Hercules Capital, Inc.
Q4 2020 Earnings Call Transcript

Published: 23 Feb 2021

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to the Hercules Capital Q4 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference call is being recorded. I would now like to hand the conference over to your speaker today, Michael Hara. Thank you. Please go ahead.

[Michael Hara:]

Thank you, Sherry. Good afternoon, everyone, and welcome to Hercules conference call for the fourth quarter and full-year of 2020. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer; and Seth Meyer, CFO.

[Scott Bluestein:]

Thank you, Michael, and thank you all for joining us today. We hope that everyone is staying safe and healthy. I am incredibly proud of what our team was able to achieve in 2020. Despite the challenges associated with the COVID-19 pandemic, Hercules Capital was able to deliver yet another strong year of solid execution, outstanding financial results, and solid credit performance. We were also able to demonstrate to our 100-plus borrowers the importance of having a partner with a strong and stable balance sheet and our ability to grow with the companies as they scale. In 2020, the health and vibrancy of the VC ecosystem, continued strength of our origination platform, robust liquidity position, and strong balance sheet put us in position to deliver achievements on multiple fronts, including record total investment income of $287.3 million, up 7.2%; record net investment income of $157.1 million, up 9.7%; record undistributed earnings spillover of $107.7 million, or $0.94 per share based on ending shares outstanding; record available liquidity of $673.3 million; record total assets of $2.6 billion, up 6.6%; over $1 billion of new debt and equity commitments for the third consecutive year; 22 IPO and M&A events; and finally, formation of Hercules Advisor as a wholly-owned subsidiary of Hercules Capital.

[Seth Meyer:]

Thank you, Scott, and good afternoon everyone. With another solid quarter for Hercules, we completed 2020 having successfully raised $77 million of equity, $170 million of debt obtained a new SBIC license with $175 million of attractive financing for qualified investments and upside our MUFG led credit facility to $400 million while improving the terms and pricing. We ended the year with record liquidity, as Scott mentioned and modest leverage positioning ourselves very well to opportunistically take advantage of the market in 2021. Our ROAE or NII over average equity was 13.8% for the fourth quarter and our ROAA or NII over average total assets was 6.6% for the fourth quarter. The year was a testament to the strength of our business, ability to access the capital markets on an as needed basis and grow where and when we saw the right opportunities. Our teams work collaboratively to manage the business from a remote working environment in a seamless way providing the sustainability of the platforming no matter the challenge.

[Operator:]

Your first question comes from the line of Crispin Love from Piper Sandler. Your line is now open.

[Crispin Love:]

Thanks. Good afternoon. Can you speak to the recent proliferation of SPACs in the market, and any impact or potential impact that you could see on Hercules or the broader VC industry? I know venture fundings are near record levels based on multiple industry sources. But are there any worries that because of the SPACs – SPAC demand that it could dampen venture debt demand in the near to medium-term?

[Scott Bluestein:]

Sure. Thanks, Crispin. There's no question that the SPAC market has exploded here over the last several quarters, and that has provided significant tailwinds with respect to the existing portfolio. If you think about our activity across the portfolio, right now we have five companies that have signed agreements as publicly disclosed to complete SPAC transactions. And that’s – for us, that's a pretty significant part of our portfolio on a relative basis compared to what we would typically see in a normal quarter. On the origination side, I don't think it's just limited to SPACs. There has been an abundance of equity inflows into the ecosystem, and that has certainly created some challenges in terms of prudent underwriting. But we take a long-term view, and we actually think that when you think about it on a long-term horizon, it's actually very beneficial to the ecosystem. It validates that these companies have a very long lifecycle. Ultimately, these companies will continue to need growth capital. And so if they do a SPAC financing or if they do an equity financing near-term, those are great opportunities for our team, which I think have some of the best relationships in the business to pursue those deals down the road. And so I think as long as you take a long-term approach to these things, which is how we've built this business and how we're going to continue to operate the business, we look at the abundance of equity, whether it's private, public, or SPAC-related as a net positive to the ecosystem.

[Crispin Love:]

Okay, thanks. That's all really helpful. How are you and the Board balancing the regular and the supplemental distribution levels right now? The regular distribution has been very stable in recent years, and recent net investment income has been covering that distribution. And then you also had that very nice spillover right now about $0.94. So what do you think that you and the Board would need to see to be able to bump that -- bump the regular distribution?

[Scott Bluestein:]

It's a great question. And as you know, we have a variable dividend policy, so it's something that the Board evaluates on a quarterly basis, and we don't just look short-term, we look long-term when we're making those decisions. We've been very clear in terms of our public guidance on the last several calls that we see absolutely no risk to that $0.32 base distribution, and we would reiterate that guidance on this call now. If you think about what we've been able to do in terms of the special distributions, we've been able to deliver to our shareholders a supplemental or a special distribution in six of the last seven quarters on top of the $0.32 base distribution. And obviously, subject to market conditions, I think one of the things that we're going to look at near-term here is trying to find a way to provide a little bit more consistency and continuity to those supplemental distributions. We're in tremendous position, where we have $0.94 spillover currently, $107.7 million. We're also sitting on, per our public filings, which were released after the close today, some pretty substantial unrealized gains across our equity and warrant portfolio. So we continue to be very confident in that spillover number. And I think one of the things that we'll look at near-term here is, again, as I mentioned, trying to provide some additional consistency and continuity to those supplemental distributions that we've done in six of the last seven quarters.

[Crispin Love:]

Okay. Thank you for all the color.

[Operator:]

Your next question comes from the line of David - Devin Ryan from JMP Securities. Your line is now open.

[Devin Ryan:]

Great. Thanks so much. Good evening, guys.

[Scott Bluestein:]

Hey, Devin, how are you?

[Devin Ryan:]

Doing terrific. So I guess first question here, like to dig in a little bit more just on kind of the pace of underwriting or investment activity in the fourth quarter and the progression into the first quarter. I think you talked a little bit about kind of looser conditions in the fourth quarter. And so, I'm curious kind of how things have evolved from that until now, clearly, a lot of activity thus far for you in the first quarter. And so is that just a function of just they're kind of looking through more opportunities, so you're seeing more of that that's interesting and you could be selective or is pricing or terms actually changed since the fourth quarter?

[Scott Bluestein:]

Yes, I think it's all of the above, Devin. When you think about our business, right, it ebbs and it flows. And I think part of being a disciplined credit underwriter is kind of knowing when to be aggressive and knowing when to pull back. In Q3 of last year, we delivered record commitments of $514 million, record fundings of $266 million. And then, frankly, in Q4, we just saw a lot more interesting activity across our portfolio as the companies continue to achieve milestones and sort of continue to show progress, that we chose to be a little bit more aggressive in terms of capital deployment across our current portfolio. And we just didn't see a lot of interesting, attractive opportunities in terms of the new business side of things. Part of that was driven by the strong equity capital markets. And part of it, as I mentioned, was there were several deals done in our ecosystem that we just thought didn't make a ton of sense from an underwriting perspective. And rather than chase those deals, we chose to sit those out. And whether that was kind of a year-end push by some other managers or not, I think it's difficult to say. But if you think about what has sort of changed for us in Q1, we haven't seen that same aggressiveness and sort of desire to put assets on the books that we saw from some other players in Q4. And I think our team has taken advantage of that. We've also kind of seen - this business is about a 90 to a 120-day cadence between when we start initiating contact with these companies and when we can sort of get through our process and get a deal done. So, a lot of the great work that our team did in Q4 has just come to fruition in Q1, and that's put us in a great position to start the year, where we've already closed $294 million of new commitments, and we have signed term sheets of another $248 million, so very pleased by what we're seeing quarter-to-date so far.

[Devin Ryan:]

Okay, terrific. And have a follow-on to some of those comments. a lot of capacity on leverage side relative to the targets and . So as you guys look out over the next few quarters, how should we think about leverage trajectory? And are you comfortable taking leverage up in what's a strong market right now, kind of in the normal course of business? Or are you really looking to keep kind of more dry powder just to the extent we get maybe some more interesting opportunities or we get some dislocation?

[Scott Bluestein:]

Yes, I'll address it at a high level, and then I'll turn it over to Seth. But our -- we've significantly delevered through the course of Q4, as you saw in our announcement, 100.6% GAAP leverage, 93% regulatory leverage. That 93% is well below our sort of target leverage or ceiling leverage on a regulatory basis of 125%. So we would expect to bring that leverage back up as we prudently deploy capital here in the first-half of the year. I also think it just speaks to the strength of our balance sheet, right? There is absolutely no need for us to do anything right now short-term on the equity side of things. And we have plenty of capacity and room within our existing leverage targets to be able to use that leverage to fund our growth in the first-half of this year.

[Seth Meyer:]

Yes. The only thing I would add is our thesis has been that we expect 2020 to be split in between a COVID period and a post vaccine period in the second-half. And we want to make sure that we're well positioned with a liquidity and leverage. And so that's why we've not taken steps to lower our liquidity. We have taken steps to make sure that our leverage stays well-maintained and we have great opportunities right now to go out and add additional leverage, but don't need it yet. So we'll see how the first-half of the year develops. And then we'll take decisions in the second-half of the year on how we deploy that capital that we already have.

[Devin Ryan:]

Got it. That makes a lot of sense. Well thanks for taking my questions and congrats on a nice end of the year.

[Scott Bluestein:]

Thanks, Devin.

[Operator:]

Your next question comes from the line of Christopher Nolan from Ladenburg Thalmann. Your line is now open.

[Christopher Nolan:]

Hey guys. Hercules advisors, could you elaborate a little bit on that? Is that -- are you going to the sub-advisor to other funds and BDCs or what?

[Scott Bluestein:]

It gives us a lot of flexibility and there's nothing definitive at this time, per se that we would be prepared to announce or discuss, but what we've done is we've sought SEC no action exemptive relief to be able to set up a registered investment advisor as a wholly owned subsidiary of the public BDC. We've received that approval in 2020 that was announced publicly in an 8-K that we put out in the middle of last year. And that now gives us the optionality to be able to explore a variety of things. We could raise private pools of capital and manage to sort of grow and diversify the platform outside of the BDC. We could do a variety of other things as well. I think the key point of distinction that I would make though, is that given that the RIA is wholly owned by the public BDC, any of the activity that we do underneath the RIA would be for the benefit of our public company shareholders.

[Christopher Nolan:]

Great. Okay, good. That's helpful. And then to realize loss offset. Is that relate to at all, or were there other loans?

[Seth Meyer:]

Yes. We did realize two losses on loans in Q4. We don't usually disclose the individual details though.

[Scott Bluestein:]

Yes, Chris, the largest driver was the OptraSCAN equity position.

[Christopher Nolan:]

Got it. Okay, nice quarter, guys. Thank you.

[Scott Bluestein:]

Thanks, Chris.

[Operator:]

Your next question comes from the line of Finian O'Shea from Wells Fargo Securities. Your line is now open.

[Finian O'Shea:]

Hi, everyone. Good afternoon. First question on the RIA, Scott, I appreciate the color and understand from Chris's question. You aren't going too far into detail, but a question on SPACs, a couple of your alternative's peers have been facilitating spec vehicles. So I think it can be very lucrative for the manager and for Hercules that would be a chance to potentially really move the needle. I'm not sure how that works under in RIA format, but is there anything you can elaborate on saving the potential, if not willingness for you to do that.

[Scott Bluestein:]

Thanks, Fin. Not at this time, I think the RIA gives us tremendous flexibility, but I think when you think about sort of what we're going to do potentially underneath the RIA, it's going to be very consistent with what we've always said, which is we're going to stick to what we're good at and where we've kind of built scale and longevity. And so, we'll certainly look at new things and we'll explore some new things, but I think there's a tremendous amount of growth for us from a platform perspective within our existing ecosystem. And I think that's where we're likely to be sort of much more aggressive short-term in any RIA related activity.

[Finian O'Shea:]

Okay. Thank you. And perhaps another sort of a technical question on your equity gains. There is obviously a few pretty large ones unrealized and there are lockups. Are you in the context of say these lockup agreements, are you able to directly hedge these equities like say backfoots to be frank, if you had to view the today's market was very frosty for those IPOs and such. Is that something you can and would do?

[Scott Bluestein:]

In the vast majority of lockup agreements, you are contractually prohibited from hedging-related activity. So in virtually -- in most cases, we're not able to do so.

[Q – Finian O'Shea:]

Okay, that's helpful. And that's all for me. Thank you.

[Scott Bluestein:]

Thanks, Fin.

[Seth Meyer:]

Thanks, Fin.

[Operator:]

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

[Ryan Lynch:]

Hey, good afternoon. First question, you know there's been a lot of discussion about the current market conditions, you talked about it, being pretty frothy as there's been a lot of activity in the venture capital markets, as well as the big increase in SPACs. I'm just curious what it and you kind of talked about you guys, the term construction has been a little weaker in the fourth quarter, which is part of the reason that you guys pulled back some of your funding, so my question is, what if these conditions continue or even increase for the next several years? Do you have any sort of, will there be any sort of change in your investment philosophy, or the way you approach the market in terms of maybe the life cycle, you look to partner with a company at or any comments on how you would approach very frothy markets for a very prolonged period of time going forward?

[Scott Bluestein:]

Yes, it's a great question, Ryan. I think you can look at our Q1 quarter-to-date activity. And I think you can ascertain from that, that it's not something that we expect, what you saw in Q4, we don't expect it to be with us for long, there will be periods and quarters where it will ebb and flow, and we'll will pull back, and we'll be a little bit more cautious. But Q1 already quarter-to-date, we're on pace to assuming all the signed term sheets, obviously get through our process and close to have over $500 million of new debt and equity commitments in Q1 alone. So I think our team has historically done a very good job at staying disciplined. I think a mistake that a lot of people make is when they chase the equity. So just because the company raises equity capital, they think that it's a great underwriting or a great credit story. And it's just our view that that's not, that's not always the case. And so, what I think our team does very well is we underwrite to the credit, and to the profile of the company. We don't necessarily underwrite to the equity story, or the post money valuation, or how much equity capital is being raised because those things come and go. And at the end of the day, you've got to have a fundamental business that you're underwriting to. In terms of sort of the broader question that you're asking, I think being able to sort of sustain the success that we've had over a 16-year period, we've now funded and financed nearly 600 different companies, we've committed in excess of $11 billion over the last 16 years. And so, we've just built-up a tremendous proprietary network of relationships and portfolio companies and deal flow that our team can take advantage of, and not just within the existing portfolio, but in new opportunities as well. And as our balance sheet has gotten stronger, as our liquidity position has gotten stronger, and as our asset base has increased, we have greater flexibility today to go upstream in terms of the types of companies we're going after, to focus more on that established stage part of the market where those deals tend to be a little bit larger, require a little bit more sophistication. And I think that's where you're likely to likely to see the majority of our activity here short to medium-term.

[Ryan Lynch:]

Got you, that makes sense. And then kind of pivoting, I appreciate the conversation and the questions that you use around dividend but you mentioned $108 million roughly of spillover income today. If I look at your portfolio with three investments, you could have realized gains of another $100 million just in 2021. Of course, those valuations could change, you never know where that will end-up. But based on today's prices, you can have an additional $100 million gain. So, $0.05 supplemental or special dividend isn't going to really work to try to manage your historical spillover income plus the potential for these realized gains. So have you developed any policy for how you're thinking about approaching, distributing or managing these potential huge gains coming in 2021, in combination with your already very large spillover income?

[Seth Meyer:]

Yes, so I think the word potential that you use there is important right, because the unrealized gains, they're potential future realized gains, right, those have not been monetized and we'll obviously see how the market reacts. And we'll make our decisions in the ordinary course in terms of when and if we do want to monetize and harvest some of those gains. We're in great position with respect to the dividend. We're sitting on, as you just said, $108 million spillover and $0.94 per share. We made the decision for this quarter, obviously to do the $0.32 base distribution and the $0.05 supplemental distribution. As I mentioned, in response to one of the earlier questions, the board is obviously aware of the size of the spillover, and it's something that we're going to evaluate here near-term. And I think the goal for us, certainly on the next call here, will be to try to find a way to provide a little bit more consistency and continuity with respect to how we handle those supplemental distributions. But it just gives us tremendous flexibility to continue to not only ensure coverage of the base dividend, but also to provide this additional upside through the form of these special dividends to our shareholders. And we'll look near-term here to try to provide a little bit more consistency with respect to how that will look certainly over the next several quarters.

[Ryan Lynch:]

Yes, certainly it's definitely a favorable position to be in and a good problem to have. So appreciate the time this afternoon, and really great quarter guys.

[Seth Meyer:]

Thanks, Ryan.

[Operator:]

Your next question comes from the line of John Hecht from Jefferies. Your line is now open.

[John Hecht:]

Good afternoon guys, thanks for taking my questions and congratulations. Most of my questions have been asked, but I guess the first one is a little bit of a follow-on from the last discussion is you talked about a bit of a frothy market and you guys don't stretch. You're very selective and you have been. But on one token you had, you mentioned kind of a frothy market. On the other side, I think your core spreads actually increased from Q3 to Q4, you've got a lot of momentum right now. So, may be just a broader discussion about the competitive environment. Clearly, it shifts on a quarter-to-quarter basis. But maybe, what are you seeing now, Scott from where we're on a intermediate or longer-term perspective and competition relative to prior couple of years?

[Scott Bluestein:]

So, first John, thanks for the question, I think the biggest competition we have right now continues to be the equity markets, we're just seeing tremendous velocity of capital in the public equity markets, which primarily impacts our public life sciences portfolio, in the private markets, which primarily impacts our private technology portfolio. And then also in sort of the alternative equity side, right, we've got five companies right now that have signed back transactions. We had eight IPOs in 2020, we had two IPOs in Q4 alone, following very strong IPO activity in Q3. And so I think right now, from a competitive perspective, the competitor that we see in the majority of deals is actually equity. There are kind of the traditional debt players that we come across in the ordinary course. And not a lot has changed there outside of what I mentioned in my remarks, which is in Q4, we did see several players just choose to get very, very, very aggressive on the debt side of a couple of deals. And our team did what we encouraged them to do, which is to kind of sit those out and let others chase those deals. We haven't seen that same trend so far in Q1. And I think that has allowed our team to be much more aggressive in terms of capital deployment. And I think that, you can sort of see that in the numbers, right with $294 million of commitments already closed, and then another $248 million signed and on top of that, we're sitting on a $1 billion pipeline, right now with deals that we've qualified, and we're actively looking at.

[John Hecht:]

Yes, okay, that's helpful. And then maybe kind of higher level commentary. I know you guys have been in similar industries over time, SAS, some life sciences and some renewables and so forth. Anything kind of big picture oriented, that would lean you into focusing on one of your subcategories more than the other in the near-term?

[Scott Bluestein:]

No, I think what we've always tried to do is run a balanced credit book. And in the current market, we're targeting that same sort of 50

[John Hecht:]

Okay. Thanks very much.

[Scott Bluestein:]

Thanks, John.

[Operator:]

Your next question comes from the line of Sarkis Sherbetchyan from B Riley Securities. Your line is now open.

[Sarkis Sherbetchyan:]

Good afternoon. And thanks for taking my question here. Just wanted to follow-up on the outlook commentary, I guess, if we were to kind of make it very simple. Right. Would you think that the first-half of '21 looks a lot, like the back half of your fiscal '20 period, and then as you kind of build the book back up for fiscal '21 second-half. Would that kind of look more like just let's say like a regular quarter of originations and repayments?

[Scott Bluestein:]

Yes, sure. Thanks for your question. So I think the second-half, I'll start with the end of your question, we would expect to be more of a pre-COVID environment. You see the evidence of the market development, even the equity markets are anticipating that increase already with pretty high valuations. So I would expect that the second-half of 2021, we would expect more of a pre-COVID environment for ourselves. Although that may take a little bit of time to kick in. For Q1 and Q2, I would expect that it would be more or like the second-half of 2020 where we're still we're being very prudent in who we're approaching and working with and taking the right deals as opposed to not all the deals.

[Sarkis Sherbetchyan:]

Great. Thanks for that. And as I look towards kind of the net interest margin, piece of the component seems to be your ability to take the cost of debt down. I guess any comments on further opportunistically taking the average cost of debt lower, and as you deploy back into a more normal environment if you will kind of the hopes of gaining the better and better spread and then essentially.

[Scott Bluestein:]

Yes, now that's a great question. I think that you're spot on that we will continue to work to drive down our cost of debt. In our current position with excess liquidity of more than 670 million available to us, we're not taking steps of approaching the market. We did in November in anticipation of expecting the 2021 was going to be a banner year again, as the growth and the vaccine comes out. But until we utilize the majority of our liquidity including the new SBIC license for $175 million. I would expect that we'll be cautious in bringing that rate down. You'll actually see it go up a little bit in the first-half of the year. And the reason why is because we're paying off that second SBIC license. The securitizations are actually running off, but our long-term debt the average price associated with that is coming down with the steps that we've taken in the private placement market, with the fact that we lowered the cost of the credit facility last year, and with the expectation that as we start to utilize the liquidity that we already have. The market is expected to stay at a very low priced basis for a protracted period of time. And the Fed indications clearly are that we can expect low interest rates for the foreseeable future. We will definitely be taking advantage of that as we need to. But first we need to use up this liquidity as the market kind of turns and when the right opportunities come our way and then we will get back to work at raising additional debt when we need it at the lower cost that we see in the market right now.

[Sarkis Sherbetchyan:]

Great. Thanks. That's all for me. Continued success for you guys.

[Scott Bluestein:]

Thanks, Sarkis.

[Seth Meyer:]

Thanks, Sarkis.

[Operator:]

Your next question comes from the line of Casey Alexander from Compass Point. Your line is now open.

[Casey Alexander:]

All right, good afternoon. Most of the questions have been answered, but I do have one question. The expansion of market capitalizations, and given the fact that you guys have a reasonably tight market capitalization constraint, could you remind us what that constraint is before alone falls into the bad asset bucket? Is that because of the expansion of market capitalization's, forcing a look at earlier stage companies, there may be a little less mature. And is that a part of the reason why perhaps you're pulling back, pull back some on originations in the fourth quarter. And is there the possibility of using the RIA bucket as a method of being able to invest in some of those larger companies and get them off balance sheet.

[Seth Meyer:]

Thanks, Casey. So, okay, three parts there. So, part one, the market cap test for purposes of the bad asset or ineligible asset test is $250 million. That's a one-time test. It's done at origination. And so to the extent the originated loan that has a market cap below that, and then it appreciates above that. It does not paint that asset. So it's a one-time test done at the original onboarding of that loan and it's $250 million. In terms of the second question, we have absolutely no impact on our new business activity. We have always maintained a pretty substantial healthy margin against that 30% bad asset bucket and we continue to maintain a very healthy margin against that bucket now. So that did not impact any of our recent or near-term investment activity. And then the third part is absolutely, yes. So one of the potential benefits of the RIA structure is that it would allow us to be more aggressive in that part of the market on a go-forward basis without the constraints of the $250 million bad asset test for purposes of the public BDC. So that is one of the drivers of that decision. And again, I think the key theme with respect to that RIA activity would be -- to the extent that we did do something in terms of a private credit fund and went after that market more aggressively because it's wholly-owned by the public BDC. It would be done for the benefit of our public company shareholders.

[Casey Alexander:]

All right, great. Thank you. That's all my questions.

[Scott Bluestein:]

Thanks, Casey.

[Seth Meyer:]

Thanks, Casey.

[Operator:]

There are no further questions at this time. I'm going to turn the call back to Mr. Michael Hara.

[Michael Hara:]

Thank you operator, and thanks to everyone for joining our call today. We look forward to reporting our progress on our next Q1 2021 earnings call. Also, we will be virtually attending the RBC Capital Markets Financial Institutions Conference in March. If you are interested in meeting with us at this event, please contact RBC Capital Markets or Michael Hara. Thank you, and good afternoon.

[Operator:]

This concludes today's conference call. Thank you all for joining. You may now disconnect.