Hercules Capital Inc (HTGC) 2016 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Hercules Technology Growth Capital Q1 2016 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, this conference call is being recorded.

I would now like to introduce your host, Mr. Michael Hara, Senior Director of Investor Relations.

Thank you, Nicole. Good afternoon everyone, and welcome to Hercules' conference call for the first quarter of 2016. With us on the call today from Hercules are Manuel Henriquez, Founder, Chairman, and CEO and Mark Harris, Chief Financial Officer.

Hercules' first quarter 2016 financial results were released just after today's market close and can be accessed on the Hercules' Investor Relations section at www.HTGC.com. We have arranged for a replay of the call at Hercules' webpage or by using the telephone number and pass code provided in today's earnings release.

During the course of this call, we may make forward-looking statements based on current expectations. 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 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 also can 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 statements or subsequent events. To obtain copies of related SEC filings, please visit SEC.gov or visit our website, HTGC.com.

For today's agenda, Manuel will begin the call with an overview of our first quarter financial and corporate highlights, followed by an overview of the venture capital market and the state of new investment market opportunities, and our perspective and outlook for the second quarter of 2016. Mark will follow with a broader summary of our financial performance and results for the first quarter 2016. Following the conclusion of our prepared remarks, we will open up the call for Q&A.

With that, I will turn the call over to Manuel Henriquez, Hercules' Chairman and Chief Executive Officer.

Thank you, Michael, and good afternoon everyone. And thank you for joining us today for the Hercules Capital first quarter 2016 earnings call. First of all, I am very pleased and proud to announce another outstanding and very busy quarter for Hercules Capital in the first quarter We're off to a very strong start in 2016, turning in a terrific financial performance and financial results for the quarter. Our outstanding team of investment professionals, once again, delivered outstanding origination activities with impressive total new commitments, funding, and net portfolio growth driving us closer to our target of $1.3 billion to $1.5 billion dollars total investment loan portfolio by the second half of 2016.

This, of course, is subject to market conditions remaining favorable. In addition, we have been actively building and expanding our various sources of liquidity by bolstering our balance sheet to ensure continued access to a healthy supply of liquidity, positioning us well as we turn our attention to the second quarter of 2016 with a strong balance sheet, solid core yields, solid ROAA, and solid ROEE financial results, and having plenty of dry powder to make new investments as we continue to drive earnings and investment portfolio growth.

Now, let me take a brief moment to highlight some of the key financial results and key messaging points that I would like to have shared with you on this call.

We started the year with a solid first quarter performance, achieving our targeted net investment loan portfolio growth. Our growth expectation for Q1 was for net portfolio loan growth of approximately $75 million to $100 million and indeed we achieved that. We achieved $90 million of investment net portfolio growth in our portfolio, above the midpoint of the range. Our target portfolio growth of $90 million places us that much closer to our desired investment portfolio target of $1.3 billion to $1.5 billion. As many of you may recall, that is the optimal point to which we start generating and that investment income covering our dividend from earnings themselves. We are now within $60 million to $110 million from that target, which may be closed in Q2 or early Q3.

Although deal flow was very strong in Q1, as evidenced by our outstanding performance of $220 million of new commitments, we are being a bit more cautious entering the second quarter of 2016 as we look to be extremely selective and new investment opportunities as we continue to deploy our remaining liquidity to new high-growth venture-backed companies that must achieve the credit standards that we are comfortable with in underwriting.

In addition, we are beginning to see some early signs of select tightening of yields in the marketplace and loosening of credit terms. Although not yet systemic, it is a pattern that is developing that we are keeping our eyes on. I would not say that we expect to see a tremendous amount of competition lowering yields, but we are seeing some entrants and some impact in that going into Q2.

Some of these new entrances in the market are new venture lenders which have little to no experience in the asset class. Those lenders are seeking higher-yielding assets than they would otherwise see in the lower middle market space by entering venture lending. We're also seeing a resurgence in activities from some of the existing venture-lending banks in the marketplace who are seeking to convert their growing deposit bases into assets or loan growth to provide greater NIM coverage.

The majority of this increased environment is seen in loans generally under $15 million in size. That is a very important distinction that I want to highlight. Typically much more competition is seen on loans between $3 million to $7 million and then additional increase, albeit it less, between $7 million to $15 million and then ebbing a little bit after that above $15 million, which is where we typically actually invest our activities today.

We're also beginning to see, albeit it anemic, some early indications of potential early loan repayment activities showing signs of increased competition, which also lead to potential early payoff activities picking up; however, we do not expect early activities to really take shape or hold until later part of the second quarter or early in the third quarter. I would like to caution, it is extremely difficult for us to have very strong perspective as to when these early activities will take place, and typically we only have anywhere between 2 weeks to 30 days in advance notice before we actually get notified by our companies from early payoff activities.

This potential pickup in early repayment activities represents an increase in our expectations to which we were only expecting to see approximately $50 million of early repayment activities for each of the quarters in the first half of 2016, which tends to emulate the same activities that we saw in 2016.

With that, Hercules now is revising its early payoff activities expectations for Q2 2016. We have adjusted slightly downward our initial expectations of new investment growth in the portfolio from $75 million to $100 million initially anticipated to a more conservative outlook, albeit it small, of $50 million to $90 million in new net loan growth in the quarter, again driven in part by the expectation of a slight increase and early portfolio payoff activities from more mature, later stage companies in our portfolio.

We then find that many of these new entrants or competitors entering the market lack any depth or experience in thoroughly understanding how to properly underwrite venture loan risks. Many are inappropriately mispricing and granting less than optimal terms and conditions in their desperate quest to secure new loans or asset growth. Having been doing this now for nearly 30 years and having seen this play out throughout my career many, many times, it's only a matter of time before many of these ill-experience new entrants begin to realize credit losses from the ill fate of underwriting loans to which they have very little experience in understanding the cycles of life science companies or that of technology companies.

With that, we have chosen to remain more cautious and more selective and refuse to match the rapidly tightening yields in certain segments of the market and allow assets to simply not fall into our lap as we pursue new investments as competitors drive margins slightly tighter than we think are appropriate in the marketplace. Because of this current cycle, our preference is to pass on ill-priced or ill-structured loans. We will continue to do as we did in Q3 and Q4, and that is preserve our liquidity for originating in better times where we see widening yield and better terms and conditions that we like.

We would rather protect our balance sheet, although I want to caution, this does not mean we will not remain active in the portfolio growth in Q2. As I said earlier, we expect the portfolio to continue to grow to $50 million to $90 million in Q2 alone. So we are continuing to grow our portfolio, just being much more selective in that process as we look to have pricing equilibrium return back to the marketplace itself.

Now, although it's still early in the second quarter, we are now expecting early path activities again to now modulate themselves in a much tighter range from between $60 million to $80 million in early portfolio payoffs during the quarter. That is up slightly from our initial expectations of $40 million to $50 million. You can basically look at it as 1 to 2 additional loans, simply paying off earlier than expected. But at this point, again, I want to caution we do not have solid visibility in that level yet, we're just seeing some noise level that we want to be cautious about and share with our shareholders on the activities that we're seeing.

We will remain and continue to remain highly selective in our new origination activities. We will continue to adhere to our philosophy of slow and steady and prefer to slow down our portfolio growth to that new modulated growth level of $50 million to $90 million in the quarter. We will wait for the desired yield to fall into place.

Finally, given the challenge that many of our BDC peers are encountering today, I would also remind our investors and new investors evaluating Hercules Capital that we do not have, nor do we focus on, oil and gas exposure. And we do not have any CLO exposure in our book. That is an important differential between us and our BDC comparative companies out there.

Now, what does Hercules Capital focus on? And what we do do and what we do well. And that is focus on the venture capital industry. We are the largest BDC focused on the venture capital industry, bar none. We are extremely active. Our brand, our reputation, our integrity have afforded us and continue to afford us a very solid source of deal flows and a very strong venture capital and private equity relationships with our financial partners for continued deal flow, as evidenced in our $220 million of deals completed in the first quarter.

Hercules shall remain focused in the venture capital marketplace, and specifically focused on later stage venture growth stage companies, companies that are expected to potentially achieve exit liquidity events typically within 36 to 48 months post our investment with these companies. We expect many of these companies to achieve an IPO or M&A event within that period of time; however, not all companies are expected to achieve those goals as many of these companies will continue to go through an elongated financing cycle as they continue to go through their clinical trials, if they are life sciences companies, or continue development of their products as they continue to improve those products once they are deployed in the marketplace with their own customer feedbacks.

Now let me share some key achievements as provided by Dow Jones Venture Source on the venture capital marketplace and venture capital activities. Surprising to us, as well as to many, the venture capitalists had an extremely robust first quarter of fundraising. In Q1 2016, the venture capitalist firms raised approximately $13.3 billion dollars of new funds compared to $35.2 billion raised in all of 2015.

So if we assume a continuation of the Q1 activity's run rate, VC fundraising may actually surpass all of 2015; however, Hercules does not expect that to occur. We expect VC fundraising to taper off and realize more in line with the activities realized in 2015 or slightly below the 2015 activities at $35 billion.

Now, turning my attention to venture capital investment activities. This as well was much higher than we had anticipated. I would like to remind everybody that we had anticipated that the venture capital activities in 2016 will actually modulate itself down to around $45 billion of activities, down from the $75 billion that we witnessed in 2015.

As to Q1 2016 specifically, the venture capitalists once again showed a healthy pace in new investments. At $13.4 billion of new investment activities to over 800 companies, receiving new capital by the venture capital community. That was much healthier and much higher than we had anticipated in new investment activities, but that said, I'm very pleased to see the activities as representative. A lot of those companies happen to be our portfolio companies that are receiving follow on capital from the venture capitalist investments.

As a reminder, many of our venture capital-backed companies typically are required to raise capital in generally 9 to 14 month intervals. As we typically see in our portfolio, turning our attention to Q1 we start seeing a significant activity pickup in many of our companies, going out for financing events in Q1 and Q2, which leads to our own self marking down of rated 3 loans to reflect the ongoing finance activities of our company in keeping with our nature of conservative mark to market in our loan portfolio.

Other encouraging news from the venture capital activity was the biopharma investment activities. To our surprise, we saw a pickup in biopharma performance in the second half or the later part of Q1 and certainly in the first half of the second quarter of 2016. In Q1, biopharma received a strengthening or a height in investment activities by the venture capitalists and I'm also happy to report that we saw a pickup in investment activities in the venture capital community and to information technologies and electronics. We also saw, however, a pullback in consumer services more commonly known as social media type investment activities by the venture capitalists themselves.

Although IPO activity remained tepid to almost non-existent, we did see, however, 6 companies complete IPO events in the first quarter. Six of those companies just so happened to be life sciences companies. Late in the quarter we also saw on technology IPO company complete an IPO and that's SecureWorks, which is basically a Dell spinoff itself. We, however, did not experience any IPO activities during the quarter. We ended the quarter, however, with approximately 4 companies in IPO registration. We did, however, see a pretty healthy pickup in M&A activities by the venture capital community, with 131 companies completing over $22 billion in value acquisitions and activities in the quarter. That compares to a total of $58 billion in all of 2015 of companies completing M&A events.

So as you'll see, the M&A activities in Q1 was actually more robust than many of us expected and quite encouraging in signs that liquidity events are still occurring for the venture capital community.

Now, let me take a moment to highlight our own capital markets and increase liquidity activities thus far in the early part of 2016. As most of you now will see, we have been very, very actively busy. We have recently bolstered and expanded as well as diversified on multiple sources of liquidity to Hercules Capital to continue to sustain and gain access to the capital markets for continuation in portfolio growth. For example, we recently completed a top off or a reopening of our existing 2014 bonds of raising gross proceeds of nearly $73 [billion] and net proceeds of just over $70 [billion] in net proceeds. That is critical in adding to our additional liquidity.

We have also expanded our relationship and our accordion with Wells Fargo Bank. We now have added a second bank to that syndicate' for an additional $45 million of liquidity being added to our Wells Fargo accordion, topping it off at $120 million of additional liquidity event for accordion for additional growth in our portfolio. Also, and of very strategic importance, is that we also reinstated and began to selectively tap and use our at-the-market, or ATM, equity line. I view this line as a just in time additional capital being raised equity capital being raised that will allow us to keep in balances our bank warehouse lines as we drop in new loans, that sometimes the loans are lumpy in size, and by allowing us to have equity buffer for the ATM access, it allows us to basically manage our ability to stage in new loans into our bank syndicates.

Please be assured that the ATM is not a large equity capital raising engine. It is meant to, and used for, just in time capital for small amounts of capital that are being raised. In fact, to give you some comfort, that all the equity raises that we have done thus far, $16 million, have all been done absolutely accretived to net asset value and accreted to earnings themselves.

This is a very effective treasury management tool that you will expect us to continue to utilize throughout the year. Again, as I said, since reinstating the ATM in early March, we have completed a mere $16 million of equity offering, all accretive to book and all useful in having us be able to manage our bank lines as well as our leverage ratios, if in fact we need to be focusing on those issues at this point, which we do not.

We currently have a regulatory leverage ratio of only 58% overall. Said differently, we have an abundance of headroom to be able to grow our regulatory leverage up to the 1 to 1 level if we so choose. We ended at the quarter with approximately $120 million, but not for the additional liquidity activities that occurred right after the quarter, we're now in a very fortuitous position to have approximately over $200 million of available liquidity to continue to grow our investment portfolio.

As a reminder, I said earlier we merely need to grow it by $50 million to $100 million before achieving the optimal $1.3 million to $1.35 billion. Said differently, we're extremely well-positioned from the liquidity point of view, origination activities, and portfolio pipeline and insight to actually hit that target relatively comfortably. This is important because we technically do have that headroom to access additional leverage. We still reserve the right and the ability to tap the debt capital markets further in the near future to refinance our more expensive 7% baby bonds that we have outstanding that we are looking to refinance at much more attractive, lower rates; however, short term rates currently remain highly volatile and not optimal for us to pursue that.

So as we invest we also manage the liabilities with the same level of prudence, that we shall remain in the sidelines until we see more favorable debt capital markets activities with the five-year Treasury said to stabilize a bit more than it is today. Because of that, we remain very patient in refinancing those old legacy bonds. I hope and expect to have those bonds refinanced sometime in the later part of 2016, but again, we will remain cautious on that.

Lastly, on leverage, I would like to remind everybody that although we are able to leverage the balance sheet to a full 1.26 to 1, we will not do that. Our optimal leverage that we feel comfortable with is at 1.1 to 1 ratio or optimally, somewhere in the neighborhood at about 1 to 1 leverage ratios themselves. Because of our ATM, we're able to manage those leverage ratios much more closely with the use of gradual issuance of equity if we need to, to help us modulate down those leverages in a case of rising higher than we anticipate those to be doing.

At this point, we wanted to make sure that we will only look at future equity raises if they make sense and if they become accretive in the short term for us today. We have plenty of capital to grow and achieve our goals currently today.

Now, turning my attention to the second quarter and a summary of my comments, Hercules Capital is extremely well-positioned entering the second quarter and the second half of 2016. We have ample access to both debt and equity capital markets for liquidity. We have an active ATM program that provides the just in time capital on an as-needed basis. We have been recently assured and have received affirmation from the rating agencies on our recent bond offerings and also all of our existing bonds now have a triple B+ rating from KBRA and we also have investor grade rating triple B- from S&P and all our existing listed bonds today in the marketplace.

In addition, Hercules continues to trade at a premium to debt asset value as compared to the broader BDC market, which currently trades at a significant discount in asset value. I would personally like to thank our shareholders for the continued faith and confidence in our team and our underwriting and allowing us to continue to trade at a premium to debt asset value. We take this very seriously and we work hard to ensure that we return that with strong financial performance for our shareholders and continue to show earnings growth for our shareholders.

Hercules is only one of a handful that consistently and continuously trades above net asset value. With that, I turn the call over the Mark.

Thank you, Manuel, and good afternoon or evening, ladies and gentlemen. I will now briefly discuss our financial results for the first quarter of 2016 and add some context to the reported numbers. As Manuel commented, we had a strong Q1 2016, and I will give some direction on where we expect to see it going forward. As we turn to portfolio growth, our loan portfolio had cost increase from $1.152 billion at the end of 2015 to $1.242 billion at the end of the first quarter, or an increase of 7.8%.

We had strong total investment fundings of approximately $170.9 million in the first quarter, including the addition of 14 new portfolio companies, partially offset by $55 million of unscheduled early payoffs and normal amortization of $21.4 million. Our effective yields were 13.2% in the first quarter, down from 14.2% in the fourth. This decrease, as Manuel has spoken to, as primarily related to the amount of early payoffs and associated acceleration of interest and fees, as previously discussed. We had early unscheduled payoffs of $105.5 million in the fourth quarter last year compared to $55 million in the first quarter of this year. That's a reduction of approximately 48%, which was in line with the expectations at the end of the year.

Given the current market condition and the age of our loan book, we expect to see $60 million to $80 million of unscheduled early payoffs in the second quarter 2016. Core yields, which exclude the effect of prepayment penalty fees and acceleration from early payoffs, was 12.9%. This was in line with our expectations, given the Federal Reserve's benchmark rate increase made in December 2015, coupled with 93% of our loans, which are variable interest rate loans. We expect our core yields to maintain between 12.5% and 13.5% on a going-forward basis.

In the first quarter of 2016, we saw an increase in our weighted average loan yields on new originations due to one, an increase in the benchmark interest rates, two, a favorable competitive environment, and three, increased demand, which led to origination of core yields of over 13% in the first quarter. This should be noted that while we saw better underwriting of terms and yields, our weighted average loan to value based on last round of financing was approximately 15% on a static pull basis for our portfolio as of March 31, 2016. This was an improvement from our year end loans to value of approximately 16% based on the last round of financing.

Before I go into the income statement, I would like to remind everybody that Hercules Capital continues to adhere to its historical aversion to PICC. PICC is less than 5% of our total investment income in the period, thus PICC is a small part of our business as we believe in our amortizing loan policy to help prevent credit concerns down the road.

Turning to the income statement, our investment income was $38.9 million in the first quarter, compared to that of $39.4 million in the fourth quarter of 2015. This difference is mainly attributable to the large one-time acceleration of income in the fourth quarter. This acceleration stems from the $105.5 million of early payoffs, compared to the $55 million of unscheduled early payments we received this quarter.

Removing acceleration from both quarters, we had an increase in our core investment income of approximately 3%, or $37.9 million in the first quarter compared to that of $36.9 million in the fourth quarter. Interest and fee expenses was $8 million the first quarter compared to $9.5 million in the fourth quarter, a reduction of 15.5%.

I'd like to remind everybody in the fourth quarter we had a one-time non-cash charge of approximately $800,000 related to the $40 million buyback of our September 2019 notes. Further, the $40 million buyback saves the firm approximately $700,00 in interest and fee charges. Thus this had an aggregate savings of approximately $1.5 million, which accounts for the difference between the two periods.

Subsequent to quarter end, we issued $72.9 million of our 6.25 2024 baby bonds. In connection with this issuance, we expect an increase in interest expense and fees on a quarterly basis of approximately $1.2 million. Therefore, we expect interest expense between $8.5 million and $9 million in the second quarter and between $9 million to $9.5 million in the following quarters, subject to credit facility usages.

Our weighted average cost of debt decreased from 6.2% in the fourth quarter to 5.5% in the first quarter of 2016. Given our $72.9 million bond offering, we expect our weighted average to increase to approximately 5.7% on a fully burdened basis going forward, again, subject to credit facility usage.

Net interest margin was $30.9 million in the first quarter 2016 compared to $29.9 million in the fourth quarter. Net interest margin adjusted for the effects of income acceleration and one-time non-cash expenses would have had a normalized level of $28.2 million in the fourth quarter, versus $29.9 million in the first quarter or growth of approximately 6%.

Net interest margin as a percentage of average yielding assets was consistent at 10.1% in the first quarter of 2016 compared to that of 10.2% in the fourth quarter of 2015. I now turn my attention to the operating expenses. Operating expenses, including interest and fees, increased to $10.8 million in the first quarter from $9.8 million in the fourth quarter, or an approximate change of 10%. We expected our operating expenses at the end last year, excluding interest and fees, to maintain between $10 million and $11 million per quarter, as this gets adjusted on variable bonus tied to Hercules' performance.

Our first quarter was well within that range that we gave.

Our general administrative expenses in the first quarter was $3.6 million compared to $4.5 million in fourth quarter last year. This is within the range we gave for 2016 and that we expect this to remain between $3.5 million and $4 million on a quarterly basis in 2016.

Employee compensation increased to $7.3 million in the fourth quarter of 2015, $5.3 million, due to changes in variable compensations in the quarter. We expect employee compensation to move in line with originations and business performance, as it is directly correlated with our variable bonus program. Again, consistent with year end, we expect employee compensation to be between $6.5 million and %7.5 million dollars in 2016 per quarter.

Our net investment income was flat at $20.1 million for both the first and fourth quarters, which was due to the increase in interest income and the lower fee income due to less early unscheduled payments. On a per share basis, NII in the first and fourth quarter were both $0.28 per share; however, NII margin has improved to 51.6% in the first quarter compared to 51.1% in the fourth quarter, which we expect to maintain between 50% and 52%.

Our return on average assets was 5.9%. Our return on average equity was approximately 10.9% in the first quarter. This is in line with, again, the guidance that we gave of return on average assets to be between 5.5% and 6.5% and return on average equity to be between 10% and 12% on a going forward basis.

We had a net change in unrealized depreciation on investments of $1.3 million in the first quarter. For further details on changes of unrealized [appreciation] we direct you to our press release. We provide a detailed table which illustrates the components of both the credit and marked to market rate adjustments. As pertaining to our loans during the period, our loan portfolio had an unrealized appreciation of $6 million in the first quarter compared to an unrealized [depreciation] of $10.5 million in the fourth quarter. This was a mix of gains from reversals and payoffs, impairments, and market yield adjustments under fair value accounting.

In our equity and warrants, our net change in unrealized depreciation was $7.4 million in the first quarter. Given approximately 35% of our equity and warrants are public, this is consistent with the first quarter capital market performance, where we saw an approximate 8% decline in value on the quarter. For example, the Russell 2000 Biotech Index was down 29% in the quarter. The Russell 2000 Technology Index was down approximately 2% in the quarter, and if we looked at narrow index, such as the S&P Pharmaceutial, Bio, and Life Sciences Index, that was down 8%. And the S&P Information Technology Index was up approximately 2%.

We now turn our attention to credit analysis. With respect to credit quality, we continued our focus on credit discipline. In the first quarter, our weighted average loan rating was 2.17 from 2.16 in the fourth quarter 2015. That's flat quarter on quarter. Although we did see an increase in rated 3 loans, much of this had to do with our portfolio companies approaching upcoming next round of financing event, where we have a policy of moving them to a 3 grading until they complete their next round of financing, have a signed term sheet, or other factors are present.

I'd like to highlight that our watch list, which are the rated 3 to 5, was approximately 23.5%, which is within our historical levels. Our non-accrual as a percentage of total investment income at cost decreased from 3.8% to 3.7% in the first quarter. While this decrease was modest we did have two loans we exited within the quarter, coupled with the addition of one loan. We continue to work on the non-accruals to further reduce our rate over the next couple of quarters.

Our cumulative net losses, which consist of loan losses offset by equity and warrants gains was $11.3 million since the inception of Hercules Capital, which is an outstanding number given the nearly $5.9 billion of commitments we have had to date, or a loss of only 2 basis points annualized.

As we discussed previously, we will continue our switch in focus on keeping cash drag and interest expense to a minimum through the use of our credit facilities, which were expanded in the quarter. Thus we had unrestricted cash of $13.5 million at the end of Q1. We had $122.5 million of liquidity at the end of the quarter, which consisted of $3.5 million of unrestricted cash plus $109 million of undrawn availability under our revolving facilities subject to borrowing-based leverage and other restrictions.

Additionally, in April and May we had 4 capital events that changed our liquidity profile to approximately $200 million. We closed $72.9 million on our 6.25% 2024, baby bonds in May. We added Ever Bank to our Wells Fargo Facility, which added another $25 million in April. We closed $4 million of ATM in the month of April and we paid back the $17.6 million of our convertible bonds in April. Our unfunded commitments are now $162.6 million in the first quarter, which consists of both available and unavailable or milestone achievement commitments. We had available unfunded commitments of $64.6 million, or 5.2% of our loan balance at cost as of Q1 2016, which was a reduction from the $75.4 million, or 6.5%, of our loan balance at cost as of Q4 2015, which is significantly down from the $159.1 million we had in Q2 2015.

We expect that our current unfunded commitments will stabilize at this level and may marginally grow with our business growth objectives.

Turning our attention to our debt-equity ratios, our regulatory leverage, excluded SBA as we have exempted relief from the FCC, was 58.6% at the end of the first quarter. This is versus 57.2% at the end of the fourth quarter. Our GAAP leverage with SBA was 85.1% at the end of the first quarter versus 83.7% at the end of the fourth quarter. Based on regulatory leverage ratio, we have the ability to add another approximately $300 million of debt without breaching the regulatory limit.

Finally, net assets was $718.4 million at the end of the fourth quarter or in an NAV per share of 9.81. While our net asset value or net assets were up slightly, we did see a decrease in NAV per share by approximately 1.3%, mainly from the issuance of common stock under our SA program, and changes in our unrealized and realized activity in the quarter.

Further, we continue to optimize our capital structure and engage in our share repurchase program and our ATM program. In January 2016, we repurchased approximately 450 shares of at an average price of $10.64 and in March 2016 we issued 1.1 million shares at an average price of $11.54.

Finally, dividends. We are pleased to be declaring our 43rd consecutive dividend of $0.31 per share that will be paid on May 23rd, as approved by our board of directors at the record date of May 16. With that report, I now turn the call over to the operator to begin the Q&A part of our call.

Ladies and gentlemen, if you have a question at this time, please press the star and then the number one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key.

Your first question comes from the line of Ryan Lynch from KBW. Your line is open.

Hey, good afternoon, and thanks for taking my questions. You mentioned that you guys are seeing increased competition in smaller loan sizes, call it $3 million to $15 million, a little more competition on the $3 million to $7 million loan size. So as I look through your portfolio, I mean, there are a quite a bit of loans under $15 million in loan size. So can you just talk about how you guys are managing, trying to grow, have good net portfolio growth over the next couple quarters, meanwhile trying to stay away from the increased competition that is residing right now in the sub $15 million VC loan market.

Thanks Ryan, for the question, as I said on the call we just completed $220 million in new origination in the first quarter. So there is an abundance of deal flow and deal activity out there. We just want to highlight that there is a bit more of increased competition coming in but I think that the cadence that we're trying to establish of new portfolio growth of $50 million to $90 million is well within our capabilities, as you saw in Q1 and we do not expect nor do we focus a tremendous amount of time on those smaller deal sizes.

But I would actually caution out that some of the smaller loans that you see there have amortized down and those were not the original balances. If you look at our portfolio on a static basis, looking at an average loan portfolio around $13 million to $15 million on average size, those balances that you're quoting just so happen to be legacy loans that have amortized down since we don't' really do $5 million or $3 million loans to speak of.

Okay, and then just sticking with the competition theme it feels like over time as the competition kind of ebbs and flows you'll see a lot of new participants come in and then they will kind of exit. It sounds like some new participants are coming in recently. How would you characterize competition currently versus maybe one year ago?

I think competition a year ago was much more sophisticated, understood the asset class much better. I think that the competition today we're seeing is a bit more sporadic, ill-prepared to understand the subtleties of underwriting venture loan and development stage companies. And I think that when they venture in, and I will use the expression ?all are welcomed? because it only takes a matter of one economic cycle and one amortization period to commence when they start realizing credit losses, not knowing how to underwrite this credit in venture lending.

It's a very complex credit underwriting. It doesn't lend itself to simple financial ratios that you otherwise see more typically used in lower middle market and you have to have both a good credit discipline background as well as the technology of life sciences makeup in order to truly underwrite and understand these credits.

So I am not losing sleep about this competition. I am not worried about this competition. It is both not sustainable and they don't have enough capital liquidity from what we're seeing, and a lot of the loans that they tend to be taking away are loans that we probably would not otherwise do. And we're in a very fortuitous position to have a very strong portfolio, a very strong legacy of underwriting good credit qualities, and we only need to grow by, again, $60 million to $110 million to achieve our end point and we're very comfortable at that pace and that liquidity that we have to achieve that.

Got it, and then just one more, I know VC access can come through a variety of different ways, M&A, also the IPO markets, but with the IPO markets essentially being closed over the past few months, are you guys seeing any increased opportunity investing in some of the more later stage VC backed companies that were maybe planning on IPO-ing and now cannot and are looking to raise additional rounds of capital?

So the answer to your question directly is yes. The clarification to your question, I would say that for the last 16 years, I don't think we've had a robust IPO market yet. I think the last really good IPO market that we had was probably 1998, 1999. Ever since then it's been a fairly anemic IPO activity with some hopes of increased activities that we saw probably take place in 2014, if you will.

But most people don't realize, and it's not written quite a bit about, but that is that venture capitalists [don't actually see] an IPO market; M&A is better. And the M&A market has remained fairly steady and robust throughout that 16-year period of time. There have been, obviously, different periods within that 16-year period of time where M&A has curtailed, but I've got to be very honest. We continue to enjoy pretty good representation IPO activities from our companies that are going on out there.

We're not necessarily concerned about that but to answer your question, yes, many of these later stage companies who are facing potentially down round valuation of that equity will be looking to supplement their capital structure with some form of debt. We're evaluating some of those players and we're passing on many of those players as well.

Great, those are all the questions I had.

Thank you, Ryan.

Your next question comes from the line of Jonathan Bock from Wells Fargo Securities. Your line is open.

Good afternoon, and thank you for taking my questions. Manuel, appreciate the comments about measured growth and more importantly competition, and just to use a comment that I think you mentioned, letting the yields come to you. We respect that. The question centers, though, around the fact that earnings are still a touch light of the dividend, so could you explain if yields aren't where you want and growth isn't where you want, why it's worthwhile to raise high-cost debt on the balance sheet, which puts us further away from dividend coverage in light of the fact that you're being so conservative. So it seems that ? help us understand how there is congruence there when at first glance, that decision to raise the high cost debt appears a bit incongruent.

Wow. Well, I want to be respectful, but I don't agree with almost all of that.

You can, and I respect that, I just want to understand what we're missing because when we put our high cost debt on the balance sheet, we end up getting further away from target coverage if you're being conservative. Normally we see folks try to lower interest costs at that time and we'll term things out kind of after we've built growth. Does that make sense?

No, because the answer is not all debt is created equal and I think this notion and this capitalizing of BDCs with short term bank lines is actually very problematic for me and one that raises all kinds of economic concerns for BDCs. Specifically, the reliance on short term bank line, albeit it optimally looks attractive at 3.5%, 4% yields if you will, or cost of capital, the reality is you're not getting a really attractive advance rate, especially in the venture asset class, where most typical banks will only advance 50% ratios on those bank lines.

While a bond, for example, which I disagree with would be very expensive cost of bonds, I just borrowed 8-year money at 6.25%, locked in 6, while my bank lines are all short term, floating rate loans that are variable in nature and allow me to have a spread that may expand or compress accordingly.

So I would rather leg out a maturity on my liabilities with a fixed rate liability. So let's take that at face value. So if I'm originating loans at effectively aa 13-plus yield today and I've got cost of capital, in this case cost of funds at 6%, I'm getting a 600 to 700 basis point wide spread on that. And that's very attractive when I can match my maturities on a long term debt facility itself.

When I blend that in to my entire liability structure, my blended overall liability is actually still exceptionally attractive around 5.5%, 5.6% on a weighted basis. So all that serves to be accretive. What people don't tend to realize is that your reliance on bank lines, albeit it is important for a short-term financing facility, you're not able to achieve the optimal advance rates on your bank lines because of single credit concentration limits and other restrictive provisions that exist within bank lines, thereby allowing bonds to be much more attractive and fluid in building a very good, robust portfolio. And I will always defer to a long term type of financing in the bottom markets than merely relying heavily on short term bank lines.

Got it, so then just taking that ? and I appreciate that, because that's a comment about advance, which is very important. So then even blending this higher expense into the cost structure, your views of easily covering the dividend from NII, that would kind of come to say that we should expect that near-term fairly shortly?

Absolutely. I mean, I said this all along in Q3 and I said it in Q4, and I'll say it again now ? I absolutely believe barring some black swan event, that this team will deliver that NII coverage, which to me is more symbolic than [reality] because the only thing I really care about is taxable earnings, which have been covering our dividend for a long time as we had earnings spillover, but that said, the street is fixated on NII to div coverage, dividend coverage.

I hear you, I know that, and I can tell you that as I said this early on and I'll say it again now ? once we achieved the optimal utility of our portfolio, that $1.3 billion or $1.35 billion, subject to whatever the yield you want to use, you will more than see that at $1.35 billion we are generating income that more than surpasses a $0.31 dividend yield.

That is expected to be achieved, probably sometime in the third quarter, whether it is at the middle or the end of the third quarter. That is a trajectory that we're on and I expect us to achieve that trajectory barring some black swan even. So yes, that is what we're marching towards and that is what we will do barring some event.

Got it, and then probably just to keep focused on the liability side of the balance sheet, but obviously with such large scale and presence, the choice between line at low rate versus term debt at higher rate, but not secured and providing the substantial flexibility, isn't there a third avenue as it relates to on-balance sheet securitization and I imagine that's likely attractively priced, granted not as longer term but certainly matched to the duration of your assets. Can you talk about that tool and its potential for use in the current market environment?

Oh yeah, I'll let Mark answer that in more detail but the answer to that is that Hercules prides itself on having a highly diversified source of funding. Securitization is very much in that wheelhouse, and you're absolutely right on your comment, and Mark will cover that in a second. But that is something that we'll be looking at as well, but I'll let Mark give you more color on that.

Jonathan, it's a great question and the answer is, first of all, no stone goes unturned. So we're absolutely looking at potential securitizations and we're looking at unsecured and we're looking at, as we're done expanding our facilities, etc., and we're trying to make sure we've always got the right mix on our liabilities. I guess the comment that I would make to you is on ? and Manuel said it rightly, which is it always seems really cheap to use the credit facilities. The problem you have with those are they're very complicated in the sense that A, you've got to put assets behind it and you've got to make sure it has the right makeup and mix and you're getting the right yields and advance rates, etc., and it's always a very careful game that you have to play with it, but also remember it's variable.

It's going to move on you, especially at a rate increase environment. So today while it may look really inexpensive, if you start going long on it and the others, where you could fix yourself in like we did on the 8-year at 6.25%, I'll take that all day long.

On the securitizations answer, we're seeing some pretty large spreads on those. So those can go anywhere from 350 to 450 or higher, and we just believe with the market feedback that we're getting on them, they're not right for us at this point in time but hey, if that changes next week, I definitely would reverse my answer.

And Jonathan, please take this at face value. We will be doing another securitization as we once again top off our bank lines, we will then term out those bank lines, i.e., warehouse facility into a longer term duration and securitization facility. And that will be happening probably later on in 2016 as well.

Makes total sense. Thank you so much.

You're very welcome.

Your next question comes from the line of Hugh Miller from Macquarie. Your line is open.

Hi, thanks for taking my questions. I wanted to just touch base a little bit on kind of we've been hearing that the VC-backed companies have been shifting focus towards achieving profitability as opposed to just really focusing on growing the business with the customer base. In that type of a scenario where you probably see a slower cash burn rate, would you say that impacts your ability to kind of deploy capital to some of those higher quality firms if they are less cash-strapped or is that not a huge issue for you?

First of all, your question is actually ? first of all, I appreciate it. It's quite insightful and very astute. But there is a difference in the answer. Actually those companies are even more attractive to us and we're more attractive to them. Because the fact of the matter is although they're pulling back their burn rate and trying to concentrate on getting to a cash flow break even or EBITDA break even, they nonetheless still need additional working capital and what they do in that case is, minimize the impact on dilution by issuing more shares, and thereby driving their EPS even lower.

So what they do is they will actually then complement lesser amount of equity to minimize the impact on the numerator of the number of shares that they're going to be issue and then supplement that with debt capital to achieve the same level or working capital and new capital they need to fund their growth, so they will actually be using much more debt in those cases to actually look to fund through a liquidity event in the near term than doing excess of equity.

Although it seems very nice to be able to tell a company that's burning $10 million a month to somehow you've then got to go to cash flow break even within three months, if their burn rate will go from $10 million a month to maybe $7 million a month and six months later maybe $5 million a month. It is very difficult for them to miraculously turn off the spigot of burn. So it takes about 9 months or longer to get these guys to stabilize, and some of them will still be burning money, just burning it at a lesser rate of money.

Definitely very helpful color there, thank you for that. In following up on your comment about preference for a favorable M&A environment versus an IPO environment, is that just a function of kind of getting the liquidity out at the time of the event as opposed to a slower drawdown via IPO as you sell down the investment or are there other factors that play into a preference for M&A over IPO?

Sure, listen, with no disrespect to IPO companies going out, the biggest risk with IPO companies are that you typically have an investment banking lockup period of 180 days. Said in different layman's terms, you have two earnings calls post the IPO event and you've got to pray and hope that they don't miss earnings. Therefore that's additional stock volatility. On an M&A event, on the other hand, an M&A happens and we get either paid out or the acquirer assumes our debt with our consent.

So it is a much better liquidity event on M&A than potentially risk an IPO event where they may not choose to pay it down or pay us off at that point. We have many companies who go public who keep our debt outstanding, but we also have a smaller set of examples of companies that go public and do pay off our debt. But our preference, clearly, would be an M&A event. We actually get paid out and we don't have aftermarket risk either on an M&A or an IPO event that happens.

Yup, that's helpful, thank you. Then last for me, you know, I heard a little bit about one of your peers that just had some challenges with their early stage VC portfolio with an uptick in kind of some of their charge offs and I wanted to just get a sense ? I know you guys focus on the later stage market, but as we look back over at history, not to say that their challenges are a proxy for the early stage market, but does there tend to be a lag between if we do see challenges in early stages ? is there a lag period in which it starts to impact a later stage? How does that relationship work through the cycle?

So to use a metaphor, early stage is not the canary in the coal mine. What happens is, it's a very simple mathematical calculation. If I'm a venture capitalist, and I only have $3 million or $4 million invested in an early stage company, and that company is still 7 years away from monetization of their products or services, or monetization of an exit or liquidity event, as opposed to a later stage company where I may have $30 million of equity capital as a single VC and in totality may have $130 million or $150 million of equity capital.

The expression that is used in this business is that the VCs are more willing to circle the wagon and protect that more capital intensive company that they had, because that company has a greater efficacy or proving that this business model is working and thereby it will have to just simply withstand the current cycle that you're in, but it has a better optimal chance of going public than later, which means that you might as well cut and run on the earlier stage companies because you don't have enough capital at risk there that really matters. Not to say that VCs do not care about those early stage companies, but it's a lot easier when you face a capital constraint environment to simply say, ?I'm not going to really support that early stage company.?

That certainly makes sense. I definitely appreciate your insight, thank you.

You're welcome.

The next question comes from the line of Aaron Deer from Sandler O'Neill. Your line is open.

Hey, good afternoon guys.

Hey, Aaron.

A couple questions. One is it was nice to see the $12 million appreciation in the loan book. I'm wondering, you sound fairly optimistic in terms of the credit outlook. I'm wondering what the potential pipeline, if you will, of additional write-ups might be to the extent that you see continued improvement in credit.

Well, we were actually ? so, look. We obviously are taking what we know how to do well, and that is evaluate credit on a very rigid basis. As always, we think that our credit book is truly reflective of what's going on in the marketplace and what's happening out there. I think that one of the things that you see in our portfolio is that many of our companies, when they achieve a new raise, we will then remark up or re-evaluate the mark on that portfolio company because they now have retopped off the coffers with additional capital, or said differently, the risk profile has dramatically improved, post the equity raise.

As many of our companies are embarked on doing right now, Q1 and Q2 is typically a fairly robust period of time for many of our companies raising capital. Hercules typically, unlike many other BDCs out there, we actually lower the risk rating in those companies until such time as to raise a new level of equity capital. Then in our mind they go off risk again.

We do not see currently a disproportionate increase in the credit outlook or credit concern of our portfolio. I think that the credit portfolio marks right now reflect what we think is a good outlook, unless again, a black swan event occurs in Q2. We think that would solve some nice resiliency of the biotech marketplace occurring in Q1, albeit it some pickup in technology but not anywhere near the pickup that we've seen in life sciences that occurred. Many of our companies, however, are in fact closing new rounds of equity capital. That is a good testament of our teams identifying and picking the right companies who are able to raise subsequent amounts of equity capital and get that additional amortization cash or capital to continue to pay down our loan. And that is a process that we see right now, but I don't see this disproportionate pickup in credit concerns right now on the marketplace, especially since we don't really do a lot of early stage deals.

Okay, so it sounds as though as these fundings come through, and you sound pretty optimistic that they will, that we can continue to see the markups outweigh the markdowns on the credit side.

I would say the answer is yes. I believe that from what we know today, I think that continued pace of continued improvement on our credit book should occur and will occur. As I said, many of our companies are currently in the midst of raising new equity rounds of capital. But only I would say less than a handful, we have a closer scrutiny on those going on right now, but the vast majority of them have or are in the process of securing new rounds of equity capital, which upon completion will dramatically improve further the credit book than what it is today, which is already quite strong.

But yes, to answer your question, I don't have this great credit concern in the marketplace today. We are nowhere 2007 or 2008, if that's what you're asking me. We're far from that today.

And then a question for Mark. If I hard you correctly in your commentary, you said that excluding the early prepayment impact that there was a 3% sequential increase in core investment income, is that right?

Correct, so what we did is we wanted to try to take the noise out of the numbers so you guys can understand how we did on a core basis. And a core basis, we grew it from Q4 to Q1 by approximately 3%.

So the average loans over that period I think were up like 6%?

Correct.

And then of course we had the 25 basis point rate hike, so what are the variances there? Is it lower deals and new investments, and then there are some other accretive impacts that are in (inaudible)?

No, not at all. So the way that you want to think about it is remember we've got some that pay off and we have, obviously, the ones that we've added on. Just on core versus non-core, the answer is as you add in ones that have a core value, that will increase the investment income amount, and that's really kind of what we generated. That's why we saw the approximate $37 million from the $35 million increase that I was speaking to in the script because we're adding those new investments on board.

So Aaron, let me take a stab this way. What is going on in a portfolio is as a portfolio continues to grow organically, we have less and less reliance on one-time events, fee-driven events in order to continue to grow earnings. What is happening is because of the lack of amortization ? sorry - because of the lack of early repayment activity going on, we're simply able to continue to add to the core portfolio, assets that are generating yields at higher and higher rates as we're originating in Q1 and hopefully additional yields in Q2. As we add those new loans at a higher yield, our core earning capacity of that portfolio is going up itself naturally. Then what happens is if you add the expected in the second half of 2016, early payoff activities, you would be generating income that should far exceed the $0.31 in dividends, driven by those early payoff activities.

What we want, and our focus is, to drive core portfolio growth, minimizing the need for one-time income events to get to that $0.31 and if that happens, you have a portfolio that when the one-time events occur, you'll be generating income well above the $0.31 by those one-time events that occur. And that's exactly what we're doing right now. We have a slide that actually shows the core portfolio of earnings growth in the portfolio as we continue to grow the assets.

Yeah, I understand all that, I'm just trying to understand the dynamics just between the fourth quarter and the first quarter. I thought that core number you were referring to that 3% increase, excluded the impacts of the early prepayment activity, but apparently I must have misunderstood. I will follow up with you afterwards and we'll get it figured out.

Yeah, okay. Sorry for the confusion that exists. Mark and you can cover it, but we're happy to kind of provide you more color and more detail on that, certainly.

I appreciate that. Thanks for taking my questions.

Your next question comes from the line of Robert Dodd from Raymond James. Your line is open.

Hi guys, how you doing?

Hi, Robert.

Going back to the competitive environment if we can for a second, would you say there is any correlation between that increasing competition and the acceleration, modest, of early repayment activity? I mean, if I was a new entrant, the first thing I'd do is try to pick off loans you've already underwritten for 200 basis points less, because you are probably a better underwriter than I am, so I would be picking off your business. So is there any connection there? Could we see that accelerate or is that just unrelated and not a problem right now?

Well, I wish that what you just said actually occurs because by that occurrence we're able then to continue to grow our portfolio and receive the benefit of the early repayment activities will further drive earnings and drive our earnings growth. So we actually would love to see that happen on select assets, we've always said that. Many new entrants are not necessarily able to distinguish good and bad credits, whether it's from our portfolio or new loans they are trying to originate.

So what happens right now is that many of the new entrants may not have the capabilities to take out a $20 million loan or a $30 million loan that we may have on our books, so they're much more willing and able to pick off those loans that are much smaller than that in our loan portfolio, or go after the more aggressive stage of development companies in that $3 million to $5 million, $5 million to $7 million, $7 million to $15 million size, are more competitive and then forego wider spreads.

So although competition will and may drive early repayment activities, with what we're seeing today the new entrants that we're seeing don't necessarily have the balance sheets or the wherewithal to really take out larger credits of ours to make a difference. So most of the credits that we may see paying off are not necessarily larger in size.

Okay, got it. One housekeeping one for Mark, or you Manuel. On the core yields you said you expect them to stay in the 12.5% to 13.5% range going forward. Would I be accurate in saying you expect essentially the core spread, and obviously if it were to rise, those core yields would rise as well. Or does that factor in kind of your expectations? Or meet expectations?

Well clearly the [12.5%] to [13.5%] encompasses any expected future appreciation or accretion in yield that we may realize over time. So that range I think is a comfortable one to stick to on that. What the early repayment activities will trigger would be an increase in activities in the effective yields, and that can literally lead, depending on the size, a $20 million early repayment activity that generated a 2% early repayment could have as much of an impact, depending on the (inaudible) up to almost half a penny in earnings accretion associated with it.

So it really depends on the maturity of the portfolio. One of the things that Mark said is the current LTV and the static age of the portfolios are two very important indicators of the health and vibrancy of the portfolio we have presently today. And I like to call your attention to that, when you look at our portfolio we currently have an LTV of 15% in our portfolio, compared to a 16% LTV last quarter, so that's an important indication in terms of a lot of our companies have both recently topped off new equity rounds of financing. Very new entrances or very new loans that we originated rarely pay off quickly because they have a 3% prepayment penalty typically associated with it. So there's not much of an appetite to take somebody out of a brand new loan. Older loans certainly now have a much lower prepayment penalty and that's where we expect to see a little bit more activity taking place. Unfortunately, some of those older loans may not really lead to a higher increase in the effective yields from those loans. And those are the ones we're seeing.

But I want to be very clear here, we're talking about maybe a $20 million to $30 million potential increase in early repayment activities, and we're not saying that's going to happen yet, but we are seeing some signs that may happen. We will have better visibility on that as we complete Q2, and as I said in Q4, we certainly expected to see much more pickup in early repayment activities in the second half of 2016 but we just get to see some signs of noise level today.

But again, it's very hard for us to have confidence level on being very specific on early repayment activities currently today.

Okay, got it. I appreciate that, thanks.

I would now like to turn the conference back over to Hercules.

Thank you Operator, and thank you everyone for joining us on this call today. We are in the process setting up numerous non-deal roadshows in the months of May and June. I expect to be touring New York, Boston, and Chicago right now and we will expand that to additional cities as we look at the schedules and investor's interest. Again, thank you very much. If you would like to schedule a meeting with us, please feel free to contact Michael Hara, available on Hercules' website or directly by calling Hercules at our main office in Palo Alto. With that, thank you Operator, thank you everybody.

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participation and have a wonderful day. You may all disconnect.