Hercules Capital Inc (HTGC) 2018 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the Hercules Capital Second Quarter 2018 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 for today's conference, Mr. Michael Hara, Senior Director of Investor Relations. Sir, you may begin.

Thank you, Joelle. Good afternoon everyone, and welcome to Hercules' conference call for the second quarter of 2018. With us on the call today from Hercules are Manuel Henriquez, Founder, Chairman and CEO; David Lund, our Interim Chief Financial Officer; and Gerard Waldt, our Corporate Controller and Interim Chief Accounting Officer.

Hercules' second quarter 2018 financial results were released just after today's market close and can be accessed from Hercules' Investor Relations section at htgc.com. We have arranged for a replay of the call on Hercules' webpage or by using the telephone number and pass code provided in today's earnings release.

During 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 of the 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 uncertainty 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 reasonable, any of those assumptions can be proved 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 our website, htgc.com.

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 on the call today. We have plenty of outstanding news to share with you today about our very strong and record-breaking start to the first half of 2018 and our continued optimism and strong outlook for the remainder of 2018, assuming, of course, the current market conditions remain as favorable as they are currently throughout the second half of 2018.

First, regarding our strong earnings performance in the second quarter of 2018, we achieved another strong quarterly performance with an adjusted net investment income of $0.29 per share after adding back the previously announced $0.03 non-cash expense related to the retirement of our $100 million bonds of the 2024 notes, which, on a GAAP basis, would have equaled to about $0.26 in NII after taking into effect the $0.03 impact of the retirement of those bonds.

In addition, given our strong loan portfolio growth and core yield growth during the quarter, we now expect to cover our dividend from net investment income beginning in Q3 2018, a quarter sooner than we had anticipated and even after including the impact of the higher share count from our previously issued equity offering, ensuring us to maintain our leverage levels below 1-to-1.

We also achieved another milestone during the quarter as a company. Thanks to our tremendous team of employees who made it possible and our growing brand within the venture capital industry as a venture lender of choice among many other venture capital firms and their portfolio companies, I am proud to share with you today that, because of our strong new origination activities in the second quarter, we now have surpassed a major milestone of $8 billion in total commitments since the start of Hercules in December 2013. We have financed more than 430 different innovative and disruptive venture capital and private equity-backed companies who have chosen Hercules Capital as one of their capital partners of choice.

This is an amazing achievement that I take immense pride in as the founder and CEO. And it underscores the amazing level of talent, discipline, and diligence that our origination team and, in fact, all of our employees have contributed towards this amazing milestone. I say to you thank you very much for everything you have done to make that goal possible.

Surpassing the $8 billion mark also reflects the importance of the Hercules Capital platform within the venture capital community, and of our industry leading reputation and brand and leadership position that we have established over the past 13 years. We are deeply grateful for the trust and faith that our venture capital partners and entrepreneurs have bestowed to us and their confidence in us as a venture capital lender of choice to help support their companies in achieving the $8 billion goal. No other BDC venture lender has our capacity or capabilities or depth of platform to originate and finance at these levels, or assemble an investment portfolio of this size, let alone originate new loans at these levels on a quarterly basis.

And now for today's call, I will be discussing the following select achievements and highlights. I will provide an overview and highlight of our outstanding financial performance and key achievements during the quarter. I will provide a brief commentary to our continued optimism as we enter the second half of 2018, and our outlook and our revised upward forecast of NII and NII covering our dividend in Q3 based on, of course, continued loan origination and growth. I will also offer some perspective and insights into the very robust venture capital marketplace and activities realized in Q2 2018, including, of course, fundraising, investment activities, as well as realized excess from both IPO and M&A events, which were both quite robust.

And then I will turn over the call to our finance and accounting team, led by David and Gerard, for more detailed specifics regarding our financial performance and financials during the quarter. And finally, I will conclude the call with a Q&A session to address any of the questions you may have.

Now for several highlights and key achievements in Q2 2018. Let me begin by saying that we had an outstanding and record-breaking second quarter, with exceptionally robust origination activities across all of our sectors that we focus on. We achieved another strong quarterly performance with adjusted net investment income, as I indicated earlier, of $0.29 per share after adding back the $0.03 of non-cash related to the retirement of our notes.

We saw impressive end demand for capital in the first half of 2018, especially in the second quarter of 2018. This demand was driven by very favorable market conditions, which we expect to continue through at least the third quarter of 2018, if not the rest of 2018. Based on this increased optimism and revised upward outlook for the second half of 2018, coupled in no small part with our strong origination performance and achievements during the first half of '18, we now have the potential to exceed over $1 billion and actually even potentially topping $1.1 billion in total new loan commitments in 2018, and potentially ending 2018 with a total debt investment portfolio in the upward revised range of $1.6 billion to $1.7 billion, assuming, of course, early payoffs remain at our expected abated level or modulated levels of less than $100 million per quarter for each of Q3 and Q4 respectively.

Our origination team delivered a historical strong and record level new origination in a single quarter. We entered into new total debt and equity commitments of more than $460 million in the second quarter, up nearly 125% year-over-year. Equally strong was our total new debt and equity commitments for the first six months of 2018, topping over $725 million, representing an increase of over 84% on a year-over-year basis and putting us well within the reach of $1 billion, if not up to the $1.1 billion, given that we still have close to seven months more origination activities to go -- excuse me, six months origination activities to go.

During the second quarter, we also closed and funded an impressive $727 million of new commitments, also up an impressive 75% on a year-over-year basis. As for the first six months of 2018, we funded over $0.5 billion, or $564 million, of new investment funded assets, representing an increase of 65% year-over-year. These are tremendous numbers and achievements thanks in no small part to our team and what they have done.

This combination of a healthy new deal flow, new pipeline of transactions pending and being reviewed, coupled with new fundings and tempered competitive environment, all contributed to driving higher our core yields and exceeding the high end of our expected yield ranges of 15 -- excuse me, 11.5% and 12.5%. In fact, core yields in second quarter were 12.7%, up meaningfully from 11.9% in the first quarter of 2018.

However, given the tempered early payoff activities that we witnessed in the second quarter, we also realized a slight decline in our overall effective yields of 13.5%. This reduction in our effective yield was directly attributed to a meaningful and material decline in early loan payoff activities, from $244 million in Q1 to less than half in Q2 of $114 million.

Our total debt investment portfolio now stands at a record high of $1.55 billion at cost, an impressive single quarter growth of 13.5% on a quarter-over-quarter basis. We expect to continue this controlled growth through the second half of 2018, and potentially growing the debt portfolio, as I indicated earlier, to the $1.6 billion and most likely the $1.7 billion level by year-end, assuming, again, the robust activities remain in the second part of 2018.

This, of course, does not assume any aberration or anomalies that may be attributed to the midterm elections or anything surrounding any geopolitical risks that may inadvertently come into the markets and affect the capital markets.

We achieved many of these results while maintaining our historical focus in prudent credit discipline, as evidenced by our historically low sub 1% nonaccrual of loans while also maintaining a very strong balance sheet and high liquidity position, with over $221 million of available capital for new investments and continued loan portfolio growth.

In addition to our robust new loan origination activities during the second quarter, we also were extremely active in the capital markets as well. We actively managed our leverage to within the desired target levels while also bolstering our liquidity and positioning us well to continue to drive loan portfolio growth in the second half of 2018. For example, just in the second quarter alone, we successfully completed the following capital markets activities.

We raised $81 million of equity at an above NAV accretive equity offering, adding equity capital to help bolster our net assets as well as manage our leverage position within the tolerance levels that we have set. We also actively used and engaged our just in time equity ATM program, raising an additional $26 million at highly accretive above net asset value and low offering costs.

If that were not enough, we also raised $75 million in a new bond offering of seven years PAR 25 at a coupon rate of 5.25%, extending out new maturities of our bonds out to 2025 while also managing to work on increasing our credit lines with Union Bank of California, where we actually increased our credit facilities by an additional $25 million to provide continued flexibility to grow our investment portfolio.

And lastly, we also were actively redeeming, as I indicated earlier, and retiring $100 million of our 6.25% 2024 notes that led to the impact of a $0.03 earnings hit in the quarter related to a non-cash charge of $2.4 million related to these bonds. These 2024 bonds had an effective cost of capital of approximately 6.6%, so the retirement of those bonds ends up being quite an accretive to the transaction on a go-forward basis.

All of these activities allowed us to finish Q2 with an enhanced and strong liquidity position which, along with our just in time equity program and continued ample access to the equity and debt capital markets, will allow us to continue to drive loan growth further while also helping to bring our overall cost of funds and manage our leverage levels lower, to within the tolerances which we want to operate the business on.

Now let me take a few minutes to share with you the activities related to new business, which remains extremely robust, driven by very strong venture capital investment activities and continuing encouraging signs of an emerging IPO market and beginning to take good shape.

We saw very strong loan demand and transactional deal flow, driven in no small part by the very impressive performance by the venture capital industry and investment activities during the second quarter of 2018, with nearly $28 billion of capital invested by the venture capitalists in the second quarter. This is a record new level of investment activities and making it one of the best quarter since 2000, according to the Dow Jones VentureSource, which is the data provider that we use to provide our facts and figures.

At this level, the venture capital investment activities for 2018 are on pace to shatter all previous records of new investment levels by venture capitalists, and are expected to potentially even exceed $100 billion of new venture capital investments in 2018. At that level, this would dramatically outpace the $90 billion or so that were invested during the dot-com era of '99 and 2000.

Liquidity; liquidity activities or realized excess by the venture capital industry or investments were also very encouraging signs during the second quarter, much of which the Hercules portfolio reaped benefits itself by seeing multiple liquidity events in M&A and IPO. Our own investment portfolio has dramatically benefitted from this new activity and is very encouraged by the IPO and M&A marketplace activities that we witnessed during the second quarter.

We remain very optimistic, as the IPO markets are continuing to show signs of very encouraging receptivity to new IPO candidates, and is dramatically showing an improvement in delivering sustained IPO offerings. In fact, in Q2 we witnessed 31 U.S. venture capital-backed IPOs complete their successful IPO debuts in the second quarter for a total of 46 companies in the first half of 2018. Those are quite strong numbers we have not seen for quite some time. In fact, we are seeing meaningful signs in our own portfolio of chatter and improved outlook from our own investment portfolio companies, with many of them preparing themselves for a potential exit through an IPO later in the second half of '18 or shortly in the beginning of 2019.

This renewed IPO optimism is something we have not seen for quite some time and is a very encouraging sign. As evidence of this continued optimism, during the second quarter we saw various Hercules portfolio companies such as DocuSign, Tricida, and Eidos complete their IPO debuts, with DocuSign being the standout, which is one of Hercules' equity investment holdings.

DocuSign completed a very successful IPO debut, generating an unrealized appreciation of approximately $13.8 million, or nearly $0.16 in net asset value appreciation based on its closing price as recently as July 30, and well above our cost base of $15.79 per share in Q1 2018, representing a multiple on investment of 3.2 times and an unrealized position of our invested capital at cost.

As a reminder of the importance and benefit of a robust and open for business IPO/M&A marketplace, Hercules Capital holds equity warrants in approximately 133 different companies. Many of these companies are leading innovative and disruptive companies backed by many of the top tier venture capital firms in the country. Many of these companies eventually may achieve a liquidity event through either an IPO or M&A event, and Hercules Capital is well positioned to potentially monetize in those warrant -- in the money warrants when they complete or realize an exit opportunity. Similar to our example in DocuSign, we expect and hope to see many of our companies complete a DocuSign type liquidity event for the benefit of our shareholders.

In addition to our 133 different warrant positions that we hold in various companies, Hercules Capital also holds a direct equity position in over 50 venture-backed and private equity-backed companies, which, like a warrant portfolio, positions us well to potentially benefit from any future gains if and when many of these companies choose to pursue or complete an IPO event.

However, as we have always said and as a word of caution, not all of our warrants or equity positions are expected to complete or realize an exit or a monetization event. We generally expect approximately 50% or less of our portfolio to achieve such an event in the future.

Now with respect to Hercules' companies and IPO registrations, at the end of the second quarter we actually had 2 companies at IPO registration. We anticipate many more potential to be filing in the second half of '18.

Another encouraging sign is that of the early payoff activities which are finally showing signs of abatement in helping to drive portfolio loan growth. After adjusting for our deliberate sector portfolio rotations and pruning that we did in Q1, which resulted in $243 million of early payoff activities, we are now beginning to see encouraging signs of early payoff activities beginning to taper and abate. And in fact, we expect early payoff activities to once again start modulating back to historical levels of $100 million, as evidenced in Q2 with $114 million of early loan payoff activities.

When we combine our record level of new fundings in Q2, we have returned to a net portfolio growth a quarter earlier than expected, with net new loan portfolio growth of approximately $185 million in Q2, representing a healthy 13.5% increase over Q1 2018. Furthermore, as I indicated earlier, we do expect and anticipate early payoff activities to return back to $75 million to $100 million per Q3 and Q4 in 2018.

As a reminder, predicting early payoff is still a very, very difficult task, since we do not control or have insight as to which company or when a company may choose to pay off its loan balances early. In fact, we typically have less than 30 days notice or visibility, so it's subject to tremendous and significant variability and market conditions that may alter the ultimate outcome of early payoff activities.

Now let me discuss our pipeline of new commitments and fundings as we enter the third quarter. As I shared with you earlier during the call, just in the first month of the third quarter, July, Hercules has already received and closed over $170 million of new or pending commitments so far just in the month of July. On a year-to-date basis, when you factor in the first half of the year activities, we are already at $899 million of flows or pending commitments just through the first seven months of the year. This is why we are quite optimistic on achieving the $1.1 billion or $1 billion in new commitments in fiscal 2018, when in the first 7 months we're already at $899 million of that activities.

Assuming, of course, all of these signed term sheets and commitments convert into new funded loans in the third quarter, we would find ourselves in a very favorable, if not exceeding, our previously set portfolio goals of $1.55 billion to $1.65 billion, and putting us in great positions to potentially achieve our revised portfolio of loan portfolio assets of $1.6 billion to $1.7 billion in total new investment portfolio by the end of 2018.

Now let me take a brief opportunity to discuss our views of the marketplace and activities as we enter the third quarter and the second half of 2018. We are extremely encouraged by what we are seeing entering Q3, as evidenced by our already strong and closed new commitments of $170 million and growing, and a new pipeline of over $1.2 billion of potential new opportunities that we are evaluating as potential new investments.

In an effort to address the increasing loan demand, we are actively expanding our offices in Boston and in Palo Alto. We are adding additional new headcounts across all levels of the company, which we expect to continue throughout the remainder of 2018 and early part of 2019. We see tremendous opportunities to continue to grow our loan portfolio rolling into 2019, and we want to make sure that we're properly capitalized as well as staffed to continue to address the strong demand that we are seeing for our capital.

Notwithstanding the strong loan demand, I do expect Hercules Capital to continue its disciplined and effective time-proven strategy of slow and steady. It's not about getting to the end of the race. It's about having the perseverance to run the race and continue to deliver on strong performance. We are well positioned to achieve just that.

We have begun a steady but controlled loan portfolio growth, and we expect to continue to see that. In fact, as evidence of the slow and steady strategy, we expect our loan portfolio growth in Q3 to grow by approximately $50 million plus or minus $20 million in either direction. Our slow and steady strategy has served us well for over a decade, and we see further signs of an improving competitive environment and economic outlook that we anticipate should accelerate our own disciplined growth and continue to drive portfolio growth even potentially beyond our expectations currently.

In closing, we had an outstanding first half of 2018 with record commitments and fundings delivering overall net portfolio growth a quarter ahead of schedule, and putting us on pace to return to covering our dividend in Q3 through NII investment income and not having to use our capital gains to further grow our undistributed earnings for later distribution for shareholders. I recognize that the importance of covering the dividend through NII is very important to many of you. That will be occurring in Q3, as I've stated.

Our outlook for the second half of 2018 has continued to remain very optimistic, and we are very encouraged about how things are trending early so far in Q3, as evidenced by the $170 million of already term sheets executed in the first month of the third quarter. And we're only at the midway point of the year.

As I always say, a quarter does not make a trend, but it certainly helps to point in a favorable direction. And we are well positioned to do just that, with over $220 million of liquidity to invest in the second half of '18.

And finally, the wrap things up, an update on Hercules Capital's view related to the recently passed Small Business Credit Availability Act, or the SBCAA, that Congress recently passed in March on asset coverage ratios, requiring its being lowered to 150% from 200%, or as it's more commonly referred to, the increase in leverage to 2-to-1 from 1-to-1.

First, I would like to say thank you to all of our institutional bond and equity holders for your time, feedback, and support over the last few weeks in recognizing the many advantages which modest and gradual controlled increases in leverage could have on Hercules and the economic benefit it could bestow upon Hercules Capital's performance, especially as an internally managed BDC.

Secondly, as we have previously shared with you, we have chosen to take the slow path forward on leverage and prefer to take a more pragmatic and slower path to any increase in leverage. It was crucial and critical to meet and speak to all of our institutional accounts, as many as we could, as well as find time to speak with all of our stakeholders, including our stockholders, our bondholders, our rating agency partners, our industry analyst community, and all interested parties that would like to discuss leverage.

It was a very important process and one that beared a lot of fruit in the process. We enjoyed the many conversations we had with many of you, and we took your feedback to heart. It was very important to hear. We expect to report our final conclusions on leverage sometime late in Q3, if not early Q4, at which point we will give clarity and guidance as to what, if anything, we intend to do related to leverage.

And now for one last and very important item that was amplified by the tremendous achievements during the quarter. None of these tremendous achievements or accomplishments would have been made possible if not for our greatest assets, our wonderful and dedicated team of outstanding employees, our human capital, who continue to step up and deliver strong results for our shareholders. And they will make Hercules Capital successful. Thank you very much, everyone, and truly an outstanding job once again.

Now let me turn the call over. Thank you, everybody.

Thank you, Manuel, and good afternoon ladies and gentlemen. Today we are pleased to report our second quarter results. This afternoon I will focus on the following financial areas; our origination platform, income statement performance, NAV performance, and realized and unrealized activity and credit outlook.

With that, let's turn our attention to the origination platform. Origination performance continues to demonstrate our strength as the market-leading platform in venture lending. We had a record quarter for total investment fundings of $327.5 million. These investments came from a total of 29 portfolio companies, 15 of which were new portfolio companies. This investment activity brings our fundings for the first six months of 2018 to a total of $563.7 million, putting us on pace for a record year.

This investment activity was offset by early repayments during the quarter of $114.3 million and amortization of $16.7 million. As a result of this activity, on a cost basis our debt investment portfolio balance ended at $1.55 billion, representing an increase of approximately 13.6% from the first quarter.

Our core yields increased to 12.7%, which was up from 11.9% in the prior quarter. The increase in core yields was primarily attributed to the early origination activity during the quarter, the weighted average yield of loans onboarded during the quarter of approximately 12.7%, and the impact of the full quarter's prime rate increase in March. Moving into Q3, we expect our core yields to be between 12.4% to 12.7%.

With that, I'd like to discuss our income statement performance for the second quarter. On a GAAP basis, our net investment income was $22.8 million in the second quarter, or $0.26 per share. On a pro forma basis, our NII per share was $0.29 after taking into account the acceleration of $2.4 million in one-time unamortized fees and interest related to the early payoff of $100 million of our 2024 notes in April.

Total investment income was $49.6 million in the second quarter, an increase of 1.8% from $48.7 million in the first quarter. The increase in total investment income is due to higher interest income of $2 million on the larger weighted loan portfolio and higher core yields of 12.7%, as I mentioned previously. Our weighted average principal outstanding increased by approximately $106 million to $1.47 billion from $1.36 billion in the first quarter. Our fee income decreased by 35.5% to $3.7 million during the second quarter due to the lower early payoff activity.

NII margin was 46% in the second quarter, which was a decrease from the first quarter of 53.5%. The decrease is due to the higher interest and fee expense on the redemption of $100 million of our 2024 notes. Our NIM would have been approximately 50.8% without the impact of the higher interest and fees related to the note redemption.

Our SG&A increased to $13.5 million in the second quarter from $12.1 million in the prior quarter, driven by an increase in variable compensation due to performance and funding objectives relative to plan, and higher stock-based compensation. We anticipate our operating expenses to be between $13.5 million to $14 million in each of the next 2 quarters due to variable compensation expense and employee-related retention programs.

Our net interest margin was $36.3 million in the second quarter compared to $38.1 million in the prior quarter. The decrease is due to the impact of interest and fees from the 2024 note redemption.

Lastly, we have a very well positioned portfolio with a highly asset-sensitive balance sheet in the event of interest rate movements. 97% of our loans are variable interest rate loans with floors, and 93% of our debt outstanding was fixed interest rate debt. A 25 basis point or 50 basis point increase in benchmark interest rates would be accretive to interest income and net investment income by approximately $3.1 million and $6.2 million respectively on an annualized basis, or $0.04 and $0.07 respectively of NII per share annually.

Now I'd like to discuss our NAV performance and credit outlook. We saw our NAV increase to $963.7 million in the second quarter from $828.7 million in the first quarter, or an increase of $0.50 per share or 5.1% to $10.22 per share. This $135 million increase was primarily the result of our equity offering and ATM activity of $106.7 million and the net change in unrealized appreciation of $38.2 million during the period.

During the second quarter, our net realized losses were $8.9 million. This net realized loss was primarily the result of the write-off of one loan position for $8.6 million. In addition, we realized $2.7 million in net realized losses related to our warrant portfolio, offset by $2.4 million of net realized gains in our equity portfolio. The net realized loss activity did not have an impact to NAV since they were previously recognized at 0 value in the prior quarter.

We had a net change in unrealized appreciation of approximately $38.2 million on our investment portfolio during the quarter, of which $37.1 million was related to our debt, equity, and warrant investments. We had net unrealized appreciation in our debt investment portfolio of approximately $24.2 million. The appreciation in our debt investment was due to $20.8 million of reversals due to payoffs, write-offs, and/or collateral-based impairments, and $3.3 million of accretive market yield adjustments.

The appreciation in our equity portfolio of $8.2 million was made up of the appreciation of $12 million in our public portfolio, offset by $2.2 million depreciation in our private portfolio and $1.6 million of reversals due to sales and/or write-offs. The appreciation in our warrant portfolio of $4.7 million was made up of approximately $700,000 and $1.6 million of appreciation in our public and private portfolios respectively, and $2.4 million in reversals in realized losses due to sales or write-offs.

We saw our return on average equity decrease to 10.2% in the second quarter, down from 12.7% in the prior quarter. Our return on average assets decreased to 5.4% from 6.5%. Excluding the one-time expense related to the pay down of the 2024 notes, the return on our average equity and average assets would have been 11.3% and 6% respectively.

I now would like to discuss our credit and near-term outlook for the quarter. In the second quarter, our weighted average credit rating was 2.21, improving from 2.43 in the first quarter. The improvement in credit rating was due to $87 million of loans on a cost basis moving to credit 1 and an additional 15 companies totaling $209 million being removed from our credit watch list due to either early payoffs, write-offs, or credit rating improvements.

Furthermore, the additional movements within the portfolio are consistent with our longstanding policy of generally downgrading credits to a grade 3 as the companies approach capital raise or critical milestones. Traditionally, our portfolio companies will need to raise capital every 9 to 14 months. Thus, it is our expectation that our portfolio companies will migrate to a 3 rating at some point in their normal life cycle with Hercules.

Our credit 4 and 5 rated companies, which are primary areas of focus, decreased to 3.1% from 5.3% on a cost basis in the second quarter, primarily related to payoffs and write-offs. Our non-accruals remained at historic lows and moved to 0.2% as a percentage of our total investment portfolio on a cost basis and from 0.8% in the prior quarter. The non-accruals were 0 at a value basis in the second quarter. This makes 4 consecutive quarters where nonaccruals as a percentage of total investments at cost are below 1%.

Finally, in addition to Manuel's remarks regarding our overall liquidity, as we disclosed today, in July we fully repaid our first SBA license, retiring the remaining $41.2 million in debentures. Based on our remarks today and our overall financial performance, we are very pleased with our second quarter results.

Thus, in closing, we are well positioned at the end of the second quarter heading into the remainder of 2018. Our long-term focused approach and disciplined underwriting standards and access to diversified funding sources will enable us to deliver strong results for the foreseeable future.

With that report, I now turn the call over to the operator to begin the Q&A part of our call. Operator, over to you, please.

[Operator Instructions.] Our first question comes from John Hecht with Jefferies.

Related to the originations, I wonder, Manuel, can you tell us I guess the pace during the quarter, was it spread out over the quarter, were they back loaded, just so we can kind of think about what that means to the upcoming quarters' dollar interest income?

Yes. As we have indicated since inception, the third quarter is simply our slowest quarter, which is why we're only forecasting probably net up $50 million plus or minus $20 million. It's now plus or minus $20 million because our typical deal size is $20 million, so one deal closing and one deal sliding can make an impact on that.

That said, we don't expect to do much funding in August. So you go July strong, quiet in August, and then you pick up the second week or so of September in the third quarter. So it's going to be more lumpier.

As to your question in Q2, it was fairly ratably distributed throughout the quarter. So you saw a nice cadence of fundings taking place. In fact, you saw the average intra-quarter weighted balance was pretty tight compared to historical levels. So we saw pretty good activities in the second quarter keeping that pretty steadily across, which ended up with a weighted average, as you'll see in our press release, page 4, you'll see that we had an intra-quarter weighted average of about $1.47 billion. And we ended the quarter at $1.55 billion. So you'll see a good cadence intra-quarter activity of fundings.

And then I'm wondering, can you talk about what's the average investment size at this point in time? Given the size of your balance sheet, are you willing to go larger? And obviously given that you're originating more, is there an appetite to do larger averages sizes as well?

We are. Look it, Hercules comfort zone is doing transactions from $3 million to $80 million in size. We can handle and hold on the balance sheet at that level quite comfortably. And in fact, we have the capabilities, given our strong origination team, to do deals in that range, in that sizes.

I think to answer your question, the arithmetic average today is -- approximately $18 million is our whole position that we have an arithmetic average. On the median, it's probably a little higher than that. But that said, $18 million becomes the arithmetic average that we have there.

And final question, I think David mentioned some comp numbers or expense numbers for Q3 and Q4, so I heard that. How I guess the capacity of the organization? Ad if this type of environment persisted, would you need to add a lot of bodies to just manage the pipeline?

Well, as I think we said earlier, and to answer your question, I think David's number -- I believe it's $13.5 million, $14 million?

$13.5 million to $14 million.

Yes, $13.5 million, $14 million is what we believe the SG&A number will be sans interest expense and fees. We think that at that level -- we feel comfortable that the next 2 quarters sustaining and maintaining those levels is probably within the range of tolerance that we're comfortable with.

Our next question comes from Ryan Lynch with KBW.

In the last quarter and actually -- or I guess in Q1 you guys had very strong prepayments. You guys had a little bit of heavier prepayments this quarter. Those are going to abate. I know part of those prepayments were driven by you guys wanting to prune some of the weaker investments from your portfolio. You talked about there still being a very robust VC environment. So as you look to the back half of the year, are you still looking to kind of prune or rotate out of some of those weaker credits, or is that largely been completed the first half of the year?

They're not necessarily weak credits, and I just want to make an adjustment to that. I think that we were taking a more jaundiced view on consumer-related industries. It is an area I think that we had some concern about if the economy were to turn, if you will. So we decided to kind of sector out the portfolio -- rotate certain sectors, excuse me, I would say.

As to the salient point of your question, we think that we're pretty much done with any sector rotations that were looking for the second half of '18. So we do not expect any anomalies above the $100 million per quarter early payoff activities. Now, obviously one deal that we're not aware of could pop up, $10 million, $15 million in either direction. But I think that we have enough comfort right now of what we're seeing in the activity that we think that $100 million for the next 2 quarters for each quarter is probably at a good level.

Now, that said, this sounds very conservative, but when you actually add up together the first 2 quarters plus another $200 million for the next 2 quarters, it's still going to be in excess of $500 million. And I'm not aware of many BDCs that still absorb $500-plus million of early payoff and another $100-plus million in amort and still grow the loan portfolio, which we're going to do. We feel very comfortable, with our strong brand and leadership position in the venture industry, that we are seeing a tremendous amount of deal flow right now.

And then I know effective yields can kind of be all over the place depending on prepayments, but core yields are typically a little more steadier. They jumped about 80 basis points in the quarter, and your guidance for Q3 was for the core yield to remain elevated. Can you just talk about what is driving core yields to stay at this kind of elevated level?

Yes. One is our leadership position in the category. Having the balance sheet that we have and the capabilities really makes the venture capital partners and their underlying portfolio companies have a lot more confidence, when they look at our balance sheet and look at our access to liquidity, that we are a capital partner that they can rely on and therefore get comfortable with.

Number two, it happens to be an arithmetic issue where in Q1 part of that sector rotation that we talked about was vacating or cycling out a few obligors that had a prevailing lower interest rate but had a larger dollar size. And when you remove that weight of larger dollars and lower yields, you automatically get this bounce back up again in your overall portfolio core yields.

And so I think that what we're saying now is that we feel comfortable that core yields in Q3 and probably Q4 will sustain themselves at the, conservatively, 12.5% to 12.7% level in the next few quarters.

And then one more on the right side of the balance sheet. You guys in the third quarter -- or I guess in the second quarter, you guys paid down some bonds. In the third quarter, you guys are paying down some of your SBIC debentures. I know this quarter you guys had about $60 million drawn on your credit facility. I know in the past you have typically wanted to not draw significant amounts on those and kind of use those as a temporary funding vehicle. Can you just talk about your plans for maybe the right side of the balance sheet as we look into the back half of 2018?

I mean, look it, it's no secret. When you actually do the math, the reason why we did a $100-plus million equity raise in Q2 was the mere fact that we were at a GAAP leverage of 95% in Q2, and we actually went above that intra-quarter. And because we have said we want to maintain leverage at 0.9 or 0.95 or below for the time being, we wanted to stay true to our word and maintain leverage levels in those areas, which is why we led the equity raise, which was a very great capital raise and ended up being quite accretive on top of that.

That said, there is no question that the bank lines continue to serve their purpose, which are intra-quarter short-term funding vehicles. As we look at the capital markets and we look at our leverage position to either proceed forward with an additional equity offering or proceed forward with a longer duration debt facility, I will say, as we've said multiple times in the past, we are evaluating additional bond offerings, whether in the form of securitization or other bond offerings in the near term, as we continue to drive growth in our book.

And yes, we will consume the $221 million of liquidity, so you can expect us to continue to add further liquidity into the equation as we go into later in the second half of '18 to position us for continued growth in 2019. We are seeing unprecedented demand for loan capital, and we want to take advantage of that market presence that we have.

However, I will tell you that our screens have not changed. We remain hyperly selective. But because we have such a strong demand for capital, we're continually able to maintain our underwriting parameters and discipline and actually -- in some cases, actually raise pricing. That you can't really say in the lower end of our market, that we're seeing the opportunities in venture lending right now.

Our next question comes from Casey Alexander with Compass Point.

I just want to make sure that I understand the operating expense guidance, and I hate to ask you to go over this again. But I assume when you're guiding over the next couple quarters to $13.5 million or $14 million, if I understand it right, what we're talking about is G&A plus compensation and benefits and stock-based comp, those three put together?

10-4.

The repayment in the third quarter of the SBA debentures, did you fund that with the credit facility?

No, we took some of the excess cash flows that we had and did that. But truth be told, cash is fungible, so let's be realistic about that. But the answer is that it came off of some proceeds. But, yes, we have borrowings under the bank line. So again, cash is fungible either way, but we used our early repayment activities and amortization.

Our next question comes from Tim Hayes with B. Riley FBR.

Can you talk a little bit more about the drivers behind the favorable market conditions you're seeing? You talked about the robust VC capital investment. But as it relates to the competitive environment, are you still seeing newer entrants leave the market? And is there still an absence in bank participation or anything else driving the demand?

I think that, Tim, you've been on some calls or seen some of our smaller venture lenders out there. I mean, some reported $30 million. Some reported $50 million a quarter. That's one deal for us.

So I think that you're seeing that now our size and our balance sheet really affords us the ability to kind of look at multiple different transactions and have the underlying venture capital partners, and underlying entrepreneurs really see the strength of our balance sheet and our partnership and our success with what we've done. So we're very grateful for that recognition.

As to competition, we don't see any sustained consistent player in the market. I think that it's both regional and sector driven competition as opposed to a national competition. We, of course, continue to see the standard usual suspects, which are the venture banks that are out there. But size also makes a differentiation that we see less competition above $20 million and we see fierce competition below $6 million.

Switching gears a little bit, how productive have talks been with the rating agencies over the past couple of months? Do you feel any better today about potentially being able to increase leverage while maintaining your investment grade rating than you did, say, a month or 2 ago?

In fairness to the rating agencies, I think that they all have taken a more thoughtful process, and I think that they're evaluating the obligors or the issuers independently now from each other. And I think that I would characterize my conversation as constructive but ongoing.

And it is certainly our hope to continue to work with the rating agencies to sustain and maintain our investment grade ratings. I suspect that that will probably happen, but I don't know until those conversations conclude, which is why we expect to report sometime in late September what the outcome of those conversations and our position is.

That said, it's important to note that we don't have the same conflicts and challenges that other BDCs do, because we're not in the hyperly competitive lower and middle market lending. Number two, we have ample access to the equity capital markets because we trade above net asset value. We have an ATM program and we're internally managed.

So there's a lot of differences that we, the Hercules platform, have that we are encouraged that the rating agencies are taking that into account and understanding our business as an internally managed BDC. And our hyper focus on credit and credit quality that we have earned over the last 13 plus years, we think all of that should get factored into their ultimate decision.

But again, it's an ongoing conversation. They're very positive and very supportive. But I cannot speak for them, nor do I know where they're going to end up. But we are certainly going to work hard as we can to maintain our investment grade ratings if and when we seek higher leverage. But I will also say if and when we seek higher leverage, it's not going to go from zero to 2-to-1 immediately, no. In fact, it's going to be a very gradual and methodical process because of prepayments, and the sheer nature of venture lending is the short duration asset.

We do anticipate if in fact we go at a higher leverage, that it'll probably take us 24 to 36 months to even get to a 1.3x leverage, if you will, or higher. It's going to be difficult. So to us, it's a very methodical, slow process, and we're hoping the rating agencies will take that into account.

And then on the early repayments, obviously more moderate activity there. But if you look back at early payoffs in 1Q and 3Q of last year, they were roughly around the same levels, yet contributed more to the GAAP effective yield. I'm just wondering if that's a function of the credit this quarter being more seasoned and older and not driving as much fee income from that standpoint.

You hit the nail on the head. Once a credit breaks over 24 months, there's not a lot of acceleration of unamortized income, and the prepayment oftentimes collapses, in some cases to zero or less than 1% or so. So yes, it has to do with the longevity of the credits. We saw older credits kind of cycle off, and that kind of drove a little bit of that distribution.

You almost had a full quarter of Gibraltar on the books now. Have you started to really reap the benefits from that acquisition? And do you think that had any impact on the lower level of repayments during the quarter?

So we have yet to integrate and work with the Gibraltar team. The Gibraltar team on their own are doing a tremendous and, frankly, great job. We are very, very delighted as their partners and the owner of that franchise in how well they're doing. It's being run by a highly credible and focused guy over there, Scott.

And I think that we are -- without getting specific, I think we've enjoyed -- in the short time that we've acquired them, I believe the number is about 35%, 40% loan growth already, and we're seeing equally growth in their income numbers. And they have yet to hit the gas post acquisition.

So I think that the Gibraltar acquisition has been fantastic. It's contributing to our earnings as we expected in Q2 -- or, sorry, in the second half of '18. And they're ahead of schedule as we expect them to be, and we're very delighted with the continued discipline and growth that they're doing at that property.

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

What's the scheduled amortization that you guys are looking at for the next couple of quarters?

I think because of the newness of the portfolio since we have been originating so robustly over the last three quarters, I think you're going to see a modulated level, probably about $20 million and $25 million for each of the next 2 quarters as opposed to the typical $35 million to $40 million, because now you have a portfolio which is what gives us comfort on lower early repayments.

The portfolio itself, on a seasoned weighted basis, is somewhere around 13 to 14 months in duration. So we typically don't see portfolio activity percolating upward until you cross over that month 16 and 18. So we don't expect much more early payoff activity, as I said about $100 million the next 2 quarters, because of the young season of portfolio that it is.

Our next question comes from Christopher Nolan with Ladenburg Thalmann.

What was spillover income?

Oh, spillover income?

Yes, please.

We're at $21 million as of end of Q2. But I got to remind everybody, intra-year spillover income has a lot of variability for realized gains or realized losses that may happen between now and year-end. But yes, it's $21 million at the second quarter mark, but it can move up or down quite dramatically later on in the year by those activities.

And what was cost of debt excluding the nonrecurring items?

6.4%.

No, no.

5.2%.

5.2% excluding the one-time events. So our spreads are quite nice, as you'll do the calculation.

Why hasn't -- are you seeing more newcomers come into the debt market for you, for the venture debt?

As I always say, the water's warm and everyone's welcome. It's a very hard asset class with a lot of barriers to entry. We make it look easy. It's anything but that, and it's a very hard asset class. I think that there are new entrants that always come in from time to time, but very few have the scale and the capabilities that we do.

Our next question comes from Henry Coffey with Wedbush.

I haven't seen you guys this excited about where the business is going since the ancient days. And when I look around, and this may be an unfair assessment, but the large identified competitors that we saw back in the '00s, I mean, I don't hear them or maybe they're out there and I just don't know who they are, but the growth opportunity is fairly large. And then the only other questions I'd sort of throw into this discussion is the access to a robust source of financing with sub 5%, is there such a beast out there that you could find that doesn't have any of the negative features of past facilities like that, where you were part of a conduit or something, or is it just the nature of the credits are such that you get the yields you get but you have to suffer the higher funding cost?

Look it, we've said this all along. Scale in this business is very critical, whether you're an Ares Capital, an Apollo, a TPG. Scale does matter in BDC world. And it certainly has a huge significance and importance in venture lending, because exactly your point.

When you have a larger scale, you can access a wider array of different types of capital. You can ladder out your maturities. You can kind of blend your different costs of funds to get to this very effective -- as we've been managing since 2011 with our treasury function, our cost of funds now are hovering around 5.2%, while our core yields are 12.7% and our effective yield's higher than that. So you can do the spread.

And so when you look at leverage in this business, and we're operating that historically at about a 75% leverage level, when you actually maintain that discipline without changing any of your investment parameters and start adding gradual leverage of 1-to-1 or 115-to-1 or 120-to-1, it only magnifies the strong credit performance that you've had into strong ROEs. And so scale is a big driver in that issue in maintaining that discipline.

But no, Henry. To your point, we are not aware of nor do we see any competitive threat of our size anywhere in the marketplace, aside from 1 or 2 of the large venture banks. But beyond that, no, we don't see that.

And when you think about leveraging in 2019 and 2020, is it going to be more likely to be some form of unsecured rated term debt or do you think there's room for an asset-based facility?

As we all know, the yield curve right now is signaling some complex mixed messages with the inversion that may have some people argue that it actually may have inverted earlier this week. But looking at the elongated part of the yield curve, it's actually more economical for me to ladder out maturities on the 10, 15 years levels than it is to do near-term bonds at the 3 to 5-year level right now because of the yield curve.

Look it, it's a very important issue for the rating agencies, and also for ourselves, to maintain a wide distribution or diversity in our liquidity structure in our capital stack. So we always like to have bank lines. We like to have the SBA. The SBA has been a great partner of ours for over a decade. We've now done 2 securitizations. We'll probably do a 3rd securitization. We've accessed the investment grade bond market. We've accessed the 5-year retail market, the 5 to 7-year retail market, and the 10-year retail market, and we do a convert.

So we have a pretty robust treasury function to manage the cost of capital and match our liquidities that we're looking for in laddering out maturities. And that's part of the overall corporate strategy that we have here, given our size, is managing that cost of funds and managing the different levels of maturities and different maturity dates that we want to have out there.

So it's going to be a complex structure going forward.

I would argue that we already have one now. But yes, it will be similar to what we have now and probably even further enhanced.

Our next question comes from Robert Dodd with Raymond James.

First, on kind of the core yield, I mean, 12.7%, very good number. Historically for '17, even earlier in '18, you were talking about kind of the range typically being 11.5% to 12.5%. Is this quarter, the 12.7%, kind of -- obviously base rates have moved higher. You've talked about the advantages you've got and the creditability in the market. Is this 12.7% an indicator of kind of a structural shift, that maybe you're going to live now at the high end of the range or maybe rub the high end of the historic range? Or is it just -- we've seen high quarters in core yields before. Is it just a good quarter but not indicative of some kind of overall trend there?

So I think -- in fairness to your question, I think it's all of the above. There's certainly embedded benefits from now nearly four rate increases have occurred and the portfolio now stabilizing without having a lot of relief happening too, is you begin to reap the benefits of that lower portfolio churn, where some of the earlier assets are benefitting from those rate increases. So yes, that's a contributing factor to that increase to 12.7%.

And the second part of your question, there's no structural change in what we're doing. It happens to be a benefit of the market catching up with where the core yields are now in the marketplace that we're originating, and the benefit of those four previous increases in the overall rate. We do not anticipate us going much below 12% for quite some time in our modeling right now. And in fact, as I said at the earlier part of the call, 12.5% to 12.7% is a range that we're pretty comfortable looking at for Q3 right now from what we're seeing in the portfolio on a core basis.

You just mentioned, obviously, the diversity of the funding sources that you want to utilize. You just paid off all the debentures in HT2. Any update on where you are on getting the next license if the application is still outstanding? I don't even know.

I think that we have begun that process. I don't want to handicap that or speculate as to the timing. But I would say to you that, given that we've been great partners with the SBA, that we have paid back the debentures, we continue to fund the economic hub zones that they want us to be invested in and helping American companies and helping American employment and American innovation, I think that we remain and continue to be one of the poster childs of what the SBA program stands for in helping advance American ingenuity.

So we're very hopeful and remain optimistic that the SBA would move quickly and also grant us our license. If it happens in '18, that's the cherry on the sundae. If it happens in early '19, that's the jimmies on the ice cream.

Our next question comes from Finian O'Shea with Wells Fargo Securities.

I'll do a higher level one on the 155 to 165 year-end target. Let's assume you hit this and raise it again, given the opportunity set remains large, which I believe it does given your deployments. Can you give us just some color on the conversations you have, say, in January regarding the year-end target, just assuming you still value growing the might of Hercules? Where are you in the lifetime context as to turning to optimize the ROE profile, for example run higher leverage, kind of focus on asset yields, as Robert was just touching on, etc.?

So I assume you're referring to fiscal January '19?

Yes. I guess I can word that much more shortly. How big do you want to grow, given the current opportunity set? And I recognize you continually -- you do this in a measured pace, but you look on pace to hit the year-end target. Just kind of trying to get a feel of how big Hercules gets.

I think that we're comfortable saying for the time being that one of the drivers on growth is certainly the vibrancy of the venture capital industry, because we are directly correlated with venture capital investments and new activities in funding of those companies. And we have a great slide in our investor deck that actually points to that we typically represent -- about 1.4% of the total venture equity dollars that are invested are matched by Hercules debt capital out there.

So by extrapolation, if you assume that the venture capital industry will do $100 billion in fiscal '18 and you keep that same percentage of 1.4% participation that Hercules Capital has had historically, you would see that that would equate to about $1.4 billion. Now, we could probably do that, but I'm not comfortable and we're not comfortable going to that level. I think we're much more prefer to be at the $1.1 billion level of new commitments in fiscal 2018.

So what that means is that I think that we're not just looking to grow to grow, because that's something we don't believe in. We grow when the asset quality makes sense and the deals and yields make sense, not just to grow to grow, because we don't get paid for AUM so it doesn't matter to us. We get paid for strong asset performance.

So what that means is, when you kind of distill all that down, I think that we're comfortable saying that the loan book can grow, on a net basis on an annual level, between $250 million and $350 million is kind of the cadence that we like to see the loan portfolio grow on a year-over-year basis. And so in fiscal 2018, you're probably somewhere in that $250 million to $350 million range on a net base that we talked about. And that's kind of the way we look at it on how we want to grow the loan book, in a much more controlled and that slow and steady growth that we talked about earlier.

I am not showing any further questions at this time. I would now like to turn the call back over to Manuel Henriquez for closing remarks.

Thank you, operator. Thank you everybody for joining us today. We will probably be going out and having non-deal road shows over the next couple of months. We're scheduled -- conferences are not to begin probably until late September, early October, at which point we'll make those announcements.

With that, thank you everybody today. Thank you for joining on the call today and thank you very much for continuing to support and being a Hercules shareholder and bondholder. Thank you everybody and have a good day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a great day.