street]. I think TriplePoint is out trying to get an IPO done. Can you just talk about the competitive landscape and who are -- who is pressuring prices, it sounds like?

Well, the three you mentioned are not at all causing pricing pressures. The pricing pressures are come coming more from commercial banks, who are to me desperate to book assets in this environment, given their continuing swelling deposit base.

And I personally think that we're probably in the early stages of a C&I bubble, and no different than probably -- going to end no different than the mortgage crisis did with some banks. I think that the amount of risks that I'm seeing banks taking on right now for some companies is unprecedented, and we're just basically not going to play that game. We're choosing to wait it out, preserve our balance sheet, and we're seeing transactions that are beginning to look extremely silly in the marketplace.

We've heard commercial banks with the new regulatory rules, particularly leverage loans are potentially having to pull back. Is there anything in the regulatory guidance that impacts your market in the VC rending market over time?

Well, there -- obviously these is. There is changes that are being contemplated in congress alone, having a 2X leverage on BDCs. I know some BDCs -- I won't name who they are -- view that as a negative issue. I actually happen to believe that seeing a 2X leverage in the BDC industry will help drive loan growth, which will help drive employment in this country. So I think it's actually a good thing to increase BDC leverage.

I also think that banks are doing a heavy job of lobbying against that because it's viewed as a threat to banks, given the fact that the Volcker will start kicking in on some of these banks on the higher leverage transactions. As you say, you have one test, which is leverage transaction, and you have a six EBITDA multiple or greater, that's high leverage transaction with high reserve requirements.

So I think it's too early to call it. I think that I'm personally waiting to see a little shake out on credit, assome of these deals are being done what I consider to be marginal underwriting. And as I've been doing this as long as I have, when I see a market like this, the greatest thing that can happen is a nice good credit shake out, and you'll see how that thins the heard quickly on competition.

Great. And one question on the interest income. Look at early repayments were similar last quarter and this quarter, 3Q and 4Q, yet the interest line went from $36 million down to $28 million. I was kind of surprised to see that decline. Could you talk about anything that was unusual movements, either high last quarter or low this quarter? Given the [repayments] were similar?

Well, I'll let Jessica answer, but to answer your question, it's a little bit of both.

Right, that's true. I mean, again, it comes down to the composition of which portfolio companies are paying [us] off. If they happen to be further in their lifecycle, and then we may have done a material modification to the loan earlier in its lifecycle, which would have resulted in some fee recognition at the time of the modification. So it's generally driven by the composition of who it is that's paying us off, and [as it happens] some of the larger credits that were in our portfolio at a more mature age happened to be the ones that paid us off this quarter.

(Inaudible -- multiple speakers).

And we are eagerly taking advantage of commercial banks insatiable appetite for assets that we are diligently continuing to be purging some of our larger credits and marginal credits off our books.

Great. And one last question, and I'll hop back in the queue. On the comp line, obviously another kind of big change quarter-over-quarter. $7 million last quarter versus $1.2 million this quarter. Can you just discuss the changes there and what should we think about kind of a normalized rate over a year long quarterly rate?

Sure. Well, as you know, we are -- we try to align our compensation with our shareholders, and we had a very robust Q4 -- Q3, precipitated by a lot of good events. And then in Q4, albeit it was a good quarter, we had some events that we were anticipating to occur on other IPOs and other items that just so happened, as you heard me say earlier, slide to Q1, and therefore that compensation will probably be more reflective in Q1 than in Q4. So we tend to align results and outcomes with compensation.

Great. Thank you.

Our next question comes from John Hecht with Stephens.

Good evening, guys. Thanks for taking my questions. A little bit of follow up from Greg's first question and in the context of near-term kind of expectations. What do you expect to see -- based on competitive trends and $50 million of reduction in portfolio, what would we expect yield drift to be in the next few months?

Believe it or not, we're not expecting much deal drift -- yield drift at all. This is why we're maintaining a higher cash balance. I mean, to make it very simple, if we decide to go out and start underwriting on some lower margin, lower yielding credits, for example, we could deploy literally $100 million of our cash and see our yields compress by about 50 to 60 basis points if we do that say at an aggressive rate of even 8% or 9%.

And so we have plenty of margin to play with in our overall yield. We have just chosen not to do that for the time being and continue to focus on credit quality and better outcomes for our portfolio. So unlike other players in the marketplace, we don't feel the pressure to simply have assets under management and earnings growth at the risk of credit quality. And for tenures we haven't done that, and I'm not about to start reaching for marginal credit at the cost of the risk of the balance sheet.

And so we are -- we don't anticipate any yield compression meaningful in Q1 over Q4, and yields -- yield compressions can move -- or yield changes can move out 15 base points in other direction relatively easy, but nothing more than that,I'm not anticipating.

Okay. And understanding your solid record of credit management, and that you don't believe your balance sheet is at risk, considering what the banks are doing, it did look like there was an increase in fair value of nonaccrual assets. Is that the one on the watch list, or what's going on there? And then [is this] -- maybe can you give us more details about the watch list credit you referred to?

Sure, this is one transactional so had an impact on bonus accrual. This is a transaction that was contemplating a sale of itself. The sale fell through, and when that happened we elevated the credit monitoring of the credit. The company has at this point ample assets, but we are monitoring it very closely, and yes, the nonaccrual is concentrated in basically one single credit.

Okay. And then, Manuel, last question, I was wondering, can you tell us -- the last quarter, if I recall, there was more [of the] normalizing -- normalization of the relationship between funding and commitments, and it seemed to drift back lower this year -- this quarter. Is there any seasonal elements there, or is that just something that changes quarter-to-quarter now depending on the portfolio you need?

Yes, great question. For those investors who have been with us for the last ten years, you may remember that the funding ratio was 75% to 80% of commitments to fundings. And it wasn't until -- I think it was the spring of 2012 that that became dislocated with drifting as low as almost 45%, 50% funding to commitment ratio. We started seeing a pick up of that again back to more normalized rate in Q3, back up to around 65% funding to commitments. And then Q4, you're obviously right, it drifted back down again.

So at this point I don't know what the real consistent pattern is other than there is no more consistent pattern. So that's the only thing I can tell you, that we're monitoring that very closely, which is why you'll see an increasing unfunded commitments of $151 million and keeping cash around $260 million to ensure that we have liquidity if and when that were to take place, for example.

But at this point, I don't know what the new norm is, other than saying that 55%, 65% is probably the right funding commitment ratio to use.

Great. Appreciate the color [that's that].

Our next question comes from Robert Dodd with Raymond James.

A question on -- kind of back to the same issue on competition. You gave color that you expect the back half of 2014 to be a lot more attractive than the first half. Can you give any more color on that? Because obviously if it's commercial banks that are driving some of the irrational pricing right now, et cetera, those guys with a lot of deposits [are going to] stay pretty solvent for a while, unless either the regulators step in and tell them to knock it off or the credit correction happens in the second half of this year. So, I mean, can you give us any more color on why you're relatively optimistic -- more optimistic about the second half?

I think that in the second half of the year, I anticipate seeing a much more robust origination activity to technology companies and earlier stage companies. I think that we are still going through a cycle of liquidity taking place. As more and more companies get acquired, and more IPOs are completed, the new crop of companies being funded by VCs are going to be much more attractively priced than they are of the existing more maturing companies in the marketplace today.

As an example, maybe in your world this is a normal for you, it isn't for me, but when I see a WhatsApp being acquired for $19 billion, when I see a Dropbox raising money at a $10 billion, when I see Palantir claiming valuations north of $9 billion. I can keep on going through a list of companies now that are deemed to be the $1 billion club, that makes me a little alarmed.

I appreciate that we have a lot of assets or investments in those legacy companies, so I appreciate the net asset value increase, but at the same time, from an overall return, when I see yield compression and increased higher valuations, it starts squeezing long-term returns, and that gives it a little bit of concern. So I want to see a little bit -- a shake out.

As to the competitive environment, I want to be very clear about this, these competitive entrants into the marketplace, whether BDCs or this other small player looking to go out and try to raise $100 million, those layers have been in the marketplace all along. They're not changing our competitive environment whatsoever.

What they are however are is much more hungry for assets and willing to do much more marginal underwriting, and because of what we believe is going to happen here in the near-term, I think that those players will suffer some significant losses and pull back, and they'll also have very limited pools of capital. And I've already disclosed two competitors of ours that have basically vacated the space, and I anticipate another two or three to occur by the next three to six months that are probably are going to be out of business as well.

Okay. I appreciate that comment. On the portfolio [size], can you give us -- one of the questions obviously is how much -- of the $50 million decline at the mid-point, how much of that is expectations that early repayments, redemptions, et cetera, will remain at the elevated level we've seen the last couple of quarters versus you guys obviously being very disciplined on [IC] deploying capital? Are we going to see another very high level of early repayments in Q1?

No, we actually think that the pay offs are tapering off. Now, there's a phenomena that is totally out of our control, which is kind of a positive thing in an odd way. And that is sometimes we get early pay offs we have monster IPOs completed by our companies. And so these are very positive development events that take place.

And some companies are about to go public, I expect some pay offs to take place from that. But that said, I don't think that we're going to be seeing $70 million, $90 million of early pay offs for the near -- the next two or three quarters. I think that the more normalized unanticipated early pay offs are probably in more the $20 million to $40 million range forthe next quarter or two. And then that's -- I'm not thinking much bigger than that.

All right. And then just a last question on the IPOs. Of the four that have happened so far this year, have you monetized the warrant positions on those, or exited rather -- you talked about $20 million to $60 million gains this year. Your talk is that you expect -- I'm reading into it that you expect a lot of that activity to happen in the first half. Any color on the four IPOs that have already happened in terms of whether those exits have been realized or are still on the books?

The only thing I'll adjust to what you said, I'm not sure I advocated the first half. I think I advocated 2014 of IPO activities. I did, however, say that I expect the first half -- to see a handful of companies complete their IPOs in the first half, but just to remind everybody it's very typical that when a company goes public, there's generally an invested banker [lock up] for 180 days.

So if they go public late in Q2, you won't see monetization of that exit until probably early December, October time frame, if you will. It all depends on when they go out. So let's -- we've got to decouple the exit event itself, the verb IPOing and the monetization or the harvesting that takes place 180 days, 190 days later.

Okay. Appreciate that. Thanks a lot.

Our next question comes from Aaron Deer with Sandler O'Neill & Partners.

Good afternoon, guys.

Hi, Aaron.

Going back to the subject of the kind of competitive environment and outlook for growth, the -- you mentioned that there were two to three competitors out there that you expect to disappear. Is that part of what you calculate in this credit shake out, or is that due to operational difficulties among those companies currently?

There's a great phenomena taking place right now in the marketplace. Small capitalized venture debt lenders are struggling. The venture debt category, which is why I [welcome] the entrance of larger BDCs in the asset class, which is well -- good underwriters, solid balance sheets, disciplined underwriting, focused on earnings.

And so what's going on is you're seeing a very significant consolidation with the private players that exist in the marketplace, struggling to gain access to capital. And then some private players now struggling to complete an IPO or try to raise some money out there -- portfolios of sub $100 million, $200 million are going to be very difficult in this marketplace when you have well capitalized players like ourselves and the other two BDCs that are in this asset class.

So it's going to be a -- the world is going to be bifurcating itself with those who have financial discipline and strong balance sheets and those who have small, weaker balance sheets.

Okay. And then, Jessica, you mentioned the debenture pay down expectations. Can you go over those details again? And then --

Sure.

Is the thought there just that because of the excess liquidity, is that why you're looking to pay those down [at this point]?

Well, we have -- if you go to the SBA discussion in our 10K, you'll find a table that shows our debentures and the interest rates fixed for ten year per each pool. We have about $35 million of debentures which are originated under our first license, which has a stated interest rate of about 6.4%. And that's an outlier relative to the rest of the debentures that we have.

So we're investigating paying those down. And like I said, as a result of that pay down, we'll probably have $0.01 hit to earnings as a result of amortizing the unamortized portion of the fees we paid at origination on those debentures. But then of course on a quarterly basis the savings will be about $0.01 due to not incurring interest expense on those debentures.

Also, Aaron, something I think we [omitted] to, and we'll be talking about this more in Q1. We're still studying whether or not we're going to do this, I want to make sure investors realize that. But one of the things that's missing in this overall narrative is that although you'll see us pay down those debentures, we will actually be filing for reincreasing that with eventually a new license, as well.

So we're going to be maintaining a $225 million capabilities under the SBA program. This is simply managing our cost of capital and recycling older mature bonds, debentured into more cost effective new ones that will be issued in the future.

Okay. And the other side of the balance sheet, what -- I know most of the loan book is variable rate. What percentage of those are currently below floors? And by how many basis points on average is that part of the loan book below the floor relative to the natural range?

Great question. And unfortunately most of our deals -- [now substantially] all of our deals are above the floors, so rates would have to move approximately 50 basis points in our calculation before we accretion on EPS basis.

Okay. That's great.

And also, just as a footnote, as I believe in having good transparency. Most of our loans are indexing off of prime, so prime would have to move at least to 3.75% before we start seeing any material impact.

Got it. Thank you.

Our next question comes from Andrew Kerai with National Securities Corporation.

Yes, hi. Good afternoon, and thank you for taking my questions. I just wanted another follow up on the funding side of the balance sheet if I could. So are you guys considering potentially if doing another securitization, maybe sometime towards the end of 2014, to the extent at some point you start growing your portfolio again as the notes continue to run off?

Well, I want to be very clear, because the tone of this call is something that's disturbing me. We're not at all stopping underwriting. I want to make sure people understand that. We have a very, very active pipeline, and I am not at all concerned about achieving our financial performance and earnings expectations that are out there.

We simply have decided to simply take our foot generally off the gas pedal in Q1. So to answer to your question, I absolutely do believe that we'll be doing securitization later on in 2014 as we have a cash need, meaning that as we convert our $260 million in earnings asset, you'll see us go back to the capital markets and do another securitization to continue to fuel the portfolio of growth.

So this whole comment that somehow competition and we're not growing our portfolio, I want to make sure I dispel that right away. We are absolutely going to be growing our portfolio, and we're absolutely going to be growing earnings and income.

Let's not take this thing out of context in Q1 while purposefully going more conservative for reasons that we're talking about right now. But I am not at all interested in losing our premier position in the venture debt category we have and continuing to originate assets. So please do not misinterpret my comments. We are going to be very much defending our venture debt position and growing our loan book.

Sure. Sure. Thank you. That's certainly helpful. And I just had a question [as well, because] I noticed in your release it said that you are looking to distribute about $0.06, about $3.8 million or soof spill over earnings from 2013. I mean, it looks like based on kind of the delta between your distributable NII and what you paid out, there's a significantly higher amount of spillover. So, I mean, is part of the thinking on your end that you're going to use some of -- I guess, some of those lost carry-forwards to offset your roughly about $15 million or so of realized gains in 2013?

Yes, you absolutely just nailed a very important issue. There's no question that earnings spill over is $0.06. And if you take in context what I just said [of] $20 million to $60 million in realized gains, and if you look at our financials, we have about $35 million of tax loss carry-forwards. All of that will be absorbed -- on a GAAP basis all of that will be absorbed with these realized gains, growing book value organically.

So I'm very optimistic about our organic book value growth and continue to in essence absorb all those tax lose carry-forwards and allowing even more potential distributions to shareholders in the form of some of these capital gains that we have.

Sure. Thank you. And then I just -- so I just wanted to clarify, if I could, as well, Manuel. So the $20 million to $60 million of warrant gains that you kind of guided to for -- to look for in 2014, that just includes the four companies that have -- they're already -- that have already filed for the IPOs, as well as the five you currently have in the pipeline, correct?

In essence -- there could be one missing there, but yes, relatively speaking, your comment is within reason, correct.

Okay. So there could be potentially additional upside to that to the extent you have additional portfolio companies filing in the second half of the year that you haven't necessarily seen within your forecast at this time?

That's correct, but again I want to make sure, if a company files and goes public in Q3, because of lock ups that naturally [compress the banking], we won't be able to harvest those gains until 2015.

Right. Right. No, exactly. And I just wondered to get back to some of the comments about kind of the market staying frothy, and you guys taking disciplined on the underwriting standpoint. So at the end of December, I mean, your cash is roughly about a quarter or so of the total assets, so just for argument's sake, let's say that the market stays Frothy throughout 2014. I mean, at what point if at all do you kind of step back and say, well, we don't want to sacrifice on credit, but if 30%, 40% of our assets aren't earning any interest at all, maybe it's prudent at some point to take a little bit of yield aggregation while maintaining credit to at least earn a positive carry on the otherwise uninvested cash.

Absolutely right. Absolutely correct. And that math is quite easy to do.

If we decide to do that -- which at this point we've chosen not to do that. If we choose to do that and it will force our competitors into matching those yields if you originate at a lower yield, because we have such a strong base of earning asset, 14.3%, 14.7%, we could afford to go down and deploy $100 million, $200 million of capital at much lower yield. And our yield compression in our overall portfolio will be only down 50, 70, 60 basis points at a whole.

So we have plenty of room to do that and still maintain like 14% yields overall. We've [just] chosen not to do that, but that option is always in our back pocket.

Sure. And then maybe would an alternative to be look to maybe some of the later stage more established credits, to where those are a bit more liquid to where -- to the extent the market turns more favorable, you can easily flip those loans and deploy them into higher yielding assets?

There's always a balance between maturity of the loan and liquidity exits of the underlying derivatives and warrants associated with the transaction. And also embedded as credit quality. All those things we take into account at all times.

But again, you're absolutely right we have chosen not to do that as of yet. If we so choose to do that, we're more than happy to deploy $200 million capital at 8%, 9%, 10%, and the impact in the overall yield is 50, 60, 70 basis points, and so we are easily able to do that and still be in a very strong overall yield position by generating tremendous earning assets.

Sure. Sure. Fair enough. Thank you for taking my questions, guys.

Our next question comes from Jon Bock of Wells Fargo Securities.

Hi, John.

Hi, guys. Thank you for taking my questions. One quick one first, Manuel, as we start. I know you mentioned that there were certain stages of companies that you were choosing to maybe deemphasize at this period in the technology or credit cycle. And so could you maybe give us some color on what those stages are as they relate to early, mid, late stage growth, et cetera? Where are you starting to see on a venture stage the most valuation bubble, or shall we say the least compelling valuations in your view?

So one of the things that no one asked me yet is what really is our competition? And I'm about to surprise everybody. Our biggest competition is none of the players that you just asked me about.

Our biggest competition is actually the venture capitalists wanting to put equities in these companies to take advantage of that last round before a liquidity event. We're losing more term sheets to equity valuations that are so inflated, that I got to be honest these companies are doing the right thing.

They should take the equity higher valuation, because they're able to establish a new valuation before they go public. And so as much as from a financial point of view they should use debt to preserve equity ownership, there's a strategic importance for them to actually use equity to set a new value. And so our largest competitor, believe it or not, is not really all these other players you're talking about. It's really the equity guys chasing these valuations.

Now that said, you're seeing a still fairly robust increase in valuation in technology companies and early stage social media companies and SaaS. We are purposely -- we are the most underinvested in technology that we've been in the history of Hercules. However, I believe that tide will change in the second half of 2014.

As all these companies finally get acquired, you'll start seeing a whole new birth of new technology companies being started that have new business models and a much more attractive valuation to be in. At which point we will wade back in with new product offerings tat we will have to offer new financial services to earlier stage companies that we don't have today to really start grabbing some of that market share and some of that void in our portfolio today.

So technology is something where we purposefully are underinvesting today. If is the easiest transaction to originate too. It doesn't require a lot of sophistication when you're first doing early stage deals to expertise needed in energy technology or life sciences investing, for example.

I appreciate that. And an additional question, and just trying to understand a little bit more. So to the extent that venture capitalists are getting more competitive, equity is getting more competitive in this space in general, I would imagine that yields would be bid down. And yet you talk about kind of looking forward that yields either are likely to remain flat to perhaps up. So walk me through the disconnect of why that's the case.

So what happens is that eventually the entrepreneurs start realizing that taking on more and more equity is dilutive to them. And it's a cycle that I've seen over 25 years. And what happens is in a market where IPOs become so hot and in demand, the entrepreneurs or the founders have much more power and control on staying with the capitalization of the company should look like.

So early stage investors and entrepreneurs themselves want to preserve as much ownership in their company as possible suddenly get -- starts becoming a much more tactical use. And they want to preserve ownership. So debt demand is going up. And that starts allowing more and more debt providers to provide capital.

However, as the market for debt gets more competitive, the smaller capitalized players -- which is exactly what's happening today -- the smaller, weaker capitalized players, the $100 million, $200 million [fun] size, when they end up using up all their available capital, what happens is they're now out of the market and the remaining players will start seeing yields start lifting up because of scarcity of capital, where you're now [concentrating] three or four large players providing capital in the marketplace.

Got it. That makes total sense. Thank you so much for taking my questions.

I would like to turn the conference back over to Manuel Henriquez for closing remarks.

Well, thank you, everybody, for being on the call today. Great set of questions. I have to tell you that I'm still not happy with the format of the earnings call, so I'm going to tweak it again. Next quarter I want to make it more succinct and make it much more Q&A for investors and our analysts to be able to ask questions about.

If you would like to arrange management meetings, please feel free to contact our Investor Relations department or contact Hercules directly. With that, operator, thank you for your time, and thank you, shareholders.

Ladies and gentlemen, this concludes today's presentation. You may now disconnect, and have a wonderful day.