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Hercules Capital Inc
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Ladies and gentlemen, thank you for standing by and welcome to the Hercules Capital, Q3 2019 Earnings Conference Call. At this time all participants are in a listen-only mode. [Operator Instructions].
I would now like to hand the conference over to your speaker today, Mr. Michael Hara, Managing Director of Investor Relations. Thank you, please go ahead sir.
Thank you, Paul. Good afternoon, everyone, and welcome to Hercules conference call for the third quarter of 2019. With us on the call today from Hercules are Scott Bluestein, Chief Executive Officer and Chief Investment Officer; and Seth Meyer, our Chief Financial Officer.
Hercules third quarter 2019 financial results were released just after today's market closes and can be accessed from the Hercules Investor Relations section at www.htgc.com. We've arranged for a replay of the call at Hercules webpage or by using the telephone number and passcode provided in today's earnings release.
During this call we may make forward-looking statements based on current expectations. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein due to timing delays between the date of this release and in the confirmation of the 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 to differ materially from those expressed in the forward-looking statements, including and without limitation the risk and uncertainties, including the uncertainties surrounding the current market turbulence and other factors we have identified from time-to-time in our filings with the SEC.
Although we believe that the assumptions on which these forward-looking statements are reasonable, any of those assumptions can prove to be inaccurate, and as a result the forward-looking statements based on those assumptions also can be incorrect.
You should not place undue reliance upon these forward-looking statements. The forward-looking statements contained in this release are made as of the date hereof and Hercules assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of related SEC filings, again you can visit our website.
With that, I will turn the call over to 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 record Q3 total findings 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 of 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 our originations platform delivered new debt and equity commitments of $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 29, Hercules has already closed an additional $191 million of new commitments and we have pending commitment of an additional $36 million in singed, non-binding term sheet. Year-to-date through October 29, our 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 transactions.
Our investment related activity in Q3 reflects our focus on three key themes and our views on the current market and competitive environment. First, building and maintaining a broadly diversified portfolio and avoiding concentrated risk; second, delivering controlled grow, 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 am incredibly proud of the entire Hercules Investment team and broader organization for our achievements during Q3 and year-to-date. Our belief since inception and throughout the course of our 15 year history has been that portfolio diversification is essential to achieving a long term, sustainable success in the venture and 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 funded during Q3 are situations where our portfolio companies achieved specific performance milestones or 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 debt commitments to reflects our focus on quality, diversification and differentiation.
We closed new financings with a blend of technology and life sciences companies and the 14 portfolio companies that we completed fundings with also reflects a similar make up. 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 that we have funded in any Q3 since inception. For the first nine months of 2019 we have funded $785 million, an increase of over 11% from last year. As noted in our earnings release, early payoffs 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 M&A 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 will continue to be a primary area of focus for us. We are comfortable sacrificing some short term growth as we focus on sustainable long term performance and total shareholder returns.
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 our 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 rated 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 non-accrual with a cumulative investment cost and fair value of approximately $9.3 million and $2.2 million respectively or 0.4% and 0.1% as a percentage of the company's total investment portfolio at cost and value respectively.
Even with our strong capital deployment in the first nine months of 2019, we are continuing to manage GAAP leverage below our stated sealing of 125%, with Q3 coming in at 111.5% and regulatory leverage excluding our SBA 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 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 of U.S. 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 sentiment regarding high profile unicorns that are considering going public. Year-to-date 2019 we have already set a new annual record with 11 of our own portfolio companies completing their IPOs. Hercules Portfolio Companies, Oportun Financial and Brickell completed their IPOs in Q3, and we have Tela Bio and three additional confidential filers in the pipeline.
We expect the IPO market to remain volatile through year-end. Assuming market conditions remain 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 IPOs 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 debt investment portfolio at $2.1 billion at cost, our NII per share in Q3 generated 116% coverage above our quarterly based distribution of $0.32 per share.
In addition to our quarterly based distribution of $0.32 for Q3, we also declared a supplemental distribution of $0.03 per share. In the aggregate, this brings our total distributions to shareholders for Q1, Q2 and Q3 to $1.02, representing an approximately 7% increase from the same period a year ago. This also represents the third consecutive quarter where the company's strong performance has allowed us to deliver an 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 spill-over to an estimated $62 million or $0.59 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 platform as we discussed in Q2. Subject to market conditions and sustained financial 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 has a proven track record of growth while establishing a high water mark for credit quality that has delivered long term, top-tier shareholder returns throughout any type of credit cycle.
Thank you very much, everyone, and I will now turn the call over to Seth.
Thank you, Scott and good afternoon ladies and gentleman. As Scott mentioned, this was another strong quarter for Hercules. In Q3 we delivered record net investment income totaling $38.9 million or $0.37 per share, providing 116% coverage of the base distribution for the quarter. Credit remained exceptionally strong and non-accruals continue to be less than half a percent of our total investment portfolio on a cost basis.
Our ROAE or net investment income over average equity was 14.9%. Our ROAA or NII 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; NAV, 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, net investment income per share was $0.37, an increase over the prior quarter of $0.36 per share. Despite two federal rate cuts during the quarter, total investment income remained flat at $69.3 million compared to the prior quarter, supported by a 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 payoffs. The important point to note is that the growth that we have seen in the portfolio over the year has created a baseline at which we can cover the base dividend without depending on non-reoccurring or non-core income. For context, compared to the same quarter of 2018, total investment income has increased 31.6%.
Our effective and core yields in the third quarter were 13.4% and 12.4% respectively, compared to 14.3% and 12.7% in the second quarter. The primary driver for the decrease in the effective yield was due to the lower early payoffs, the core yield reduced due to the two fed rate 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 the prior quarter, which is the highest we have 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 – in the second quarter. Interest expense and 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.
SG&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 reduced discretionary and variable compensation accruals are a direct result of the company's seasonally reduced debt fundings in the quarter compared to the prior quarter. Partially offsetting this was an increased tax provision. Our weighted average cost of debt was 5.1%, a small reduction compared to 5.2% in the prior quarter, and a more material reduction compared to the 5.6% in the same quarter last year.
Now let's switch the focus to NAV, unrealized and realized activity. During the quarter our NAV decreased by $0.21 per share to $10.38 per share, largely related to unrealized depreciation attributable to market volatility impacting the fair value of our investment portfolio.
We had unrealized depreciation of $25.5 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 of two impaired non-accrual 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 appreciation 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 appreciation, primarily related to the monetization of two equity positions. Both resulted in realized gains that were accretive to our spill-over.
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 sealing of 125%. As a reminder, our early payoffs and normally amortization provide us with significant monthly inflows that we can use to delever 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 a floor, which mitigates some of the potential 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 portion of loans at the contractual floor increases to approximately 60%.
For the fourth quarter we expect SG&A expenses of $16 million to $17 million. As communicated previously, the reduced expense level due to the settlement with our former CEO will partially be offset by increased investment in our team and infrastructure. Should market conditions remain favorable and origination activity exceed our expected growth, the SG&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 and greater use of our credit facilities. Finally, although very difficult to predict, we expect $100 million in prepayment activity in Q4.
In closing, we continue to see Hercules Capital well positioned for the remainder of 2019.
I will now turn the call over to the operator to begin the Q&A part of our call. Operator, over to you.
[Operator Instructions]. The first question is from Tim Hayes of B. Riley FBR. Your line is open.
Hey, good afternoon guys. Thanks for taking my questions and congrats on a great quarter. My first one, can you just touch on the supplemental dividend. I know you made some comments, but this is your fourth straight quarter of supplemental dividend payments. How do you think about these dividends in relation to the amount of spillover you'd like to keep on hand?
Yeah, first Tim, thanks for the comments. It’s the third straight quarter where we've issued the supplemental distribution, there was a gap in between Q3 and Q4, but we didn't have one.
Oh! Excuse me.
Sure, our goal as we 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 and the second is through the supplemental. Given the trajectory of the business, particularly in 1Q and Q2 and Q3 of this year, we felt and the board supported our decision to declare the supplemental distributions which had 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 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 pay-offs or accelerations.
The spill-over 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 and depth of our team and we think that that's an important thing to be able to do without impacting NII on a go forward basis. And the second point is, as we’ve sort of shown, we look at that as a way for us to continue to deliver supplemental dividends to our shareholders as a way to increase and 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 the year, that's something that the management team and board will be evaluating and as I mentioned in 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, yeah, that makes sense. I appreciate 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 NII for the past two quarters, irrespective of the early prepayment income you are receiving there too.
You know your very constructive around or seem constructive around growth in the lending environment in general, so I noticed Seth made some comments about where yields could shake up given the recent fed cap. But what gives you pause at the moment in raising the quarterly distribution just given where your core earnings or just your earnings power is at this point?
Yeah, I think, you know we're in a unique position now and I view it sort of as a position of strength where I think 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 that both the base distributions, 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 – you know this is the second quarter as you mentioned where the core income is covering the base distribution. We’ve obliviously had some yield compression in the business as Seth mentioned in his comments from the three rate cuts that we've seen. You know we want to see what the rest of Q4 looks like, the markets have been 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 were there year end up.
But we are very optimistic about what lies ahead for us and we think that we're in a unique position, which is a position of strength as I mentioned where we have the ability to look at both the base distribution, as well as some increased supplemental distributions on a go-forward basis.
Got it, makes sense and a 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, you know including expanding the product offerings set and/or partnering with other investors.
Sure. So the pipeline right now is about $1 billion, which is strong. I think the portfolio – sorry, the pipeline right now is I would sort of describe it as healthy and it’s sort of typical where we are in the year. There is no question that our performance this year, both 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 things 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 know 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 where we delivered $1.2 billion in commitments; through 10 months we’re already at $1.4 billion.
So I can't tell you exactly sort of what percent or 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 and some of those things that we're continuing to work on, that we hope to roll out 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 you know as you prepare for the next level of record portfolio size, you know what type of investment do you see making and how does G&A trend. I know it’s a lot of questions in 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 and the platform and in 2016, we talked about and we felt comfortable that that would get us to roughly the $2 billion portfolio mark.
We crossed the $2 billion 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 sort of reinvest once again in our team, in our systems, in our platform, and the goal there is really 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 in both 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 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 and two years away, we would again then look to make some additional investments in the platform at that time.
Yeah, the only thing that I would say Tim as far as managing expectations on costs, we feel that we can do this at the run rate of the $16 million to $17 million that I mentioned at least for this quarter; we’ll reevaluate that in the future. We are 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 you know, 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 for taking my questions.
Thanks Tim.
The next question is from Aaron Deer of Sandler O'Neill. Your line is open.
Hi, good afternoon guys.
Hi Aaron.
Seth, just follow-up on, it sounds like you were just guiding towards something in the range of $16 million, $17 million of OpEx. I’m guessing that that’s G&A compensation and stock compensation combined.
Yes.
Okay, and then I thought I heard too that you are expecting around $100 million in pre-pays 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 year end?
Yeah, you know we don't provide guidance with respect to funding activity in the quarter. What I can tell you is that you know Q3 is typically our slowest quarter and you saw that. Q3 was our slowest quarter, but it was also a record Q3 for us. We typically see a pick-up in Q4 and what I can tell you is we've already started to see signs of that pick-up.
If you look in our press release and if you focus on what I said in the prepared remarks, for the month of October we've already closed new commitments of over $190 million. 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 pre-payment that Seth mention, they are very difficult for us to predict, but based on what we've seen so far in the quarter and what we're aware of, we think that the $100 prepayment mark is appropriate for modeling purposes for Q4.
I appreciate that, and then lastly the – given that you do have a pretty strong growth outlook here, obviously your still below maybe your target or the sealing leverage ratio, but with the stock price, you know it hasn’t seen some good performance of late, what are your thoughts on getting back and using the ATM at this point?
So you know, we’ll always have it as an option. We’ll continue to evaluate whether that's the stuff we want to take. We consider that the markets are open and appreciate the ease that we had in June when we stepped out and very quickly raised capital. So no plans at the moment, but we appreciate that it's readily available, thanks to the fact that we're trading well above our books value.
Okay, great. Thank you for taking my questions.
Thanks Aaron.
Our next question is from John Hecht of Jefferies. Your line is open.
Good afternoon, guys, and congrats on a good quarter.
Thanks John.
You guys talked about rates. I think– did I hear you right; as of the rate cut today, 60% of the loans are through their floors or at or through their floors or was that number incorrect?
No, that’s correct. And you’re incorrect to say that you know some are below at this point, but that's where we land as a result of the cut today.
So in the interest rate sensitivity table where you show the benefits of rising rates and the vice versa, does that 75 basis – for instance, is that example where you give a 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?
No, no, no, that incorporates the floors. So what we could say is annually based on that table, we'd approximately go down $0.03 per share annually again, as a result of the rate cut today. But at that level, then 60% of the portfolio is at the floor and which is why you will see that it only increases $0.02 per share when you go to 50 basis points.
Yup, and that’s got a non-linear angle that you mentioned.
Exactly, yeah.
Okay, and then I guess maybe talk about – Scott, talk about the universe, the VC mentality. I mean given some of the big market IPOs and their post IPO performance, clearly there's a lot of demand. Maybe are there any structural changes that you see on going in the industry that you suggest the addressable market, it either has like a longer duration before seeking IPO or is just larger overall.
Yeah, sure. There's a couple of things going on. You know first, and I think this is probably the most important. We are 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 of VC equity capital invested into the ecosystem.
Your know last year was a record year. It was about $107 billion, $108 billion. Based on what we're seeing, assuming Q4 is sort of consistent with expectations, this would be the second consecutive year we’re over $100 billion as invested. You are also continuing to see tremendous strength from the fund raising perspective. $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 consecutive 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 with respect to those key metrics that we use sort of as a guide to sort of speak to the overall health of the ecosystem.
There is no question that there have 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 had a record year, year-to-date in terms of IPO activity with 11 of our portfolio companies completing IPOs. Certainly some of those have underperformed post completion of the offering, but we have several that have performed very well.
We don't look at what's going on with sort of the few, isolated, larger later stage IPOs that either having gotten off or having done really poorly as indicative of anything sort of systemic with respect to the ecosystem that we play in.
And then I would just add as a closing comment, in some ways we view the noise with respect to the sort of isolated group, that's potentially beneficial to us, because it really focuses the industry and it focuses the market really back on a rationalization of business models, more of a focus on sort of unit economics and underlying KPIs, and I think if anything, you know that's where our investment team really excels from an understanding perspective, and it's our belief that some of that noise with respect to that sort of isolated bucked could create some additional opportunities for us from a debt financing perspective.
Okay. Thank you very much for the update. I appreciate it.
Thanks John.
[Operator Instructions] The next question is from Ryan Lynch of KBW. Your line is open.
Hey, good afternoon Scott. My question – kind of wanted to follow up on your last comments on kind of those isolated incidents of recent struggles in the IPO market. One of the concerns with some of those recent struggles, as well as some private VC company, the struggle recently is that the valuations in later stage companies might be inflated and there might have to be some revaluation of those companies which could put some pressure. I wanted to just get your thoughts and comments on how you feel some of these later stage VC backed valuations are today?
Sure. So look, there's no question in that again. In a small, I think isolated part of the market you know valuations got ahead of themselves and you’ve clearly seen that with a couple of high profile situations over the last 30, 60, 90 days and I don't think that's a bad thing in terms of a re-rationalization of valuations and a focus on sort of underlying business models and unit economics.
You know I can tell you that with respect to our portfolio, you know if you look at our marks from an equity perspective, you know in virtually every single case we are either below or well below you know the most recent round of financing for a valuation perspective, so I feel very good about where our book is from a fair value perspective.
We had a little bit of unrealized depreciation in the quarter, which Seth talked about in his comments. I think the important thing to note there is you know exactly what Seth said. When you really break it down, the $25.5 million of unrealized depreciation, the vast majority of that was in the sort of the public book from the mark-to-market perspective. Only $2.5 million of it was attributable to the unrealized piece from the credit perspective, which is a pretty immaterial amount on a quarterly basis and we really haven't seen any further degradation subsequent to the 930 marks that would lead us to believe that there's further erosion with respect to valuations in our portfolio subsequent to quarter end.
Okay, that’s good color. I wanted to switch over to interest rate sensitivity. I appreciate your comments on the 6% of your portfolio. Is that your floor level I believe, that's because you guys structure loans a little bit differently than most middle market lenders.
Kind of on that point, when I think of you know most BDCs doing middle market leverage buyouts, it feels like those borrowers are going to be very interest rate sensitive because they are doing a little bit of financial engineering to make the math work versus a VC borrower. It feels like to me it’s more looking to take on some debt, so that they don't dilute their equity state 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 ability will be to potentially offset some of that, by not only the floors to be having your portfolio, but also potentially increasing the spread or the fees you charge on those VC borrowers?
Sure. So I think our view is that we will be able to offset some of the degradation in rate through other means and that's certainly something that we've seen. If you look at the fundings that we've completed quarter-to-date, you know we've been able to do that, which will certainly help us offset some of that rate degradation.
I think the important part is sort of what Seth spoke to. With the rate cuts announced today, you know approximately 60% of our portfolio right now is already at 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 475, which is essentially where prime is to-date.
We also have the ability when a loan comes up for restructuring or an amendment to sort of try to do things to either reset floors or continue to drive that number up and it would be our hope that irrespective of what the fed does, that certainly as we get closer to year end into the early part of next year that we can drive that 60% number up substantially, so that we won't have any really further significant impact on the downside with respect to short term rates.
Okay, those were all my questions. I appreciate the time.
Thanks Ryan.
The next question is from Christopher Nolan of Ladenburg Thalmann. Your line is open.
Hey guys. You know philosophically how do you look at companies which are trying to grow at all costs, and I'm specifically thinking about the WeWork situation. When you see a company like that, what is you're underwrite approach?
Yeah, so look I think WeWork is sort of one of those isolated situations you know that I mentioned. I don't think that’s endemic you know to the entire venture ecosystem and again, the way we look at that situation is we actually look at it from a positive perspective. You know I think 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 what our team does every single day.
You know we've always been a firm I think that's 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.
You know every deal that we do, you know we are looking at the core fundamentals of that business. You know 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’ve raised. We're looking at the KPIs, 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 you know best-in-class credit performance. We are very, very, very grateful and appreciative of the fact that you know 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 that's not something that’s easy to do when you're lending to growth stage, cash flow negative companies and I think that's directly attributable to the work that our team does from a diligence perspective and how we’re able to sort of understand what the numbers are actually telling us versus what you know post money gets done at from a round perspective.
Scott, are you seeing the entrepreneurs for these select unicorns having more leverage over investors than before?
Yeah, you know we haven't seen that. You know I think there’s still again a little bit of a rationalization you know going on in the market. You know there are some companies that we are aware of that are exploring an IPO and you know 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 you know with respect to entrepreneurs, nothing leveraged over VC. I think it's really specific to the individual investment rather than sort of an industry wide issue.
Got it. Thanks for the color.
The next question is from Fin O'Shea of Wells Fargo Securities. Your line is open.
Hi, thanks for having me on. Just a first question, a small question on the equity evolved this quarter. Just glancing at some you know small cap, biotech indices which is usually pretty indicative of you know your equity portfolio, I see things slightly down but not meaningfully so. Is that correct to say – is it more concentrated or broad based on your equity markdowns?
Equity markdowns, so yeah there are 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.
Yeah, so you know I think a couple of things Fin. You know if you look at sort of S&P biotech index you know in Q3, you know down 13.2%. So there was clearly a pretty substantial pullback with respect to some of the key indices that we used to kind of track our portfolio in Q3. If you look at you know our unrealized depreciation in the quarter, again as Seth mentioned in his remarks, you know $11.5 million attributable directly just to market – mark-to-market volatility with respect to equity and warrant positions. There was sort of a downdraft, both on the tech side and on the equity side, but 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 is helpful. And then just, not to make things repetitive on the larger cap headlines we are seeing, and you've been answering today. But to the description of stressed valuations being isolated, can you expand a little bit on how you're defining – you know what’s isolated? Is it sort of the unicorns? Is it a specific sector or is it really just 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, that sort of drive the narrative. We've not seen again a service 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 you know the one or two or three very high profile public situations get a lot of publicity and I think that's what you really seen from the 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 it's systemic with respect to – you know there's an issue across the venture landscape because we absolutely have not seen that. There are a couple of higher profile situations that have obviously been noisy, but 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 understanding that you’ve always faced some sort of in and out players in the venture lending space and you know there's – because it’s a very specialized vertical, but you know more broadly in private debt you see a lot of a larger managers really trying to diversify their pipelines.
So, would you say – you know would you agree with that and see there's more of a – a more meaningful commitment from some of your competitors in entering the VC space – sorry, the venture lending space?
Yeah, so what I would say is there’s 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 and 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’ve been very fortunate now to have financed over 500 different companies; we’ve partnered with over a 1000 different VC and growth stage investment firms, and what we hear on a pretty consistent basis from the companies that we're speaking to and that we’re 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.
Like 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 years, some have been successful, some have not been successful, we hear pretty consistently from the companies that we associate with, concerns about you 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 a traditional EBITDA leverage based financing situations, and that's why we continue to be very optimistic about our market and our growth trajectory on a go forward basis.
Thank you for your time today. That’s all from me.
Thanks Fin.
The next question is from Henry Coffey of Wedbush. Your line is open.
Yes, greetings and thank you for taking my question. I'm intrigued 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 they're IP, their tech companies and all that other goofy stuff, what is the fundamental nature of where your companies are in your view compared to say a year or two ago, you know their ability to successfully execute on their business plans and you know successfully get out product there and sort of grow to the next stage.
You know, I can't imagine that WeWork’s, which is basically REIT, not getting its IPO done at something like $12 trillion or whatever the number was, has anything to do with that. So where are we from getting all the fluff? Where are we in terms of the fundamental substance of the companies you're investing in?
Sure. You know 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. A 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 walked through that our rated four and rated five credits this time make up less than 2% of our portfolio from a fair value perspective.
Our portfolio is continuing to largely perform 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 negative impact from the few isolated situations that we talked about on this call and 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 perspective. We just announced another quarter were 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.
How do you translate – you're principally a lender, so how do you translate all this into your sense of how and again your loans are performing exceptionally well; 98% of them are in really great shape. If I could look at each of your portfolio companies, which would take me forever, what would my fundamental assessment be of how they are performing relative to plan, how close are they to profitability, what do the companies themselves look like from your perspective.
Yeah 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 or anything related to some of the higher profile situations, that we just talked about.
Now I'm also looking at slide 22 in your deck, which I always find very helpful. Clearly in Q2 ‘18 there was sort of a step down in where coupons and yields were – I’m sorry, where gross and effective yields were. Actually coupons went up, and then since then it’s – I mean we've had a major cut in rates and you’re effective – your core yield is gone from 12.7 to 12.4, which means you only suffered a third of the cuts out there.
Is that what we're likely to see going forward, is a very small downward moderation in yields as rates go lower and lower or are we up for another step down? And are we going to wake up by next year and see the 11.5% is where the business should be or…
Yeah look, we’ve always said this; we managed the business based on a middle line, right on page 22 that you're referencing.
Right.
We focus on core yield, the top line which dipped down in Q2 of ‘18 on the effective yields, that’s a direct correlation with respect to how much we have on a quarterly basis in terms of pre-payments. In Q2 of ‘19 we had nearly $180 million or $185 million of prepayment, so you had this spike to 14.3% from an effective. Our prepayments were down slightly to $140 million in Q3, so it will be effectively down to about 13.4.
Seth 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 that's inclusive of the fed cut from today. So you know we certainly do not expect to wake up at the end of Q4 and see the portfolio at 11.5%, otherwise we wouldn't have just given the guidance that we did with respect to our ability to maintain ourselves.
Well, obviously I didn't mean the fourth quarter, but you know next year. I mean if you are looking at the same chart I am, you could almost draw some lines through it, where there's a shift that occurs periodically. And if you think…
Henry, I’d point to slide 25 where you see the dynamics, the shape of the portfolio change significantly with a dramatic pay-down in Q1 and we are not seeing that development.
Henry, 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 of commitment that we've already managed to on board in Q4 and as I mentioned, we have not seen any real degradation in terms of our ability to target deals that we’ll be able to maintain our core yield in our target ranges.
So, even the newest business is being set up at levels that allows you to keep at it, let's just call it 12%, 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 York of JMP Securities. Your line is open.
Hey guys, thanks for taking my question. So Scott you’ve produced back-to-back quarters of record originations. So I'm curious whether you think you are taking market share here as being a primary driver of the record growth. Because the U.S. venture ecosystem was also very, very, very strong in ‘18 with respect to VC investments.
Sure. So I think it’s the combination of two things. You know 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 we've crossed $2 billion, we have 95 active debt portfolio companies. Our portfolio from a debt perspective is very vibrant, very growth focused and so there are a lot of opportunities for us to demonstrate the strength and 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.
We are 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.
Got it, that’s helpful, and then following up a little bit on that and then maybe a little bit on Fin’s question earlier. As you know a lot of venture capital backed companies are staying later for longer before completing their IPO and it seems that some of these rapidly growing tech companies are now changing sponsors oftentimes from VC to PE. So I’m curious on your level of interest and then willingness to grow with the company at later stages, but potentially lending at lower yield than what is traditionally associated with venture debt.
Yes, so there are certainly a couple of situations that we are aware of, that sort of occurred in Q3 where you had sort of a situation along the lines of what you just described, where later stage sort of non-traditional VC, more like a PE or a sponsor came into a growth stage company and 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. You know the reality for us is, if a company and 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 you know 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're going out and they're getting much cheaper financing than we're going to provide.
We do think that there is a tremendous opportunity with respect to companies that are a little bit further away from their IPOs. So the company that was initially thinking about doing an IPO in 2021, maybe that company has second thoughts now. We think that's a great opportunity for us to sort of engage with those companies and we're actively speaking to a couple of them, you know 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, I wasn’t going to say a name, but one that just came to mind that would be maybe like a Postmates type that you would be focusing on as opposed to some others that maybe took you out this quarter from a private equity perspective.
Yeah. I mean I don't want to address any particular situation; you know Postmates is a portfolio company of ours today.
Yeah, yes exactly. Okay and then just two housekeeping questions. So in terms of your prepay expectations of $100 million, what is the average duration of the portfolio pay-out for that?
It’s about 15 months.
Okay, and then Seth maybe this one for you as well; FTEs, full time employees at quarter end and then what is your budget for new investment professional 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 their current FTEs, we have about 77 employees at the moment.
Okay, so up a little bit, quarter-over-quarter and then so if you don’t have the budget, any ideas, maybe just kind of stuff on growing debt and being strategic in hiring a couple of new investment professionals.
Yeah look, we are 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 we've 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 investment in our team broadly speaking, not just the investment team, and if we can find some individual that we think will be accretive and add value and allow us to continue to expand our breadth and diversification from a platform perspective, you know we’ll certainly be interested.
You know this is a – we talked a little bit about this historically, but you're Hercules is a difficult place to higher into because the expectations are very high and it’s unique what we do. Our investment team is very talented, because their domain experts in the areas that they focus in, 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 or the life sciences side. So we can't just go out and hire someone from a commercial bank or someone from a competitive firm, because if we think what we do is truly differentiated in terms of how we approach the market.
Makes a lot of sense. That's it for me. Thanks Scott, thanks Seth and thanks Mike.
You bet.
Thanks Chris.
I’m showing no further questions at this time. I would now like to turn the conference back to Scott. Please go ahead, sir.
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 4th Annual BDC Summit in London, Zurich and Frankfort. If you are interested in meeting with us at any of these events, please contact JMP Securities or Jeffries for their respective events or Michael Hara.
Thank you and have a great day!
Ladies and gentleman, that concludes today's conference call. Thank you for participating. You may now all disconnect. Have a good day!