Good day, and thank you for standing by. Welcome to the Hercules Capital First Quarter 2024 Earnings Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Michael Hara, Director of Investor Relations. Please go ahead.

Thank you, Gerald. Good afternoon, everyone, and welcome to Hercules Conference Call for the First Quarter of 2024. 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 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 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.

Thank you, Michael, and thank you all for joining the Hercules Capital Q1 2024 Earnings Call. Following our record operating performance in 2023, Hercules Capital is off to a tremendous start to 2024. Our record origination and funding performance in Q1 continues to reflect the benefits of being able to operate an institutional venture and growth stage lending platform at scale. Our ability to consistently deliver strong results for our shareholders and provide custom-tailored solutions for our growth stage borrowers in a variety of market environments speaks to the quality of our employees, the strength of the platform and team-first culture that we have built, and our 20-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 serve. As of the end of Q1, Hercules Capital is managing more than $4.5 billion of assets, an increase of 14.7% from where we were a year ago. We continue to expect 2024 to be another year with higher-than-normal market and macro volatility and a higher for longer rate environment. But as we discussed on our last call, we expected the market environment for new originations to improve throughout 2024. We have already witnessed this in Q1, and we are now benefiting from the balance sheet decisions that we made throughout 2023 where we went long liquidity and low leverage. We continue to manage our business and balance sheet defensively while maintaining maximum flexibility to shift to offense quickly and aggressively if deal quality warrants it, as we did in Q1. This includes continuing to enhance our liquidity position, maintaining low leverage, tightening our credit screens for new underwritings, and maintaining our higher-than-normal first lien exposure, which remained relatively flat at 88.4% in Q1. Let…

Thank you, Scott, and good afternoon, ladies and gentlemen. Hercules record first quarter originations performance was a testament to the amazing team and the relationships we have in the venture and sponsor-backed space in which we operate. The portfolio growth was supported by our low leverage and cost of debt as well as strong liquidity entering the quarter, a position we maintained strategically throughout 2023. To further support our current and anticipated growth, in the first quarter, we took advantage of the ATM by raising $66 million of very accretive capital, helping us to maintain a strong leverage position below 1:1 on both a GAAP and regulatory basis. We continue to maintain strong available liquidity of approximately $0.5 billion as of quarter end and more than $850 million across the platform, including the Adviser funds managed by our wholly owned subsidiary, Hercules Adviser LLC. Speaking of Hercules Adviser, the performance for the quarter enabled us to increase our second quarterly dividend to $1.6 million which, when combined with the expense reimbursement of approximately $2.9 million, resulted in $4.5 million of cash delivered to the BDC in Q1. With that in mind, let's review the areas of the income statement performance and highlights, NAV unrealized and realized activity, leverage and liquidity and the financial outlook. Turning our attention to the income statement performance and highlights. Total investment income was on par with the record prior quarter at $121.6 million driven by the prior year and year-to-date growth in the debt portfolio. Core investment income, a non-GAAP measure, remained stable at $114.2 million. Core investment income excludes the benefit of income recognized as a result of loan prepayments. Net investment income decreased to $79.2 million or $0.50 per share in Q1, an 8% quarter-over-quarter decrease, driven by an increase in variable compensation…

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

First, on first quarter fundings, very strong here with net Hercules fundings at nearly $500 million. And Scott, you mentioned the pent-up demand of companies that put off debt decisions in 2023 coming back to the table early in the year. Do you view the first quarter here as somewhat of an anomaly? Or could this pent-up demand just remain a tailwind through the next few quarters to continue to drive fundings to elevated levels or even levels similar to the first quarter?

Thanks, Crispin. The funding activity in Q1 was exceptionally strong. As you pointed out, $605 million of gross fundings, nearly $500 million net in the BDC that led to net debt investment portfolio growth of over $325 million. If you look at our pending and closed pipeline, you can see continued momentum. So I would say that we are very optimistic about a continuation of a strong funding environment over the next couple of quarters. Do we expect it to reach the levels that we saw in Q1? Most likely not. But we certainly don't expect to see a reversion back to the levels that we saw a year or so ago.

Great. That all makes sense. And then a little bit of a bigger picture question just on the competitive environment, can you just talk a little bit about how the competitive environment has shifted just over the last year or a year and a few months since the bank turmoil of March last year? Are you seeing any recent activity from banks coming back or increasing exposure? And then just separately, are you seeing more of a pickup from private lenders or others in the space or any retrenchment? Just curious on the competitive environment as a whole.

Sure. I think for us, it's still status quo on the competitive side. As I pointed out in the last few calls, there are still venture banks that are active in the market. We continue to see First Citizens-SVB from time to time on transactions, we've seen HSBC on a handful of transactions, and we've seen a couple of other venture banks that have been in and out of the market. The reality is we are not primarily competing with venture banks on transactions. When you think about sort of the nonbank side of the market, there are a handful of competitors that we compete with on a deal-by-deal basis, but there really is no consistent source of competition that we see on a deal-by-deal basis. The changes that we've made to our business in terms of being able to strengthen our balance sheet, do deals that on the low end are $10 million, on the high-end are $300 million, do deals that are both expansion and established stage, go after companies that are looking for that last round of financing, have really put us in a unique position where we can play on both ends of the market, and we can really dominate everywhere in between. And so not much has changed on the competitive side for us, and we continue to focus on the things that we can control. And obviously, that's leading to tremendous results both on the operating side and on the funding side as well.

Our next question comes from the line of Brian Mckenna with Citizens.

I appreciate all the commentary on new funding activity and the outlook there, but I guess what I'm trying to figure out is the trajectory of the portfolio from here just in terms of growth. So it grew 10% in the quarter sequentially. I appreciate it likely doesn't increase that much moving forward every quarter. But if there's a way, how should we think about the cadence of portfolio growth in the coming quarters? And then what might that mean for the trajectory of NII, assuming kind of no material shift in the rate backdrop?

Yes. Thanks, Brian. We don't, on a quarterly basis, provide funding guidance. And we certainly don't provide our expectations in terms of net debt portfolio growth. We did provide, as we always do, updated prepayment guidance for Q2, and we expect prepayments to increase pretty substantially in the second quarter. The guidance that we gave was $200 million to $300 million. Based on what we're seeing right now, I would expect it to be on the high end of that number. So that's almost double what we saw in Q1 where we had $160 million of prepayments. So in Q2, we're certainly not expecting to deliver another $300-plus million of net debt portfolio growth. I think if you think about sort of the basic cadence of the business, we are generally going to do somewhere between $300 million and $400 million, $450 million of gross fundings on a quarterly basis. You can obviously pull out the normal course amortization and then you can pull out the prepayment guidance that we give, knowing that the prepayment guidance is just our best guess based on what we know as of the date of this call.

All right. Great. Helpful, Scott. And then just maybe a question on credit. So you added 1 company to nonaccrual status. Can you just talk about that 1 investment a little bit? And then just more broadly, nonaccruals are still low in the absolute, but are there any areas across the portfolio you're watching closely today? Or any situations you're maybe looking to get out in front of?

Sure. So we're always watching the totality of the portfolio very, very closely. That's our DNA. That's what we do. We run this firm as if it's a credit shop, which is the way a venture lending firm really should be run. The overall credit book continues to perform very well. If you look at the numbers that we just reported, less than 3% of the entirety of our book is in Grade 4 and Grade 5 credits. It's about $89 million in Grade 4 and about $8 million in Grade 5, so it's very small on a relative basis. We did add 1 small loan to our nonaccrual list in Q1. That loan has about a $12 million cost basis, has a fair value of approximately $5 million, and our expectation is that we'll have that situation resolved before our next earnings call.

Our next question comes from Finian O'Shea from WFS.

Scott, going back to some of your introductory remarks on positioning the company with liquidity to take advantage of this market. It looks like it worked out pretty well. Are you able to update us on what you're thinking today and how much growth at Hercules the overall BDC you sort of hope for or plan for this year, next year?

Sure. Thanks, Finian. We're planning for a strong robust year in terms of originations and growth. We were pretty clear in terms of our positioning last year that we were preparing for an improved origination environment in 2024. That's what we saw in Q1, and that's what we expect to see over the next several quarters. Having said that, if there is a quarter where we don't see deal quality, we'll pull back just as we would do in the ordinary course. In terms of how we're positioning the business and how we're managing the business now, it's going to be very consistent with what we did last year, which is to generally be defensive in terms of how we manage the balance sheet. We don't want to be caught in a position where we end up low liquidity or over-levered because we think that just takes away optionality and flexibility. So Seth and I and the team are going to continue to focus on making sure we have a strong balance sheet, a healthy liquidity position and that we're managing the business relatively conservatively with respect to leverage so that if we do have an opportunity like we saw in Q1, we're able to very quickly take advantage of it.

Great. It's helpful. And a follow-up for Seth, I think I caught the guidance for the Adviser dividends to be at least at the midpoint, a little bit below what it started out at. Does that imply a cessation in growth there or less origination? Or how do we think about that?

Yes. Sure, Fin. It really, in the first instance, the first dividend that we paid in Q4, there's a little bit of pent-up cash and a little excess earnings and profits that we could distribute, and that kind of spilled over into the first quarter as well. So I would stick with the guidance of $1 million to $1.5 million, but we certainly hope that that's going to continue to grow.

Our next question comes from the line of Casey Alexander with Compass Point Research & Trading.

First of all, congratulations on the 20th anniversary. It's quite an accomplishment in this business. My first question is, I totally understand the strategy of being long liquidity in 2023, especially following the upheaval at the beginning of the year, but at what point in time do you start to take the leverage ratio up some in order to more optimize the earnings of the BDC while still being well within the leverage limits? I mean you could certainly deliver a lot more NII to shareholders if you were running at 1.1x. And it seems to me that you're in a much more stable environment than you were 3, 4 quarters ago.

Yes. Thanks, Casey. And first, thanks for the congratulations. It is a tremendous accomplishment for the company and for the team, and the credit really does go to the team. So thanks for that acknowledgment. In terms of leverage and liquidity, I think if you look at what we just did in Q1, we did begin to take leverage up. We ended the year with GAAP leverage of about 87%. We ended Q1 with GAAP leverage of about 94%. So for us, that's a pretty meaningful quarterly increase given that we had over $300 million of net debt portfolio growth. On the Q4 earnings call, Seth and I were clear that we do expect to take leverage up slowly throughout the course of 2024, and that continues to be our intent. Are we going to get to 1.1x? Are we going to get to 1.15x? It's really difficult to say because that will largely depend on what happens on the prepayment side of the business, but we do expect to continue to take leverage up slowly and cautiously throughout the next several quarters, which will help further drive the profitability of the business.

Okay. Great. Secondly, first quarter is normally kind of a quieter quarter after usually following a year-end rush. And you had basically 2 years of very lackluster activity and pent-up activity that looks like it's starting to come to the marketplace and your deal size is so much larger than it was a couple of years ago. So I'm curious why you wouldn't expect your deal activity to be similar to levels of Q1 as the year goes along when deal activity actually traditionally increases?

Yes, it's a great question, and I would point out a couple of things. Despite the fact that we have the capability now to do significantly larger deals than we did 1, 2, 3, 4, 5 years ago, the average dollars funded for us actually has remained fairly constant. In Q1 of '23, for example, which is the year-ago period that you just referenced, our average dollars funded per portfolio company was about $21 million. If you look at that data today, as of Q1 '24, it's about $23 million, average dollars funded per POCO. So there really hasn't been that much of an increase in terms of the average dollars. And a lot of that is sort of self-imposed. We're very focused on diversification and granularity within the portfolio. I think a mistake that a lot of our competitors make is when they chase the big deals and forget about granularity within the portfolio. So we focus very intently on our top 5, our top 10, as a percentage of our total book and what that average dollars outstanding per POCO number is. We do see some opportunity to continue to move upstream and we expect to be able to continue to do that. There were a handful of deals that we booked in Q1 that were larger in nature. There's a handful of deals that are in our pipeline right now that are also larger in nature, but we're also still focusing the majority of our time on the bread-and-butter deals where we think we can continue to add significant value to the ecosystem.

Our next question comes from the line of John Hecht of Jefferies.

First one is, I guess, the timing of the fundings, were they kind of skewed toward the back end of the quarter? And I don't think that's untypical. But just because you have such substantial growth and your interest income was somewhat flat with last quarter.

Yes, a pretty typical quarter for us where we have funding activity in each of the 3 months of the quarter, but the vast majority did come once again in the last month of the quarter.

Okay. And then the core yield guidance, is that a function of bigger, later-stage companies? Or is it just market rates? Or how do we think about that?

Yes. You're thinking about it the right way as far as larger, later-stage deals that we're concluding, John. And as I had mentioned in my commentary, the decrease in the core yield was largely related to those new originations. And that's what causes us to guide down a little bit looking forward.

Okay. And then kind of fees as a percentage of, call it, activity, which would be both originations and then prepayment. I guess it's more prepayment or repayment fees. Is there anything changing there? Anything we should be cognizant about in terms of what's going on in the new deal market?

No. Pretty consistent, John. So we're not seeing any change. Quarter-to-quarter, we do have a variety of outcomes based on the specific transactions that pay off prepay, on whether they do have back-end fees, what the size of the back-end fee is, how old the deal is. And so while we typically give the guidance of either 3% to 4% on the acceleration, it could be much less or it can actually be higher, in some instances. So it really depends on the specific deals what the arrangements were and the age of that deal, whether it's fully or nearly fully amortized. So that changes. But as far as the agreements that we're putting in place and the fees that we're arranging on new business, there's no trend difference there.

Our next question Vilas Abraham of UBS.

Just one for me. Given the strong origination outlook that you're discussing on the call, can you just talk a little bit about Hercules capacity right now, ability to support that just from a people and a technology perspective and any areas you might be thinking about doing further investment in?

Sure. Thanks, Vilas. If you look at what we did in '21 and in 2022, we made significant investments in the business. Our full-time employee account now is up over 110. Throughout the course of the last 24 months, we've added to all groups and at all levels of the company. We made some very strategic, intentional additions to the investment team over the course of the last 12 months. We have boosted our back office and credit team. We have improved our operations team and our finance team. We've added to our legal team. So we feel very good about where we are right now from a head count perspective and the fact that we have the ability to support some pretty extensive growth over the next year or so. In terms of the balance sheet, the balance sheet, as we've mentioned several times, is very well positioned. We have nearly $500 million of liquidity in the BDC, nearly $850 million of liquidity across the platform. We are under-levered relative to our historical targets from a GAAP perspective and from a regulatory perspective. And so we think we're very well positioned to be able to take advantage of growth. I think the key caveat and comment that I'll make is we're going to take advantage of the growth if it's quality growth, right? We're not interested in growing the business just for the sake of putting assets on the books. Every deal that we do has to meet our credit screens and it has to be a deal that we think is in the long-term best interest of our shareholders and stakeholders.

Our next question comes from the line of Christopher Nolan.

Congratulations on a really good quarter. Last week, Moody's downgraded the outlook or gave caution to the outlook for direct lenders. While Hercules was not specifically listed among the ones that did, have you guys had any direct conversations with Moody's related to this at all?

We are in constant contact with all the rating agencies in which we work with. There's no indication that they have any concern about our business. In fact, the guidance they shared with us was just trying to be cautious about the sector, the outlook. The performance of our competitors, as you know, Chris, has not been stellar. So I think that we stand out a little bit differently than them. And that's basically the conversation that they have with us as well.

Okay. And have they been expressing any concerns or outlook or anything related to the venture capital market, that tiered ecosystem because you guys do stand a little bit apart from the other guys.

Not that they shared with us, but I would definitely discuss that with them and see what their view is on that.

Finally, you have some debt maturing in 2024. Is the idea to just use the credit facility to refinance that?

Presently, that is the plan. We'll take a look at the market a little bit closer to that maturity. It's $105 million, well below the capacity that we have and the $800 million of credit facilities in total. So we'll make the assessment closer to the date.

That concludes the question-and-answer session. I would now like to turn it back to Scott Bluestein, CEO and Chief Investment Officer, for closing remarks.

Thank you, operator. And thanks to everyone for joining our call today. As a final note, we will be participating in the Wells Fargo Financial Services Investor Conference on May 14 in Chicago. If you are interested in meeting with us at this event, please contact Wells Fargo directly or Michael Hara. We look forward to reporting our progress on our Q2 2024 earnings call. Thanks, and have a great night.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.