Good day, and thank you for standing by. Welcome to the Hercules Q1 2023 Earnings Conference Call. At this time, all participants are in 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. I would now like to hand over the conference to today's speaker, Michael Hara, Managing Director of Investor Relations. Please go ahead, Michael.

Thank you, Mark. Good afternoon, everyone, and welcome to Hercules conference call for the first quarter 2023. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer; and Seth Meyer, CFO. Hercules' financial results were released just after today's market close and can be accessed from Hercules Investor Relations section at investor.htgc.com. An archived webcast replay will be available on the Investor Relations webpage for at least 30 days following the conference call. During this call, we may make forward-looking statements based on our own assumptions and 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'll turn the call over to Scott.

Thank you, Michael, and thank you all for joining the Hercules Capital Q1 2023 Earnings Call. Following our record operating performance in 2022 and despite a volatile market backdrop, partially driven by the failure of our largest competitor in the asset class, Hercules Capital delivered another quarter of record operating performance in Q1. Our ability to consistently deliver strong results speaks to the quality of our employees, the strength of the platform that we have built and our 18-plus year history of operating with an emphasis on prudent underwriting asset and liability diversification, and an unwavering commitment to the venture and growth stage ecosystem that we service. Building a venture and growth stage lending business that operates at scale and consistently delivers strong credit and financial performance does not come easily or by accident. Since inception in 2003 and throughout our history, we have focused on sticking with our steadfast core principles; steady, patient and disciplined underwriting, diversifying and strengthening both sides of our balance sheet, maintaining strong liquidity and continuously investing in our team and systems. From the beginning of 2021, our platform has raised more than $2.5 billion in new capital and significantly increased our credit facilities with better flexibility and terms. We further enhanced and expanded our reach and capabilities with the creation of our wholly-owned RIA, which manages our three private funds. And now with the unexpected changes in our competitive environment in Q1, we are presented with a tremendous opportunity that we believe will grow our presence and further strengthen our leadership position in the venture and growth stage lending landscape. The current market requires a combination of playing skilful and selective offense in terms of new business and disciplined and tight defense on credit. We intend to do both and we believe that we…

Thank you, Scott, and good afternoon, ladies and gentlemen. Hercules' first quarter performance was a great way to kick off 2023. The portfolio growth was complemented by strengthening our balance sheet to support our current and anticipated growth. In the first quarter, we renewed the $400 million MUFG credit facility, executed and subsequently increased the SMBC letter of credit facility from $100 million to a total of $175 million, and took advantage of the ATM by raising $65 million of accretive capital. We continue to maintain strong available liquidity of $553 million as of the quarter end, more than $120 million higher than what we maintained just a year ago. Despite the increase in our ready to access credit facilities, more than 80% of our leverage is fixed rate and 73% is unsecured, helping us keep financing costs low and optionality high. We continue to explore more cost-effective ways to manage our liquidity needs as the opportunities to invest increase while maintaining our consistent credit and return standards. We've positioned ourselves well to continue scaling our platform, most recently by adding additional capital managed by our wholly owned RIA. As previously communicated, we expect the RIA to move beyond expense relief for the BDC and start delivering dividends to the BDC later this year and further enhance our returns to our shareholders. With these points 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. Starting with the income statement performance and highlights. This was the second quarter in a row that total investment income exceeded $100 million at $105.1 million driven by the prior year and current quarter growth in the debt portfolio on solid new business underwriting and an increase in benchmark rates.…

[Operator Instructions] Our question will come from John Hecht from Jefferies.

Congratulations on putting together a good, stable, strong quarter in an unstable world. Scott, I just -- you did -- you referred to kind of the SVB sale to First Citizens and kind of you referred to the opportunities and sort of disruptions that, that presented to the market. But I'm wondering, maybe stepping back and think about the next few quarters, if you could describe to us what is -- is First Citizens going to operate SVB from your perspective largely as it was? If there are changes, how does it affect the ecosystem in which you work? And then what does that mean in terms of either opportunities or challenges for your portfolio companies and then boil that back to how does that create an opportunity for Hercules over time?

Sure. Thanks, John. A couple of things. We can't speak to what First Citizens will or won't do, but certainly I want to take a minute to maybe make a couple of comments on the SVB situation. The first thing that I want to say, what happened to SVB in Q1, certainly from our perspective, had absolutely nothing to do with the health or vibrancy of the venture ecosystem. And it certainly had nothing to do with the credit quality of their venture lending book. What happened to Silicon Valley Bank in the first quarter was a result of a mismatch in terms of their asset and liability management, which created obviously significant pressure from a deposit perspective. We, as an organization, have tremendous respect for that team and for the SVB business. SVB was an instrumental part of the ecosystem for the last 40 years. As a firm, we are saddened by the failure of the bank, and we obviously feel terribly for the approximately 10,000 employees of the bank. Having said that, we view what happened to SVB in the first quarter as a tremendous opportunity for HTGC. You saw some of the early impact of that positivity in terms of our Q1 numbers. You're seeing more of that impact now in our pipeline numbers that were publicly reported in our press release, where we have over $500 million of signed term sheets. The quality of our pipeline since the SVB failure has continued to grow both in terms of size and in terms of quality. We look at the opportunity realistically, and we also look at it as an opportunity for us to honor our 18-plus year commitment to helping fund the companies that make up the venture and growth stage ecosystem. We are very well positioned. We believe we are the only lender in the venture lending space positioned to be able to aggressively take advantage of the opportunity that has been created by SVB's exit from the market.

There's -- I know we're aware of some other smaller venture lenders, too, but without being terribly close to them, I'm not totally familiar with their liquidity positions, but I do think that they had strained liquidity certainly in relation to you guys. So the question is outside of SVB, is the competitive market also getting favorable? Meaning that are other market participants weakened by the current situation relative to you guys, which are strengthened?

Sure. Without mentioning names, John, because I don't think that, that would be appropriate, I will say that we are absolutely seeing some signs of stress across the venture lending landscape, not just with respect to SVB but with respect to others. I can only speak to how we are positioned. And I can tell you that from our perspective, we are incredibly well positioned. We have always managed this business with a conservative balance sheet. We ended the year with net regulatory -- sorry, we ended Q1 with net regulatory leverage of under 100%. We ended Q1 with over $550 million of liquidity in the BDC, over $1 billion of available liquidity across the HTGC platform. We have made tremendous investments over the last couple of years, in our team, in our systems and in our infrastructure. We currently have over 105 full-time employees. We added significant new talent to the organization in Q1 and we intend to continue to do whatever we need to do to ensure that we are positioned to fill the void left by SVB and potentially others.

And our next question will come from Crispin Love with Piper Sandler.

Scott, you said early in the prepared remarks that you're avoiding marginal deals that you're currently seeing. Can you just expand a little bit on that, on what you're seeing currently? And then just also speak to your confidence on closed funding accelerating in the back half of the second quarter.

Sure. I'm not going to say too much, Crispin, with respect to what exactly we're seeing on the marginal deal front because, obviously, we're avoiding those deals. I'll make a general comment, which is that our pipeline right now continues to be at record levels. Our investment team, which is now comprised of about 56 to 57 full-time employees. Screening, seeing, evaluating and looking at a record number of transactions, the vast majority of the transactions that we are seeing are simply not tractions that meet our credit underwriting screens and we're passing on those. And I will tell you, we continue to see many of those deals get done in the market, and we'll have to see over the next couple of quarters how that plays out. We are being very selective in terms of new business. We have the balance sheet to be able to be aggressive on new business when and where we want to be. But the single most important part of our new business effort right now is on making sure that the credit quality is strong and that it meets our very tight underwriting parameters.

And then just on credit, and specifically, one of your portfolio companies, Codiak BioSciences. So they filed for bankruptcy in late March, which is out there publicly. So just curious on what type of recovery you might expect there. Just looking at their balance sheet, they had a little over $50 million of cash as the third quarter and that compared to your $25 million loan, which looks to be about a $17.5 million principal now. So unclear what their cash burn has been since the third quarter just given disclosures. But curious if you're confident on a full recovery there based on their cash position or anything else worth pointing out?

Sure. Thanks, Crispin. As you pointed out, we do have one company out of about 120 debt positions that did file for bankruptcy at the end of Q1. Bankruptcy for us as a senior secured first lien creditor does not mean that we are going to have a loss on that position. When the company filed, we had $25 million of principal outstanding. Subsequent to the filing, we have worked cooperatively and constructively with the company, with the advisers and with the investors. We have already received $10 million of cash pay downs. So that $25 million principal loan has been reduced to $15 million. The company remains 100% current through the May 1 date on all payments of principal and interest to Hercules. The company has a vast pool of assets that they are currently looking to monetize, obviously, in consultation with Hercules and their advisers. And while there are no guarantees in any of these situations, we feel very good about the ultimate recovery of that position. I would also say that for us, what we just said is not just words. We have a very long track record of being able to be able to navigate through challenging workouts and bankruptcy situations. If you look at the last several workouts and bankruptcies that we, as an organization, have had, we've had very strong recoveries, and we're not seeing anything with respect to Codiak specifically that we believe will lead to a different outcome.

And our next question will come from Kevin Fultz, JMP Securities.

My first question might sound familiar from another BDC earnings call, but I wanted to get your point of view as well. I know you closely review the PitchBook NBCA venture monitor, and there is a figure in the 1Q '23 report that highlights the funding gap that has recently accelerated within late-stage VC. And essentially, the figure shows that the late-stage capital demand to supply ratio has reached a decade high in the first quarter of 2023 at just above 3.2x, which compares to 0.9x in the first quarter. I'm just curious what your view is on the shift in capital availability for late-stage companies, both what you're seeing in the market and within your own portfolio and also what that could mean in terms of venture stage companies ability to raise additional capital.

Sure. Thanks for the comment and the question, Kevin. A couple of comments there. There absolutely remains a significant amount of capital on the sidelines, which is available for late-stage companies. What we are seeing and what I think equity investors are seeing is that there continues to be a disconnect from a valuation perspective with respect to where the venture capital firms want to be on valuation and where management teams and entrepreneurs want to be on valuation. The capital that is sitting on the sidelines for the most part, is not going away. That capital will be there in Q2. It will be there in Q3. It will be there in Q4. And what typically happens during these periods is there's a period of sort of a slow delicate dance. And at some point, the valuations will meet and these deals will start to get done. The other comment that I would make with respect to sort of the broader data that we're seeing from NBCA and PitchBook is, although the Q1 data with respect to VC equity investments was down materially, I think sort of the folks that are out there thinking that this is a sort of a dark winter and the worst period that we've seen, at least it doesn't add up with our view of the market. In Q1 of 2023, there were approximately 2,856 companies that received venture funding, and the venture funding in Q1 totaled approximately $37 billion. When you compare that to what the market was able to achieve between 2020 and 2022, so during the COVID period, the numbers are down materially. But if you compare that to the numbers between 2012 and 2019, which we view as sort of the steady state of the market, those numbers were approximately 3,900 deals per year and approximately $70 billion invested. So on a comparative basis to what we view as the normal market, the numbers in Q1, although down materially, were still fairly healthy. And that's the way that we are currently viewing the market.

And then just one more, if I can. I'm curious if current market conditions are presenting the opportunity to scale the private funds in RIA at a more accelerated rate than you initially anticipated?

Absolutely. And I would reiterate what we said on the last call, which is we continue to expect to be able to begin the dividend distributions from the RIA up to the BDC in the second half of this year. So not only will the shareholders of HTGC be benefiting from the expense reimbursement, we expect in the second half of this year for our shareholders to begin to benefit from distributions from the RIA business up to the BDC. There is tremendous momentum for us, not just in the BDC, but also in the private fund business. If you look at what we announced most recently, we did launch a new private vehicle, which is specifically designed to take advantage of the market dislocation that we're currently seeing. We deployed a significant amount of capital in the private funds in Q1. That was about $121 million of fundings and that's on top of about $400 million that we funded in the private fund business last year alone.

Our next question will come from Christopher Nolan with Ladenburg Thalmann.

Scott, strategically, two things and just a follow-up on the earlier question. Would you consider participating in a new bank targeting the venture capital space?

The answer to that is no. We're not in the banking business. We think that our business works better without being tied into relying on deposits. And so the answer would be no.

Second question is how do you think AI is going to affect the VC lending business?

So AI is something that we're obviously watching very closely. We think that there are positive scenarios and then, of course, negative scenarios as well. We're looking at it pretty optimistically. We think that AI has the ability to further accelerate innovation across the technology and life sciences landscape. Every few years, there is new innovation that is disruptive. AI is sort of the current phenomenon. And while we do have some concerns about the impact that AI could have on certain businesses, overall, we're actually pretty optimistic about what AI will mean for the overall health of the innovative economy.

Our next question will come from Casey Alexander Compass Point Research & Trading.

Scott, you described SVB, Silicon Valley Bank, as a competitor. But in many ways, they were also a partner to you and you guys had joint positions with companies. I'm curious from your seat, what opportunities does that create for you to take a more senior position in the lending stack with those companies and also hammer down your incumbency position with those companies? And then secondly, with Silicon Valley Bank, there's been a lot of migration of talent that has gone around. Has Hercules been able to make any key hires that have been able to take advantage of some of the dispersion of some of that talent?

Sure. A couple of great questions, Casey, and thanks for your questions there. First thing, with respect to the partnership, I mentioned collaborative and competitive relationship. I would tell you that over the years, Silicon Valley Bank was a great partner of ours in terms of helping us finance many great companies across the venture capital ecosystem. We have a pretty high bar in terms of who we will partner with, and SVB was one of the few firms that we were comfortable partnering with in terms of the market, both on the life sciences and technology side. Having said that, as you just pointed out, that creates a tremendous opportunity for us given that we do have a handful of partner deals with the bank to be able to do something strategically to help lock down our incumbency position. I will also say that with respect to those partner deals, to date, First Citizens has honored 100% of the commitments across our portfolio. First Citizens continues to fund those companies that we are partnered on. And we don't expect there to be any negative disruption in that regard, but there is certainly an opportunity for us to continue to take some added market share with respect to not just those deals that were partnered on currently but that we were contemplating partnering with them prior to the situation that developed in Q1. With respect to talent, in my opening remarks, I made the comment that we have tremendous respect for the SVB business and for that team. There were a handful of employees that we identified that we thought would fit in very well with the Hercules culture and team. And we have made a handful of hires from SVB over the course of the last 30 to 60 days, and we're very pleased with what we've seen to date from that group of employees.

My other follow-on question is there were gross fundings of $476 million, and you called out 9 new borrowers out of 31 companies, so 22 borrowers were existing borrowers. Out of that $476 million, can you tell us how much was drawn down off of the unfunded commitments as opposed to being direct originations?

Sure. I can give you the breakdown. Roughly $476 million of fundings in the quarter, about $185 million of the fundings were new fundings to new companies. Approximately $150 million of the fundings were new fundings as part of new commitments to existing portfolio companies, and approximately $140 million were fundings from unfunded commitments.

Our next question will come from Finian O'Shea of Wells Fargo.

Can you provide us any detail on what the new private fund means for Hercules' economics and if it's part of the RIA or a separate vehicle?

So the new fund will, in the same way as the first two funds, provide a management fee and performance fee to the RIA. So yes, to answer to your second part of your question, it is part of the existing RIA fund. And so very similar and consistent with what Scott mentioned in the back half of 2023. It will provide expense relief in the immediate term. As it builds up the portfolio, it will start to generate those revenues from the management and performance fees, which will then eventually turn into additional dividends that come up to the BDC.

And Fin, I'll just add to that. When we launched the private fund business about two and half years ago, we made a commitment publicly and privately that 100% of the benefit from that private fund business would accrete to the benefit of HTGC's public shareholders, and we remain committed to that commitment. So anything that we do in the private fund business will be under the RIA, which is a wholly owned subsidiary of the public BDC.

Our next question comes from Ryan Lynch with KBW.

First one I had is you mentioned a lot of the details around the SVB collapse and kind of the aftermath on that as far as the opportunity set goes. I was just curious if you could talk about post the collapse of SVB, has there been any sort of shift in investor sentiment or action from the DC equity investors and their willingness to support the existing companies, just broadly in the BC marketplace? Obviously, the trends have been getting worse as far as the level of investment activity have been kind of going lower for the last several quarters. But I just wasn't sure if you've seen any sort of acceleration of those trends post SVB or not.

Thanks, Ryan. I don't think we've seen any acceleration necessarily. Obviously, what happened with Silicon Valley Bank was a surprise to the vast majority of the ecosystem. And I think for the first couple of weeks, sort of post failure, a lot of people on the equity side and on the credit side were sort of just sort of taking a step back to catch their breath and figure out what just happened. Obviously, subsequent to SVB, there's been some additional turmoil, First Republic, obviously, some additional regional banks that are currently exploring strategic options. So I don't think there's anything specific in terms of an acceleration that we saw post SVB. The equity markets right now and the credit markets continue to be volatile. There's obviously a lot of uncertainty. We continue to focus on what we can control, and that's ensuring that our credit portfolio continues to outperform, that our BDC continues to be incredibly well positioned and conservatively managed. And that, we think, puts us in a great position to be able to benefit and take advantage of whatever the opportunity set is over the next couple of quarters.

And the other question I had, you mentioned repair account is about $22 million of appreciation in your loan book. I think you said half of it was due to companies expected to prepay. Can you talk about what drove the other half of the appreciation and that just given the market environment? I just would love to hear why that book increased. And then also in your press release, you talked about $4.7 million of unrealized depreciation related to privately held equity warrants and investment funds. Can you talk about what was the driver behind there? Were some of your portfolio companies are actually doing up rounds in this marketplace that revalued some of those equity warrant positions or what drove that $5 million?

Sure. Thanks. So as you know, every quarter, we go through and revalue the entire portfolio. So we'll go through and we'll do individual adjustments on the portfolio companies based on their performance against our original underwriting plan. For those companies that are performing a little bit better, maybe they're having faster rounds of capital raised, maybe they're progressing faster through an FDA approval process. They will slightly tweak the valuation on those portfolio companies, both the debt and the equity positions, obviously, if they're private. And we'll go through and do a market yield analysis compared to a benchmark portfolio that we use, the SMI index, to see where we should be adjusting the overall portfolio based on benchmark interest rates as well. So the appreciation beyond that, that we did for about half of the mark-to-market, as you mentioned, for the early repayments, it's really based on that performance. The impairments stayed very consistent. You noticed that we had only two nonaccrual loans, maintained very consistent valuation, small adjustments on those. And so net-net, the portfolio is performing better than writing thesis on a market basis -- adjusted basis. Keeping in mind that our -- 95% of our portfolio is floating with a floor so that we're not having reductions in values as the benchmark interest rate goes up. So that was on the debt portfolio. And then Scott, do you want to comment on the private equities?

Sure. Ryan, with respect to the $4.7 million of unrealized appreciation on the private equity and warrant positions, the substantial majority of that appreciation came from an up valuation with respect to Hercules Advisor, which is the wholly owned registered investment adviser. That was a result of two things. One, we raised and we launched the new fund and continued growth with respect to the AUM in the first two private funds.

At this time, I would like to turn it back over to Scott for closing remarks.

Thank you, Mark, and thanks to everyone for joining our call today. We look forward to reporting our progress on our Q2 2023 earnings call. Thank you all, and have a great day.

Thank you, everybody, for your participation in today's conference. This concludes the program. You may now disconnect.