Hercules Capital, Inc. (NYSE:HTGC) Q4 2023 Earnings Call Transcript
Hercules Capital, Inc. (NYSE:HTGC) Q4 2023 Earnings Call Transcript February 15, 2024
Hercules Capital, Inc. beats earnings expectations. Reported EPS is $0.56, expectations were $0.5. Hercules Capital, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Thank you for standing by and welcome to Hercules Capital Fourth Quarter and Full Year 2023 Financial Results Conference call. At this time, all participants are on a listen-only mode. After the speaker's presentations, there'll be a question-and-answer session. [Operator Instruction] Please be advised that today's call is being recorded. I will now return the conference to your host, Mr. Michael Hara, Managing Director of Investor relations. Please go ahead.
Michael Hara: Thank you, Valerie. Good afternoon, everyone, and welcome to Hercules conference call for the fourth quarter and full year 2023. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer, and Seth Meyer, CFO. Hercules financial results were released just after today's market close and can be accessed from Hercules' Investor Relations section at investor.htgc.com. An archive webcast replay will be available on the investor relations webpage for at least 30 days following the conference call. During this call, we may make forward-looking statements based on our own assumptions and current expectations. These forward-looking statements are not guarantees of future performance and should not be relied upon in making any investment decision.
Actual financial results may differ from the forward-looking statements made during this call for a number of reasons, including but not limited to, the risks identified in our annual report on Form 10-K and other filings that are publicly available on the SEC's website. Any forward-looking statements made during this call are made only as of today's date and Hercules assumes no obligation to update any such statements in the future. And with that, I will turn the call over to Scott.
Scott Bluestein: Thank you, Michael and thank you all for joining the Hercules Capital Q4 and full year 2023 earnings call. Following our record operating performance in 2022, Hercules Capital once again raised the bar higher and delivered record performance in 2023. 2023 was a banner year for Hercules Capital, where we set several new financial and performance records and I am incredibly proud of what our talented and growing team accomplished. Our record-setting performance in 2023 culminated with the strongest total and net investment income quarter in the company's history and the recent declaration of a new supplemental distribution program for our shareholders. Our performance in 2023 reflects the benefits of being able to operate an institutional venture and growth stage lending platform at scale, maintain robust liquidity and a strong balance sheet, and working with a best-in-class team with significant experience in this asset class.
Thanks to the growth of both the BDC and our private credit funds business, Hercules Capital is now managing approximately $4.2 billion of assets, an increase of over 15% from where we were at year-end 2022. Despite ongoing market, macro and geopolitical volatility, which impacted growth stage companies throughout 2023, the continued strength and expansion of our origination platform, robust liquidity position and strong balance sheet put us in position to deliver achievements on multiple fronts in 2023, including record full year 2023 total gross fundings of $1.6 billion, an increase of 9.1% year-over-year. Record full year 2023 total investment income of $460.7 million, an increase of 43.2% year-over-year. Record full year 2023 net investment income of $304 million, an increase of 61.7% year-over-year.
Four consecutive years of delivering supplemental distributions to our shareholders. And finally, strong net debt portfolio growth of over $240 million, which excludes the portfolio growth of our private fund business. We are pleased that we were able to deliver record operating performance in Q4 and the full year, while at the same time managing the business quite conservatively with very low leverage and excess liquidity. We expect 2024 to be another year with higher-than-normal volatility and a higher-for-longer rate environment, but as we discussed on our last call, we expect the market environment for new originations to improve throughout 2024. We are already seeing this come to fruition in Q1, where we are benefiting from the balance sheet decisions that we made in 2023.
Going forward, we will continue to take steps to manage our business and balance sheet defensively while maintaining maximum flexibility to shift to offense quickly and aggressively if deal quality warrants it, as we are doing in Q1. This includes continuing to enhance our strong liquidity position, maintaining low leverage, tightening our credit screens for new underwritings and driving our first lien exposure up, which reached 89% in Q4, our highest level since Q1 2017. Let me now recap some of the key highlights of our performance for Q4. In Q4, we generated record total investment income of $122.6 million, up 22% year-over-year and record net investment income of $86 million, up over 38% year-over-year or $0.56 per share and providing 140% coverage of our base distribution of $0.40 per share.
We were able to achieve 140% coverage of our base distribution despite ending the quarter with very conservative GAAP leverage of 87.1%. This is our third consecutive quarter of over $100 million of quarterly core income, which excludes the benefit of prepayment fees or fee accelerations from early repayments, and our fifth consecutive quarter of delivering record net investment income. We also generated return on equity in Q4 of over 20% for the third consecutive quarter. Our portfolio generated a GAAP effective yield of 15.3% in Q4 and a core yield of 14.3%. Our balance sheet remains very well positioned to support our continued growth objectives and serves as a key differentiator of our business relative to others in the asset class. The focus of our origination efforts in Q4 was once again on quality and diversification.
Our Q4 originations activity was driven by both our technology and life sciences teams delivering healthy funding performance during the quarter, although new business activity was again intentionally weighted slightly more towards life sciences companies. In Q4, approximately 57% of our fundings were to life sciences companies, while approximately 66% of our commitments during the quarter were to life sciences companies. This reflects our slightly more cautious view on the technology sector through year end. We funded debt capital to 27 different companies in Q4, of which five were new borrower relationships. Consistent with what we have seen throughout the year, we expanded our funding relationship with numerous portfolio companies that continued to show strength and achieved performance milestones during the fourth quarter.
In addition, the strong level of fundings to existing companies also helped to maintain our available unfunded commitments at approximately $335 million, which decreased from $400 million in Q3. As anticipated, our origination activity has begun to accelerate in Q1. Since the close of Q4 and as of February 13, 2024, our deal team has closed $551.8 million of new commitments and we have funded $383.8 million. We have pending commitments of an additional $506.5 million in signed, non-binding term sheets. The bar for us on new originations remains very high and we continue to pass on the vast majority of deals that we are currently seeing in the market. Many of the quality, later-stage deals companies -- excuse me, that put off debt decisions in 2023 are now back at the table and that is driving our very strong start to the year on originations.
Having a strong balance sheet, staying power and relationships that run wide and deep in the ecosystem gives us great confidence in our ability to continue to generate and deliver quality asset growth over the coming quarters. 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 will remain disciplined on new originations and we will prioritize credit quality over chasing higher-risk transactions with a yield premium. Given the market backdrop throughout 2023, we are pleased with the exit activity that we saw in our portfolio during the year. In Q4, we had two additional portfolio companies complete acquisitions. For fiscal year 2023, we had one portfolio company complete their IPO and two additional portfolio companies file for IPOs, along with 17 portfolio companies completing M&A transactions.
Our solid portfolio activity, despite the challenging, broader exit environment, continues to validate the great work and selective underwriting that our investment teams do. As we anticipated, early loan repayments increased in Q4 to approximately $278 million, which came in above our guidance of $150 million to $250 million. For Q1 2024, we expect prepayments to decrease from Q4 levels and be in the range of $125 million to $225 million, although this could change as we progress in the quarter. Credit quality of the debt investment portfolio remains stable. Our weighted average internal credit rating of 2.24 improved slightly from the 2.28 rating in Q3 and remains at the lower end of our normal historical range. Our Grade 1 and 2 credits improved to 62.6% compared to 62.1% in Q3.
Grade 3 credits were slightly lower at 34% in Q3 versus 34.5% in Q3. Our rated four credits increased moderately to 3.4% from 2.6% in Q3, and we had no rated five credits in Q4. In Q4, the number of loans on nonaccrual decreased by one. We have one debt investment on nonaccrual with an investment cost and fair value of approximately $30.9 million and $0 million, respectively, or 1% and 0% as a percentage of the company's total investment portfolio at cost and value, respectively. As of our most recent reporting, 100% of our debt portfolio companies remain current on contractual payments to Hercules. Our workout efforts with regards to Convoy remain ongoing and our recovery efforts will likely wrap up early this year, although that situation remains ongoing and fluid.
With respect to our broader credit book and outlook, we generally remain pleased by what we are seeing on a portfolio level and our monitoring remains enhanced given continued market volatility and uncertainty. Our focus on credit underwriting and a diversified asset base is continuing to serve us well. We are continuing to see general outperformance and positive momentum in terms of capital raising, M&A activity and milestone achievement throughout our life sciences book, while things continue to remain more muted on the technology side, with respect to the same. During Q4 and throughout the year, we experienced many of the same themes that we have been discussing over the last several quarters. With so much attention paid to what the market has been describing as a VC winter, capital raising across our portfolio remained relatively strong, with over $1.1 billion raised in Q4.
In total for the year, we had 58 portfolio companies raise approximately $6 billion in new capital, which was heavily weighted towards our life sciences portfolio. During Q4 2023, Hercules had net realized gains of $2.8 million, comprised of net realized gains of $4.6 million, primarily due to the gain on equity investments, offset by approximately $1.8 million due to the loss on debt and warrant investments. For 2023, we generated $8.4 million of realized gains. Our net asset value per share in Q4 was $11.43, an increase of 4.6% from Q3 2023. We ended Q4 with strong liquidity of nearly $750 million. Inclusive of available liquidity in our private funds, we have more than $1 billion of liquidity as of the end of Q4. Our balance sheet is both strong and stable, and it puts us in a strong position to be able to benefit from a new business environment that we anticipate will get better throughout 2024.
Venture capital ecosystem fundraising and investment activity finished 2023 with fundraising activity at approximately $67 billion and investment activity at approximately $171 billion according to data gathered by PitchBook-NVCA. To put that into perspective, investment activity equaled 2020 levels in both dollars invested and number of companies raising capital at over 13,000 companies. Fundraising for the year exceeded 2019 levels. However, we expect fundraising to stay at the current level for the foreseeable future. We do not expect investment activity to reach the levels that we saw during the COVID pandemic near term, but we do expect investment activity to remain at healthy levels with more selectivity in terms of the profile of the companies that are receiving equity funding.
With our record operating performance in 2023, we exited Q4 with undistributed earnings spillover of over $125 million or $0.80 per ending share outstanding. We are also very pleased to announce that our RIA has delivered its first distribution to HTGC shareholders. For Q4, we are maintaining our base distribution of $0.40 and we declared a new supplemental of $0.32 for 2024 which will be distributed equally over the next four quarters or $0.08 per share per quarter for a total of $0.48 of shareholder distributions. This is our fourth consecutive year of being able to provide our shareholders with a supplemental distribution on top of our regular quarterly base distribution. In closing, 2024 marks our 20th year investing in the venture and growth stage asset class, which is another milestone for our company.
Our scale, institutionalized lending platform and our ability to capitalize on a rapidly changing competitive and macro environment continues to drive our business forward and our operating performance to record levels. Our success since inception over 20 years ago is attributable to the tremendous dedication, efforts and capabilities of our employees and the trust that our venture capital and private equity partners place with us every day. 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 2023. In addition to record investment activity in 2023, Hercules broke quarterly and annual records in many dimensions, including total investment income, net investment income, core income and many more, all while managing the balance sheet conservatively with low leverage and strong liquidity. In 2023, we further validated the benefits of operating at scale by demonstrating meaningful operating leverage as we grew assets under management to record levels. This allowed us to deliver NII margin of 70.2% in Q4, the highest that we have ever achieved. In 2023, our weighted average cost of debt remained below 5% and leverage remained conservatively low, putting us in a very strong position relative to others in our asset class.
We were able to do this by proactively strengthening our balance sheet and liquidity positions early in the year by renewing our $400 million credit facility led by MUFG and putting in place a new committed letter of credit facility with SMBC to cover $175 million of our available unfunded commitment in a more cost-effective manner. We continued to supplement liquidity by raising net of fees $108 million with the equity offering in August and another $230 million throughout the year via our ATM program. We have started 2024 with nearly $750 million in available liquidity, a net regulatory leverage of approximately 72% in possession of our fourth green light letter from the SBA, which will provide $175 million of additional regulatory exempt leverage and a very small maturing private placement of $105 million in July.
This positions us very well to invest in the strong pipeline Scott discussed, and be able to strategically time accessing the market for additional liquidity to support the business side of the balance sheet if needed. With all that in mind, let's review the following areas, the income statement, performance and highlights, NAV unrealized and realized activity, leverage and liquidity and the financial outlook. First, on the income statement performance and highlights for Q4. Total investment income exceeded the prior quarter at $122.6 million, driven by the year-to-date growth in the debt portfolio on consistent business underwriting and a small increase due to the $1.4 million dividend from our wholly-owned RIA. Core investment income, a non-GAAP measure, again exceeded $100 million at $114.5 million.
Core investment income excludes the benefit of income recognized as a result of loan prepayments. Net investment income was another record at $86 million, a 12% quarter-over-quarter increase or $0.56 per share in Q4. As mentioned, NII margin was 70.2% for Q4 and has increased every quarter since Q1 2022. Our effective and core yields changed modestly in the fourth quarter to 15.3% and 14.3% respectively, compared to 15.5% and 14.2% in the prior quarter. The decrease to the effective yield was due to lower back-end and one-time fees on prepayments versus the prior quarter. Turning to expenses. Our gross operating expenses decreased to lower -- on lower compensation accruals of $38.2 million compared to $42.4 million in the prior quarter. Net of costs recharged to the RIA, our net operating expenses decreased to $36.6 million.
Interest expense and fees increased modestly to $19.9 million from $19 million in the prior quarter due to greater utilization of the credit facilities. SG&A reduced to $18.2 million below my guidance of $21 million to $22 million on lower compensation accruals. Net of costs recharged to the RIA, the SG&A expenses were at $16.6 million. Our weighted average cost of debt was 4.9%, a slight increase compared to the prior quarter reflecting greater utilization of the credit facilities. Our ROAE or NII over average equity increased another 110 basis points to 21.3% for the fourth quarter and our ROAA or NII over average total assets was 10.6%. Switching to the NAV unrealized and realized activity, during the quarter, our NAV increased $0.50 per share to $11.43 per share.
This represents a NAV per share increase of 4.6% quarter-over-quarter. The main drivers were the record net investment income of $86 million, unrealized appreciation of $31.3 million, including the reversal of prior unrealized depreciation of $9.9 million, net realized gains mainly on the sales of equity positions of $2.8 million, accretion due to the use of the ATM, all of which exceeded the dividends paid in the quarter. Our $31.3 million of unrealized appreciation was primarily driven by $9.2 million of net unrealized appreciation on the loan portfolio and $12 million of appreciation to the public equity and warrant portfolio. On leverage and liquidity, our GAAP and regulatory leverage decreased to 87.1% and 77.4% respectively, compared to the prior quarter due to the equity raise via our ATM.
Netting out leverage with cash on the balance sheet, our net GAAP and net regulatory leverage was 81.6% and 71.9%, respectively. We ended the quarter with nearly $750 million of available liquidity. As a reminder, this excludes capital raised by the funds managed by our wholly-owned registered investment advisor subsidiary. Inclusive of these amounts, the Hercules platform had more than $1 billion of available liquidity at year end. The strong liquidity positions us very well to support our existing portfolio companies and source new opportunities. As a final point, we continued to opportunistically access the ATM market during the quarter and raised approximately $100 million, resulting in a $0.16 per share accretion to NAV. For the year, we raised approximately $230 million from the ATM program.
On the outlook points, for the first quarter, we're maintaining our core yield guidance range of 13.8% to 14%, excluding any future benchmark interest changes. As a reminder, approximately 95% of our portfolio is floating with a floor, so any Fed decreases in interest rate may not have an equal reduction in our core yield. Although very difficult to predict, as communicated by Scott, we expect $125 million to $225 million in prepayment activity in the first quarter. We expect our first quarter interest expense to remain relatively flat compared to the prior quarter. For the first quarter, we expect SG&A expenses gross of $25.5 million to $26.5 million and an RIA expense allocation of approximately $2.5 million to $3 million. As a reminder, the first quarter always has higher payroll taxes and benefit expenses.
As previously guided, the advisor business began paying dividends in the fourth quarter to Hercules Capital. Going forward, we expect a quarterly dividend from the RIA of approximately $1 million to $1.5 million per quarter. In closing, as we reflect on the record achievements of 2023, we remain optimistic about 2024 and our ability to continue to drive growth across the platform while maintaining focused on delivery and best-in-class shareholder returns. I will now turn the call over to the operator to begin the Q and A portion of our call. Valerie, over to you.
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