Q3 2019 Earnings Call
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I would now like to have the constant so what's your speaker today Mr., Michael how are managing director of Investor Relations. Thank you. Please go ahead Sir.
Thank you Paul Good afternoon, everyone Welcome Hercules Conference call for the third quarter 2019.
What's on the call today for Hercules as Scott, who Steen, Chief Executive Officer in Chief Investment Officer, and Seth Meyers Chief Financial Officer.
Hercules third quarter 2019, released financial results were released just after market close can be accessed from the Hercules Investor Relations section that age TGC dotcom.
We have arranged for a replay of the call Hercules web page or by using the telephone number and passcode provided in todays earnings release.
During this call we may make forward looking statements based on current expectations actual financial results followed with the Securities Exchange Commission rate there from those contained herein due to timing delays between the date of this release trimming the confirmation 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 could differ materially.
Expressed in forward looking statements, including without limitation, the risks and uncertainties, including the uncertainty surrounding the current market turbulence and other factors me I've identified from time to time in our filings with the FCC.
Although we believe that the assumptions on which these forward looking statements are real and either assumptions can prove to be inaccurate and as a result to forward looking statements based on those assumptions also can be incorrect.
You should not place undue reliance upon these forward looking statements for forward looking statements contained in this space are made out of the date hereof.
At Hercules assumes no obligation to update the forward looking statements or subsequent events.
Two came copies of related 60 fines forget you can visit our website with that I'll turn the cauldron Scott.
Thank you Michael and good afternoon, everyone and thank you all for joining us today.
Q3 was another strong quarter for Hercules capital, where we delivered a record Q3 total fundings of 177 million, while continuing to deliver strong and consistent credit performance and operating results.
Even though Q3 is typically our slowest originations quarter.
Our team was once again able to deliver a record quarter, which highlights the scale and depth of our investment platform.
Our overall performance in Q3 has put us in a strong position to deliver yet another record year in 2019 and more importantly, we believe positions us well at this particular juncture up the credit and economic cycle.
Our year to date performance was highlighted by multiple interim records, including new commitments total fundings total investment income net investment income and total portfolio investments and assets all while maintaining our historical strong credit discipline and underwriting.
Standards.
In Q3 originations platform delivered new debt and equity commitments.
241.3 million.
An increase of nearly 3% from the same period last year.
For the first nine months of 2019, we delivered 1.19 billion in new debt and equity commitments, an increase of nearly 24% compared to the same period last year.
Since the close of Q3 and as of October 29th Hercules has already closed an additional 191 million of new commitments and we have pending commitments of an additional 36 million in signs nonbinding term sheets.
Year to date through October 29 are closed new debt and equity commitments are at 1.4 billion.
With two full months remaining in 2019, we have already delivered a new historical record of annual commitments for 2019.
In addition, our current pipeline remains strong with approximately $1 billion in potential transaction.
Our investment related activity in Q3 reflects our focus on three key themes and our views on the card market and competitive environment.
First building and maintaining a broadly diversified portfolio and avoid any concentrated risk.
Second delivering controlled growth without sacrificing our credit and underwriting standards and discipline.
And third positioning the portfolio best for where we believe we are in the credit cycle.
During Q3, we were successful in each of these three areas and I'm incredibly proud of the entire Hercules investment team and broader organization for our achievements during Q3 and year to date.
Our beliefs since inception and throughout the course of our 15 year history has been that portfolio diversification is essential to achieving long term sustainable success in the venture growth stage lending space.
During the third quarter, we funded six new and 14 existing portfolio companies.
The majority of the 14 existing portfolio companies that we've funded during Q3, where situations where our portfolio companies achieved specific performance milestones for growth targets that unlocked additional capital.
We believe that this both speaks to the quality of our portfolio, but also our ability to support our companies as they grow and scale.
We ended the quarter with a total of 95 debt portfolio companies.
The profile of the six new companies that we made commitments to reflects our focus on quality diversification and differentiation.
We closed new financings with a blend of technology and life Sciences companies and a 14 portfolio companies that we completed fundings with also reflects a similar makeup.
In all our total fundings in Q3 were split evenly between technology and life Sciences companies.
At the end of Q3, our top five and top 10 debt positions made up 16% and 28% of our total debt portfolio at cost respectively.
Our focus remains on being intentionally diversified by stage sector geography and sponsor.
In the current market and macro environment, we believe that this will best position us for sustained success.
The 177 million that we funded in Q3 represents the most can be has funded in any Q3 since inception.
For the first nine months of 2019, we have funded 785 million in.
An increase of over 11% last year.
As noted in our earnings release early pay offs remained at a higher level, but down quarter over quarter.
In Q3, we had 140 million of early payoffs, which was down from 178 million in Q2.
Nearly 70% of the Q3 payoffs were attributable to either related events.
Or prudent credit management, where we cycled out of certain credits as part of our ongoing risk mitigation strategies.
This has been and we'll continue to be a primary area of focus for us.
We are comfortable sacrificing some short term growth as we focused on sustainable long term performance and total shareholder returns.
Net portfolio net debt portfolio growth of 24.1 million in Q3 drove our debt investment portfolio to a record 2.1 billion at cost.
We had net debt investment growth for the first nine months of 2019 of 348.4 million.
Subject to market conditions and are expected level of Q4 early payoffs, we now expect to exceed the high end of our debt investment portfolio growth targets for 2019.
Credit quality on the debt investment portfolio improved slightly in Q3 with a weighted average internal credit rating of 2.17 as compared to 2.18 in Q2.
Our rated one credits as a percentage of our overall investment portfolio went down slightly to 11.4% in Q3.
From 12.4% in Q2, largely driven by payoffs of several.
One credits that we were anticipating.
Our rated two credits as a percentage of our overall investment portfolio increased to 64% in Q3 from 63.9% in Q2.
And our rated four and rated five credits decreased to 1.5% in Q3 from 3.6% in Q2.
Making up less than 2% of our investment portfolio at fair value.
Non accruals remained low with three debt investments on nonaccrual with a cumulative investment cost and fair value of approximately $9.3 million and 2.2 million, respectively, or <unk>, 0.4% and 0.1% as a percentage of the company's total investment portfolio at costs.
Cost and value respectively.
Even with our strong capital deployment in the first nine months of 2019.
We are continuing to manage gap leverage below our stated.
125%.
Q3, coming at it coming in at 111.5% and regulatory leverage excluding our SB eight debentures coming in at 97.8%.
Our diverse and well structured balance sheet is designed to provide a long term focused and sustainable investment platform and give us the flexibility to drive growth when we feel prudent.
We ended Q3 with over 284 million of liquidity, which was strengthened by our 105 million dollar private placement of unsecured bonds at a fixed rate of 4.77% in July .
We continue to see strong loan demand and transaction deal flow driven partly by the continued strong pace you asked venture capital only investment activities.
Which invested 23 billion and raised another 12 billion. According to Dow Jones Q3, 2019 venture capital report.
Through the third quarter Vcs have invested a total of 79 billion and raised over 40 billion of new capital.
At this pace 2019 could represent the second consecutive year.
Of over 100 billion being invested by vcs into growth stage companies.
The IPO market has slowed somewhat given the change in Investor Center sentiment regarding high profile unicorns are considering going public.
Year to date 2019, we have already set a new annual occurred with 11, our own portfolio companies completing their ipos.
How do we portfolio companies.
Opportune financial and legal completed their ipos in Q3, and we have tele bio and three additional confidential filers in the pipeline.
We expect the IPO market to remain volatile through year end.
Assuming market conditions remain fail favorable.
We are anticipating M&A exit activity in our portfolio to continue at a steady pace.
In Q3 163 companies were acquired for nearly 26.9 billion in total consideration versus approximately 19, IPO, which raised approximately $6 billion in the quarter.
I would now like to spend a few minutes discussing our shareholder distributions.
With our total investment portfolio at $2.3 billion at cost and our investment portfolio at $2.1 billion cost are and I per share in Q3 generated 116% coverage above our quarterly based distribution of 32 cents per share.
In addition to our quarterly based distribution of 32 cents for Q3.
We also declared a supplemental distribution of three cents per share.
In the aggregate this brings our total distributions to shareholders for Q1, Q2, and Q3, two a dollar and two cents representing an approximately 7% increase from the same period a year ago.
This also represents the third consecutive quarter, where the company strong performance has allowed us to deliver in increased distribution to our shareholders.
In addition to our quarterly income exceeding our base distribution.
We are also fortunate to have been able to grow our undistributed spillover to an estimated 62 million.
For 59 cents per share subject to final tax filings in 2019.
This provides us with tremendous flexibility with respect to our dividend going forward and the ability to continue to invest in our team and plastics.
As we discussed in Q2.
Subject to market conditions and sustained.
Actual performance, we hope to be in position to potentially declare a larger supplemental distribution.
Once we finalize year end numbers early next year.
In closing.
Our performance in Q3 and throughout the first nine months of 2019.
Truly underscores the depth and level of talent discipline and diligence that our organization has.
And the scale that we have collectively managed to achieve.
I am proud to be leading this organization and very excited about the opportunities that lie ahead for us.
We believe that our venture and growth stage lending model is unique.
And as a proven track record of growth, while establishing high watermark for credit quality.
That has delivered long term top tier shareholder returns throughout any type of credit cycle.
Thank you very much everyone I will now turn the call.
Thank you Scott and good afternoon, ladies and gentlemen.
As Scott mentioned.
It was another strong quarter for Hercules in Q3, we delivered record net.
From an income totaling 39 million worth 37 cents per share.
Provide being 116% coverage based distribution for that.
For sure.
Credit remains exceptionally strong and non accruals continued to be less than half a percent.
Our total investment portfolio on a cost basis.
Our our ROE.
Our net income over.
Average equity was 14.9%.
Our own a.
Or eni over average total assets was 7.5% for the third quarter, which continues to increase with our prudent use of leverage and portfolio growth.
Today I will focus on the following areas income statement performance and highlights any the unrealized and realized activity.
Leverage and finally the outlook.
With that let's turn our attention to the income statement performance and highlights.
As I mentioned that net income per share.
37 cents.
An increase over the first quarter of 36 cents per share.
Despite two federal rate cuts during the quarter total investment company flat.
At 69.3 million compared to the prior quarter supported by.
Hi.
4.1% increase in total interest income due to portfolio growth.
In the second and third quarter.
Fee income decreased in the quarter due to lower early pay offs.
The important point to note is that the growth that we have seen in the portfolio.
The year has created at baseline and which we can cover that these dividends without depending.
Non recurring or non core income.
For context compared to the same quarter of 2018 total investment income has increased 31.6%.
Our effective in core yields in the third quarter were 13.4%.
12.4%, respectively, compared to 14.3% and 12.7.
Percent in the second quarter.
The primary driver for the present effective yield was due to the lower early pay offs the core yield reduced due to the two separate cuts in the quarter with the July cut being the main driver.
Net investment income margin increased to 56.1% in the third quarter compared to 50.9% in.
In the prior quarter, which is the highest we've delivered in nearly three years.
The reason for the increase was primarily due to the higher levels of core income due to the portfolio growth as well as lower operating expenses.
Turning to expenses, our total operating expenses for the third quarter reduced to 30.4 million compared to 34 million in the same quarter on in the second quarter.
Interest expense of fees decreased again to 15 million from 15.2 million in the prior quarter.
Thanks to all the steps taken year to date to improve our funding sources and conditions.
SGN, a expenses decreased as well to 15.4 million.
From 18.8 million in the prior quarter. The main drivers for the decrease were lower long term compensation expenses and legal costs.
Due to the settlement with our former CEO as well as decreased discretionary and variable compensation costs, the Rick the reduced discretionary and variable compensation accruals.
Our a direct result of the company's seasonally reduce debt fundings in the quarter compared to the prior quarter.
Partially offsetting this was an increase tax provision.
Our weighted average cost of debt was 5.1% a small reduction compared to 5.2% in in the prior quarter and a more material reduction compared to the 5.6% and same quarter last year.
Now, let's switch the focus to NPV unrealized and realized activity.
During the quarter, our NPV decreased by 21 cents per share to 10, Dollarsthirty eight cents per share largely related to unrealized depreciation attributable to market volatility impacting the fair value our of our investment portfolio.
We had unrealized depreciation of 25.
Point 5 million in our investments comprised of 5.8 million in our loan portfolio 13.9 million in our equity portfolio.
And 5.8 million in our warranty portfolio.
In addition, we had 1.1 million in unrealized appreciation.
On other assets and liabilities, bringing the net unrealized depreciation for the quarter to 24.4 million.
We also realized net gains of 4.8 million during the quarter.
The unrealized depreciation on our loan portfolio was attributed to market yield adjustments of 7.2 million and 2.6 million of impairment adjustments primarily related to one loan.
Offset by 4 million of appreciation due to the reversal of unrealized depreciation arising from the successful resolution.
Up to non accrual impaired nonaccrual loan positions.
One of the loans was resolved at our second quarter, Mark and the other was resolved approximately 1.2 million better than our second quarter Mark.
Our equity and warrant portfolio had an unrealized depreciation of $19.7 million.
Mark to market adjustments of 11.4 million were driven by volatility in the market along with $8.3 million of depreciation due to the reversal of unrealized depreciation primarily related to the amount of monetization of two equity positions.
Both resulted in realized gains that were accretive to our spillover.
Next I'd like to discuss our leverage.
At the end of the quarter, our GAAP and regulatory leverage was 111.5% and 97.8% respectively.
Which increased compared to the second quarter due to the private placement in July and continued growth.
We continue to manage the business to ensure that we remain below our 2019 communicated leverage ceiling of 125%.
As a reminder, our early payoffs and normal amortization provide us with significant monthly inflows that we can use to de lever when and as needed. We will closely monitor the macro political and market conditions in determining future potential debt and equity capital timing.
Finally, let's address our expectations on outlook points.
Despite the actions taken today by the fed we maintain our core yield guidance of 12% to 13%, though clearly we will be at the lower half of the range.
As a reminder, the majority of our loans are issued with the floor, which can mitigate some of the potential down downside due to rate decreases.
As a result, the impact of our rate decreases is not linear to the impact of rate increases.
With the fed rate cut today of 25 basis points. The pour the portion of loans at the contractual floor increases to approximately 60%.
For the fourth quarter, we expect operating expenses, 6% to $17 million as communicated previously the reduced expense level due to the settlement with our former CEO will partially offset being offset by increased investment in our team and infrastructure.
Should market conditions remain favorable and origination activity exceed our expected growth the SGN Jay X gene a expenses could increase based on origination activity during the quarter.
We expect our borrowing costs to increase slightly due to increased activity in Q4.
Thank you start credit facilities.
Finally, although very difficult to predict we expect a 100 million and prepayment activity in Q4.
In closing, we continue to see Hercules capital well position for the remainder of 2019.
I'll now turn the call over to the operator to begin the Q and a part of our call operator over to you.
As a reminder to ask a question you will need to press star one on your telephone to withdraw your question. Please press the funky. Please standby will be compiled weakening roster.
First question is from Tim Hayes.
Riley FBR your line is open.
Hey, good afternoon, guys. Thanks for taking my questions and congrats on great quarter.
My first one can you just touch on the supplemental dividend I know you made some comments, but this was your fourth straight quarter supplemental dividend payments. How do you think about these dividends in relation to the amount of spillover you'd like to keep on hand.
Yes first Tim Thanks for the for the comments, it's the third straight quarter, where we've issued just supplemental distribution.
There was a GAAP in between.
Q3, and Q4, we didnt have one.
Sure our goal as we've stated on the last several calls is to really focus and drive total shareholder return and there are two ways to do that one is obviously through the base distribution in the second just through the supplemental.
Given the trajectory of the business, particularly in Q1 Q2 in Q3 of this year.
We felt in the board supported our decision to declare the supplemental distributions, which have increased on a quarterly basis as the performance of the business has continued to improve throughout the year.
The base dividend for US is really driven up primarily off of what we believe the business can generate from a core income perspective.
If you look at our business now we're now at a point, where we're covering the base distribution alone from core income. So we're not really relying as Seth mentioned on non core income associated with payoffs or accelerations.
The spillover is something that we look at from two different perspectives. One we look at it as a way for us to continue to invest and expand the platform and the scale in depth of our team and we think that Thats, an important thing to be able to do without impacting eni on a go forward basis.
And the second point is as Weve sort of shown we look at that as a way for us to continue to deliver a supplemental dividends to our shareholders as a way to increase in drive total shareholder return.
We don't have a specific dollar threshold in mind in terms of what we plan to keep from a spillover perspective, but as we get towards the end of the year as something that the management team and board will be evaluating and as I mentioned to my comments based on what we're seeing right now and based on obviously our performance quarter to date.
We hope and we expect to be in a position, where we can deliver a larger special distribution to shareholders. Once we do the true up.
Subsequent to year end.
Okay, Yes that makes sense and appreciate the the additional comments there and then if I could just pick on the dividend again, you talked about the quarterly dividend and how you handily covered it with.
And I have in the past two quarters irrespective of the.
Early prepayment income you receive in there too you're very constructive around or seem construct around growth in the lending environment in general So I know that sets made some comfort about where yields could shake.
Given the recent fed cut but what gives you pause at the moment and raising the quarterly distribution, just given where your core earnings or just your earnings power is at this point.
I think we're in a unique position now and I view that sort of as a position of strength, we have flexibility both with respect to the base distribution as well as the supplemental distributions and that's something that we're going to be looking at closely once we again true up the final year end numbers and I think the bolt the based distribution as well as additional special.
Supplemental distributions are certainly on the table for us to explore as we get into 2020, when we looked at sort of the decision with respect to this quarter. This clearly this is the second quarter as you mentioned, where the core income to covering the based distribution.
We've obviously had some yield compression in the business as Seth mentioned in his comments from the three rate.
From the three rate cuts that we've seen we want to see what the rest of Q4 looks like the markets have been booked more volatile than they were over the last 30 to 90 days and we really just want to sort of catch our breath, a little bit and then assess things once we see where the year year ends up but we're very optimistic about what what lies ahead for us and we think that were in a unique position, which is a position of so.
But as I mentioned, where we have the ability to look at both based distribution as well as some increased supplemental distributions.
On a go forward basis.
Got it makes sense and good position to be in for sure.
Switching gears, a little bit can you size your pipeline today, and maybe talk about how much of that is attributable to some of the strategic initiatives you've undertaken over the past couple of quarters, including expanding the product offerings said, we're partnering with other industries.
Sure. So the pipeline right now is about $1 billion, which is which is strong.
I think the portfolio sorry, the the pipeline right now is I would sort of describe it as as healthy habits are typical where with where we are in the year.
There is no question that our performance this year bolt on the commitment side and on the funding side is partially driven by some of the things that we've done that you mentioned.
We've done a couple of things from a product perspective, we've done a couple of things from the strategic perspective that we believe have helped us capture some additional market share. We also think that there's a lot more room for growth with respect to those thing and some other things that the team and I are actively working on currently.
If you look at the commitment numbers on a year to date basis as we mentioned you're essentially at 1.4 billion. When you include what we've already done in the month of October alone.
2018 was a record year for us what we delivered 1.2 billion in commitments through 10 months. We're already at 1.4. So I can't tell you exactly sort of what percent are what dollar amount is directly attributable to those things, but we are certainly of the view that you're seeing a significant impact from a lot of those things that we've been talking about in some of those.
Things that we're continuing to work on that we hope to rollout over the next several quarters.
Okay got it and then just one more for me.
What portfolio size.
Can you support today, given your current infrastructure and as you prepare for the next level of.
Record.
Folio size, what type of investments do you see making and how does.
In a trend I know that's a lot of questions one, but just from a high level would be helpful. Sure I'll take the first part and then Seth can take the second part we talked a little bit about this on the Q2 call, but when we made the big investment in sort of the team in the platform in 2016, we talked about that we felt comfortable that that would get us to roughly the.
$2 billion portfolio, Mark we crossed the 2 billion dollar portfolio Mark in Q2, and that's why on the call last quarter, we talked about the fact that we were now going to start to serve reinvest once again.
Our team in our systems in our platform and the goal there is really position us to position us to get to the next portfolio Mark that we believe is roughly $3 billion. In Q2, we made several investments we've continued to make some investments again, what the team and in the platform in Q3.
And we have confidence that the investments that we're making now and we'll probably continue to continue to make through the end of the year.
Will position us to be able to support a debt investment portfolio of roughly $3 billion. Once we cross that threshold, which is probably somewhere between a year in two years away. We would again then look to to make some additional investments in the platform at that time.
And the only thing that I would say, Tim as far as managing expectations on cost we feel that we can do this at the run rate of the 16 to 17 million that I mentioned at least for this quarter, we'll reevaluate that.
In the future, we're not talking about expensive transformations, adding people here and there making sure that our systems are leveraging the technology that is available these days.
Of eliminating human touch in between things.
As much as possible so.
I've been now with the organization for I guess seven.
Eight months.
I'm impressed by how efficient things work, but there are certain additional steps that we can take.
By leveraging technology, a little bit further that will enable us not to add a person every time, we grow by 100 million.
And that's what we're trying to achieve.
Understood. That's helpful. Thanks, again, guys after taking my questions.
Thanks.
The next question is from Aaron Deer of Sandler Oneill. Your line is open.
Afternoon, guys.
Our.
Just following up on it sounds like you're just guidance towards something in the range of 16 17 million on.
I'm guessing that Thats DNA compensation stock compensation combined yes.
Okay.
And then.
I thought I heard to that.
Question around 100 million in Prepays here in the fourth quarter.
Any sense in terms of.
What the origination volumes might be or where the debt investment portfolio might be at cost when we get to your end.
We don't we don't provide.
Guidance with respect to funding activity in the quarter, what I can tell you is that.
Q3 is typically our slowest quarter and you saw that Q3 was this quarter was all it was also a record Q3 for us.
We typically see picked up in Q4 and what I can tell you is we've already started to see signs of that pickup. If you look in our press release and if you. If you folks are focused on what I've said in the prepared remarks for the month of October we've already closed new commitments of over 119.
Million dollars. So we're continuing to see very strong momentum, we feel very optimistic about where Q4 will shape up.
And then with respect to the prepayments as Seth mentioned, they're very difficult for us to predict but based on what we've seen so far in the quarter in what we what we're aware of we think that the 100 million dollar prepayment Mark is appropriate for modeling purposes for Q4.
Okay, and then lastly, the.
Given that you do have pretty strong growth outlook here.
Obviously, you're still below maybe your your target or feeling of leverage ratio, but.
With the stock price.
I haven't seen some good performance of late.
What are your thoughts and getting back and using it to him at this point.
So we always have it as an option.
We'll continue to evaluate whether that's the.
The step we want to take.
We consider the markets urban and appreciate the east we had in June we sat down and very quick Glee raise capital. So no plans at the moment, but we appreciate that its readily available. Thanks to the fact that were trading well above our book value.
Okay, great. Thank you for taking my questions.
Thanks Aaron.
Our next question is from John Hecht with Jefferies. Your line is open.
Afternoon, guys and congrats on a good quarter.
Thanks, John Guy you guys talked about rates I think the did I hear you write your.
As of the rate cut today, 60% of the loans or through their floors are at or through their forwards or was that number incorrect I don't know thats correct.
Area correct to say that summer are below at this point, but.
That's where we land as a result of the cut today.
So the in the interest rate sensitivity table.
Yep, where you show the benefits of rising rates and and.
Vice versa.
75 basis for instance is that exactly the 75 basis point decline does that incorporate the floors as well in that analysis or is that just sort of a shock factor to the whole portfolio internal that increment that incorporates the floors. So what we could say is annually based on that table.
We had approximately go down 3% three cents per share annually again.
As a result on the rate cut today, but at that level than 60% of portfolio is at the floor, which is why you see that it only increases two cents per share. When you go to 50 50 basis points. Yes, that's got on nonlinear angle that you mentioned exactly yeah. Okay.
Okay and then.
I guess, maybe talk about Scott talked about the universe. The VC mentality I mean, given some of the big Big market Ipos in their post perform that post IPO performance clearly, there's a lot of demand maybe other any structural changes that you see going in the industry that suggests the.
Market is either has like a longer duration before seeking an IPO or is just larger overall.
Sure there's a.
Couple of things going on first and I think this is probably the most important we're continuing to see a very robust and vibrant.
Ecosystem.
$23 billion of VC equity invested in Q3 alone.
If you sort of look at that from an aggregate year to date perspective, you're at nearly $80 billion VC equity capital invested into the ecosystem.
Last year was a record year with 100 708 billion dollar.
Based on what we're seeing assuming Q4 is sort of consistent with expectations. This would be the second consecutive year were over $100 billion isn't the best.
You are also continuing to see tremendous strength from the fund raising prospective $12 billion raised by venture capital firms in Q3, roughly $40 billion raised year to date.
If you look at sort of the trends in the industry over the last five years, you basically have five.
Second of years, where the VC firms have raised north of $40 billion.
In each year, so a lot of sort of momentum and a lot of sort of vibrancy and with respect to those key metrics that we use sort of as a guide to sort of speak to the overall sort of health.
The ecosystem.
There is no question that Theres been a couple of fairly high profile.
IPO situations that either didn't work out or that have performed materially below expectations.
Post offering what I would tell you is that we sort of view those as isolated situations. We've we've had a record year to date in terms of IPO.
The with 11 of our portfolio companies completing ipos certainly some of those have underperformed upon completion of the offering but we have several that have performed very well, we don't look at what's going on but sort of the few isolated larger later stage IPO, either having gotten off or have done really poorly as indicative of.
Anything sort of.
Systemically with respect to the ecosystem that we plan.
Just as a closing comment in some ways we view.
With respect to this sort of isolated group as potentially beneficial to us because it really focuses the industry focused.
Focus as the market really back on a rationalization of business models more of a focus on sort of unit economics and underlying CPI is and I think if anything.
Thats, where our investment team really accelerates from an understanding perspective, and it's our belief that some of that noise with respect to that sort of isolated bucket could create some additional opportunities for us from a debt financing perspective.
Okay.
Thank you very much the update appreciated thanks John .
Okay.
Again, ladies and gentlemen, if you have questions at this time. Please press Star then the number one, but let me touch them telephone.
Question has been.
Or you wish to remove yourself from the Q. Please press the bank.
The next question is from Ryan.
KBW Your line is open.
Hey, good afternoon Scott.
My question kind of wanted to follow on your last comments on kind of those isolated incidents.
Since.
The IPO market one of the concerns with some of those recent struggled as well some.
Private the seed company.
Does that have struggled recently is that the valuations in later stage companies.
Might be and weighted and there might have to be some.
One of those companies.
I wish to put some pressure.
Wanted to just get your thoughts and comment on how you feel some of these.
Yes.
Hdc back valuations are today.
Sure. So theres no question that again in a small I think isolated part of the market valuations got ahead of themselves and you've you've clearly seeing that with a couple of high profile situations over the last 30 60 90 days.
And I don't think and I don't think Thats, a bad thing in terms of a re rationalization of valuations and a focus on sort of underlying business models and unit economics.
I can tell you that with respect to our portfolio. If you look at our marks from an equity perspective in virtually every single case, we are either below or well below the most recent round of financing from evaluation perspective, So I feel very good about where our book is from a fair value perspective, we had a little bit of unrealized.
Appreciation in the quarter, which set talked about in his comments I think the important thing to note. There is exactly what's that said when you really break it down 25.5 million kind of unrealized depreciation the vast majority of that was in the sort of the public book from a mark to market perspective.
Only two and a half million dollars of it was attributable to the unrealized piece from the credit perspective, which is a pretty materially or immaterial amount on a quarterly basis.
Seeing a further degradation.
Subsequent to the 930 marks that would lead us to believe that there is further erosion with respect to valuation our portfolio subsequent to quarter end.
Okay. That's good color.
Wanted to switch over to interest rate sensitivity I appreciate your comments on.
The 6% of your portfolio is that your floor levels I believe that's because you guys structure loans, a little bit differently than than most middle market lenders kind of on that point.
When I think of most bdcs are doing middle market leveraged buyouts. It feels like us borrowers are going to be very interest rate sensitive because they're doing a little bit of financial engineering to make that math work versus VC.
Borrower.
Is it feels like to me is more looking to take on some debt. So that they don't dilute their equity stake and may not be as interest rate sensitive. So my question is.
To the extent that short term rates keep going lower.
How do you think your bill.
We will be to potentially offset some of that not only the floors to have in your portfolio, but also potentially increasing the spread what are the fees you charge on those VC borrowers sure.
I think our view is that we will be able to offset some of the degradation in in.
In rate.
Through other means and that's certainly something that we've seen if you look at the fundings that weve completed quarter to date, we've been able to do that which will certainly help us offset some of that rate degradation.
The important part is sort of what sets FFO to with the rate cuts announced today.
Approximately 60% of our portfolio right now is already asked the contractual floor any new loan that we originate in Q4 from this point on will be at the contractual floor, because we'll set it off of a prime floor of for 75, which is a square prime is today.
We also have the ability when the loan comes up for a restructuring to sort of try to do things to either reset floors or continue to drive that number up it would be our hope that irrespective of what the fed because that's certainly as we get closer to year end into the early part of next year that we can drive that 60% number ups this step up substantially.
So that we won't have any really further significant impact on the downside with respect to short term rates.
Okay.
Those are all my questions and I appreciate the time thanks right.
The next question is from Christopher Nolan of Ladenburg Thalmann. Your line is open.
Hey, guys.
Philosophically, how do you look at companies, which are trying to grow.
At all costs and I'm, specifically thinking about the we work situation.
It's when you see a company like that what is your under.
Approach.
Yes. So look I think we work is sort of one of those isolated situations that I mentioned I don't think thats endemic to the entire.
Venture ecosystem and again the way we look at that situation is we actually look at it with sort of from a positive perspective.
A rationalization in the market, a refocus and an emphasis on unit economics.
On the cost of growth are generally good things, because that's where our team does every single day.
We've always been affirm thats a little bit unique in this part of the market, where we actually focus on underwriting to the individual credits as opposed to some others, who tend not to get as deep into the weeds as we do from an underwriting and credit perspective.
So we view that as a positive. It every deal that we do we are looking at the core fundamentals of that business. We're not just looking at the syndicate. We're not just looking at the post money. We're not just looking at how much capital. They raise we're looking at the CPI is we're looking at the overall market. We're looking at sort of the numbers and really getting pretty deep.
Into the weeds, which we believe has led to our.
Best in class credit performance, we are very very very grateful and appreciative of the fact that we've now done $9.7 billion of commitments from a cumulative perspective.
And we've got net losses of $26 million right. Our net our annual loss rate right. Now is basically under two basis points and Thats not something that's easy to do when your lending to growth stage cash flow negative companies and I think thats directly attributable to the work that our team does from a from a diligence perspective.
Now, we're able to sort of understand what the numbers are actually telling us versus what you know a post money gets done at from around perspective.
Scott how are you seeing the entrepreneur as for these select few towards having more leverage.
Over investors some before.
Okay.
Yes, we havent, we haven't seen that I think theres still again are little bit of a rationalization going on in the market.
There are some companies that that we are aware of that are exploring.
That are exploring an IPO in.
Also exploring sort of a private round just given some of the volatility that we've seen in the market, but we haven't really seen anything specific with respect to entrepreneurs, having leverage over vcs I think it's really specific to the individual investment rather than sort of a industrywide issue.
Got it thanks for the color.
The next question is from Fin O'shea Wells Fargo Securities. Your line is.
Hi, Thanks for having me on.
Just a first.
Question small question on the equity evolve this quarter.
Just glancing at some small cap.
Biotech indices, which is usually pretty indicative of your equity portfolio I see things slightly down but not meaningfully so is that.
Correct to say is it is it more concentrated or broad based on your equity markdowns.
Our equity markdowns so.
Yes, it's there's specific ones that obviously, we have public marks on the equity and warrant positions of 9.6 million.
Down I mean are you looking for a concentration within that.
Yeah. If it's more you know if it's three names that are way down or if it's 40 names that are slightly down.
Yes.
A couple things then if you look at sort of S&P biotech index in Q3 down 13.2%.
So there was clearly a pretty substantial pullback with respect to some of the key key indices that we used to kind of track our portfolio in Q3.
If you look at our unrealized depreciation in the quarter again as Seth mentioned in his in his remarks.
11.5 million attributable directly just to market mark to market volatility with respect to equity in warrant positions.
There was there was sort of a downdraft both on the tech side and on the equity side and there were four or five names that drove the vast majority of that but it really wasn't specific to any one or two situations.
Okay that that is helpful. And then just the not to make things repetitive on the.
Larger cap headlines were seeing in you've been answering today.
But.
To the description of stretched valuations being.
Isolated.
Can you expand a little bit on on how you're defining.
What's isolated is it sort of the unicorns or is it a specific sector or is it really just these these couple of headlines that we've all seen.
Our view is that it's really a couple of headlines that we've all seen thats or drive the narrative.
We've not seen again sort of a systemic issue with respect to valuations or fund raising or financing with respect to the vast majority of our addressable market.
The unfortunate reality of the kind of the current environment from a new cycle perspective is the one or two or three very high profile public situations get a lot of publicity I think thats, what you've really seen from a focus perspective, we do expect kind of the IPO market to remain volatile as a result of those situations, but again I don't think its and its systemic with respect.
Two.
There is an issue across the venture.
Landscape, because we absolutely have not seen that there are couple of higher profile situations that have obviously been noisy.
But we're not we're not seeing that sort of trickle down to the vast majority of our addressable ecosystem.
Thank you and just one more if I may.
On competition so.
My understanding that you've always faced.
So some sort of in in now.
Players in the venture lending space and.
Theres Theres this it's a very.
Specialized.
Vertical but.
More broadly in private that you see a lot of larger managers really trying to.
Diversify their pipeline.
So would you say.
Would you agree with that and see there's no more of a.
A more meaningful commitments from from some of your competitors and entering the VC space sorry, the be venture lending space.
What I would say is or two things number one we have seen.
A robust competitive environment.
Throughout the course of 2019, and we did not see any change in that regard with respect to what we saw in Q3.
The second thing I think this is the more important thing from our perspective, we've been doing this now for 15 years, we've done $9.7 billion of commitments. We have been very fortunate now to have financed over 500 different companies, we partnered with over 1000 different.
C and growth stage investment firms and what we what we hear on a pretty consistent basis from the companies that were speaking to and that were financing is these companies their board members their investors they want to partner with someone on the debt side, who they know understands the market who they know has been in the market through a cycle or.
Two right Hercules is not a lender that comes in and comes out and when people partner with us they understand that and so while some of the larger asset managers have sort of tried to come into the space over the last couple of years. Some have been successful some have not been successful we hear pretty consistently from the companies that we assume.
Appreciate with concerns about where they will be in a year or two because the reality is lending to a growth stage cash flow negative company is very different than lending to a cash flow positive company in a sort of in traditional EBITDA leverage based financing situation and Thats why we continue to be very optimistic about our market and our growth.
Both trajectory on a go forward basis.
Thank you for your commentary that's all for me. Thanks.
The next question is from Henry Coffey of Wedbush. Your line is open.
Yes, greetings and thank you for taking my question.
I I'm I'm treat obviously with all this.
Chatter about what's going on in the tech community, but.
If you forget.
The unicorns and real estate companies that think their IP, there tech companies and all that other goofy stuff.
What is the fundamental nature of where you are companies are in your view compared to say a year or two ago.
Their ability to success.
Access fully execute on their business plans.
And.
And success successfully get out products, there and sort of grow to the next stage.
No I can't imagine that that we works, which is basically a return.
Not getting its IPO done at something like 12 trillion dollars or whatever the number was has anything to do that so where are we from forgetting all the.
The fluff where are we in terms of the fundamental substance of the company's you're investing sure. Yes, I think we believe our portfolio is in great shape, and I think the numbers speak to that.
For the quarter, our weighted average credit rating was 2.17, that's essentially flat slight improvement from where it was in Q2, 2.18% last quarter.
One of the other things that we look at is what percent of our portfolio is in our rated four and rated five bucket. We just walk through that are rated four and rated five credits at this time make up less than 2% to our portfolio from a fair value perspective.
Our portfolio is continuing to largely performed to expectations. Our portfolio companies are largely continuing to have success, both from a public equity perspective, and a private equity financing perspective, and we really have not seen a slowdown or a negative impact from the from the few isolated situations that we've talked about.
On this call that you referenced again in your remarks, so we feel very good about where our portfolio is from a health perspective and from an overall credit perspective, we just announced another quarter, where we had nearly $5 million of additional realized gains and we're continuing to be very optimistic based on what we're seeing so far in Q4.
But how do you translate your principally a lender.
So how do you translate all this into your sense of how you and again your loans are performing exceptionally well, 98% of them are and really great shape.
When you look at the if I can look at each of you a portfolio companies, which would take me forever.
What we do my fundamental assessment be of of how they're performing relative to plan how close are they to profitability.
What other companies what to the companies themselves look like from your perspective, Yes, I would reiterate what I said I think our view on a portfolio level is that our portfolio right now is in really good shape.
We've not seen.
Degradation from a credit perspective at all in Q3 at or anything related to some of the higher profile situations.
That we just talked about.
No I'm also looking at.
Slide 22, and your debt, which always find very helpful. Clearly and Q2 18, there was sort of Uh huh.
Step down in aware coupons in yields were while I'm, sorry, where gross and effective yields were actually coupons went up.
And then since then it's it I mean, we've had a major cutting racing and your effective.
Core yield has gone from 12.7 to 12.4, which means you've only suffered a third of the cuts out there.
Is that what we're likely to see going forward is is that he's a very small dollywood moderation in in yields as rates go lower and lower or how we up for another step down.
Going to wake up by next year and see that 11 in that 5% is where the business should be or yes look we've always said as we manage the business based on that Middle line right on page 22 that you're referencing right before focus on core yields the topline, which dip down in Q2 of 18 on the effective yield that's a direct correlation with respect to how much we haven't.
Quarterly basis in terms of prepayments.
In Q2 of 19, we have nearly 180 or 185 million of prepayments. So you have the spike to 14.3% from an effective our prepayments were down slightly to 140 million in Q3. So the effective was down to about 13.4.
Seth on in his prepared remarks, just reiterated our guidance with respect to core yields and we feel very confident that we're going to be within our range, but at the low end of that range, which is 12% to 13% and thats inclusive of the fed cut from today. So.
We certainly do not expect to wake up at the into Q4 and see the portfolio at 11 in the half percent otherwise we wouldn't have just given the guidance that we did with respect to our ability to maintain ourselves well, obviously idea I didn't mean to fourth quarter, but next year I mean, as if you're looking at the same chart I am you could almost draw some lines through it where there is a net.
There's a shift that occurs periodically.
And I would you think Henry I point to slide 25, where you see that dynamics the shape of the portfolio change.
Significantly with the dramatic pay down in Q1, and we're not seeing that development and we also have we also look very closely at what our Onboarding yields are so we look at the deals that we were able to onboard in Q2, we look at the deals we were able to onboard in Q3, we look at the 190 million a commitments that we've already managed to onboard.
In Q4, and as I mentioned, we have not seen any real degradation in terms of our ability to target deals that will be able to maintain our core yield in our target ranges. So so the even the newest business is being set up at levels that allows you to keep at it let's just call it 12%.
That that allows you to keep the business and you think that's where it's going to be next year that is correct.
Thank you very much.
The next question is from Chris you weren't of JMP Securities. Your line is open.
Hey, guys. Thanks for taking my question.
So Scott Youve.
We have produced about Tibet quarters of record originations. So I'm curious, whether you think youre taking market share here is being the primary driver of the record growth because the U.S. century ecosystem was also very very very strong and 18 with respect to VC investment.
Sure. So I think it's a combination of two things it's our belief that we are taking some additional market share.
It's also our belief that and we talked about this on the last call. We've now gotten the portfolio to a point, where weve crossed $2 billion, we have 95 active debt portfolio companies.
Our portfolio of our portfolio from a debt perspective is very vibrant.
Very growth focused and so there are lot of opportunities for us to demonstrate the strength in the breadth of our platform by continuing to finance our own portfolio companies on a go forward basis, either with respect to unfunded commitments that get unlocked or new commitments as they continue to achieve growth objectives. So I think it's really a combination of those two things.
Capturing some additional market share largely driven by some of the changes that we've made from a product perspective from a strategic perspective, as well as being able to really take advantage of the fact that we're one of the only players in the space, that's actually been able to achieve a portfolio of scale.
Yes.
Got it that's helpful and then following up a little bit on that.
Good on since question earlier, you know a lot of venture capital backed company interesting leader for longer before completing their IPO. It seems that some of these rapidly growing tech companies are now changing sponsors.
Oftentimes from DCP. So I'm curious on your level of interest and then willingness to grow with the company at leader stages, but potentially lending at lower yield than what is definitely associated with.
Venture debt.
Yes. So there are there are there are certainly a couple of situations that we're aware that sort of occurred in Q3, where you had sort of a situation along the lines. What you just described where it will later stage sort of non traditional VC more like a PE or a sponsor came into a growth stage company in sort of did a final round of financing.
We have not seen a real impact when that change happens in terms of the type of debt financing that those companies are focused on.
The reality for US is if a company in our market is exploring sort of a pre IPO debt financing.
That most likely is not going to be done from us because those deals are done at much lower yields than we would be comfortable with we are trying to find situations, where we can generate from a risk adjusted return perspective, a yield and a return profile that we believe makes sense for our shareholders and.
That tends not to be in those situations, where you have the growth stage Tech company. That's six to 12 months away from an IPO because they are going out and they're getting much cheaper financing. There we're going to provide we do think that theres a tremendous opportunity with respect to companies that are a little bit further away from their IPO. So the company that was initially thinking about doing an IPO in 2000.
21, maybe that company has second thoughts now we think thats, a great opportunity for us to sort of engage with those companies and we're actively speaking to a couple of them right now where we can provide a fairly large structured financing that will enable them to be well positioned if they decide not to pursue that IPO in 18 to 24 months.
Got it so maybe image that one.
I was going to say a name, but one that just keep in mind there would be maybe like a puts me that you would be focusing on as opposed to some others that may be took you out this quarter from a private equity perspective.
I don't want to address any particular situation postmates is up as a portfolio company of ours today.
Yes exactly okay.
And then just to help questions. So in terms of your prepay expectations of 100 million what is the average duration of the portfolio at payout for for that.
And it's about 15 months.
Okay, and then maybe this one for you as well.
You're welcome inquiries at quarter end and then what is your budget per new investment professionals.
Hires in 2020.
So I don't have a budget yet for 2020, what we plan on putting forward to the board next month.
So I don't have anything to share with you yet on that for the current fts, we have about 77 employees at the moment.
Okay, so up a little bit.
Quarter over quarter, and then if you don't have the budget any ideas.
Seth on growing that and being strategic in hiring a couple of new.
Investment professionals.
Look we're going to continue to be strategic in terms of our hiring decisions. We talked in Q2 about sort of reinvesting in the team and the platform.
Over the course of the last two quarters Weve added to our investment team at all levels. We've also added to our finance team we've added to our legal team and we've added to our credit team. So I think you're going to continue to see us make strategic investments in our team broadly speaking not just the investment team and if we if we can find some individuals that we think will be accretive and add value.
And allow us to continue to expand our breadth and diversification from a platform perspective. It will certainly be interested this is a we talk a little bit about this historically, but hercules is a difficult.
Placed us or higher into because the expectations are very high and its unique what we do.
Our investment team is very talented because there are domain experts in the areas that they focus in there they understand how to underwrite and structure credit, but they also understand growth and equity and sort of the technology driven aspects of our business whether it be on the technology side with the life Sciences side. So we can't just go out and hire someone from a commercial bank or.
Someone from a competitive from because it we think what we do is truly differentiated in terms of how we approach the market.
Makes a lot of since that's it for me. Thanks, Scott. Thanks, Thanks, Mike.
Thanks, Chris.
I'm showing no further questions at this time I would now like turn the conference back to school.
I'd say.
Thank you operator, and thanks to everyone for joining our call today, we look forward to reporting our progress on what has been a strong year. So far on our next Q4 earnings call.
In November we will be participating at the JMP Financial services Conference in New York and the Jefferies fourth annual BDC summits in London, Zurich and Frankfurt.
If you are interested in meeting with us at any of these events. Please contact JMP securities or Jefferies for their respective events or Mike O'hara.
Thank you and have a great day.
Ladies and gentlemen, and that concludes today's conference call. Thank you for participating you may now disconnect happening.
Ooh.