Hercules Capital, Inc. — Q3 2022 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2022. Hercules is a business development company that primarily makes senior-secured loans to venture- and institutionally backed companies in technology, life sciences, healthcare, and related sectors. Figures below are in U.S. dollars; financial statement amounts are generally in millions unless stated otherwise.
Key financial metrics
| Metric | Q3 2022 | Q3 2021 | Nine months 2022 | Nine months 2021 |
|---|---|---|---|---|
| Investment income | $84.2 | $70.2 | $221.5 | $208.5 |
| Net investment income | $50.0 | $38.1 | $125.9 | $109.6 |
| Net realized gains | $5.3 | $21.1 | $0.8 | $14.6 |
| Net unrealized appreciation (depreciation) | $(2.1) | $(35.7) | $(87.1) | $46.2 |
| Net increase in net assets from operations | $53.2 | $23.5 | $39.5 | $170.4 |
| Net investment income per share | $0.39 | $0.33 | $1.01 | $0.95 |
| Distributions per share | $0.50 | $0.39 | $1.46 | $1.15 |
At September 30, 2022, total assets were $2.925 billion, investments at fair value were $2.826 billion, debt was $1.521 billion carrying value ($1.542 billion principal), and net assets were $1.363 billion. NAV was $10.47 per share, versus $11.22 at December 31, 2021. Cash and cash equivalents were $57.1 million, with another $8.3 million restricted.
For the first nine months, operating activities used $359.9 million of cash, compared with $28.7 million provided in 2021. Financing activities provided $289.1 million, including debt and ATM equity proceeds; total cash, cash equivalents, and restricted cash ended at $65.4 million. The cash-flow figures reflect investment funding and portfolio collections and should not be read as operating earnings.
Changes versus comparable periods
- Q3 investment income rose 20% year over year, principally reflecting higher average loan balances and higher benchmark rates. Q3 net investment income increased about 31%.
- Nine-month investment income increased about 6%, while net investment income rose about 15%. However, nine-month operations fell to $39.5 million from $170.4 million, mainly because the portfolio recorded $87.1 million of unrealized depreciation in 2022 versus $46.2 million of unrealized appreciation in 2021, and realized gains were much lower.
- Portfolio fair value grew to $2.826 billion from $2.435 billion at year-end 2021. Debt investments increased to $2.661 billion from $2.210 billion; equity and warrant values declined to $134.1 million and $27.2 million, respectively, from $184.7 million and $38.4 million.
- Debt principal outstanding increased to $1.542 billion from $1.250 billion at year-end. Hercules issued $350 million of 2027 notes, $150 million of 2031 asset-backed notes, and $50 million of 2025 notes, among other financing; it repaid the 2022 notes and convertible notes.
- The weighted-average debt portfolio core yield increased to 12.4% from 11.4% at year-end 2021; effective yield was 12.9%, unchanged. The 9-month market total return was negative 24.34%, versus positive 23.05% in 2021.
Liquidity, portfolio, and risk considerations
- Management reported $700.1 million of available liquidity, including $57.1 million cash, $443.0 million available under the MUFG facility, and $200.0 million under the SMBC facility. Facility availability is subject to borrowing-base and other conditions.
- Asset coverage was 199.4% excluding SBA debentures and 188.1% including them. The company reported compliance with borrowing arrangements. Most outstanding debt was fixed-rate; $127.0 million under credit facilities was floating-rate.
- About 95.1% of debt investments bore floating rates. Management’s sensitivity analysis estimated that a 100-basis-point increase in base rates would raise annualized net investment income by approximately $23.4 million, or $0.18 per share, assuming no other changes. Actual results may differ, and rising rates could also pressure borrowers.
- Unfunded commitments available at portfolio companies’ request rose to $659.0 million from $286.8 million at year-end 2021. The total excludes $203.2 million associated with Adviser Funds and commitments dependent on unmet milestones; some commitments may expire undrawn.
- Credit quality showed some deterioration: weighted-average debt investment grade moved to 2.20 from 2.10 (1 is highest quality). Grade 3 investments represented 31.1% of debt fair value, versus 26.3% at year-end. Non-accrual investments were 0.5% of portfolio amortized cost, down from 1.0%.
- Exposure is concentrated by sector: drug discovery and development was 38.6% of portfolio fair value, software 24.1%, and internet consumer and business services 17.3%. Eight portfolio companies each represented at least 5% of net assets; the largest, Corium, was 10.0%.
- Approximately 96.6% of total assets were investments whose fair values are determined through valuation processes; most portfolio investments are Level 3. Management cautions that fair values based on significant unobservable inputs may differ materially from realizable values.
Management outlook, distributions, and unusual items
Management gave no specific earnings or portfolio-yield guidance in the supplied filing text. It said it believed liquidity was ample for near-term requirements, while emphasizing uncertainty from market volatility, inflation, supply-chain disruption, geopolitical events, and the continuing effects of COVID-19. It is monitoring portfolio companies proactively; some borrowers may draw most or all of available revolving or delayed-draw commitments.
Q3 realized gains included gains from investment sales, offset by write-offs and losses; the nine-month period also included a $3.7 million loss on debt extinguishment. The 2022 portfolio’s unrealized depreciation was concentrated in equity, warrants, and investment funds, alongside depreciation in debt marks. Hercules also recognized $14.9 million of PIK income for the nine months; this is non-cash income that may nevertheless contribute to taxable distributions.
On October 13, 2022, the Board declared a $0.36-per-share cash distribution plus a $0.15 supplemental distribution, payable November 17, 2022. This completed the $0.60-per-share supplemental distribution declared earlier in 2022. The company’s variable distribution policy targets quarterly distributions approximating 90%–100% of estimated taxable income, but future distributions are not assured.
The filing states that current legal matters were not expected to materially affect financial condition or results, while noting outcomes cannot be assured. Disclosure controls were assessed as effective, with no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Review subsequent portfolio performance, borrower liquidity, non-accrual status, and realized collections—particularly among the largest exposures and lower-rated loans.
- Assess whether the $659.0 million of available unfunded commitments is drawn and how it is funded alongside planned distributions.
- Verify borrowing-base availability, asset-coverage headroom, debt maturities, and the cost and terms of facility borrowings.
- Examine the assumptions behind Level 3 valuations and whether the $87.1 million nine-month unrealized depreciation signals further mark risk.
- Track floating-rate income benefits against higher borrower stress and funding costs, including LIBOR transition provisions.
- Confirm the tax character and sustainability of distributions; the filing’s year-to-date tax characterization is not a guarantee of full-year treatment.