Ladies and gentlemen, thank you for standing by, and welcome to the Hercules Capital Q3 2021 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. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to turn the conference over to your speaker for today, Michael Hara. You may begin.

Thank you, Swarna. Good afternoon, everyone, and welcome to Hercules conference call for the third quarter 2021. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer; and Seth Meyer, CFO. Hercules third quarter 2021 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 at Hercules web page or by using the telephone number and passcode 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 and final audit results. In addition, the statements contained in this release that are not purely historical are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements, including, without limitation, the risks and uncertainties, including the uncertainties surrounding the current market turbulence caused by the COVID-19 pandemic, and other factors we identified from time-to-time in our filings with the SEC. Although we believe that the assumptions on which these forward-looking statements are reasonable, any of those assumptions can be prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions are also - can also be incorrect. You should not place undue reliance on these forward-looking statements. And 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 for subsequent events. To obtain copies of related SEC filings, please visit our website. And with that, I will turn the call over to Scott.

Thank you, Michael, and thank you all for joining us today. We hope that everyone is staying safe and healthy. 2021 continues to produce unprecedented levels of opportunity on multiple fronts for Hercules. Q3, 2021 was no exception. Commitments, fundings, liquidity, credit quality and portfolio company exits and liquidity events all continue to set records. The momentum that we saw in the first half across our investment portfolio accelerated even more in Q3. Our investment team delivered record Q3, 2021 and year-to-date performance for both gross new debt and equity commitments and fundings. As a result of our record-breaking origination efforts through the first three quarters of 2021 and the strength of our pipeline, we now expect to comfortably exceed $2 billion of total gross new debt and equity commitments for 2021. During Q3, we continue to focus on the key themes that we have highlighted throughout the course of 2021. Maximizing liquidity, staying disciplined on new underwritings, expanding our platform capabilities through our new private funds and driving down our cost of debt capital, while strengthening our balance sheet. There continues to be an abundance of liquidity across our core markets and we did not see any material change in this regard during the course of Q3. Let me recap some of the key highlights of our record performance for the quarter. We originated a record of over $719 million of gross new debt and equity commitments, an increase of over 35% from our previous quarterly record and delivered record gross fundings of over $431 million, an increase of 17% from our previous quarterly funding record. With three consecutive quarters of strong origination activity, we have already established a new annual record with over $1.69 billion in gross new debt and equity commitments and total fundings of $1.07 billion…

Thanks, Scott, and good afternoon and evening, ladies and gentlemen. Q3 was an extremely active and strong quarter for Hercules Capital. The investments that we made in our team and platform have contributed to our success through the first three quarters of 2021, and we are very well positioned heading into Q4. From a finance perspective, we had a very active treasury quarter. As previously announced, we completed the redemption of $75 million of 5.25% 2025 retail notes at par on July 1st. We took steps in the quarter to refinance the two securitization vehicles that are in run off by issuing $325 million of institutional unsecured notes as our first index eligible offering at a very attractive fixed coupon of 2.625% in September. The proceeds were utilized in October to redeem in full $289 million of the two securitization vehicles also at par value. As a reminder, the securitization vehicles bore interest rates of 4.6% to 4.7%, resulting in approximately 200 basis points of annual interest savings. These targeted actions further shift the composition of our debt portfolio to unsecured institutional based financing and help us further drive down our overall cost of debt capital, which has been a primary focus for us on the treasury side. As usual, I'll focus on the following areas: Number one, the income statement performance and highlights; number two, NAV unrealized and realized activity; number three, leverage and liquidity; and number four, finally the outlook. Turning our attention to the income statement and performance highlights. Net investment income was $38 million or $0.33 per share in Q3, an increase compared to the prior quarter attributable to the growth in the net interest margin. Total investment income was $70.2 million, also an increase compared to the prior quarter. The increase in fee income was…

Thank you. [Operator Instructions] Our first question comes from the line of Crispin Love with Piper Sandler. Your line is open.

Thank you and good afternoon. So one question on portfolio activity, have you seen any slowdown at all in activity for life sciences when you look at it relative to technology? Just looking at the pitch book quarterly data, it seems that the healthcare activity has slowed a bit following the surging growth during COVID? So I'm curious if you're seeing that all in your portfolio. I know I heard some strength in your commentary, but just curious, life sciences versus tech, if there's been any slowdown in life sciences?

Thanks, Crispin. So we have not seen any slowdown in that regard. If you look at our funding activity in Q3, we funded approximately $431 million. We committed approximately $720 million. Our funding activity was split nearly evenly between the two core verticals, technology and life sciences, and that was also very consistent with what we saw in Q2. So that's two consecutive quarters where we've seen that 50-50 target come to fruition. So in terms of what we're seeing the pipeline continues to be incredibly robust both for our life sciences business and our technology business.

Okay, great thanks that's helpful. And then just one more question for me on liquidity, but not your liquidity, but the liquidity of your portfolio of companies, is there any color that you can give there or any metrics? I think in the past you've given - some metrics in middle of COVID of 12 months liquidity, 18 months plus et cetera. So just curious on some commentary on liquidity of your portfolio of companies and if there's any metrics you could give?

So, we have not updated the data that we provided during the first 12 months of COVID, it is certainly something that we do continue to track. And what I would tell you is that we continue to see record levels of liquidity across our portfolio, both with respect to our public positions and our private positions. We don't have the data in terms of 12 months or 18 months, but we do look at it holistically and we are continuing to see record levels of liquidity across our investment portfolio.

Great, thank you very helpful. Thanks for taking my questions.

Thank you. Our next question comes from the line of Devin Ryan with JMP Securities. Your line is open.

Hi, good afternoon. This is Kevin Fultz on for Devin, and thank you for taking my questions. First question, over the past few quarters you describe the deal making environment as frothy. Just curious if you could discuss the current competitive landscape relative to what you're seeing earlier this year?

Sure thanks, Kevin. Yes, I think it's pretty similar to what we've discussed on each of the Q1 and Q2 calls. Yes, the biggest competitive threat that we're seeing now continues to be the strength of the equity markets, both from a private perspective and from a public perspective. When we lose transactions, the majority of the cases or cases where we are losing those transactions to the equity markets, whether the companies are raising in the public markets or private markets. From a debt perspective, we are continuing to see certain lenders being very aggressive in terms of structuring transactions and that's something as we've always done, we're going to avoid. But there really hasn't been much change in terms of the competitive environment over the last several quarters from what we've seen in our business.

Okay, that's helpful. And then just one other question overall, portfolio credit quality is in very good shape. I know as you mentioned in the prepared remarks, the great three bucket increased a bit to 20.2%, which is up from 18% in the prior quarter. Can you talk about the investments that were downgraded and the factors that led to the increase there?

No I mean, I can't talk about the specific investments, but that's a pretty small move for us in the grand scheme of things. We tend not to focus on individual movements between Grade 2 and Grade 3 or Grade 2 and Grade 1. We look at it from a portfolio perspective. There were a small number of loans that we downgraded in the quarter. There were also several that were upgraded. The buckets that we focus the most on are the rated 4 and rated 5 credits and those continue to make up less than 0.4% of the portfolio at fair value.

Okay, that makes sense, and congrats on the quarter and thanks for taking my questions again.

Thanks, Kevin.

Thank you. Our next question comes from the line of Christopher Nolan with Ladenburg Thalmann. Your line is open.

Hey, guys. Given changes in the yield curve and knowing that you have an asset sensitive balance sheet, as the change in interest rate environment so far contributed to earnings in the quarter?

So, certainly with the refinancing activities that we've done, it has - you may have noted that I mentioned that the increase in the spread really contributed to that. It's something that we've been successful for the duration of the company's existence of managing and maintaining a healthy spread between - the cost in which we are lending at and the cost of which we are borrowing at. So we'll continue to try to take advantage of that and continue to lower our cost of debt as we persist and have opportunities to refinance instruments like we just did by paying off the securitizations just a week and a half ago.

And then as a follow-up, is the increase in prepayments in anyway related to concerns for higher taxes or interest rate hikes in coming months?

Yes, we don't think so. We've looked very closely at our prepayment activity like year-to-date. It was obviously a large number $678 million of prepayments, but the vast majority, continue to be from either M&A events or companies raising more equity capital than they had anticipated. We have several companies in the portfolio that are sitting on $500 million plus of liquid cash and it just becomes a function of what makes sense for them from a balance sheet management perspective. And as we've continued to see tremendous strength across our investment portfolio, we've seen a subsequent increase in the prepayment activity based on what, were seeing right now. We expect that trend to continue in Q4, and then we'll reassess our expectations for next year once we get a little bit more, further into the year.

Great thank you.

Thank you. Our next question comes from the line of Sarkis Sherbetchyan with B. Riley Securities. Your line is open.

Hi, thank you for taking my question here. Scott you're raising the base distribution to $0.33 per share and you're maintaining the supplemental at seven. And I think you mentioned on the prepared remarks that you'll kind of reevaluate that supplemental policy for fiscal 2022. I guess I'm curious with the spillover of about $182 million call it. Where do you think that goes and what would the cadence look like?

It's a difficult question to answer, because that's obviously a Board decision and that decision will not get made until early next year. I think we had a very consistent theme with respect to our distributions. With respect to the base quarterly distribution, we generally set that at a level that we feel comfortable can be covered by ordinary net investment income and that gave us comfort in terms of moving from $0.32 to $0.33 for the quarter. And going forward when we sort of look at the supplemental distribution program, we expect to announce a new supplemental distribution program early next year for fiscal year 2022. In terms of the cadence, we would expect it to be similar to 2021 in terms of it being on a quarterly basis. But in terms of what that ultimate number will be, that will be something that we will finalize and discussions with our Board after we finalize the tax dividend numbers at the end of this year.

No, understood. And I guess the real premise of my question is as you lower the cost of debt capital and as your net interest margin increases, and it seems like you're more than comfortably going to cover even the base distribution here at $0.33 per share. So just wanted to kind of get a sense for your core earnings relative to this big spillover, it seems like there is an opportunity to increase that distribution. Is that the right thought process?

I think it is. We are incredibly well positioned with respect to our balance sheet and our distributions going forward. Again what that number ultimately is for next year is to be determined, but all else being equal, I think what you characterize that is a fair characterization.

Got it. And just kind of looking at your quarter-to-date here in 4Q closed commitments and pending commitments, any reason why you shouldn't be able to continue to have net origination activity?

It's still early in the quarter. We've given guidance that we expect between $200 million and $300 million of payoffs. That is our best estimate based on what we have in front of us today that could change up or down, obviously, as we get further into the quarter. We already either closed or have signed an additional roughly $500 million of commitments. We expect the funding to commitment ratio to be consistent with what is historically has been in that 60% to 65% range. So we never give guidance in terms of what we expect the net growth to be. But we are very comfortable that Q4 based on what we are seeing right now will be another very strong quarter for us.

Great, thank you. That's all for me.

Thank you. Our next question comes from the line of Ryan Lynch with KBW. Your line is open.

Good afternoon. First one, Scott I just wanted to talk about kind of market activity and portfolio activity. Obviously you mentioned, there is a lot of equity capital in the venture capital ecosystem that's been driving a lot of prepayments in your portfolio. Based on the market data that doesn't seem like that's slowing down anytime soon, so that seems like that's going to be something that's with us for a while? So my question is there anything or any, are there any strategic things that you guys can do. But when you guys are looking to deploy new capital and structuring the deals to potentially slowdown of the level of prepayments in your portfolio for the deals you guys are putting out today or is it just a matter of, kind of continuing to grow that top-line origination number to outpace the prepayments?

Sure thanks, Ryan. I think its two fold. So number one, we have done several things to increase the pie and increased the addressable market for us. Biggest driver of that year-to-date has been the initiation of our private fund business, which we launched in Q1 and that has continued to grow very nicely. That is certainly one of the big drivers of the tremendous funding and commitment activity that we've delivered year-to-date. So, one of the things that we are going to potentially offset some of the prepayment activity is continue to grow the commitment numbers and the funding numbers. In terms of sort of a more granular response, there are absolutely things that we are doing structurally, in some of these deals to try to dampen down some of those prepayments. But at the end of the day, we continue to be of the view that the prepayments that we are seeing really are a credit to the work that our team does. Because in a market like this where liquidity is a strong as it is, if companies are not paying off to us that would be a pretty negative signal. And the fact that we're seeing prepayments yes, it create some headwinds, but we clearly think and believe that it validates our business model and validates the work that our team does in selecting the right companies.

Okay, fair enough. The other question I had was, you mentioned the new supplemental, distribution policy as will likely in that for 2022. I know the distribution policy is set by the Board, but as CEO and a Board member, is it your preference to maintain the same sort of distribution policy what you set? A certain level of dividend distributions that are then going to be at a second number that would be paid throughout the year or is it your preference to set sort of a variant dividend policy where you have a core dividend on a quarterly basis. And then on a quarterly basis on top of that a supplemental dividend will be paid out based on various factors that you see fit?

The former, I think our objective is to drive to the best possible total shareholder return. And I think we continue as a company to believe that doing that is best accomplished by doing what we did in 2021 making sure that our base quarterly distribution is a number that we feel confident is covered by net investment income and then setting a supplemental distribution program payable on a quarterly basis based on where we end the year. And obviously that can change on a quarterly basis if there are events that are positive or negative. But the policy that we put in place in 2021 in terms of paying out a set amount on a quarterly basis is likely to be what we do in 2022 obviously with the potential for it to be a higher number given the strength of our current spillover.

Okay, thanks for that. I appreciate the time this afternoon.

Thanks, Ryan.

Thank you. [Operator Instructions] Our next question comes from the line of Finian O'Shea with Wells Fargo Securities. Your line is open.

Hi everyone, good afternoon. A follow on, on the funding mix, it looks like a lot of the newer companies are in the life science area. Can you talk about any sort of - if that's something you agree with any sort of you know the competitive dynamic and software that's kind of pushing you away from new companies, or if it's just the let say [ph] available volume is much higher, or perhaps something else?

Thanks Fin. If you look at the Q3 funding activity, whether you look at it on a dollar basis, the $431 million, or if you look at it in terms of the number of companies that we financed, it's pretty evenly split, in each case between our technology and life sciences business. So we really did not see any significant differentiation between technology and life sciences in the quarter, whether it's with respect to the dollars being committed, the dollars being funded or the number of companies that we're funding. Every quarter, our mix within our two core verticals in terms of industry sub sector will change and that's just based on our team's evaluation of where we see the best risk adjusted returns. Last quarter and in Q2, we talked a little bit about this on the call, we did pull back a little bit on the software space just given how competitive that market has become and the team did not see strong risk adjusted returns. We saw the same trend there in Q3, but that's something that we evaluate on a quarterly basis, but there was really no change in terms of that technology/life sciences mix in terms of those key metrics.

Okay and that's helpful. And just a follow-up on, are you able to comment - at all higher level on Gibraltar, and that seems to be moderately, stating sequentially, looking at the different security tranches there. I mean anything you could kind of provide us with color on that?

Sure, as we say every quarter, it's a portfolio company. So we're not going to provide any specific information that the company doesn't disclose individually. But I can tell you from a high level perspective, we continue to be very pleased with the investment and we are very supportive of that investment. The fair value mark will fluctuate quarter-to-quarter as does each of our investments and I wouldn't read too much into what it is on a quarterly basis up or down.

Okay makes sense. Thanks so much.

Thank you. I'm showing no further questions in the queue. I will now turn the call back over to Scott Bluestein for closing remarks.

Thank you, operator, and thanks to everyone for joining our call today. As a note, we will be participating virtually in the Jefferies BDC Summit on November 17 and the JMP Securities Financial Services and Real Estate Conference on November 18. If you would like to arrange a meeting with the Hercules management team, please contact each of the financial institutions directly or Michael Hara. We look forward to reporting our progress on our next year-end earnings call. Thanks everybody and have a great day.

Ladies and gentlemen that concludes today's conference call. Thank you for your participation. You may now disconnect.