Earnings Labs

Hercules Capital, Inc. (HTGC)

Q2 2022 Earnings Call· Thu, Jul 28, 2022

$15.67

+1.20%

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Transcript

Operator

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hercules Capital Second Quarter 2022 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference over to your host, Mr. Michael Hara. Sir, please begin.

Michael Hara

Analyst

Thank you, Howard. Good afternoon, everyone, and welcome to Hercules Conference Call for the Second Quarter 2022. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer; and Seth Meyer, CFO. Hercules' second quarter 2022 financial results were released just after today's market close and can be accessed from Hercules' Investor Relations section at investor.htdc.com. An archived webcast will be available on the Investor Relations web page for at least 30 days following the conference call. During this call, we may make forward-looking statements based on our own assumptions and the current expectations. These forward-looking statements are not guarantees of future performance and should not be relied upon in making any investment decision. Actual financial results may differ from the forward-looking statements made during this call for a number of reasons, including, but not limited to, the risks identified in our annual report on Form 10-K and other filings that are publicly available on the SEC's website. Any forward-looking statements made during this call are made only as of today's date, and Hercules assumes no obligation to update any such statements in the future. And with that, I will turn the call over to Scott.

Scott Bluestein

Analyst

Thank you, Michael, and thank you all for joining us today. Despite a more volatile and challenging economic and capital market environment, Hercules Capital continued to deliver strong operating results in Q2 and took additional steps to further position the company for continued asset and earnings growth in the second half of 2022. Our record originations performance in Q1 continued with record Q2 gross debt and equity commitments of over $1.04 billion, the first time in our history that we have delivered over $1 billion of new commitments in a quarter. Our gross fundings were also strong during the quarter with over $439 million. For the first half of 2022, we delivered record gross debt and equity commitments of $1.66 billion and record gross fundings of over $790 million. Similar to what we saw in Q1, early payoffs during Q2 remained low, which resulted in strong sequential net debt investment portfolio growth of over $169 million during the second quarter and a record $360 million for the first half of 2022. We anticipate that this record net debt investment portfolio growth from the first half of 2022 will continue to drive our core income and NII per share higher during the second half of 2022. This, combined with the current rate environment, has put us in a strong position to be able to raise our quarterly base distribution to $0.35 for Q2, our second base distribution increase in the last 12 months. Our outlook on originations remains favorable. And as a result, we executed on a series of capital markets transactions during Q2, which boosted our liquidity position to over $779 million, and put us in a great position heading into the second half of 2022. Let me recap some of the key highlights of our performance for Q2. Our…

Seth Meyer

Analyst

Thank you, Scott, and good afternoon, ladies and gentlemen. While the capital raising environment and broader markets deteriorated in Q2, this was a very busy and successful quarter for Hercules in terms of accessing the capital markets. To support the record net debt portfolio growth that the investment team delivered in the first half of 2022 and with support of our financial institutional partners, Hercules was able to leverage our recognized credit-first culture and strong investment-grade ratings to raise over $530 million of equity, debt financing and credit facility capacity in Q2. With the addition of our fourth investment grade rating from Fitch in May, we continue to benefit with a significant competitive advantage in terms of being able to raise institutional capital in a cost-effective manner. These steps have positioned us well for the continued uncertainty in the broader market and compared to our competitive landscape. Net investment income was $40.1 million, a 12% quarter-over-quarter increase or $0.32 per share in Q2. This was achieved by delivering record core income despite a historically low volume of prepayments which overall impacted second quarter NII, but is beneficial for the long term, especially in this rising interest rate environment. With that in mind, let's review the following areas: the income statement performance and highlights, NAV unrealized and realized activity, leverage and liquidity and the financial outlook. Turning to the income statement performance and highlights. As previously mentioned, net investment income was $40.1 million, a 12% quarter-over-quarter increase or $0.32 per share in Q2. Total investment income was $72.1 million, an increase compared to the prior quarter, driven by 16% growth in the debt portfolio year-to-date on strong new business, lower prepayments and an increase in benchmark rates. Our effective and core yields in the second quarter were 11.5% and 11.3%, respectively,…

Operator

Operator

[Operator Instructions] Our first question or comment comes from the line of Crispin Love from Piper Sandler.

Crispin Love

Analyst

First one I have is on credit quality. So I'm just curious if you can speak to your outlook for credit quality for the next several quarters. There's some worries out there that venture-backed companies are burning cash at a quicker rate and then just some confidence is deteriorating and I appreciate the liquidity numbers you provided earlier, but I'm just curious on how you're viewing the credit environment from your seat looking forward?

Scott Bluestein

Analyst

Sure. Thanks, Crispin. We continue to feel good about the credit portfolio. We have always maintained a very disciplined approach to underwriting, and that really has not changed over the last few years. There is no question that there has been an increasing amount of volatility in the equity markets, but we really have not seen a material impact yet with respect to our portfolio company's ability to raise capital. In Q1, the markets were very choppy. Our portfolio companies raised over $1 billion of new equity. In Q2, the volatility of the equity markets increased. Our portfolio companies once again raised over $1 billion of equity capital in the quarter. We have several companies right now that are in the middle of equity financings that we expect to get done. So we're obviously watching credit very closely, but we have not yet seen any material impact that would cause us to be concerned. The other key things that we look at very closely, weighted average credit rating across the portfolio. Historically, that range for us was about $220 to $230. That was sort of the normal range for us on a weighted average portfolio basis, even with a slight uptick that we saw in Q2 from 2.10 to 2.13 still below the low end of that range. We also watch our rated four and rated five credits very closely. Those continue to make up less than 0.6% of the entire portfolio at fair value. And we have 2 small legacy loans that are on nonaccrual, and we don't have any additional loans right now that we're watching for nonaccrual. So I think, all in all, we continue to feel positive about the credit environment. We're watching, obviously, the volatility of the equity markets. We have taken some additional steps to be a little bit more cautious and a little bit more prudent from a monitoring perspective, but we feel pretty good about what we're seeing right now.

Crispin Love

Analyst

Okay. Great. And then just 1 other one for me. Can you just remind me on the mechanics of the undistributed earnings spillover. Does the $1.18 of spillover that you currently have, does that need to be paid out over the next 12 months or is there another time frame? I'm just curious what the details are on that spillover?

Seth Meyer

Analyst

Sure. Absolutely, Crispin. So we've already distributed the majority of what needs to be distributed in the current year related to the spillover related to last year. So we have to distribute about 90% of our earnings annually within the following year. And so the distributions that we've made already in the year count towards that. We have very little after we make the distribution in August that is required to be distributed for last year.

Operator

Operator

Our next question or comment comes from the line of Kevin Fultz from JMP Securities.

Kevin Fultz

Analyst

Could you talk a little bit about how the competitive environment has shifted over the past three quarters, given increased market uncertainty? And how that's impacting documentation and deal pricing. I'm just hoping you can quantify the change in pricing that you've seen as market conditions have evolved?

Scott Bluestein

Analyst

Sure. Thanks, Kevin. So a couple of things with respect to the competitive environment. We are continuing to see, I think, a healthy competitive environment. I think the 1 or 2 things that we have noticed, particularly over the last quarter or so is that several of our competitors appear to be pulling back a little bit given some leverage and liquidity constraints. That's why we went out of our way to emphasize our conservative leverage position and the abundance of liquidity that we have on the balance sheet. So we've seen a little bit of a pullback just kind of given liquidity and leverage across some of our competitor balance sheets. The other thing that we've seen a little bit is that from a competitive perspective, some funds are making the strategic choice to chase yields. So there have been several deals that have been done in the markets throughout the course of Q1 and Q2. Our assessment of those deals is that they are higher risk deals, and therefore, lenders are able to generate some higher onboarding yields on those deals. That's not the model that we've taken historically, and that's not the model that we're taking into the current environment. We're comfortable with the yield that we're getting on new originations. We have seen a little bit of an uptick in terms of onboarding originations, just given the rate environment that we're currently in, but it's not one for one, and we made this comment on the Q1 call as well. So if you assume prime rate for us is up about 200-plus basis points over the last several quarters, we have not seen a 200-basis point increase in our ability to generate higher onboarding yields. We've seen about a 25 basis point to 50 basis point increase in onboarding yields. So there is some correlation, but it's certainly not one to one. We did increase our core yield guidance for the portfolio. That range last quarter was 11% to 11.5%. Our new guidance for that, as Seth indicated, is 11.5% to 12%. Part of that is obviously driven by the fact that 95% of the book is floating and the majority of our portfolio is now going up from a rate perspective. But the other part of that is also that we're onboarding deals at a slightly higher yield relative to where we were 1 or 2 quarters ago.

Kevin Fultz

Analyst

Okay. That's all really helpful. And then just a follow-up, a modeling question around fundings. Funding is allocated to the private funds. Clearly, that was elevated this quarter. Was just curious if you expect the first private fund to be fully ramped by the time you launched the third fund and what the timing is for launching that third fund as well?

Scott Bluestein

Analyst

Yes. So we're not going to provide any guidance in terms of timing for a potential third private fund. I would tell you that the two private funds that we currently manage have continued to grow. We did give some guidance with respect to sort of size at the end of the year, and we're not going to update that now outside of the quarterly allocation numbers that we're providing on a quarterly basis. Q2 was very strong in terms of investments for us out of the 2 private vehicles that we manage. We expect that number to sort of come down a little bit and probably revert back to what we saw throughout the course of last year for Q3 and Q4.

Operator

Operator

Our next question or comment comes from the line of Christopher Nolan from Ladenburg Thalmann.

Christopher Nolan

Analyst

Congratulations on a really solid quarter. The interest rate sensitivity, I noticed in the Q that you guys are not hedging your interest rate sensitivity. What are your thoughts about that? Because you talked to different people on the outlook on these changes dramatically. Some people are not quite so certain that the Fed alone is going to be continuing to raise. So a little clarification in terms of what you're thinking is along those lines...

Seth Meyer

Analyst

Yes. No. Historically, we have not hedged our interest rate exposure, mainly because as the -- our expectation for the fixed environment versus floating is that often the yield curves are way out of whack compared to what actually evolves. And so what you end up doing is trying to pick the correct yield curve position. So we're very comfortable with choosing the right moment to fix our interest rate. And when you look at Q2, we are very careful about choosing the duration and the amount versus the amount that we decided to pick into the credit facilities. So in allocation, stratification giving us optionality, but not a preference to swap into a floating rate environment. Scott?

Scott Bluestein

Analyst

Yes. And Chris, the one thing that I would just add to that is we do have some built-in protection given how we structure these loans when we onboard a new loan. Generally speaking, they are floating with a floor and that contractual floor is set at the base rate at origination. So to the extent that we're originating deals right now, there is no downside in those loans to the extent that the Fed starts moving backwards over the course of the next year or so. So yes, I would just sort of add that back to what Seth said.

Christopher Nolan

Analyst

Great. And as a follow-up, in your comments, you mentioned the focus on larger companies, which seem to be new verbiage compared to more recent earnings calls. Does this imply that you're focusing on larger companies given your increased scale? And if so, does that mean that we should expect higher operating expenses to scale up the operation further?

Scott Bluestein

Analyst

Yes. So no real change in OpEx expectations outside of the guidance that Seth gave in his prepared remarks. The comment that we made about the focus is consistent with what we said in Q1. Given the volatility that we're seeing sort of across the venture and growth stage landscape, we made the strategic decision starting Q4 of last year to begin to shift our underwriting screens a little bit into more later stage, more established companies, takes away some of the inherent risk with earlier-stage companies. That's not to say that every deal is going to fit that sort of specific parameter, but that's really the focal point for us from an origination perspective. So these are companies that have raised 3 to 4 rounds of institutional capital. These are companies that to the extent that they are public are generally trading at a $500 million to $1 billion plus market capitalization even after significant pullbacks. And on the technology side, just much more established, better capitalized companies, which you may be down a little bit from a yield perspective, but we think it's the right decision from a credit perspective. And at the end of the day, we're managers of credit, and that's always going to be our focal point.

Operator

Operator

Our next question or comment comes from the line of Kenneth Lee from RBC Capital Markets. I'm sorry it's Mr. Lynch from KBW. Q - Ryan Lynch I have a couple of questions. The first one, I was very interested by your comment regarding that your portfolio companies were not having any increased difficulty raising additional capital. I think you quoted that the numbers were very similar in Q1 and Q2. I wonder if you could just provide some more color on that because that seems very counterintuitive to what we're hearing in the market with fundraising being down and capital deployed on the venture equity side coming under pressure recently, and we've seen all the memos from the Sequoias and that sort of stuff of telling founders that capital raise is going to be much harder to tighten the belt. So I'm a little bit surprised to hear that fundraising really hasn't been an issue for any of your portfolio companies? Are they just raising at flat or down rounds or what's going on next? That's kind of counterintuitive to what's going on in the broader markets?

Scott Bluestein

Analyst

Sure. So the comment that we made was not that we have not had any portfolio companies have trouble raising capital. What we said was that we have not seen any real material impact across the portfolio in terms of the ability to raise equity capital. We monitor our company's ability to raise capital on a quarterly basis. As you mentioned, in Q1, that number was over $1 billion across the portfolio. In Q2, equity market volatility for our companies clearly increased, and yet our portfolio companies -- yes, there was a little bit of growth, but our portfolio companies once again went out and raised over $1 billion of equity capital, and that was spread across well over a dozen different names. What we have seen is that it is taking a little bit longer to raise capital. Valuations are not what the Board members, investors, management teams initially wanted or expected. But we have not seen it yet turn into an inability to raise capital for good companies. I think what you're seeing from a PC perspective is much more selectivity. They're being much more focused in terms of their capital deployment. But there should be no doubt that venture capital firms are continuing to invest meaningful amounts of capital. If you look at the data that we have, in Q1, venture capital firms invested over $70 billion of equity. In Q2, venture capital firms invested once again over $70 billion of equity capital. So you're at over $140 billion of venture capital equity invested in the first half of this year despite the volatility. That funding is going to fewer companies, but it is still flowing into companies that deserve to be funded. And so given our historical -- flowing into companies that deserve to be funded.…

Scott Bluestein

Analyst

Yes. It's a great question. And I'd say a couple of things. So first, for us, we're following the same playbook that we have successfully followed for the last 17-plus years. Irrespective of market conditions, we think our first and utmost priority is to be disciplined managers of credit. So we think we take a very conservative and prudent view on underwriting new credit, and that doesn't change whether we're talking about 2020, 2021 or 2022. In terms of the fundings to commitment ratio, that absolutely has come down, and it's really a function of 2 things. Number one, we are specifically targeting later stage more well-capitalized companies. Those companies, by definition, are going to want to borrow less at closing. The second part is we are using milestones more aggressively than we even have historically. And this is a function of the current environment and just a more cautious approach on our side. And so as we utilize more performance covenants as we utilize more capital raising covenants that funding-to-commitment ratio is naturally going to come down. In Q2, it was below 50%. So on $1 billion of commitments, we funded $440 million. Really, the first time that I can recall where that number has been below 50%. We think the right way to think about it right now is really in that 50% to 60% range, and that's where we expect it to sort of normalize into. The last point that I would make despite the record growth that we delivered in the first half of the year, the net debt investment portfolio growth for Hercules was over $360 million in the first half, which is a record for us. Despite that, we're not managing this business and running this business focused on growth. So what we have told our investment teams is to continue to make sure that we are doing the right deals, not every deal. We're an internally managed BDC. We're not going to get paid more or less depending on what our asset base is, and that really gives us the ability to focus on making sure that we are doing the right deals with the right companies.

Operator

Operator

Our next question or comment comes from Kenneth Lee from RBC Capital Markets.

Kenneth Lee

Analyst

For your portfolio companies, given potential changes to private company valuations, what's your best sense of how loan-to-value ratios have changed within your portfolio?

Scott Bluestein

Analyst

Sure. Thanks, Ken. So we track loan-to-value on a quarterly basis. Generally speaking, if you look at our book, historically, our LTVs on a weighted average basis per quarter have been in the 7% range up to 20% to 25% on the high end. If you look at where we were in the sort of latter half of last year, our LTVs were down to sort of low teens, about 11%, 12%, 13%. Right now, even with the significant pullback that we've seen from a valuation perspective, our LTVs on a weighted average basis across the portfolio are in the 15% to 17% range. So we've certainly seen a little bit of movement up, but it still continues to be a very conservative number, given what our onboarding LTVs tend to be on these companies.

Kenneth Lee

Analyst

Got you. Got you. Very helpful there. And one follow-up, if I may. Have you been having conversations with the financial sponsors of the portfolio companies? And if so, how would you assess their willingness or their tone to provide additional capital if need be during the really volatile market times?

Scott Bluestein

Analyst

Sure. So I think a really important part of what we do and what our teams do on a daily basis is to have open communication with our management teams and with the Board members and investors of all of our companies. And those conversations take place in good markets. Those conversations take place in bad markets. And so our teams are continuously talking to our companies. What we're continuing to hear is obviously concern about the broader market. We're seeing and we're hearing VCs and Board members push companies to reduce expenses, to reduce spurn to extend runway. But at the same time, we are seeing the VC firms continue to fund the companies that they think deserve to be funded. And that's why we had, again, our companies raised over $1 billion of equity capital during the quarter. Some of that was on the private side. Some of that was on the public side. So I think you're seeing sort of caution from the investor community, but you are still seeing capital being deployed in the right opportunities.

Operator

Operator

Our next question or comment comes from the line of Finian O'Shea from Wells Fargo and Company.

Unidentified Analyst

Analyst

This is Jordan on for Finian today. Wanted to ask about -- there's a handful of companies you guys have that had planned to go public via SPAC or de-SPAC but have basically turned on that and announced the termination of that -- of their plans to go public that way. Just as a category, could you maybe give us some color on how that process or the end of that process might affect their exit potential? And maybe a little -- some of your thoughts on whether or not your underwriting is inside of that new path to the public markets or M&A or however the new exit might be?

Scott Bluestein

Analyst

Sure, Jordan. So we've seen sort of a mixed bag on the SPAC side. We've had some companies make the strategic decision to go through with SPAC transactions and execute successful SPAC transactions. We had one that got done in Q2. We've had other companies that have made the strategic decision that they did not want to pursue the SPAC route and ended up terminating their SPAC agreements. Those are obviously still private companies, so we're not going to speak to anything that we should be speaking to in terms of their plans. But what we can tell you is that in each of these cases, we underwrite to the assumption that the SPAC transactions are not going to get done. So with respect to the deals that we specifically underwrote to that were in SPAC transactions, we continue to feel very comfortable with those companies and their ability to raise equity capital privately now that the SPAC transactions have been terminated.

Operator

Operator

Our next question or comment comes from the line of Casey Alexander from Compass Point.

Casey Alexander

Analyst

I have a couple of questions. One is the volatility of the equity markets affects things in a lot of different ways. The vintage of loans that you're writing now, as you said, you're onboarding at a little bit higher yields. But would it also be your expectation that you're setting a basis point on the equity slices that you get from those at a lower level because of comps? And would it be your expectation that you would be able to generate better ROEs on the loan vintage that you're originating right now?

Scott Bluestein

Analyst

Yes. So the answer to that, Casey, is yes. If you remember, there are 2 components to sort of the equity pieces that we generally get in transactions. In certain cases, we'll receive warrants. Most of the time, those warrants will be priced at the better of last round or next round. So we'll have next round protection to the extent that there is a down round in the future. We generally have protection, and we reset our price and valuation. So we have some inherent upside with respect to the warrant position. The second equity component that we get in a number of our deals is the RTI, which is the Right to Invest. That Right to Invest is a contractual Right to Invest in a subsequent equity round. So if those companies are going out and raising equity rounds, whether it's publicly or privately, at more attractive valuations this year. To the extent that we think the equity investment makes sense and we choose to exercise that RTI, we do think that there will be some, again, inherent upside in those equity positions on a go-forward basis, just given that the valuations appear to be more attractive.

Casey Alexander

Analyst

Okay. Secondly, you guys did an outright sale of debt investments during the quarter of $73 million. I'm curious why it's not something that you guys do on a regular basis? How many loans were involved? Was it one or several loans? And how did you go about it? Because generally, that's not a super liquid market for just going out and selling loans?

Scott Bluestein

Analyst

Sure. So it is not something that we've done historically. I would add one point to that, that those loans were not sold in the general market. Those loans were sold to our 2 private funds, so just a little bit different than what we typically do, which is when we assign those fundings at closing. This quarter, given how strong our commitment numbers were and how strong our funding numbers were, we made the decision to also do a sale of a couple of pieces of a handful of loans. I think the number was about 5 or 6 loans. They were not the entirety of the loans. They were parts of specific loans. And that was really done one, just given the strength of the funding activity and commitment activity that we saw during the quarter, but also as we sort of think about portfolio diversification, as we think about concentrations, as we think about ineligible assets, we obviously are watching those things very closely. So in this quarter, there was an opportunity for us to sort of, in addition to the assignments to the private funds, sell down an additional $73 million, $74 million of loans to the private funds, which remain very well capitalized. And from our perspective and from a BDC perspective, given that those private funds are managed by the wholly owned RIA, the benefit of those loans ultimately accretes back to the shareholders regardless.

Operator

Operator

I'm showing no additional questions in the queue at this time. I'd like to turn the conference back over to management for any closing remarks.

Scott Bluestein

Analyst

Thank you, operator, and thanks to everyone for joining our call today. We look forward to reporting our progress on our next earnings call. Thanks, and have a great earnings call.

Operator

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.