Hercules Capital Inc (HTGC) 2014 Q1 法說會逐字稿

Good day, ladies and gentlemen. Thank you for standing by, and welcome to the Hercules Technology Growth Capital first-quarter 2014 earnings conference call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference to our host, Ms. Jessica Baron. Ma'am, you may begin.

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

Hercules's first-quarter 2014 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's webpage or by using the telephone number and passcode provided in today's earnings release.

I would also like to call your attention to the Safe Harbor disclosure in our earnings release regarding forward-looking information. Actual financial results filed with the Securities and Exchange Commission may differ from these 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 the actual results to differ materially from those expressed in the forward-looking statements, including, without limitation, 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 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 can also be incorrect. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained on this release are made as of the date hereof, and Hercules assumes no obligation to update these forward-looking statements or subsequent events. To obtain copies of related SEC filings please, please visit sec.gov or visit the webpage www.htgc.com.

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

Good afternoon, everyone, and thank you for joining us today on the call. I'd like to start by once again attempting to make this call more succinct in our prepared remarks and focus on the key highlights. I tried that in the fourth quarter, and that didn't work quite as well as I would like it, so I'm going to try it again today.

So I will try a new format to try to reduce the repetition of the information released in our earnings press release, and then allow for greater time for Q&A for the investors on this call and participants on this call. With that, I'd please encourage everyone to send us feedback on this call. I want to understand how we can continue to improve this call and move that on a forward basis for the benefit of our investors.

So as of today, the agenda: I want to speak briefly about our operating performance for Q1 2014; an overview of the current market conditions, including venture capital activities and IPO and M&A activities; our perspective or outlook for investment activities for Q2 and the rest of 2014; and then I'll turn the call over to Jessica Baron, our CFO, who will go into the financial details and results of our performance for the first quarter 2014.

Highlight of operating performance of Q1: the first quarter was an outstanding start for a great year of 2014. We delivered healthy growth in earnings, increased the credit quality of our investment portfolio by maintaining a high degree of credit outlook and performance in our credit portfolio. Recognized some significant gains from our existing $110 million-plus warrant and equity positions during the first quarter.

We achieved a solid performance of approximately 22% year-over-year growth in net investment income of approximately $18.3 million or $0.30 per share. We also increased the first-quarter DNOI by approximately 23% year over year to $19.9 million or $0.33 per share.

Net commitments were also robust at $156 million, while fundings were also equally strong at approximately $112 million for the first quarter of 2014. We also achieved an impressive showing for IPO exits during this quarter, with five Hercules portfolio companies completing their IPO debuts in the first quarter of 2014, which is a great testimony to our investment professionals in identifying the right companies in which to invest in.

In addition, I am very happy to report that we have chosen to begin the deployment of our excess liquidity off our balance sheet of nearly $225 million in cash into new interest-earning investments. Although this process has just begun in the second quarter of 2014, we do not expect to see a true impact to our earnings growth until the second half of 2014, and certainly do not expect to see much impact in Q2 2014 earnings, as most of these new investments are expected to close at the end of the quarter and fund at the end of the second quarter.

I am also very encouraged -- and we anticipate that the portfolio will grow in the second quarter by approximately $20 million to $40 million up, and early or unanticipated payoffs during the quarter to continuously decline, and declining to a level of $70 million to $80 million in our current forecast, what we know today, excluding the normal amortization of approximately $35 million. The punchline of that bullet point is we expect $20 million to $40 million up in growth in the portfolio in the second quarter.

We also expect to continue to deploy our excess liquidity of $225 million in cash on a more aggressive pace in the second half of 2014. And we expect to convert at least $150 million to $200 million of this $225 million into new interest-earning assets as we turn to the second half of 2014, and more heavily weighted in the fourth quarter, as it has been historically due to seasonality on the investment activities.

We also declared a $0.31 dividend per share in the first quarter, consistent with the prior dividend declared in the fourth quarter. This represents our 35th consecutive dividend since inception.

Now, let me turn my attention to the liquidity events in our portfolio. As I indicated earlier, we had five completed exits in our portfolio between M&A and IPO events. On the IPO front, as I indicated earlier, we had five completed public offerings in the first quarter of 2014. And we finished the quarter with approximately four companies currently in IPO registration, of which one completed a traditional IPO post the end of the quarter.

Despite the recent and Hercules-anticipated frothiness collection in valuations, many of you may recall that for the last two quarters, Q3 and Q4, we have been advocating caution regarding the tech valuations that exist in the marketplace. Subsequent to this period of time, we have now seen the unfortunate but anticipated correction in valuations -- that most technology companies in life sciences have experienced a 25% to 30% decline in valuation. This actually bodes well for our business, as demand for capital has actually increased due to the cooling of the IPO market as of late.

Now, turning my attention to M&A: we had three completed M&A events during the first quarter. This actually helps to reinforce our continued selections of the right companies and continued liquidity within our portfolio itself.

Now let me turn my attention briefly to the venture capital activity. In the first quarter, the venture capitalists invested an incredibly -- very large amount of $11 billion by the venture capitalists, well in excess of my own anticipated forecast for the first quarter of 2011. This data is provided to us by Dow Jones Venture source.

Of the $11 billion that was invested, 860 companies benefited from the new capital invested by venture capitalists. This represents an 18% increase over capital deployed over the same period last quarter.

In terms of exits, IPOs to begin with: an astonishing and impressive first-quarter of 2014 IPO activities, with 38 companies completing their IPO offerings, raising a whopping $2.9 billion of capital. What makes this so important is this is the highest level of IPO activities that we've seen since the third quarter of 2000. And that is 2000 -- not 2001, 2010 -- 2000, where 75 companies completed their IPO offerings.

I'd like to highlight of the 38 IPO offerings, 5 of those were Hercules portfolio companies during the quarter. As I indicated earlier, M&A activity was also robust and also very impressively strong for the quarter. We saw 119 companies complete M&A events during the quarter, garnering a $19 billion in valuation. Not to be left behind with the IPO, also the highest M&A recorded since Q3 of 2000, where $238 million in valuations were realized during that period of time.

Finally, venture capital fundraising activities: also a very impressive number. The venture capitalists raised $9.6 billion to 73 new venture capital funds. This data is important because it gives us ability to look at the longevity and durability of the venture capital investment activities on a go-forward basis, which represents a primary source of repayment in much of our debt investments into innovative, venture-capital-backed companies.

Now, turning my attention to our outlook for Q2 and the remainder of 2014: we are in the midst of making many critical changes to our organization as we set the foundation for our next 10 years of growth. Having recently completed our 10-year anniversary, culminating in a tremendous accomplishment for our investors and generating returns for our investors in a commensurate 10-year period of time, we actually took a deep evaluation of how we'd done our business over that on 10-year period of time and looked to make changes to ensure that we are in the proper setting for the next 10 years of our growth.

As expected, many of these changes have manifested themselves and continued into generating a high-quality investment portfolio, and more importantly, increase our income generation by seeing earnings growth, which should translate into higher dividend growth for our shareholders. We have made a conscious decision to make investments choices to accelerate our investment pace and actually convert much of our liquidity in our balance sheet into interest-earning assets.

Part of this innovation of our own Company is very much like our own portfolio of companies do every day. We are looking to take a different approach on how we have done business over the last 10 years. We are doing this for multiple reasons.

Many competitors have entered into the space, much of which are doing the investment activities in venture debt we deem to be incorrectly, and will eventually have their own credit challenges in the marketplace. We want to remain the leaders in the asset class, and we want to be the leaders in innovating on continued offering new investment vehicles and investment products for our portfolio of companies and to drive earnings growth for our shareholders.

With that said, we are targeting portfolio growth of approximately 20% to 25% over 2013 and 2014, in hopes of finishing with an investment portfolio by the end of the year at approximately $950 million to $1 billion -- subject, of course, to market conditions remaining robust. This represents, as I indicated, a 20% to 25% increase over the investment portfolio currently of approximately $800 million today.

As we focus on this portfolio growth and earnings growth, we expect our overall yields to gradually compress as we continue to build earnings in our portfolio, compressed by approximately 30 to 50 basis points per quarter as we convert our excess liquidity into interest-earning assets. This is a significant competitive advantage that we have in the marketplace, by being able to use yields to our benefit without compromising credit quality, given the robust high levels of yields that we have accomplished historically and continue to see in the marketplace today.

As a result, we believe this will drive an additional $0.04 to $0.06 in quarterly earnings in the second half of 2014 as we continue to deploy this liquidity over the second half of 2014. As of May 1, the pipeline is it remains very robust. We have over $1.2 billion of transactions in the pipeline today, of which $171 million of that is represented by signed term sheets today, giving us very good visibility for continued portfolio growth.

However, as I've done many times in the past, not all signed term sheets will convert into earning assets; and not all signed term sheets necessarily will convert to commitments that we'll actually fund. As part of this environment, we have increased the use of milestones in our commitments, and therefore we do not expect immediately for all our commitments to translate into earning assets. We remain optimistic if these companies achieve the milestones of which we establish, those unfunded commitments should begin to convert in the second half of 2014.

So far in the second quarter of 2014, we have closed $60 million of transactions already and funded $27 million of that, which is representative of the comment I just shared with you earlier -- that the funding ratios, so commitments to fundings, will continue to lag, driven in part by our own risk mitigation strategies.

We have signed, as I said earlier, $171 million of signed term sheets that we expect to close and convert into earning assets over the next two to three quarters -- translate that into higher increased earnings, as I indicated, by $0.03 to $0.04 as we continue to deploy our liquidity.

We finished nearly with $190 million of unfunded commitments. This is a very significant number and a very important number. This unfunded commitment number also gives us visibility, and strong visibility, into future earning assets that would convert upon the drawdown of our unfunded commitments in the second half of 2014.

We are quite optimistic and we are very, very bullish on our outlook now that much that we had been anticipating on the frothiness of valuations have taken place, and we're seeing an increase in demand for capital as we look to deploy that capital for the benefit of our shareholders and increase earnings.

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

Thanks, Manuel. I'd like to remind everyone that we filed our 10-Q as well as our earnings press release after the market closed. I'll briefly discuss now our financial results for the first quarter of 2014.

Turning to our operating results, we delivered total investment income or revenues of $35.8 million, an increase of 15.5% when compared to the first quarter of 2013. This year-over-year growth was driven by increased interest income from higher average asset balances outstanding and due to early payoffs.

We also recorded increased income attributable to the early payoffs, as I noted, which totaled $89 million during the first quarter. Note that our period-end debt investment balance on the cost basis is $887.7 million, a decline of $18.6 million from our 2013 year-end balance.

The all-in effective yield of our debt investments during the first quarter was 17.9%, approximately up 280 basis points relative to the previous quarter. This increase is primarily due to the effect of the acceleration that occurred from those early payoffs as well as loan restructurings.

Interest expense and loan fees were approximately $9.2 million during the first quarter of 2014 as compared to $8.7 million during the first quarter of 2013. The year-over-year increase is primarily attributed to the acceleration of fee amortizations related to the early payoff of the $34.8 million of SBA debentures and due to paydowns of $26 million of our securitization notes during the quarter. As a result of these fee amortizations being triggered by reductions in our liabilities, the weighted average cost of debt increased to 6.9% in the first quarter of 2014 versus 5.9% during the first quarter of 2013.

Operating expenses for the quarter were $8.2 million as compared to $2.7 million in the first quarter of 2013. This increase was largely driven due to an increase in full-time headcount from 3/31/2013 to 3/31/2014 and due to restricted stock units vestings, attributable to higher share count and award fair value.

In Q1 of 2014, net investment income was $18.3 million compared to $15 million in the first quarter of 2013, representing an increase of approximately 22%. Net investment income per share was $0.30 for the first quarter of 2014 as compared to $0.27 for the same quarter ended 2013.

We recorded approximately $1 million of net unrealized depreciation from our investments during the quarter. We recognized $7.4 million of depreciation due to collateral-based impairments on debt investments with two portfolio companies. We also recorded $9.7 million of depreciation to reverse previously-recorded unrealized appreciation on investments that were sold during the quarter. This was offset by $16.1 million of appreciation due to market yield adjustments for our other fair value determinations.

Our net realized gains for the first quarter was approximately $4.9 million. We recorded $5.4 million of gross gains from the sale of warrant and equity investments in five portfolio companies. These gains were offset by approximately $0.5 million in warrant and equity write-offs.

We ended Q1 of 2014 with total investment assets, including warrants and equity, at a cost basis of approximately $887.7 million. This was net down by $18.6 million from our investment portfolio balance of $906.3 million as of December 31, 2013.

The current-quarter portfolio decline on a cost basis was the result of principal and PIK repayments of $132.6 million, $1.8 million of fee accelerations due to early payoffs, and $2.7 million of reductions due to the sale and write-off of investments. These reductions were offset by approximately $114 million of new debt equity and warrant additions to the portfolio, as well as $4.6 million in net fee accretions.

I'd like to remind everyone that amortization typically commences 9 to 12 months after an interest-only period we have on our own term loans, and the amortization is scheduled to occur over a 36- to 42-month time frame. Apart from early repayments, we currently have scheduled amortization of $30 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 of our portfolio was 2.05 as of March 31, 2014, reflecting an improvement from 2.20 reported at the end of Q4. We had three investments on nonaccrual at the end of the quarter, with a cost basis of $24 million and a total fair value of $7.7 million, representing less than 1% of the total investment portfolio at fair value.

Turning to liquidity, at the end of the first quarter, we had approximately $329.5 million in available liquidity, which included $225 million of cash and $105 million of credit facility availability. As of March 31, our debt-to-equity leverage ratio, including our SBA debentures, was 76.1%, lower than 85.8% as of December 31, 2013, due to the SBA debenture and asset-backed note paydowns.

As a reminder, our $190.2 million of SBA debentures that are outstanding are excluded for regulatory leverage calculations. The exemption effectively allows us to lever beyond the 1 to 1 debt-to-equity ratio to 1.29 to 1, which means that at the end of the first quarter we had additional capacity to add $350 million of leverage to our balance sheet.

Our net leverage, which is calculated based on total debt minus cash, is approximately 41.7% at the end of March. Our net asset value at March 31 was $653 million or $10.58 per share compared to approximately $650 million or $10.51 per share as of December 31. Finally, consistent with prior quarters, we'll be distributing a dividend of $0.31 to our shareholders, and this payment is scheduled for May 19.

So in closing, as Manuel mentioned, we continue to take a cautious and steady approach to onboarding new assets in the second quarter of 2014 and beyond. We expect our debt portfolio to be up approximately $20 million to $40 million in the second quarter.

We remain committed to our strategy of controlled growth, and we intend to continue to apply our stringent underwriting standards, which have resulted in our first-quarter stellar performance and our first 10-year stellar performance.

So with that, operator, we are now ready to open up the call for questions.

(Operator Instructions) John Hecht, Stephens.

Forgive me if you mentioned this, because you did have a lot of figures in the presentation here. X the prepayment and other related fees, what would nominal yields have been in this quarter? And what are trends there?

Our effective yields for the quarter were slightly down on a normalized basis relative to the previous quarter, but there wasn't a fundamental material change in that number.

Do you have that number handy?

I think the number is 14% -- 14.1% --.

Right.

On a normalized basis. Let me speak to that. I've gotten a lot of investor feedback on that comment. And what we were doing historically was creating a level of transparency higher than the peer group.

And since no one else has bothered to report non-normalized yields, meaning backing out one-time events -- people were asking us questions, why our yields were lower. And so that's what we've now reverted back to reporting.

Apples to apples, like everybody else is reporting, basically GAAP yield, which is that 17.9% -- which we all understand and realize is not repeatable, because it has a bunch of noise in it for one-time events. But unfortunately, it's what the industry is doing as a whole. And so we've reverted to the reporting as everybody else is doing right now.

Okay. And when you talked about deploying excess capital accretion to earnings, I completely understand that; but you also mentioned -- expect yields to come down by, I think, 20 or 30 basis points a quarter. Is it the yields on that nominal rate of 14.1% -- we should kind of think about takedown, and then you would obviously augment that as you would get ongoing prepayment activity?

I think there's no question that -- to be very clear here -- that when you look at the non-noise level of one-time events, if you consistently apply a 14%/14.2% yield, if you will, as a base, you will definitely see -- and again, yield compression will only happen if we choose to be more aggressive on accelerating earnings growth, which we are doing as we speak. So what would happen is: as we decide to reach down to be more competitive on yields, you would see the overall portfolio yield of Hercules decline anywhere between 30 to 50 basis points per quarter as we deploy the excess liquidity, which then that would translate to higher earnings per share.

So, for example, if we do $100 million at a lower yield spread than our historic levels, you would see yields compressed by 30 basis points. But you'd see earnings go up by $0.03 to $0.05 per quarter on a go-forward basis.

Understood, thanks. Your pending commitments are up meaningfully. I'm sure this is in concert with your strategy to begin to deploy capital in the year. What's going on in the marketplace? Where are you seeing any opportunities? What verticals are you focused on? And what's going on with competition?

It's funny. Look, a lot has changed in the last -- since the last earnings call, much of which we have been advocating or expecting, and that is the frothiness in valuations that -- unfortunately, a lot of people were upset that I was being so open about the visibility in the marketplace.

But unfortunately, it has manifested itself exactly as we anticipated, with much of the high-profile technology companies, even the public ones, seeing valuations compress between 30% and 50% in some cases, which -- unfortunately, what it does is it causes a lot of the investments that have been made lately to now be potentially underwater from a valuation point of view, which is what we've been expecting, to now go in the marketplace. So what you'll see us do in the next few quarters is begin to deploy our capital very selectively into those companies that we now feel have a much better valuation reset and also offer a high level of credit integrity.

Secondly, what we're doing is we're expanding our product offerings. We are now being much more competitive with banks that we had historically done without compromising credit quality. And what we're doing is we're offering now a much broader suite of financing solutions to our companies.

Given our capabilities and the size of our balance sheet, we are now able to do much more blended rates of financings to a portfolio company by offering a strip of, for example, ABL lending; offering a strip of just either working-capital purposes structured term loans or other investment products to provide the company a one-stop solution without reaching down the cap structure out of that company, taking on more risk.

There's a lot of VCs out there who are weighing into the venture debt space by doing second-lien deals, and I've spoken about this many times in the past. Second-lien lending in venture space is quite dangerous, and it's not the same as doing lower middle market lending. And that will correct itself here shortly, as credit things surfaces for some of those other VCs doing that type of lending.

Okay. So it sounds like even the blended financing products you'll offer, such as the working capital and so forth -- they will continue to be asset-based in nature?

Absolutely. In fact, the biggest challenge will be for some of the smaller VDC venture debt players in the marketplace, as we decide to use our source of strength on our balance sheet to actually drive earnings growth by being able to lower yield, it's going to cause industrywide yield compressions much more severe than whatever would affect us, given that we're starting from a basis of either 19 -- 17.9% or 14.3% on a normalized basis.

So we have decided to really accelerate earnings growth for the second half of 2014. That's what you'll see.

Great, thank you very much.

Greg Mason, KBW.

Great, thank you. Could you talk a little bit about the early repayments? The last four quarters you have been running $90 million to $100 million of early repayments each quarter. Can you talk about, first, what are you seeing in 2Q? And long term, where do you see that run rate leveling out?

Sure. So most of the folks on this call and investors have been with us a long time. When we take a -- when you start seeing our cash balance is being built up, as you saw us do, we do that purposefully because we think that there's issues in the market. And so one of the things that we also take advantage of when we see that -- we will actually encourage any marginal credit to leave off our balance sheet.

So to answer your question: most of 2013, the run rate on early payoffs is probably running $80 million to $100 million, and in some quarters actually exceeded $140 million. That said, because we've now dramatically improved the credit outlook of the portfolio by divesting ourselves from some of these marginal credits, you'll see the portfolio now normalizing itself to probably a $70 million to $80 million potential early payoffs in Q2. And I think that will taper off quite dramatically further in Q3 and Q4.

And the only time that we'll see additional early payoffs take place would be probably driven by exit events, meaning IPO or M&A. And so right now we expect that level of activity to start dropping off pretty dramatically after Q2.

Great. And then the prospects for growth that you're looking at: do you expect any new headcount additions to also supplement this growth? And where do you think about the compensation line? In 2012 you had $13.3 million in comp and benefits; last year, $16.1 million. You're kind of on a $17 million run rate in the first quarter. Any kind of color you can give us on the comp?

Absolutely. To answer your question in the order you asked it: yes, we expect to see a fairly significant increase in headcount throughout 2014. In fact, we are actively in the market right now, looking to bring on board anywhere between 5 to 7 additional individuals across the organization, as part of the restructuring that we have done or in the midst of doing to align ourselves for the next 10 years is that we have gone through a fairly meticulous process of reevaluating our organization and really bolstering up our investor professionals, both on the originations side and also on the operations side of the equation.

I will be honest; I probably expect to see one or two more turnovers take place that will probably be controlled by us, as well as continue the hiring of new professionals in that. So I think when you look at the normalized run rate, compensation -- because we actually operate on a pay-for-performance basis, meaning that depending on the outlook and the credit performance of your investments, the investment professional will benefit from some of that origination activity. So if the compensation number is going up, it is because earnings are going up along with it, and so are the assets that take place.

So if you look at the numbers I said, that we expect to see the investment portfolio rise between 20% and 25% between now and year-end, to the tune of $950 million or $1 billion, I think that you'll see variable compensation probably go up by a commensurate $1 million to $2 million on a variable comp basis from what we know right now.

Great. And then, finally, one last question; I'll hop back into queue. You've got a number of public equity stocks now in your portfolio, and a lot of those will be rolling off of their six-month lock-up period. Given where the public tech markets have gone, what is your thought about exiting those and your previous guidance of -- I believe it was $30 million to $60 million of realized gains in 2014?

Sure. The number I indicated earlier was $20 million to $60 million in realized gains. And there's no question about it, that: A, the range that I provided is one that I still feel confident in, which means that the midrange is probably somewhere in the neighborhood of $40 million or so.

And so with $5 million under our belt already in Q1, it is absolutely very clear, and you'll see from our schedule of investments that we have also seen an adjustment in valuations, given the recent pullback from some of the technology and life sciences companies.

Now, that pullback to us is temporary, if you will, so the fundamentals of the companies that we invested in remain very strong. We don't need to simply sell -- to sell those assets to realize gains. But we intend to continue to approach seeking exits on those investments as the opportunity gives rise to windows of capital appreciation or stock appreciation that may occur.

Great, thanks, Manuel.

Ron Jewsikow, Wells Fargo.

Kind of following up on Greg's question about some of the volatility in the public markets, has the recent volatility changed how you view some of the public fallen angel investments, which you kind of were active in in 2013? Or are you still viewing that as an attractive place to invest?

There's no question of having a little bit of air let out of the balloon. Certainly makes these opportunities a little more attractive, because what happens is the underlying companies now have the cost of equity being even higher for them to issue. So this adjustment in valuation in the marketplace is actually very positive, because it only increases demand for debt. So we think it's actually a good thing, and that's one of the reasons why were weighing back into the market the way we are.

The more important part of it is, on the later-stage side, much of our competitors who were eagerly looking to put capital to work did in the third and fourth quarter on valuations that they now probably look back and wish they didn't have investments at in the market, which -- we were diligently waiting for this adjustment in value going on right now.

So we actually think this letting of air out of the balloon, if you will, from the valuation perspective is actually very good for the industry and very good for ultimate long-term investments. So we're encouraged by that.

Yes, that's good color. And then just kind of circling back to the shift into maybe slightly lower-yielding investments, using your cost of capital and liquidity position: would we expect any change in the terms outside of yield, such as higher warrant coverage? Or maybe these are higher-quality VC borrowers?

You know, I think it's too early to call that, because what we are going to be doing as well is that we're going to be increasing our investment activities into early-stage companies. So you will see a very concerted effort across the development stage of these companies, where were going to make a much more forceful advancement now in our technology portfolio, pursuing later-stage valuation companies who now have had a valuation correction.

So you'll see us increase our exposure significantly more in Q2 2014 to the technology. And you'll see us increase our investment activities into earlier-stage life sciences and earlier-stage technology companies as well as we go into the third and fourth quarter of next year.

So we think both are quite attractive candidates right now. We're seeing a lot of demand for our capital. And because of our source of strength on the balance sheet, we are able to invest across the spectrum of the development stages of these companies without really compromising much significant yield.

Let's be clear. Our current yield today is running about 14.1% or 14.2%. And so if we decide to continue to accelerate earnings growth by merely getting out 30 to 40 basis points per quarter, you're looking at on an annual basis giving up -- maybe, if we decide to be this aggressive -- 120 basis points in total of our overall yield and deploy almost $200 million of capital that would translate into somewhere in the neighborhood of $0.08 or more in quarterly earnings.

So it's a very powerful impact, and we are approaching that very selectively. But that is our intent.

Yes, it makes total sense. Thanks for taking my questions.

Aaron Deer, Sandler O'Neill and Partners.

Just kind of following up on that same line of thought: what kind of deals are you seeing out there now, where you are still feeling compelled to walk away? It sounds like you're getting more aggressive on pricing, so what kind of structure issues are you running into?

Well, I don't necessarily want to give -- divulge our competitive advantage or strategic perspective of what we're doing here is. But one of the wonderful things that's going on is that -- look, I've been doing this for almost 30 years, and providing equity capital and venture debt to technology and life sciences companies. And one of the things that I know is when I see a frothiness in a trend or silliness in deal structures, I'm going to simply pull back and let our competitors fill their coffers with marginally-structured deals. And I think a lot of that is taking place right now, and that will manifest itself here in the next 12 to 18 months with some of our competitors in some of these deal structures.

So one of the things that we will not do is that there are deal terms out there doing 24- and 30-month interest-only into venture debt companies that, in my world, that's called equity; and a lot of our competitors are weighing into the space, providing debt capital and taking on equity risk by achieving a debt return. That is a very silly and very dangerous thing to do. When you then have a significant capital loss, you have no margins to recoup from that.

But I don't run those other VDCs. They are doing what they want to do, and we do what we're very good at, which is controlled investments; driving earnings growth for our shareholders; and maintaining a very strong credit book, as we've done historically.

As a soundbite to that, when you actually look at the numbers, which are a little bit shocking to me -- when you actually look at our net credit losses, you're looking at something of 9 basis points on a net basis over an actualized 10-year period of time. It's to the point of being a little too low.

Okay. And then Jessica, a question for you on the unrealized appreciation within the loan book itself. I recognize there was the $7.2 million, which is effectively credit impairment, and then the $4.8 million listed under Level III assets. What is that?

So when we have an investment that pays us off -- as you know, we're supposed to apply SCA 20, where we're supposed to mark all of our loans based upon our valuation methodologies; and if we have a premium assigned to that loan which happens to pay us off, we have to reverse that premium.

And the same goes true with a loan which we might have marked at a discount. So those changes are what those reversals are. That's basically when those loans are paying off at par, we have to unwind whatever appreciation or depreciation we might have on them.

Okay. So that's effectively a recovery there.

Sure, yes.

Okay, thank you. Thanks for taking my question.

Chris York, JMP Securities.

Most of my questions have been asked, but I did want to get a follow-up. Last quarter you talked about strategic initiatives. Could you give me a little bit more color on that? And did that include potentially expanding into product offering that you talked about, like ABL and working capital loans?

Absolutely. Part of that strategic discussion that we alluded to in Q4 is in fact going underway right now. By the way, more will come. By the time I expect to have our second-quarter earnings call, I think much of the strategic things or changes that we're doing to enhance the Company and enhance our operating capabilities will have been completed by then.

But yes, one of those items is in fact expanding our product offering to the needs of our portfolio companies. So widening our capital capabilities; we are working to lower our cost of capital even further, to pass both of those savings on to our portfolio companies and also, potentially, our shareholders with increasing dividends.

We are adding additional staff. We're expanding, potentially, geographic footprint. We will be -- we are looking at, without divulging things, possible acquisitions, among many other things that we are actively involved in right now. I am working with the Board, and my management team are looking at setting the foundation for the next 10 years of growth and repeating the success we've had for the last 10 years on the prospective 10 years going forward.

As you may realize, many acquisitions look attractive until you end up doing due diligence. And oftentimes the case, they don't necessarily work out the way we would like them to be, or they're excessively overvalued, and will pass on them. But we have been very active in that market, evaluating opportunities, and we expect to continue to be doing that as well on a go-forward basis.

Now, Hercules has a great brand. And thinking about your 10-year strategy and expanding some of these product offerings, do you need to increase marketing spend or awareness to get that in the marketplace that you guys are now expanding into new offerings?

You know, the wonderful thing about Hercules is its employees, and the integrity and reputation of its employees and our brand in the venture capital marketplace is one of the highest of any institutions out there. There is absolutely unprecedented that -- just in 10 years we've deployed over $4.2 billion in capital to technology/life sciences companies. And that is in no small part with the brand name and reputation that we established at Hercules.

So I don't believe that we need to spend -- which we haven't really done historically -- much money on that front whatsoever. Our reputation, our employees' names and reputations, are a great source of deal flow. The entrepreneurs that we work with are a phenomenal group of entrepreneurs who continuously provide us with additional deal flow. And so I expect that to continue. And this is where size does matter, and reputation does matter.

Thanks for that color. And then the last one here is just to get some clarification. In the prepared remarks I thought I caught that you were expecting the second half of the year $0.04 to $0.06 in quarterly earnings growth. Is that from this net investment income level?

Yes. As you may recall -- and you look at our investor presentation deck, which is available on our website -- we have provided an illustration of hypotheticals on what $100 million of capital being deployed at a 8% yield if you will. And no, we're not advocating that we would be doing deals at 8%, but to show the impact. So, for example, if we do $100 million at 8%, you would actually look at, annually, $0.13 in earnings for that $100 million that we deploy. On the other side of that spectrum, if I would deploy the same $100 million at 14% yields, based on current yields today, we will see a 23% annual contribution in earnings.

So you can actually surmise that our new investment activities is actually working within the tolerances of 8% and 14%. And that's where you start getting into the $0.05 to $0.06 in quarterly earnings as you convert the cash on our balance sheet to earning assets, which drives our dividend growth for us -- eventually for our shareholders as well. And we do expect that to start really taking hold in the second half of 2014, probably really seeing itself come to a head in Q3 and beyond.

Great. Again, Manuel, that color is extremely helpful. Last here is just a comment. Just wanted to say congrats to Scott on the promotion.

And Scott will probably be on these calls on a go-forward basis now. So we -- Scott has been a great partner of ours, and I'm very proud of his work ethic and his performance. And I look forward to having him be my Chief Investment Officer and partner as we then turn to the future of growth for Hercules.

Great. Thanks again.

Finian O'Shea, Raymond James.

Thank you, a lot has been answered. I was wondering if your debt to equity has come down a bit? Do you see that continue to drift down, or hold here as you ramp up the portfolio this year?

So to make sure we calibrate the terminologies apples to apples here, our current GAAP yield is approximately about 76% -- I think it is, Jessica? -- on a GAAP basis, which includes the SBA. When you actually back out the $225 million of cash leverage that we have and also back out the SBA, you're looking at somewhere around 41% or 42% leverage.

Now, as we indicated, we expect to convert about $150 million or $200 million of that $225 million in current cash on the balance sheet into earning assets between now and the end of the year being a little more back-end weighted.

And when you do that, you'll probably see a pro forma leverage somewhere in the neighborhood of around 73%, 75% leverage -- meaning that we expect to maintain anywhere between $25 million to $50 million of cash on hand is typically what we like to do. But you'll see us start ramping up our leverage.

On page 25 of our investor deck, which is available on our website, you will see that Hercules has the ability -- under regulatory exemption with the SEC, we have the ability to get a full pro forma of 1.29% leverage. However, we've indicated historically that our willingness to increase leverage is probably more in the neighborhood of 1.1% to 1.2%, subject to the capital markets and the debt markets being open and predictable.

If those markets are not as open and predictable, you'll see that leverage kind of cap out around 0.8% to 0.9% if those markets are not as predictable and stable.

Okay, thank you.

Douglas Harter, Credit Suisse.

Manuel, just a little more color in exactly where you think we are in kind of the revaluation that you are seeing in deals? Do you think we're through with it? Do you think there's more to go? And just your thoughts on that.

Unfortunately, I was going to use a hockey metaphor, but given the San Jose's performance last night, it's probably not a good metaphor to use. So I'll revert to baseball. We are probably in the fifth inning of the correction process.

I think that -- as Twitter reported recently, I think that you have a little more -- sorry, LinkedIn was today. A little more shakeout to occur.

I think that the shakeout is actually good for the industry. People try to get me to say that we are in a bubble. Having lived through the 1997, 1998, 1999 and 2000 time frame, I don't think we're in a bubble in terms of a broader technology and marketplace. But I do think that we have segments within the technology sector that have bubble-ish characteristics to them.

That's good, because I think letting about 20% of the air out of the valuation of the balloon is probably a good thing. And I think that has happened. You've seen some of the more high-profile companies have valuation corrections to as much as 50%.

Unfortunately, folks like a Nimble Storage have seen some significant corrections, or even Splunk. I mean, these business models have not fundamentally changed that much, so it's just investors changing their perspective or appetite. But these companies still have very good fundamentals.

So I think that we are in the fifth inning, and I think that we probably have another 15 to 20 points on some tech sectors to go. And then I think we'll start seeing it start going back up again.

I guess with that backdrop, you guys were rightly cautious to miss the beginning of that. How do you weigh the thoughts of waiting a little bit longer versus the desire to put some of your cash to work?

Well, remember, my focus right now is moving more towards earlier-stage deals. So you'll see us be much more aggressive on earlier-stage deals, because we think that those are attractively priced these days. But some of the later-stage rounds right now, especially how we structure deals -- we can mitigate a lot of the volatility in terms of valuation by how we structure deals.

We're not going to necessarily share with the Street how we mitigate the valuation structure, because a lot of our competitors tend to want to emulate what we do. And that's why we're being a little more cautious on how we describe our investment activities, because we know what we do well. And we are the leaders in this category in this asset class. We intend to remain in that level, and we intend to defend and grow our portfolio.

And we will proceed cautiously, as we've done historically, into that area. But if you are a small, $100 million, $200 million venture debt provider, you're going to be feeling the squeeze of margin much more than we are. Because our ability to deploy $100 million of cash at a very low yield perspective, for example, is only 50 to 60 basis points impact on us; and to them, it could be a 200 to 300 basis point impact on their overall portfolio.

That makes sense. Thank you, Manuel.

Andrew Kerai, National Securities.

Most of what I had has already been answered. But just wanted to -- if I could just chat about the SBIC debt. So you guys obviously paid down about $35 million of that in Q1. So given that there's $225 million of cash on your balance sheet, obviously, you guys don't look like you need the capital at this point in time.

But the other side of that, obviously, is the 10-year at roughly 2.7%, right? Kind of depending on your viewpoint for where the 10-year moves, SBA debt -- you know, the cost of SBA will, I think one would reasonably assume, would increase, probably, throughout -- maybe later in 2014 or 2015.

I guess with that being said, how do you guys think about the potential to sort of issue that $35 million of SBA debt, given where the rates are, versus the fact that you don't necessarily need the capital, given the high level of cash?

Andrew, you hit a very important nail on the head strategically: what we're doing, and why we did what we did. Because we have taken a very controlled outlook on investment activities historically, we were carrying some legacy debt. So the $35 million-ish of SBA debt that you referred to had a historical cost of capital attributed to somewhere in the neighborhood of 6.5%, 6.3%.

And so one of the things that we had been working in great partnership with the SBA and the SBA staff -- who have been, to be honest with you, very, very great people to work with -- we have been working with them because we're going to be applying for a third license here and eventually seek additional SBA financings by having the ability to draw it down instead of having it outstanding on our balance sheet.

So we will have a just-in-time availability under our new SBA license that, as you may or may not know, could take another 3 to 6 months to get, which is fine with us. And as we work with the SBA staff, the intent is to retire some of those older SBA debentures and position ourselves to be able to then, in the future, draw down new SBA debentures at a much more cost-effective rate for 10 years. So this was a very controlled and cautious move on our part for many strategic reasons for long-term lowering cost of capital.

Right, no, thank you. Makes a lot of sense.

And then if I could just touch on dividend policy for a second, as well, too? I think pretty clearly, you guys generate a higher level of NII if you deploy the cash here, and certainly appreciate the color on that.

Given your outlook for the $20 million to $60 million of net realized gains this year, along with the increase in NII, presumably above the $0.31 quarterly dividend payout at this time -- I know historically you haven't shown this preference for special dividends, but is that something you talked about, in kind of just weighing the distribution of realized gains versus applying some of your remaining loss carryforwards, as well? Because -- just any color on that would be helpful that you could provide.

Not to give you a legal response, but I think you asked and answered your own question. I think you are absolutely right. I think the mindset of our Board, rightfully so, has been to first absorb the capital losses that we have, which you'll see it our 10-Ks are quickly, quickly vanishing because of our profitability and our capital gains. So this is a good thing, which means that you're organically building book value.

Eventually, we will exhaust all of those tax loss carryforwards, and we'll be faced with an ever-increasing potential to have a special dividend. If our Board so deems that to be the right steps, I do not want to at all preempt my Board's discourse or dialogue with respect to making that decision.

I think that is an option that we have been studying and certainly have been contemplating that may come to a head here in 2014, with our increased profitability and increased outlook. And we'll probably revisit that in, most likely, Q3 or probably Q4.

Great, great. Thank you. Then just last question I had, too, on the acquisitions front: I know you, Manuel, have mentioned that as something that you're considering from a strategic initiative standpoint on the last call as well, too.

Are you thinking -- you know, buying up slices of portfolios, sort of whole portfolios? Or maybe even acquiring a smaller competitor, in terms of acquiring the company as a whole instead of just the portfolio?

I would add all of the above; and plus, we've been approached by acquiring a whole entire origination team. We been approached by many other permutations of strategic moves to look at. We have spent pretty significant time in the fourth quarter and first quarter on evaluating some significant targets.

We are very much committed to continue to push on that endeavor. But like we underwrite credits on the front end, we are very, very picky and very, very selective. And I guess one of the things that we're not buying into or drinking the Kool-Aid is that we believe some of the valuation inflations that we're seeing in some of the other specialty finance companies -- i.e., some of the targets, is approaching the level of frothiness that we're just happy to walk away, because it doesn't make any sense.

So we care about a cultural fit. We care about the culture of underwriting. We care about the accretion to earnings. And you can find a great team that's overvalued, that's not accretive -- we're not going to do it.

Sure, sure, makes sense. Thank you for taking my questions, guys.

You're welcome. All right, operator, I think with that, I think we're done with the Q&A session.

I look forward to investor meetings in the coming weeks. We'll have many investor conferences coming up, in particular the Wells Fargo Specialty Finance Conference in New York on May 21 in Manhattan. And we also have the Stephens Spring Investment Conference in June 3. And we also have been recently invited to a Raymond James conference, and I apologize about not having that date here. But certainly give a call to our investment relations department, and they'll be happy to do that.

In the course of May, I will be traveling to Boston, and New York, and possibly Chicago and Baltimore. And I'll be happy if I have time to meet with investors, along with my team, if it's appropriate from our schedule.

With that, thank you very much. And I appreciate you continuing to be our shareholders and investors in Hercules.

Ladies and gentlemen, that does conclude today's conference. Thank you for your attendance. You may now disconnect. Everyone have a great day.