Hercules Capital, Inc.

Today's conference is scheduled to begin shortly. Please continue to stand by. Thank you for your patience. Again, today's conference is scheduled to begin shortly. Please continue to stand by. Thank you for your patience. . . . Thank you. Ladies and gentlemen, take your stand by and welcome to Hercules Capital Q1 2021 earnings conference call. At this time, all participants are listened on the mode. Later, we will conduct a question and answer session and instructions will follow at that time. If anyone should require assistance during the conference, please press a star then zero on your touchstone telephone. As a reminder, this conference call is being recorded. I would now like to turn the call over to Mr. Michael Hara, Managing Director of Investor Relations. Please go ahead, sir.

Thank you, Charlie. Good afternoon, everyone, and welcome to Hercules Capital Conference call for the first quarter of 2021. With us on the call today from Hercules are Scott Blustein, CEO and Chief Investment Officer, and Seth Meyer, CFO. Hercules' first quarter 2021 financial results were released just after today's market close and can be accessed from Hercules' Investor Relations section at htgc.com. We have 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 and 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 and including, without limitation, the risks and uncertainties, including the uncertainty surrounding the current market turbulence caused by the COVID-19 pandemic and other factors we identified from time to time in our findings 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 on 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, please visit our website. And with that, I'll turn the call over to Scott.

Thank you, Michael, and thank you all for joining us today. We hope that everyone is staying safe and healthy. Q1 2021 was another strong quarter for Hercules Capital. We delivered solid operating results, strengthened and expanded our investment platform, and continue to emphasize credit discipline across our investment portfolio. Our investment team hit the ground running in 2021 with record Q1 performance for both gross new debt and equity commitments and fundings. Even as the population continues to progress with vaccinations, more states announce plans for reopenings, and the broader markets continue to show strength. We continue to conservatively manage the business by maximizing liquidity, staying disciplined on new underwritings, ensuring a strong balance sheet, and maintaining substantial operational flexibility. The public and private equity markets continue to perform exceptionally well. and an abundance of liquidity across our core markets requires us to prioritize prudent underwriting and investment discipline more than ever. Let me recap some of the key highlights of our performance for Q1. We originated nearly $531 million of gross new debt and equity commitments and delivered gross fundings of over $355 million. Our debt and equity commitments and fundings in Q1 were weighted towards new portfolio company relationships and were balanced nearly evenly between our core technology and life sciences verticals. We saw strength across each of our areas of focus during the quarter. As we saw throughout 2020, many of our portfolio companies continue to achieve certain performance and capital raise milestones during Q1, which allowed us to once again expand our lending relationships with several companies in our existing portfolio. Even though our new business originations were strong in Q1, we chose to stay disciplined and focused on strong underwriting parameters as an abundance of equity capital and loosely structured debt has continued to create certain challenges in terms of prudent new business origination. Our platform scale and brand reputation continue to give us exposure to an active pipeline that currently exceeds $1 billion of potential investments. The quality of the companies in our pipeline is the best that we have seen in some time, but we will continue to evaluate each opportunity with a focus on staying true to what has made us successful on a sustained basis over the last 16 years. Since the close of Q1 and as of April 27th, 2021, Hercules has already closed 135 million of new commitments, and we have pending commitments of an additional 152.9 million in signed non-binding term sheets. We expect the majority of our Q2 funding activity to be weighted towards the back end of the quarter. Through April 27th, 2021, our closed and pending commitments total 818.8 million, which puts us on pace to comfortably exceed over 1 billion of total new commitments for the fourth consecutive year. During Q1, we continued to see strength in terms of portfolio company exits and portfolio company liquidity events. This, combined with continued very strong performance across our portfolio, again drove high levels of early payoffs. Early loan repayments were at the high end of our guidance of $150 to $200 million at over $191 million. but decreased from 282 million in Q4. For Q2, we again expect prepayments to be between 150 million and 200 million, although this could change materially as we progress in the quarter. Even with the continued elevated levels of early payoffs, our strong fundings during the quarter produced net debt investment portfolio growth of over 82 million, after allocating over 47 million of new fundings to the private fund that we now manage through our wholly owned registered investment advisor. In Q1, we generated total investment income of 68.8 million and net investment income of 34.6 million, or 30 cents per share. The decline in both total investment income and net investment income was consistent with our guidance and due to the lower debt portfolio balance attributable to the record Q4 payoffs and lower fee income as a result of a lower level of prepayments during the first quarter. Our portfolio generated a GAAP effective yield of 13.2% in Q1 and a core yield of 11.6%, which was above the midpoint of our previous guidance for 2021. With net regulatory leverage at a very conservative 83.5% and continued robust liquidity across our platform, we remain very well positioned. Credit quality on the debt investment portfolio again improved in Q1 with a weighted average internal credit rating of 2.01 as compared to 2.16 in Q4. This was our strongest internal credit rating since 2011. and it speaks to the strength that we are seeing in our core markets. Overall, our grade one and grade two credits increased to 79.6% in Q1 versus 68.7% in Q4. Grade three credits decreased to 19.5% in Q1 versus 29.7% in Q4. Our rated four and five credits made up 0.9% of the entire debt portfolio fair value. In Q1, we had four debt investments on non-accrual with a cumulative investment cost and fair value of approximately $24.1 million and $8 million, respectively, or 1% and 0.3% as a percentage of the company's total investment portfolio at cost and value, respectively. As a result of continued strong performance across our portfolio, the exceptionally strong equity capital markets, and robust exit and IPO activity, our Q1 net asset value per share increased by nearly 1% to $11.36. We ended Q1 with strong liquidity of $550 million. which provides us with substantial coverage of our available unfunded commitments of $258 million and the ability to fund our ongoing anticipated business activity. Overall, we believe that our balance sheet is exceptionally strong and well-positioned. The venture capital ecosystem continued to exhibit strength in Q1 after a record year in 2020. For Q1, venture capital funds raised a total of $32.7 billion and invested over $69 billion in the US, according to data gathered by PitchBook and the NVCA. The overall vibrancy of the VC ecosystem has continued to positively impact our portfolio. As of the most recent data that we have, we estimate that approximately 80% of our portfolio continues to have at least 12 plus months of current liquidity. And since just our last earnings call, we've had an additional 12 of our debt portfolio companies raise new capital, totaling over $655 million. Year to date, we have had four new M&A events, two of which have closed, and seven companies that have either filed registrations for their initial public offerings or have agreed to SPAC transactions. In addition, several of our companies are currently working on either new capital raises or strategic transactions, and we expect M&A and IPO SPAC activity to remain strong over the next few quarters. I would also like to discuss our supplemental shareholder distribution program for fiscal year 2021. In addition to our ninth consecutive quarterly cash distribution of 32 cents per share, We are also declaring a supplemental distribution of 28 cents per share for fiscal 2021, which will be distributed equally at 7 cents per quarter for the next four quarters, beginning with the first quarter distribution payable in May 2021. As of Q1 2021, we have generated undistributed earnings spillover of approximately 109.1 million. or 94 cents per share, subject to final tax filings. This provides us with additional flexibility with respect to our variable-based distribution going forward and the ability to continue to invest in our team and platform. Finally, I would like to briefly touch on the progress that we made in the first quarter in terms of strengthening and expanding our investment platform. After establishing Hercules Advisor as a wholly owned registered investment advisor in 2020, we are very pleased to have raised and closed our first institutional private credit fund. Having this first fund and potentially future funds gives us the opportunity to expand and diversify our investment platform while enhancing our level of service and capabilities to our current and future venture growth stage companies. While we anticipate that it will take time to ramp up our activities under our RIA, we do expect that over the short term, Hercules Capital will benefit from being able to share certain expenses with Hercules Advisor and having a more diverse platform for the funding of new investments. Longer term and subject to the ultimate performance and size of the funds managed by Hercules Advisor, We expect Hercules Capital to potentially benefit from distributions from the advisor as that business ramps up. In closing, our employees have continued to work tirelessly to ensure that Hercules Capital remains the premier provider of growth capital to venture and growth stage companies. I am grateful and thankful to each of them for their work, effort, and commitment. I would also like to thank each of our 100 plus portfolio companies and their institutional investors that have chosen to make Hercules Capital their preferred financing partner. I will now turn the call over to Seth.

Thank you, Scott, and good afternoon, ladies and gentlemen. As Scott mentioned, the investment team gave us a great start to 2021. This was another very strong commitment and funding quarter for Hercules. We were able to grow the loan book by 82.5 million at cost during the quarter, which allowed us to replace a portion of the portfolio decline from Q4, which was the result of elevated prepayments during the prior quarter. We delivered total investment income of 68.8 million and once again had NAV appreciation per share triggered by the strength of our portfolio and the broader market. our early payoff levels reduced to $191.5 million, which was again elevated but within the guidance range. During Q1, we successfully closed our first private fund, and as a result, we allocated a portion of certain commitments and fundings to the initial private fund. This also allowed us to allocate certain expenses to Hercules Advisor, our RIA managing the private fund during the quarter. Net of allocations to the initial fund, the healthy loan growth helped our total investments grow by $88.4 million to $2.4 billion at cost. As usual, I'll focus on the following areas, income statement performance and highlights, NAV, unrealized and realized activity, leverage and liquidity, and then finally, the outlook. With that, let's turn our attention to the income statement performance and highlights. Net investment income was $34.6 million or 30 cents per share in Q1, a decrease compared to the prior quarter attributable to the elevated early repayments in Q4 2020. Total investment income was $68.8 million, a decrease compared to the prior quarter. The main driver for the decrease to the total investment income was lower interest and fee income as a result of the higher payoffs and related portfolio decline experienced in Q4. Our effective and core yields in the first quarter were 13.2% and 11.6% respectively, compared to 13.3% and 11.8% in the fourth quarter. The quarter yields were largely in line with the prior quarter with a slight decline in the core yield due to a modest decrease in income from expired, unfunded commitments. Turning to expenses, our gross operating expenses for the quarter increased to $35.1 million compared to $33.2 million in the prior quarter. Net of costs recharged to the RIA, our operating expenses were $34.2 million. Interest expense and fees increased slightly to $17.5 million from $17.2 million in the prior quarter due mainly to the acceleration of fee recognition for the partial pay down of the SBA debitors and securitizations due to the reinvestment period ending for those instruments. SG&A expenses increased to $17.6 million from $16 million in the prior quarter The increase was driven by higher compensation expenses related to the increase in fundings and first quarter payroll taxes, which normally run higher in the first quarter. Net of costs recharged to the RIA, the SG&A expenses were $16.7 million. Our weighted average cost of debt was 5.5%, which represented a small increase compared to the prior quarter, driven by additional fees associated with early debt retirements from both our securitizations and SBA debitor loan repayments. The adjusted cost of debt, excluding fee acceleration, was consistent with the prior quarter at 5.1%. Let's now switch to NAV unrealized and realized activity. During the quarter, our NAV increased by 10 cents per share to $11.36 per share. This represents an NAV per share increase of 0.9% quarter over quarter. The main driver for the increase was the net change in unrealized appreciation of $21.9 million after reversal of prior unrealized appreciation of $7 million, mainly due to investments disposed or written off. million of net change in unrealized depreciation was primarily driven by the mark-to-market of our equity and warrant portfolio, which contributed $13.8 million of the movement. Our debt portfolio also benefited from declines in market yields, contributing $8.1 million of the appreciation. The net realized gains in the quarter of $7.8 million, comprised of $8.8 million of net gains from the disposal of equity positions, offset by $1 million of realized loss pertaining to one loan position. Moving on to discuss leverage. Our gap in regulatory leverage was 94.6% and 89.2%, respectively, which decreased compared to the prior quarter due to the partial repayment of the two securitizations, which are now in runoff. Netting out leverage with the cash on the balance sheet, our gap in regulatory leverage was 88.9% and 83.5%, respectively, putting us in a very strong position heading into the next quarter. Our leverage includes the March issuance of 50 million five-year notes in a private placement with a fixed coupon of 4.55%. This was the second tranche of the arrangement announced in November 2020, totaling $100 million in private placement financing. In addition, we have started to utilize our third SBA license, drawing down $37.5 million of debitures and an attractive annual interest rate of 0.77%. As a result, we ended the quarter with strong liquidity of $550 million, This excludes the additional amounts available via our new SBA license, as well as capital raised by the RIA. As a reminder, our liquidity continues to be enhanced by our normal course monthly principal and interest collections, as well as early repayments. Finally, on the outlook points, our core yield guidance of 11 to 12% continues to apply for Q2 2021. For the second quarter, we expect SG&A expenses of $16 to $17 million, slightly below the prior quarter, as Q1 always has higher employer payroll taxes. We expect our second quarter borrowing costs to decrease modestly. This is dependent on whether early repayments are heavily weighted to portfolio companies assigned to the two securitizations, which are now in natural runoff, and trigger an increased capitalized fee recognition. We have assumed a normal weighted allocation to the securitizations. Although very difficult to predict, as communicated by Scott, we expect $150 to $200 million in prepayment activity in the second quarter. Now that the RRA is operational and managing outside capital, we anticipate being able to allocate expenses to the RRA on a go-forward basis. For the second quarter, we expect a similar level of expense allocation to what we saw in Q1. In closing, we are pleased with the start of 2021 and look forward to building on the success of the quarter. We continue to focus on the things that we believe will position us best given the current operating environment. I will now turn the call over to Charlie to begin the Q&A portion of our call. Charlie, over to you.

Thank you, sir. Ladies and gentlemen, if you have a question at this time, please press a star, then the number one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, press the pound key. Please limit your question to one and one follow-up. Your first question comes from the line at Vignon O'Shea with Wells Fargo Securities. Your line is now open.

Hi, everyone. Good afternoon. First question on the RIA question. Scott, I saw there were some drop-downs into that vehicle over the quarter. Can you provide some color on, you know, if that was just a startup-type transaction or if that will be ongoing? And then for that matter, how different will the strategy of the private funds or at least this one be versus Hercules BDC?

Sure. Thanks, Finn. We're only going to speak to this fund because that's the one that has been raised and is currently being invested out of. What you saw in Q1 was essentially an allocation of certain of the HTGC commitments and fundings to the private fund. We would anticipate that you will continue to see that to a varying degree on a go-forward basis, on a quarterly basis. You know, the reasons and the drivers for that can vary on a quarterly basis. It could be diversification. It could be the size of the deal. It could be industry or concentration issues. But we would anticipate that parts of certain deals will continue to be allocated to the private fund on a go-forward basis. And we would also anticipate at the same time that the private fund will do certain transactions on its own that will not be originally originated or funded from the HDGC business.

Okay. And just to be clear, those were new origination co-invests rather than existing issuer drop-downs?

Correct. Those were new commitments and new fundings in Q1 that were allocated to the private fund.

Okay. Thank you. And then just a second on expenses. I think Seth said there was a payroll taxes were up. Is that, was that most of the, the driver versus can you kind of break that down between, you know, larger AUM you know, market costs in general and what, you know, if we can expect any change in the expense rate going forward, overall compensation and such.

Yeah. So it, The expenses were mainly up related to the increase of the funding spend. So that was a pretty significant jump quarter on quarter. The payroll taxes will run off as they regularly do. Q1 is always a higher employer payroll tax quarter than the rest. And for the guidance going forward, really we can only say 16 to 17 million for Q2, and beyond that, we'll give guidance as we get closer.

Okay, great. That's all for me. Thanks so much.

Your next question comes from the lineup Kristen Love with Pfeiffer Sandler. Your line is now open.

First, can you give a little more color on the credit quality trends that you've been seeing? The 2.01 grade for the portfolio is the best quarterly metric that I think I have on record in my model. So what did you see that drove it significantly lower during the quarter, and I guess just what has changed versus recent quarters?

Sure. Thanks, Kristen. Yeah, I think it's two things. Number one, it's just the overall strength from a portfolio perspective that we're seeing here. most of which is attributable to liquidity. As we've kind of highlighted on the last several earnings calls, we've had more and more companies raise larger and larger rounds of financings. Several of our companies continue to have right now record liquidity. And so if you look at the migration that we sort of show on a quarterly basis, when we started Q1 of 2020, which is sort of the first quarter of the COVID pandemic, we had a weighted average credit rating of roughly 2.34, and then we've had now four consecutive quarters of improvement. In Q1, we were down to 2.01. The two biggest drivers were an increase in the rated one credits. Those are the companies that are either abundantly capitalized or performing well above our expectations. And the second driver was a reduction in the rated three credits, Those are the companies that are contemplating or are about to raise equity capital. And then our general philosophy is once those companies raise capital, we upgrade them either to a rated two or rated one. So those were the two biggest drivers. And I think it just speaks to the tremendous job that our team has done in terms of identifying the right opportunities to invest in and the strengths that we're seeing across the portfolio.

Okay, great. Thanks. That's helpful. One more from me. Yeah. Can you just talk about some of your recent investments? I think you said that they were geared towards new relationships. I'm curious that what caused that, that it's more for a new relationship? Does that have to do with recovery and reopening and changing the way that your diligence process is going? Or is it just more comfortable with kind of the diligence process that you've had for the last several months during the pandemic?

Sure. I think the credit really goes to our investment team. We've just seen tremendous performance from both our technology team and our life sciences team, and we're seeing it across the venture and the growth stage parts of our markets. Our team has done a great job in terms of building and expanding our pipeline. I made the comment that our pipeline right now is over a billion dollars. And from a quality perspective, we think it's the strongest pipeline that we've seen from a quality perspective in some time, both on the technology and on the life sciences side. And I think the team has been very aggressive in terms of trying to pick the ones that we want to go after and then finding creative, flexible solutions that allow us to get deals done with those companies. And that's what you saw in Q1. We had strong funding and commitment performance, both with respect to new portfolio investments and existing portfolio investments. But as we mentioned in the call, the numbers were weighted more towards new investments in Q1.

Your next question comes from the line of Devin Ryan with JMP. Your line is now open.

Good evening, everyone.

Evening.

So most of my questions have been asked. Maybe one just on the SPAC market. It's starting to hit a little bit of indigestion and, you know, some maybe additional SEC scrutiny. So I'm just kind of curious how that may be affecting things at all with the Some of the companies kind of in process, not sure if that slows things down. Are there any other considerations or, you know, things that you guys have to plan for just with some of the developments in the stock market, but bigger picture kind of just your expectations going forward?

Sure. We're certainly monitoring the SPAC market pretty closely, and I think it's fair to say that there has been a little bit of a slowdown here over the last 30 to 60 days. There's a backup in terms of filings. There's a backup in terms of SEC review. The SEC is raising some new issues now, primarily around accounting related to legacy warrant positions that is is creating some issues for certain companies. I would tell you that within our portfolio, we have not seen much of a slowdown at all. Right now, we have five companies that have announced SPAC transactions that are in process. All of those remain in process as of the current date, and we're aware of several other additional portfolio companies that are on active conversations, force-back transactions. So, you know, we're monitoring it. We are aware of a broader slowdown in that market, but we have not seen that impact our portfolio yet.

Okay, terrific. And just a quick follow-up on institutional private credit fund, obviously, congratulations on that. And If you can, what is the size of that and then just expected kind of investment cadence? Any other color you can give on that would be helpful.

Sure. So it's a non-registered institutional private credit fund. We're not going to disclose the size of the fund at this time, at least for the initial fund. As that fund ramps up, we will make disclosure around what level of AUM the RIA is managing and I think the bigger picture comment that I would make is that this initial fund gives us several hundred million dollars of additional dry powder to invest with. We expect the private fund, the first one, and potential future funds to be very accretive to the Hercules platform. It should give us the ability to go after larger transactions. It should give us the ability to go after select smaller transactions. It should give us the ability to offer some differentiated structures and differentiated pricing models, and it should also, over time, give us the ability to explore some new verticals to potentially expand into as well. So it's something that we've been working on for a number of years, and it's something that we're very excited about in terms of diversifying and expanding the HDGC investment business.

Yeah. Okay, great. Well, congratulations, and I appreciate you taking my questions.

Sure. Thanks.

Your next question comes from the line of Ryan Lynch with KBW. Your line is now open.

Hey, good afternoon, guys. First one, I just had another one on the private fundraise. Can you just talk about what is that strategy comparative to the strategy at HTGC? And what I'm getting at is if the strategy is somewhat different from In what ways and what sort of new deal opportunities will that open up? Or is it basically the same strategy that you guys currently run at HTGC that will just allow you to take down larger commitment sizes to your potential borrowers?

Sure. Ryan, I think the answer is it's both. Initially, it's more ancillary and complementary to the existing investment strategy. You know from having covered us for a number of years, there are certain restrictions that we have to deal with being an internally managed BDC. Having this private credit fund will allow us to manage and potentially mitigate some of those challenges and historical issues that we've had in terms of diversifying and growing and expanding the platform. Over time, we would expect the private credit fund business to allow us to potentially go into new asset classes, new verticals. But at least initially, I think what you're going to see is that the investment strategy is very ancillary and very complementary to what we're doing. And it will allow us to just take advantage of opportunities that we may otherwise not be able to do because of the internally managed BDC structure.

Okay. Understood. You mentioned a really strong pipeline, billion plus of deals. You also said these are very high quality companies in that pipeline. I guess, what are the characteristics that you guys use that determine what sort of company or potential deal could go into your pipeline? Are these just strong companies that could use debt financing? Are these conversations you're already having just because With the amount of capital that's been raised in the venture ecosystem, as well as the valuations in that space, it seems like equity financing could be a very big competitor to the venture debt side. And so when we're just talking about a big pipeline and a pipeline of really high-quality companies, What's the chance that, you know, a good deal of those companies, you know, go the equity route versus the venture debt route, given the background?

It's a great question, Ryan. And, look, there's no question, and we've said this now for the last two or three calls, that, you know, our biggest competitor right now in the market is the equity markets, both from a public perspective and from a private round of financing perspective. I would also say, and we've seen this over the years, You know, the companies that we are investing in are continuing to burn capital. They are continuing to invest in growth. And they have a voracious need for capital. So, yes, we are competing with equity right now at a pretty aggressive state. Yes, a lot of these companies are continuing to raise meaningful rounds of capital. But in many cases, the companies still choose to supplement that equity with structured debt as long as it can be structured and priced appropriately. And I think that's what our team is spending the majority of their time doing, looking at these quality opportunities that are well capitalized, that may have raised equity capital recently, and trying to find creative, flexible, custom-tailored solutions that work for both sides. And I think that's what you're going to continue to see from us. In terms of what we include in that pipeline, we have an internal system that we use to sort of track opportunities. And the companies that we include in that pipeline number are are companies that are in markets or sectors that we are interested in pursuing, companies that are backed by institutional investors that we are comfortable working with, companies that are looking to raise debt capital, and companies that we have had at least one conversation with where we believe it's a viable opportunity.

Okay. That's really helpful, Culler. That's all from me. I appreciate the time this afternoon.

Sure. Thanks, Ryan.

Your next question comes from the line of Sarkis Serbichan with B. Riley Securities. Your line is now open.

Good afternoon, and thanks for taking my question here. Just wanted to touch on origination activity for the second quarter. Do you think that's going to be in line with first quarter levels? And how do you expect the cadence of originations to play out as we think about that billion-dollar pipeline you mentioned throughout fiscal 21?

Sure. So, you know, we're not going to provide any Q2 guidance in terms of fundings or commitments. You know, in the subsequent events disclosure, we obviously highlighted the fact that we've already closed $135 million of commitments quarter to date through April 27th. We have another $153 million that are signed non-binding term sheets. That gets us to approximately $819 million of closed and pending through April 27th. With our pipeline, we feel pretty optimistic that Q2 will be another strong quarter from a fundings and commitments perspective. But where we end up in the spectrum of numbers, I think, is still to be determined. Our focus is on quality. Our focus is on making sure that the documentation is appropriately structured and documented. And, you know, sometimes things slip quarter over quarter. So I think, you know, we don't manage the business on quarterly fundings or quarterly commitments, but I think that pipeline gives us tremendous confidence in terms of our ability to have a very strong year in terms of commitments.

No, great. Thanks for that. I just want to have a follow-up here on the advisor. Maybe if you can speak to the planned plan. economic contribution to the BDC, you know, in terms of maybe fee income generation and at what point or at what scale would you feel comfortable providing us with more metrics along those thoughts? Thank you.

Yeah, sure. So initially we expect that the main contribution will be the cost sharing. Like you saw in Q1, it was about $900,000, so just under a million. We would expect in Q2 a similar amount allocation of costs. Maybe towards the next midpoint of 2022, we would hope, based on the amount of funds that we raise, based on the performance of the fund, that we might see some dividends start accruing to the BDC. But it'll take time to generate enough fee income to cover the costs that are being allocated and then eventually a dividend stream to the BDC. But that's the way I would think about it initially as a cost reimbursement, a cost sharing that's going to happen, and then eventually a dividend stream.

Great. Thank you.

Your next question comes from the line at Casey Alexander with CompassPoint. Your line is now open.

Good morning. Yeah, that's a lot of my questions, but I do have two here. One is that the RIA is showing a value of $9.8 million with no cost basis in the schedule of investment. So I'm just curious how that value was arrived at.

Yeah, sure. We went through a discounted cash flow analysis based on the way that we see the fund developing as originations occur and allocations occur. And really going back to the prior question, Casey, of when we expect dividend flows to occur. And so we did a discounted cash flow analysis based on the first fund that we've raised, and that was the result of it. And then we did a comparison of other RAA valuations that are publicly available that we could compare it to and made sure that it made sense.

Okay, so this is done with a DCF based upon your sort of expectation of filling out the portfolio and the fees that will eventually be generated. So we shouldn't look for a great variation to that number until there are other funds that are being managed by the RIA. Is that correct?

That's precisely right, Casey. That's a good analysis.

Okay, great. My second question is... You know, given that the net originations after the prepayments for the quarter were about $157 million, so about 30% of the net originations went into the external funds, which seems like a large amount, but I don't know how large the fund is, capital that is committed to the fund relative to the size of the Hercules portfolio. So I'm curious. what the allocation policy is because when you have a co-investment vehicle, my understanding is that you need to have some sort of a stated allocation policy.

Sure, Casey. So we've adopted a fairly conservative equal footing allocation policy. Deals will be allocated primarily based on available liquidity and but we do have the flexibility and the ability to change that depending on diversification sector and overall investment strategy and focus. I would also just point out, I think your 30% number is just, it's certainly higher than the way we think about it and the way we're looking at it. You know, we look at the new fundings in the quarter of roughly $350 million. about 47 million of the fundings were allocated. So, you know, you're about 10% to 15% versus the 30% that you were speaking to in your comments.

Right, but the new fund doesn't have any prepayments coming back to it. Okay, so in essence, you know, I understand it's getting only 15% of the new fundings, but it is drawing – investments away from the BDC itself?

Sure. It is on an initial basis as it ramps up, potentially taking some investments away with the two caveats that we mentioned before, that number one, there are a lot of deals that we're now able to do at the BDC level that we probably could not otherwise have done if we didn't have the private vehicle to be investing alongside us. And then number two is This is not an externally managed private fund. This is a private fund that's managed by a wholly owned RIA, so 100% of the benefit from the RIA activities accrues and accretes to the shareholders of the public BDC.

Okay, great. All right, I appreciate you taking my questions. Thank you.

Your next question concerns the line of Christopher Nolan with Ladenburg-Tolman. Your line is now open.

Hi. Quick question on the RIA again. How much leverage are you going to look to run that entity with?

So we're going to target a leverage ratio of one to one over the life of the fund.

Gotcha. And why declare the full supplemental dividend in the first quarter?

It's something that we've talked about on the last couple of calls, and I think we stated pretty clearly on the Q4 call that one of our goals was to establish a policy for 2021 that provided a little bit more clarity and continuity to our shareholders with respect to that base distribution. We thought that the 28 cents was an appropriate number given two things. Number one, we are still sitting on a record level of spillover at 94 cents. And number two, our confidence in the trajectory of the business for the course of 2021. And based on those two things, we thought that it was more appropriate for us to declare the 28 cents, give our shareholders sort of consistency and comfort that it would be 7 cents per quarter versus what we've done for the last two years, which is in six of the eight quarters declare supplemental distributions on a quarterly basis. This just provides a little bit more visibility and a little bit more clarity to our shareholders, which we think is an important thing to do.

Finally, the Biden administration has discussed significantly increasing the capital gains tax. if what they outlined were to become law, what would you think that would be the impact on the venture debt market and also on HTGC specifically?

Yeah, I don't think you'll see much of an impact, honestly, with respect to HTGC. I think there could be a little bit of an impact from a negative perspective on sort of not just the venture debt market, but I think the broader kind of growth markets. So it's still very early. These things change a lot. It has to go through a process, and I think it's still very much TBD in terms of how it will play out from an overall tax reform perspective. It's something that we're watching. We don't think it has a material impact on our business or our markets, and we'll just watch it closely over the next couple of quarters. Okay. Thanks, Scott. Sure.

Your next question comes from the line of John Heck with Jeffries. Your lines stand open.

The last question was similar to what I was going to ask. But one thing I'll ask is, given kind of, I guess, what we've observed over the last year and, you know, living through the pandemic, Scott, is there any kind of change in what you think your opportunity set is for focusing on within the portfolio investing versus, you know, biotech versus other channels of technology? Or do you think it's going to be pretty consistent going forward?

I think it's pretty consistent. The way we built this business, it's with a focus on diversification, and I think that's what's made us successful. We have the ability to focus on life sciences. We have the ability to focus on venture technology. We have the ability to focus on later stage sponsor-backed technology transactions. Having the ability to do all three of those things is a tremendous competitive advantage. And we're going to continue to sort of focus on making sure the business is broadly diversified and that we have the ability to outperform irrespective of what's going on from a macro perspective.

Perfect. Thanks very much.

Sure. Thanks, John.

Once again, if you would like to ask a question, please press star 1 on your telephone keypad. Your next question comes from the line of opinion, O'Shea with Wells Fargo. Your line is now open.

Hi, guys. Just a follow-up on your dialogue with Casey a moment ago. On the allocation policy on the RIA, I think you said it would be based on liquidity. My understanding is that the convention is co-investment is based on allocable capital that's leveraged rather than, you know, cash available at any given fund, you know, where a newer fund might be advantaged. So is that the case? Is that why the new fund got so much allocation, or is it normal as described?

Yeah, I think it was, again, I think it was fairly normal. You know, it was about 10% to 15% of the gross fundings of the business. It was not every deal being allocated. It was done pursuant to our board-approved allocation policy where the primary driver is available liquidity across both of the vehicles. And, again, you know, I wouldn't look at it as, you know, it's deals being taken away, right? In most cases, these are deals that the BDC would have issues or challenges with doing on its own. And now that we have the vehicle, we're able to do these things that otherwise we likely could not have done.

okay that's helpful thank you sure thanks man once again if you would like to ask a question please press star 1 on your telephone keypad and we have no further question at this time presenters please continue thank you operator and thanks to everyone for joining our call today

We look forward to reporting our progress on our next Q2 2021 earnings call. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.