Hercules Capital, Inc. (NYSE:HTGC) Q4 2022 Earnings Call Transcript

Hercules Capital, Inc. (NYSE:HTGC) Q4 2022 Earnings Call Transcript February 16, 2023

Operator: Good day, and thank you for standing by. Welcome to the Hercules Capital Fourth Quarter 2022 Earnings Conference Call. . Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Michael Hara, Managing Director of Investor Relations.

Michael Hara: Thank you, Josh. Good afternoon, everyone, and welcome to Hercules Conference Call for the Fourth Quarter and Full Year 2022. 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’ll turn the call over to Scott.

Scott Bluestein: Thank you, Michael, and thank you all for joining the Hercules Capital Q4 2022 Earnings Call. Following our record operating performance in 2021, Hercules Capital raised the bar higher and once again delivered record performance in 2022. 2022 was a historic year for Hercules Capital. And I am incredibly proud of what our talented and growing team accomplished. Our record-setting performance in 2022 culminated with the strongest total and net investment income quarter in the company’s history. And the recent declaration of an increased quarterly base distribution and a new supplemental distribution program for our shareholders. Hercules Capital delivered another strong year of record originations performance, record financial results and continued strong credit performance.

Our performance in 2022 reflects the benefits of being able to achieve and operate at scale, maintain robust liquidity and a strong balance sheet and working with the best-in-class team that is highly experienced in this asset class. Thanks to the growth of both the BDC and our private credit funds business, Hercules Capital is now managing in excess of $3.6 billion of assets, an increase of over 38% from where we were at the end of 2021. Despite continued market and macro volatility, the continued strength and expansion of our originations platform, robust liquidity position and strong balance sheet put us in a position to deliver achievements on multiple fronts in 2022, including record total gross debt and equity commitments of $3.12 billion, up 18% year-over-year and the first time in our 18-year history where we have been able to deliver over $3 billion of new commitments in a year.

Record debt investment portfolio growth of nearly $600 million; record total investment income of $322 million, up 14% year-over-year; record net investment income of $188 million, up 25% year-over-year; increased our base distribution 3x in 2022 with our most recent increase to $0.39 per share in Q4. Record cash distributions of $1.96 declared for 2022, an 18% increase year-over-year, 3 consecutive years of delivering supplemental distributions to our shareholders. And finally, over $330 million of investments assigned to and/or funded directly out of the adviser funds that we manage through our wholly-owned RIA. 2022 was also another year of investment in the company, where we took additional steps to strengthen our platform, originations capabilities and back office functionality and sophistication.

These investments provide us with continuing optimism and confidence in the trajectory of our business heading into 2023. Our results in Q4 can be summarized by record earnings strong portfolio growth and momentum, improving yields and stable credit. Let me recap some of the key highlights of our performance for Q4. Our record originations performance in the first 3 quarters of 2022 continued with strong Q4 gross debt and equity commitments of $645 million. Our gross fundings continued to be strong during the quarter with over $367 million, which led to strong net debt investment portfolio growth of over $133 million during the fourth quarter and a record $598.5 million for 2022. The net debt investment portfolio growth that we achieved in 2022, combined with the current yield environment puts us in a strong position to be able to deliver strong net investment income growth in fiscal year 2023.

Our Q4 originations activity was driven by both our technology and life sciences teams, delivering strong performance during the fourth quarter. Our commitments and funding activity demonstrated balance between our 2 core verticals, and this continues to provide us with the unique ability to actively target both verticals depending on where we are seeing better opportunities and risk-adjusted returns. We funded capital to 25 different companies in Q4, of which 9 were new borrower relationships. For 2022, we added 52 new borrower relationships, which further expands our scale in the market and reputation as the lender of choice for growth-stage companies looking for a long-term and stable financing partner that has been active in the market through several cycles.

Consistent with what we saw throughout the first 3 quarters of 2022, we were again able to expand our funding relationship with numerous portfolio companies that continue to show strength and achieve performance milestones during the fourth quarter. With over $3 billion of new commitments in 2022 and a lower-than-typical funding-to-commitment ratio driven by conservative credit underwriting, we expect this trend of increased follow-on fundings to existing portfolio companies to continue in 2023. The momentum that we saw throughout 2022 has carried into 2023, and we are pleased by our performance on originations quarter-to-date. Since the close of Q4 and as of February 13, 2023, our deal team has already closed $189 million of new commitments and funded over $192 million.

We have pending commitments of an additional $263 million in signed, nonbinding term sheets. Volatility across the equity markets, particularly for growth-stage companies continued to stabilize in Q4. Valuations for both public and private companies remain under pressure, and the capital markets have stayed more selective on the equity side. This is continuing to drive strong demand for our capital and why we expect our pipeline to continue to be healthy near and medium term. We believe that Hercules is best positioned in the asset class for continued and sustained success. Consistent with our historical approach to underwriting credit, we are remaining patient and disciplined on new originations, and we will prioritize credit quality over chasing higher risk transactions with a yield premium.

We believe that we are incredibly well positioned in the current market and that our scale and portfolio and VC diversification afford us the ability to say no on new credits that do not meet our underwriting parameters. This is particularly important in today’s market with a number of growth-stage companies looking for structured debt has increased dramatically. Hercules has always maintained a credit-first culture, and we expect this to continue to serve us well, particularly in periods of volatility. During Q4, portfolio company exits and liquidity events for the industry continue to reflect the ongoing pressure in the equity markets as well as the trends in M&A that we anticipated on our Q3 earnings call. For 2022, we had 19 total exits comprised of 5 IPOs and 14 companies announced or complete M&A transactions.

Although the exit environment in 2022 was suppressed relative to 2021, our 19 exits were consistent with our historical average. As the IPO market remains uncertain, we continue to expect to see an acceleration of M&A transactions over the next several quarters. Since our last earnings call on November 2, we have had 9 portfolio companies announced or complete M&A transactions. This includes Ouster announcing a merger with Velodyne in Q4 and completing it in Q1. And Evernote announcing its acquisition by Bending Spoons also in Q4. During Q1 quarter-to-date, we have had 7 additional portfolio companies announced or complete M&A transactions. This includes Fungible being acquired by Microsoft. Albireo Pharma being acquired by Ipsen; Agrivida being acquired by Novus; Concert Pharmaceuticals being acquired by Sun Pharma; Logicworks being acquired by Cox Communications; AVEO being acquired by LG Chem; and Oak Street’s recent announcement that it is being acquired by CBS.

This reflects the quality of our loan portfolio as well as our team’s ability to continue to identify and target the most promising growth stage companies in the market. Early loan repayments were approximately $131 million in Q4, close to the midpoint of our guidance of $100 million to $150 million and a modest increase from $125 million in Q3 2022. For Q1 2023, driven in large part by M&A, we expect prepayments to be between $150 million and $200 million, although this could change as we progress in the quarter. In Q4, we generated a record total investment income of $100.2 million and record net investment income of $62.1 million or $0.47 per share, providing 121% coverage of our recently increased base distribution of $0.39 per share. Our portfolio generated a GAAP effective yield of 14.7% in Q4 and a core yield of 13.8%, which exceeded our guidance for the quarter and is indicative of the recent rate increases and higher onboarding yields for certain new loans.

With net regulatory leverage at a very conservative 100.1% and continued robust liquidity across our platform, our balance sheet remains very well positioned. Additionally, we have no long-term debt maturing in 2023, which affords us the ability to be opportunistic and selective on raising new capital. Credit quality on the debt investment portfolio remained strong and stable. Our weighted average internal credit rating of 2.23 was slightly higher than the 2.20 rating in Q3, but it remains at the low end of our normal historical range. Our Grade 1 and 2 credits decreased to 61.5% compared to 67.4% in Q3. Grade 3 credits were higher at 36.3% in Q4 versus 31.1% in Q3. Our rated 4 credits made up 2.1% of the portfolio and rated 5 credits were 0.1% in Q4.

As of our most recent reporting, 100% of our debt portfolio companies are current with respect to contractual payments of principal and interest. As of the end of Q4, we had only 2 debt investments on nonaccrual with an investment cost and fair value of approximately $18 million and $1.7 million, respectively or 0.6% and 0.1% as a percentage of the company’s total investment portfolio at cost and value, respectively. We ended Q4 with strong liquidity of over $606 million. Subsequent to year-end, we signed a new letter of credit agreement with SMBC, which provides for a letter of credit facility of up to $100 million. In addition, we amended and extended our MUFG led facility. The venture capital ecosystem finished 2022 with fundraising activity at a record $163 billion and investment activity at $238 billion according to data gathered by PitchBook and the National Venture Capital Association.

With the amount of available capital to invest at historic highs, we remain optimistic that venture capital activity will accelerate in 2023. Despite more selectivity and valuation sensitivity from venture capital investors, capital raising across our portfolio remained strong throughout 2022, with 58 companies or more than half of our portfolio companies raising over $5.6 billion of new capital. In Q4 alone, we had 20 different companies raised over $1.6 billion of new capital. We exited Q4 with undistributed earnings spillover of nearly $125 million or $0.94 per share. The undistributed earnings spillover continues to provide us with the added flexibility with respect to our shareholder distributions going forward and the ability to continue to invest in our team and platform.

For Q4, we increased our base distribution to $0.39 from $0.36 and declared a new annual supplemental distribution of $0.32, which will be paid equally over the next 4 quarters beginning in March 2023. This was our third increase to our quarterly base distribution in 2022 and our third consecutive year of being able to pay out supplemental distributions to our shareholders. We will continue to evaluate the quarterly, variable base distribution with a particular focus on the debt portfolio growth and NII growth that we are expecting to materialize. In closing, our momentum remained strong throughout 2022, and we remain well positioned in 2023 from all aspects to take advantage of market conditions and grow our core income generating assets, and as a result, the earnings power of the business.

Our core themes for 2023 will largely remain consistent with 2022, and they reflect maintaining a strong balance sheet and liquidity position and staying disciplined on new underwritings, while continuing to invest in our investment teams and platform. We are thankful to the many companies, management teams and investors that continue to make Hercules their partner of choice. I will now turn the call over to Seth.

Seth Meyer: Thank you, Scott, and good afternoon, ladies and gentlemen. As Scott mentioned, this was another record quarter for Hercules Capital, capping off a record-breaking 2022. In addition to record investment activity in 2022, we continue to strengthen our team, expand and enhance our balance sheet and ensure our cost of leverage was optimized in a rising interest rate environment. Throughout the year, we were able to further validate the benefits of operating at scale by demonstrating meaningful operating leverage as we grew AUM to record levels. This allowed us to deliver an NII margin of 62% in Q4, the highest that we have achieved since 2007. During 2022, our weighted average cost of debt remained below 4.6%, putting us in a very strong position relative to others in our asset class.

We were able to do this by refinancing more expensive legacy instruments in 2021 and into early 2022. And then focusing our balance sheet flexibility once the markets became more challenging from a rate perspective. As a recap, in June, we completed 2 institutional debt financings and expanded our capacity on both credit facilities to support the continued growth of the portfolio. In total, $470 million of additional debt financing and credit facility capacity was made available to Hercules Capital, demonstrating our ability to raise significant amounts of capital at attractive rates in a period of significant volatility for the capital markets. We’ve started 2023 with the same success, amending and renewing early, our largest credit facility led by MUFG and putting in place a new letter of credit facility with SMBC to cover $100 million of our available, unfunded commitment in a more cost-effective manner.

The consequence of these steps is greater flexibility, lower financing costs and consistently strong liquidity to support our business and portfolio companies. We will continue to focus on these themes in 2023 as well as focus on other operational efficiencies and scale of the platform. With that in mind, let’s review the following areas: number one, income statement performance and highlights, number two, NAV, unrealized and realized activity; number three, leverage and liquidity; and then finally, number four, the financial outlook. Focusing first on the income statement performance and highlights. Total investment income was another record at $100.2 million driven by 27% growth in the debt portfolio over the year on strong new business underwriting combined with lower prepayments and an increase in benchmark rates.

Net investment income was a record $62.1 million, a 24% quarter-over-quarter increase or a record of $0.47 per share in Q4. Our effective and core yields in the fourth quarter were 14.7% and 13.8%, respectively, compared to 12.9% and 12.4% in the third quarter. The increase in the core yield was due to an increase in coupon interest as a result of base rate interest increases. While we expect this trend to continue in the first quarter with the full quarterly impact of the fourth quarter Fed policy interest rate changes and the partial impact of the most recent rate change, we are forecasting a leveling of core yield thereafter due to expected loan onboarding yields and less movement from the Fed. Turning to expenses. Our gross operating expenses for the quarter increased to $40 million compared to $36.1 million in the prior quarter.

Net of costs recharged to the RIA, our operating expenses were $38 million. Interest expense and fees increased to $18 million from $16.7 million in the prior quarter due to the growth of the investment portfolio and slightly higher weighted average cost of debt. SG&A expenses increased to $22 million from $19.4 million in the prior quarter, above my guidance on higher funding for the quarter versus our forecast. Net of cost recharge to the RIA, the SG&A expenses were at $20.1 million. Our weighted average cost of debt was 4.6%, a slight percent increase compared to the prior quarter, reflecting greater utilization of the credit facilities due to growth of the investment portfolio. Our ROAE or NII over average equity increased another 350 basis points to 18.2% for the fourth quarter and ROAA or NII over average total assets was 8.8%.

Switching to NAV and unrealized and realized activity. During the quarter, our NAV increased $0.06 per share to $10.53 per share. This represented an NAV per share increase of 0.6% quarter-over-quarter. Net investment income accretion due to modest use of the ATM was offset by the dividends paid in the quarter, including the $0.15 per share spillover distribution of 2021 earnings. Net realized loss of $1.7 million related to the write-off of the legacy equity and warrant positions. Moving on to leverage and liquidity. Our GAAP and regulatory leverage were 113.7% and 101.3%, respectively, which slightly increased compared to the prior quarter due to the net growth of the investments, offset by the modest use of the ATM. Netting out leverage with cash on the balance sheet, our GAAP and regulatory leverage was 112.6% and 100.1%, respectively.

We ended the quarter with more than $600 million of available liquidity. As a reminder, this excludes capital raised by the funds managed by our wholly-owned RIA subsidiary. We believe our strong and flexible liquidity positions us very well in the current rate environment. With the renewal of the MUFG credit facility and the addition of the SMBC letter of credit facility, we have no near-term debt maturities, giving us the ability to be opportunistic should we decide to raise additional capital to support the business. We continued to opportunistically access the ATM market during the quarter and raised approximately $40 million, resulting in an $0.08 per share accretion to NAV. For the year, we raised approximately $230 million from the ATM program.

Finally, on the outlook points, for the first quarter, we’re increasing our core yield guidance range to 13.5% to 14%, excluding any future benchmark interest changes. As a reminder, approximately 95% of our debt portfolio is floating with a floor, so the recent interest rate hike and any additional in 2023 will benefit our core yield going forward. Although very difficult to predict, as communicated by Scott, we expect $150 million to $200 million in prepayment activity for the first quarter. We expect our first quarter interest expense to increase compared to the prior quarter due to the balance sheet growth experienced in the fourth quarter and anticipated in the first quarter. For the first quarter, we expect gross SG&A expenses of $21 million to $22 million in a similar level of RIA expense allocation compared to the fourth quarter.

As a reminder, the first quarter always has higher payroll taxes and benefit costs. In closing, as we reflect on the achievements of 2022 and our ability to deliver both record AUM and record NII per share, we remain optimistic about 2023 and our ability to continue to drive growth across the platform while remaining focused on delivering best-in-class total shareholder returns. I will now turn over the call to Josh to begin the Q&A portion of our call. Josh, over to you.

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Q&A Session

Operator: . Our first question comes from Crispin Love with Piper Sandler.

Crispin Love: In your prepared remarks, you talked about how half of your companies — portfolio companies raise equity capital in 2022 for, I think, you said about $5.6 billion and that’s with — as the industry activity fell off meaningfully. So can you just speak to why you believe that your portfolio companies were in a position to raise significant capital while the industry as a whole wasn’t able to?

Scott Bluestein: Sure. Thanks, Crispin. I think a lot of it really has to be attributable to the quality of our team. We have over 55 professionals on the investment team. This is an incredibly experienced investment team. The average industry experience across that investment team is approximately 10-plus years, and they have a long track record of working successfully together to identify and then win transactions with some of the best quality companies in the market. So I think a lot of the credit has to go to the team. The second thing that I would point out is that at least from what we’re seeing, there has certainly been some pressure in terms of valuation. But the companies that remain strong companies are able to raise new equity capital, and that’s really what we saw across our portfolio in 2022.

And those numbers that you cited were exactly where they came out for us. In Q4, we had 20 different companies raised over $1.6 billion of new capital. And for the year, we had approximately 58 companies raised approximately $5.6 billion of new capital.

Crispin Love: And Scott, how does that $5.6 billion compared to 2021? .

Scott Bluestein: I don’t have the data for you for 2021. So I’d have to get back to you on that. .

Crispin Love: Okay. Not a problem. And then, Scott, you also mentioned during the prepared remarks about being patient and disciplined on new originations. Are you able to drill into that a little bit deeper and what that might mean for your expectations for new debt fundings or debt fundings growth in 2023 or at least what you’re seeing over the near term?

Scott Bluestein: Sure. So as a firm, we are incredibly optimistic about what the environment will look like for us in 2023. We’re off to a great start in Q1, and I provided some quarter-to-date closed commitments and quarter-to-date pending commitment numbers, and we’re off to a great start in regards to both of those numbers. The team is continuing to look at and evaluate a record number of transactions. So when we look at our pipeline activity, it is as large as it’s been in a long time. Having said that, and this was also part of the prepared remarks, because of the turbulence that we’re seeing in the equity markets, both public and private, we’re seeing a tremendous increase in the number of companies that are looking for venture debt or growth-stage debt funding solutions.

And as you know, having followed this business for a long period of time, you simply can’t hit the bid for every company that’s looking for debt financing. So our team is being very thorough in terms of our screening, very diligent with respect to the number of companies that we are progressing along in our pipeline activity. And we believe that we are closing transactions with the best qualified companies that we are seeing on a quarterly basis. I would also reference, last year, we did $3 billion of commitments. When you look at our funding-to-commitment ratio, last year was approximately 55% to 60%. So there are a lot of funding that we anticipate taking place from the existing portfolio over the course of the next 6 to 12 months.