Hercules Capital, Inc. — Q3 2023 Form 10-Q
Business and period. Hercules Capital is a business development company (BDC) and regulated investment company (RIC) specializing in senior secured and structured loans to venture- and institutionally backed companies, primarily in technology and life sciences. This unaudited filing covers the quarter and nine months ended September 30, 2023; balance-sheet comparisons are with December 31, 2022.
Key financial results
| Metric | Q3 2023 | Q3 2022 | Nine months 2023 | Nine months 2022 |
|---|---|---|---|---|
| Total investment income | $116.7 million | $84.2 million | $338.1 million | $221.5 million |
| Net investment income | $76.8 million | $50.0 million | $218.0 million | $125.9 million |
| Net realized gains (losses) | $(2.6) million | $5.3 million | $5.6 million | $0.8 million |
| Net change in unrealized value | $(46.2) million | $(2.1) million | $(6.3) million | $(87.1) million |
| Net increase in net assets from operations | $28.0 million | $53.2 million | $217.3 million | $39.5 million |
| Net investment income per basic share | $0.52 | $0.39 | $1.53 | $1.01 |
- Q3 net investment income was approximately 66% of investment income, compared with 59% a year earlier; nine-month figures were approximately 64% and 57%, respectively.
- At September 30, total investments at fair value were $3.261 billion, up from $2.964 billion at year-end. Senior secured debt was 92.7% of the portfolio; 95.5% of debt investments had floating rates.
- Net assets were $1.652 billion and NAV was $10.93 per share, versus $1.401 billion and $10.53 at December 31, 2022. Common shares outstanding rose to 151.2 million from 133.0 million.
- Debt principal outstanding was $1.649 billion ($1.633 billion carrying value), compared with $1.594 billion principal at year-end. Regulatory asset coverage was 211.9% excluding SBA debentures and 200.0% including them.
- Cash and cash equivalents were $32.0 million, with $5.3 million of restricted cash. Management reported $598 million of available liquidity, including $175 million under the SMBC letter-of-credit facility and $52 million and $339 million of borrowing capacity under the SMBC and MUFG facilities, respectively.
- Nine-month operating cash flow was $(62.6) million, compared with $(359.9) million in 2022; financing cash flow was $74.3 million versus $289.1 million. Cash flow included substantial investment purchases and repayments. The filing reports $37.2 million of cash, cash equivalents and restricted cash at period-end.
Material changes and notable items
- Investment income increased year over year, driven mainly by a larger average loan portfolio and higher benchmark rates. Nine-month weighted average core yield was 14.2% and effective yield 15.5%; the filing’s comparative table reports 13.8% and 14.7% at December 31, 2022.
- Fee income more than doubled for the nine months, to $18.8 million from $9.1 million, largely reflecting accelerated fees on early repayments. Early repayments totaled $647.4 million for the nine months, compared with $242.4 million in 2022.
- Q3 operating expenses rose to $40.0 million from $34.2 million; nine-month expenses rose to $120.1 million from $95.6 million. Management cited higher debt costs and variable employee compensation among the drivers.
- Q3 unrealized depreciation was mainly associated with Convoy, downgraded to the lowest credit grade and placed on non-accrual. Hercules reported a $50.8 million quarterly change in Convoy debt valuation; its investment had $74.9 million cost and $24.6 million fair value at quarter-end.
- Non-accrual investments were 2.7% of portfolio cost, versus 0.6% at year-end. Tectura’s PIK portion was also on non-accrual; its debt fair value was $6.2 million.
- Available unfunded commitments were $400.6 million, down from $628.9 million at year-end. These may be drawn by portfolio companies, although some commitments can expire undrawn or depend on contractual requirements.
- Hercules issued 16.2 million shares in the first nine months for $238.3 million net proceeds, including an August offering of 6.5 million shares. The filing also notes authorization to issue shares below NAV through July 20, 2024, subject to conditions.
- Distributions declared for the first nine months totaled $1.42 per share. Subsequent to quarter-end, the Board declared a $0.40 base and $0.08 supplemental distribution, payable November 22, 2023.
Outlook, risks and contingencies
- Management said it believes liquidity is sufficient for near-term requirements, while noting uncertainty from inflation, higher interest rates, geopolitical events, supply-chain issues, banking-sector disruption and other macroeconomic developments.
- Most loans are floating-rate, but credit-facility borrowings are also floating-rate. The filing’s sensitivity analysis estimates that a 100-basis-point rate decrease would reduce annualized net income by about $22.9 million, while a 100-basis-point increase would raise it by about $12.3 million, assuming no other changes.
- Approximately 97.8% of total assets were investments, and most private-company holdings use Level 3 valuations based on significant unobservable inputs. Management cautions that actual realization values could differ materially from estimates.
- Portfolio concentration remains notable: six investments each exceeded 5% of net assets, with the largest, Axsome Therapeutics, at 9.6%. The ten largest portfolio companies represented 29.6% of investment fair value.
- The company disclosed ordinary-course litigation and does not expect current matters to materially affect results, but cannot assure that future effects will be immaterial. It reported compliance with borrowing arrangements and no defaults upon senior securities.
Important facts for investors to verify
- Whether Convoy’s non-accrual status and marked-down valuation, and the broader increase in non-accrual cost, lead to further credit losses.
- The sustainability of investment income and distributions, including the contribution from elevated rates, PIK income, and accelerated fees from early repayments.
- Portfolio fair values and sensitivity to credit deterioration, market yields, and other unobservable valuation assumptions.
- Liquidity and asset coverage under potential commitment draws, debt maturities, changing borrowing costs, and continued equity issuance.
- Potential dilution from share issuance, including any below-NAV issuance, and the coverage of distributions by taxable income and cash receipts.