Michael Hara - Senior Director of IR Manuel Henriquez - Co-Founder, Chairman, CEO and President Gerard Waldt - Controller.

John Hecht - Jefferies LLC Henry Coffey - Wedbush Securities Ryan Lynch - KBW Jonathan Bock - Wells Fargo Securities Timothy Hayes - FBR Capital Markets & Co. Casey Alexander - Compass Point Research & Trading.

Good day, ladies and gentlemen, and welcome to the Hercules Capital Q3 2017 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host for today's call, Mr. Michael Hara. You may begin..

Thank you, Marie. Good afternoon, everyone, and welcome to Hercules' conference call for the third quarter 2017. With us on the call today from Hercules are Manuel Henriquez, Founder, Chairman and CEO; and David Lund, Interim Chief Financial Officer.

Hercules' third second quarter 2017 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 on Hercules' web page 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 those forward-looking statements, including, without limitation, the risks and uncertainties, including the uncertainties surrounding the current market turbulence, and other factors we identify from time to time in our filings with the Securities and Exchange Commission.

Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can be proved 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.

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 sec.gov or our website, htgc.com.

With that, I will turn the call over to Manuel Henriquez, Hercules Chairman and Chief Executive Officer..

Thank you, Michael, and good afternoon, everyone, and thank you for joining us today for the Hercules Capital third quarter 2017 earnings call. I would like to say welcome back, David Lund, for the many years of service you provided us and recognition of having you come back as our Interim CFO.

For those of you who may recognize David Lund's name, David was our former CFO from the IPO back in 2005 through 2011, where he oversaw a period of tremendous growth for Hercules Capital, which included the difficult period of time during the whole global credit crisis of 2008-2010, where he did an amazing job during a challenging period for the entire industry, if not the world.

I am delighted to have a trusted, seasoned and experienced executive such as David and a confidant that I have with David as our interim CFO in conjunction with working with Gerard. David will oversee our outstanding accounting and finance department, along with Gerard.

David's prior knowledge and experience with Hercules Capital became the logical choice to help us oversee during this transition period and, most importantly, the integration of our new acquired loan portfolio, as well as help oversee the other potential acquisitions that we're currently evaluating and reviewing as we continue to focus on growth of the overall company.

David, thank you and welcome back as our interim CFO.

During today's call, I will be discussing the following items, an overview of our strong financial results and selected achievements during the quarter; our recent acquisition of the Aries Capital Venture lending portfolio; our successful and oversubscribed inaugural investment-grade institutional bond offering of $150 million; a quick summary of the select venture capital marketplace activities; and conclude with a brief outlook for Q4 2017 and the first half of 2018.

We will then conclude after Gerard's remarks a brief Q&A session. And of course an update on where things stand regarding our externalization and strategic analysis. So let me first address the issue that has been on many of our shareholders' and bondholders' top of mind over the past few weeks and months.

We have been touring the country visiting with many of you our shareholders and our bondholders, including industry analysts. I'm very grateful for the candid and direct feedback that we received during this process and I found the process to be a sometimes difficult but a very, very important process of getting to the right answer.

Effective immediately, and after an extensive strategic evaluation process that included countless discussions with various shareholders evaluating multiple different strategic alternatives and options and analysis, working with our outside advisers and independent board of directors, we have concluded that the best course of action for Hercules is to remain an internally managed BDC and thereby cease pursuing for the foreseeable future the externalization process.

We derive that conclusion given much of the market changes that we're seeing tin the marketplace today.

We think that the externalization process will continue to be a distraction from the core business which happens to be improving and showing very strong signs as indicative with the recent acquisition and the financial results that we'll cove duding this call.

In fact, we are beginning to see improving signs across many key leading indicators in our business. We are encouraged with what we're seeing but need to be monitoring to ensure that what we're seeing truly leads to a trend and not just simply a blip in the quarter.

At this point, the trending seems to be taking shape and pointing in the right direction. For example, we're seeing favorable and improving trends that include, but not limited to, rising core yields. Many of you may recall that in Q2 we indicated that we expected Q3 yields to drop down to around 11 to potential 11.2%.

You will soon see that those yields rose higher than we anticipated, to 11.6&. We are also witnessing increasing net asset value.

We're beginning to see net loan portfolio growth as we continue to work hard to stay ahead of early repayments and as loan repayments are beginning to show signs of slowing and ebbing, which will eventually lead to portfolio growth, which is optimistic as we look at Q4 and 2018.

We're also seeing a dramatic improvement in our credit outlook and performance as evidenced by our historical low and the fact potentially record low non-accrual level rates that we've had.

In fairness to the non-accrual statement, the non-accruals were clearly impacted favorably by the write-offs of 2 older legacy loan that were previously depreciated and already included in our net asset value that we realized in the third quarter. Over all, you have seen a consistent strong credit performance over our 14-year history.

And in fact, I'm proud to say that cumulatively our net losses throughout that same period of time are just under $30 million, against a backdrop of over $7 billion of commitments that we originate through the same period.

Lastly, we are seeing encouraging signs of an improving competitive landscape as many of the existing venture lenders continue to struggle for portfolio growth and deal flow. Our team does not have that problem. We continue to see robust deal transaction ad deal volume as evidenced with the numbers that we'll run through shortly on this call.

Our focus remains to be one of the top performing BDCs. This is something that our shareholders strongly emphasized of our historic strong credit performance and performance as a BDC.

It is important that I share with our shareholders that we heard you loud and clear and, with that, we took these comments seriously and to heart as we evaluated multiple strategic options.

This is why I'm proud to say and confident to tell you that remaining internally managed for the foreseeable future is the right strategy and will lead to continued shareholder growth.

After which I will turn the call over to Gerard to cover in more detail the financial results and specific details of our accomplish from our financial performance in Q3. Now externalization.

I had previously indicated in my opening remarks now that externalization is behind us, we will continue to operate for the foreseeable future and since we have since inception as an internally managed BDC.

I want to thank many of our shareholders whom we met with over the past several months who shared their views, concerns and constructive ideas son the subject of externalization, as well as strategic commentary that we received from you. I am deeply grateful for the many kind words of recognition, many of you shared during these discussions.

Some of these discussions were very difficult, but I'm still grateful nonetheless for your candor and providing your insight and support and allowing to draw the appropriate conclusion that we have done regarding our status to remain internally managed.

We shared your feedback with our independent directors and their respective financial and legal advisers, culminating in a decision to remain internally managed.

We do not intend to pursue externalization for the foreseeable future and will revisit as the market changes positive or I do not anticipate that occurring for some foreseeable time and, certainly not throughout 2018. With that said, let me get started on how we continue to build and realize value for our shareholders.

Many of you are probably aware early this morning we announced that we have successfully acquired the venture lending portfolio of Aries Capital for approximately $125 million in cash.

The acquisition complements our slow and steady growth strategy in delivering further growth and net investment income to our shareholders, the portfolio acquisition demonstrates a continuous efforts to explore unique investment opportunities that may lead to further expanding our growing market leadership position, scale within the venture lending marketplace, while enhancing and diversifying our overall debt investment portfolio through a disciplined and accretive growth strategies such as this acquisition.

The acquisition follows on the heels of our first inaugural investment grade institutional bond offering of $150 million at 4.625% for notes due on 2022.

the offering further demonstrates or critical important access to a wide variety of capital market liquidity sources to fund the growth of our investment portfolio while also optimizing our balance sheet while lowering our overall cost of borrowing to ensure healthy gross margins to run our business and lead to continued dividend and dividend growth and support.

Gerard will cover the projected accretive benefits of the portfolio acquisition to earnings, as well as the one-time and non-cash charge associated with the retirement and issuance of our new investment-grade bond offerings which are replacing our older and more expensive 6.25% coupon bonds that have an effective rate or cost of capital of approximately 6.6%.

Now to turn my attention to our accomplishments in Q3. We delivered another strong seasonal quarter, with net investment income, or NII, of $0.29 per share and DNOI of approximately $0.31 per share for the third quarter.

This is an outstanding achievement that was made possible by the hard work and dedication of our origination team and business development teams who delivered another impressive performance. With $164 million of new commitments in Q3, which is typically our seasonal slow quarter of the year, the team outperformed itself with $154 million.

Not being left behind, gross fundings were equally as strong. We saw gross fundings in the quarter of $147 million for the third quarter ending September 30, 2017.

with over $164 million in new commitments this quarter, I am very pleased to report that we surpassed yet another important benchmark or milestone and that is we have now originated over $7 billion of total new commitments since our inception in December 2003 to over 375 disruptive, innovative venture capital-backed companies.

As one of the founders of Hercules Capital, this is an important and impressive milestone and one that we are very proud to have achieved, as it reflects our world-class team and industry-leading franchise that we have built over the past 14 years.

As the BDC industry begins to show signs of consolidation, scale has become paramount, especially in the direct private lending world as it affords many advantages and multi-facets of business that so skill smaller BDCs are unable to realize or accomplish.

We enter Q4 2017 with a very strong and healthy loan demand and activity amongst our current and prospective portfolio companies as demonstrated by our total new commitments in the year of over $0.5 billion to $551 million of commitments realized in the first three quarters of the year, culminating in over $487 million in gross new fundings for the first 9 months of 2017, putting us on pace for another strong and potential record year of new originations.

Further evidence in the growing demand of our healthy is evidence of our healthy demand for new transaction is our pipeline. We are entering Q4 with approximately $1 billion of transactions of potential companies seeking capital from us. Now for some key highlights and achievements during the quarter.

In an environment where origination activity continues to be challenging for many BDC peers, coupled with tightening credit spreads, margin compressions, increased levels of early loan repayments, the Hercules Capital direct lending platform continues to prove its resiliency and strong brand recognition amongst the venture capital and innovative venture growth clients by allowing us to realize solid third quarter results and year-to-date results ending in the third quarter of 2017.

Year-to-date, we have originated nearly over $0.5 billion of new commitments to these high brand high awareness recognition venture-backed companies, some backed by some of the leading top tier venture capital firms in the country.

This great success that we've had so far this year has culminated us finishing the quarter with over $1.6 billion in total assets at the end of the quarter. Now to specifically cover some of the achievements during the third quarter, specifically some of the high-level performances.

We delivered year-over-year growth for our shareholders across many key indicators. We grew total assets by approximately 8%, to $1.6 billion. We grew total debt investments, our debt portfolio, at a cost base by approximately 3%, to $1.3 billion. This despite $150 million of early payoffs.

We grew or quarterly total investment income by approximately 25, to $46 million. And we grew NII by approximately 1%, to $24 million. In addition to these great achievements, we also continued to generate strong returns for our shareholders.

On a total shareholder return for the 1-year, 5-year, 7-years, Hercules realized 4.3%, 71.1% and 105%, respectively, on a TSR basis for our shareholders. This was achieved by a very strong and continued healthy ROAs of 6.4% and an ROE exceeding 12% during the quarter so far.

And finally, we accomplished much of these results while maintaining our historical strong discipline to credit underwriting maintaining a very strong and fluid and liquid balance sheet as well as high liquidity position of over $335 million able to continue to originate new investments and also complete the acquisition of the Aries transaction that I referred to earlier.

Now turning my attention to some key highlights and market developments within the venture capital industry and the innovative marketplace, our primary focus of originations.

The venture capital marketplace continues to show solid levels of vitality and sustained pace of new investment activities, with $16.3 billion of capital committed and invested by the venture capitalists in the third quarter, culminating in excess of $46 billion of capital invested in the first 3 quarters of the year, which places venture capital investments on pace to easily exceed the 2016 levels of $49 billion according to Dow Jones Venture Source report.

This is quite encouraging, as we're also seeing favorable signs of venture capital investments and also demand for our capital that we're seeing as you're witnessing in our loan volume of new transactions that we're doing.

Our continued achievements and success over the past 13 years is because of our outstanding and dedicated employees who each quarter works extremely hard to deliver these outstanding results for our shareholders and support of our client portfolio companies.

I am deeply grateful to our employees and their hard work, to our shareholders who shared very strong candid feedback and insights and of course our venture capital partners and to the many wonderful innovative entrepreneurs whom we support who continue to generate wonderful and new ideas and innovations for the American economy.

I want to say thank you to all of you for trusting us as your capital partner and continue to allow us to help you grow your companies successfully. Now let me take an opportunity to discuss our views of the market and anticipate activities as we enter the fourth quarter of 2017 and early 2018.

As we enter the fourth quarter, we are extremely well positioned and have a low net leverage position, just barely above 50% net leverage after taking into account our cash balance.

We have a high liquid balance sheet that we're able and prepared to use to originate for quality assets similar to the purchase of the Aries portfolio as well as organic growth as we continue to selectively underwrite some of the most promising companies that we see come forward.

I expect Hercules Capital to continue to effectively and pursue its time-proven growth strategy which has served us well over a decade of slow and steady and continue to pursue and evaluate other strategic acquisition opportunities that we're currently evaluating and reviewing as we speak.

We see signs of an improving competitive environment, as I indicated earlier, which should continue to lead to strong economic growth and outlook for our own company. At a time where many BDCs are struggling, we're beginning to see a promising new light coming forward as we enter 2018.

Our ability to call this a fully improving trend line we are certainly encouraged for what we're seeing and evidenced in our own portfolio as we're seeing hard results manifesting itself into positive upward trends that we're seeing.

These encouraging signs are allowing us to begin to be more confident in our predictability of portfolio growth as we seem to have gotten an edge over the early payoff activities. Therefore, we are now expecting to see early payoff activities in the fourth to begin to normalize more in the neighbourhood of the $75 million to $100 million level.

So far through the month of October, we have seen fairly modest levels of activities and we do not have an awareness of leading to early transaction payoff that would come anywhere close to exceeding that anticipated forecast.

As these early repayments begin to ebb, we anticipate realizing modest loan portfolio growth, over all, in Q4, and we expect to stay ahead of early repayment activities in the fourth quarter and generate net portfolio growth of approximately $75 million to $125 million growth including post the acquisition with the Aries transaction.

I would also like to remind everyone that predicting early repayments is a very difficult task which we do not have control or insight and we barely get notice that's 30 days end time before a company pays us off early.

Over all, the business continues to be robust and has proven itself to its resiliency by fully absorbing $381 million of early payoff and when I add to that scheduled amortization of $100 million, our team proudly and successfully absorbed $481 million of early payoff activities.

I'm not aware of how many companies in the marketplace can fully absorb $481 million of loan portfolio runoff and still fully replace it and still grow the loan portfolio. That is an achievement that I'm very proud of our team and what they have done and proven themselves capable of doing.

We are entering Q4 with a solid book of business, as I indicated earlier, with nearly $1 billion of promising transactions seeking capital from us. However, we remain extremely discerning on selecting new investment opportunities while attempting to maintain a fine balance of portfolio growth while also sustaining margin discipline.

As I indicated in Q2 and in Q3, we are more than willing to not make investments and keep cash on our balance sheet if we don't believe the investments make sense. We will invest or chase yields down the cap structure simply to make quarterly earnings.

We are focused as a credit shop and we'll remain disciplined in our credit underwriting, first and foremost, as indicated in our longstanding credit history. As a wrap up my prepared remarks, let me share with you some quick updates on key developments for the venture capital industry beyond what I shared earlier with you.

Fundraising remains very strong from the venture industry. For the first 3 quarters, venture capitalists has raised $32 billion in new funds that give us a perspective of future capital deployments by the VCs. Investments were equally as strong, at $46 billion invested for the first 3 quarters of the year.

And we're seeing very robust activities in the IPO, although the IPO market remains fairly nascent, it was encouraging to see 32 venture-backed companies successfully complete IPOs through the third quarter of 2017. That is, for the first 9 months of the year. That, believe it or not, is a very encouraging issue.

I'm proud to say that one of our own companies completed their IPO debut recently, FourScout, successfully completed its IPO debut and we have another company of ours, Acwanshia, which is looking to pursue their IPO, also. We currently have 4 companies remaining in IPO registration.

We also have seen improvement in the IPO market with the most recent IPO o Roku and MongoDB. This has been very encouraging, creating optimism among venture capitalists and many of the unicorn companies interested in pursuing IPO events which should unlock further value in our portfolio if and when it occurs. M&A remains exceptionally strong.

Even within our own portfolio, we've seen heavy transactions in M&A activities. We saw a pickup in M&A activities in the venture capital marketplace and continue a steady and healthy pace.

Through Q3, 129 different transactions have been completed on venture-backed companies culminating in nearly $50 billion of transactions completed for the first 3 quarters of the year. 17 of those transactions were Hercules companies representing 4% of the M&A activity realized by the venture capitalists in the third quarter.

Now, in closing, we completed another outstanding quarter with a solid finish to the first 33 quarters of 2017.

Despite a higher-than-anticipated early repayment activity of $15 million, which along with scheduled amortization represented nearly 40% of our existing loan portfolio turnover, we successfully absorbed that, replenished it and grew our investment portfolio. I am not aware of any company that can do this, as I shared earlier, with you.

We continue to be well positioned for growth, with $335 million liquidity. We continue to evaluate and expect to close approximately 4200 million to $250 million of new commitments in the fourth quarter and we expect to finish the year with approximately $1.45 billion to $1.5 billion of investment assets in our loan portfolio.

With that, and externalization now finally put behind us, and we finally closed the open question of externalization, I want to reinforce the statement again. We will remain internally managed. We are committed to making our resources and continuing to deploy new capital.

Convert our liquidity into earning assets as we have done with the acquisition of the Aries portfolio. And turn that into continued growth in our EPS earnings for our shareholders. With that, I'd like to turn the call over to Gerard to review our Q3 2017 financial results and performance.

Gerard?.

Thank you, Manuel. And good afternoon and evening, ladies and gentlemen. I am pleased to report our third quarter results. Today I would like to focus on the following read that impacted our third quarter earnings.

Our origination platform realized losses in unrealized appreciation in the portfolio and income statement performance in the quarter, credit outlook, NAV performance and our liquidity. With that, let's turn my attention to the origination platform. Our originations platform continues to demonstrate its resiliency.

We had total investment fundings of $146.7 million in the third quarter, from a total of about 16 portfolio companies, offset by $135.7 million in payments from unscheduled early payoffs and regularly scheduled amortization, for net investment portfolio growth of $11 million.

On a cost basis, our debt investment portfolio balance ended at $1.314 billion at the end of the third quarter. Our core yields were 12.6%, up from 12.1% in the previous quarter due to the origination of high-yielding loans at the end of the second quarter continuing into the first half of Q3.

Further, we announced our acquisition of the Aries Venture loan portfolio for approximately $125 million, yielding approximately 11%. We expect to see about a 2% NII per share impact based on 82.5 million weighted shares outstanding as of September 30, 2017.

I would now like to discuss the realized and unrealized activity that occurred during the quarter. We had net realized losses of $24.5 million in the third quarter, which was primarily the result of 2 positions. In Q3, our investment in Sky Cross Inc.

was deemed wholly worthless and written off and an investment in a second portfolio company was sold resulting in a realized loss. The loss on those positions was already reflected in net asset value through unrealized depreciation in prior quarters.

We had a net change in unrealized appreciation of approximately $33.6 million when our investment portfolio during the quarter. We had net unrealized appreciation in our debt investment portfolio of approximately $22.2 million, due to reversals of unrealized depreciation from write-offs.

The appreciation in our equity portfolio was made of up $5.7 million in our public portfolio and $3.3 million in our private portfolio, which was offset by approximately $200,000 in reversals due to disposals.

The appreciation in our warrant portfolio was made up of approximately $400,000 and $5 million in our public and private portfolios, respectively, which was offset by $2.5 million in reversals due to disposals. Third, I would like to discuss our income statement performance for the third quarter.

Our net investment income was $24 million I the third quarter, or $0.29 per share, which is a decrease of 5.1% and 6.5%, respectively, from the second quarter of 2017. Total investment income was $45.9 million in the third quarter, down from $48.5 million in the second quarter, or a decrease of 5.3%.

The decrease is attributable to a lower amount of one-time accelerations from early unscheduled payoffs of $114.7 million during the quarter. NII margin was 52.3% in the third quarter, which was a slight increase from the second quarter of 52.2%.

Our interest and fee expense was $10.5 million in the third quarter, which was in line with our expectation and slightly below the second quarter of $10.6 million.

Our SG&A decreased to $11.4 million in the third quarter, from 412.6 million, which is in line with our expectation that we previously stated in our last earnings call, where we believe that our SG&A will be between $11 million to $12 million, but on the lower end for Q3 and the higher end for Q4 as the third quarter is typically quieter in funding than the fourth quarter, which is usually our stronger funding quarter.

Our net interest margin was $35.4 million in the third quarter, down from $37.9 million in the second quarter. Lastly, we have a very well positioned portfolio with a highly asset-sensitive balance sheet in the event of movements.

97% of our loans are variable interest loans with floors and 100% of our debt outstanding was fixed interest rate debt, a 25 basis point and 50 basis point increase in benchmark interest rates at the end of the third quarter would be accretive to interest income and net investment income by approximately $2.6 million and $5.5 million, respectively, on an annualized basis or $0.03 and $0.07, respectively, of NII per share annually.

Now I would like to discuss or credit and near-term outlook.

In the third quarter, our weighted average credit rating improved to 2.24 from 2.27 in the second quarter, and our watch list grades 3 to 5 decreased from 33.6% to 39.4% on a cost basis, primarily due to the closing of the 2 previously discussed transactions that resulted in a realized loss and payoffs from four other companies that was on the watch list as of the second quarter.

Our non-accruals decreased to 0.9% as a percentage of our total investment portfolio on a cost basis and 0.2% on a value basis in the third quarter. We expect 2 to 3 companies to be sold or have definitive workouts in the fourth quarter, which we believe has the ability to further reduce our non-accruals in the future periods.

Now looking at our NAV, we saw our NAV increase to $836.3 million in the third quarter, from $817.5 million in the second quarter, or an increase of 2.3%, to $10 per share.

This $18.8 million increase was the result of net realized and unrealized investment activity of $9.1 million or $0.11 per share, and the relaunch of our equity ATM program of $9.4 million, or $0.02 per share.

We saw our ROEs decrease to 12.1% in the third quarter, down from 13.2% in the second quarter, and our ROAs decrease to 6.4% in the third quarter, from 6.8% in the second quarter. Next, our liquidity position at quarter-end.

We finished the end of the third quarter with $335.6 million in available liquidity, which was composed of $140.6 million in cash and $195 million of undrawn availability under or revolving credit facilities which are subject to borrowing base leverage and other restrictions.

Further, we relaunched our equity ATM program which instituted another approximately 768,000 shares with net proceeds of approximately $9.4 million at an average price to book of 1.25.

Our net regulatory leverage excluding SBA debentures as we have an exemptive relief from the SBC, declined to 49.4% at the end of the third quarter, versus 50.9% at the end of the second quarter. Or net GAAP leverage with SBA debentures also declined, to 72.2% in the third quarter, from 74.1% at the end of the second quarter.

As Manuel had mentioned in his comments, we closed our first investment-grade bond offering of $150 million at an interest rate of 4 5/8. We announced our intention to use those proceeds to partially redeem our 6.25% 2024 notes for $75 million.

The partial redemption will result in a one-time charge of $2.4 million, which consists of the non-cash charge on the acceleration of our 6.25% 2024 notes of $2 million and the one-time expense overlap of approximately $400,000 pertaining to the double interest of both the 2024 notes and the new bond we completed.

As we stated in our press release, we expect to save approximately $1.3 million in annual interest and fee expenses, or $0.02 on NII per share annually. Based on 82.5 million weighted shares outstanding as of September 30, 2017. Finally, in closing, we are well positioned at the end of the third quarter.

Our liquidity position allows us to grow our book strategically and cautiously. Or long-term focused approach and disciplined underwriting standards will enable us to deliver strong results for the foreseeable future. With that report, I now turn the call over to the Operator to begin our Q&A part of our call. Operator, over to you, please..

[Operator Instructions]. Your first question comes from the line of John Hecht, from Jefferies..

Manuel, I appreciate your update on the externalization contract and I know it must have been a tough decision, but appreciate all the effort you guys put into that.

The first question I have is just sort of modeling perspective, is that $1.45 billion in loans at the end of the quarter - expected loans in that range at the end of the quarter, does that include the Aries acquisition of the Aries portfolio?.

It technically does not fully include it because when we did this - so the answer is, no, it doesn't. So with the Aries portfolio, you're probably going to be closer to the $1.55 billion level when you fully include the Aries portfolio and giving way to the early amortization.

So I would tell you that you're looking at a portfolio that with Aries would probably be between $1.5 billion to $1.55 billion with Aries in it..

And does the Aries portfolio have similar - once you I guess you've embedded it in your portfolio will it have any meaningful impacts on the yield or anything? Or is it fairly consistent with respect to its characteristics?.

Well the Aries portfolio, first of all, was a high quality portfolio, which is why we transacted. Aries did a really good job of underwriting that book. It has lower yields than e typically see. It's probably - we're anticipating it when we fully onboard the loan book, it's probably going to be in the low 11%s.

So we think it's going to be probably between 11% and 11.2% on a blended basis when we finally onboard the loans to that, versus our currently we're seeing our yields rising. So we expect at this point when we look at our Q4 forecast we're exciting to see a possibility of anywhere 10 to 20 basis points degradation in our overall core yields.

But as I said, until we fully onboard the loan book that's an estimate that we're forecasting right now to see the 12.6% maybe leg down to be 10 to 20 basis points in Q4..

Okay. That's very helpful. And then you mentioned you had a more favorable competitive environment, which is improving core yields, but also it sounds like a favorable environment where you even getting some potential other portfolio acquisition opportunities. I wonder if you can shed a little light on both.

In the core yields, is that like-for-like structured loan you're seeing loan stabilize or you're actually seeing yields improve? And how much room does that have to grow, do you think? And second, on the portfolio acquisitions, maybe just give us a little color on what you're seeing and where..

So, as I said in the beginning of the call, one quarter doesn't make a trend. So I want to be cautious of that. But the signs that I'm seeing from our deal teams are quite encouraging. Now it's not going up 150, 200 basis points. Let me be very clear.

My enthusiasm is tempered to the tune of probably 50 basis points that we're seeing a nice gradual rise to be occurring here. But if that could turn into a much more increase in rise if the environment that we're beginning to see is taking shape. We're not seeing a lot of our smaller venture debt players out there making any meaningful origination.

In fact, most of them are seeing portfolio contractions or concentrations in their books. We in the in turn are seeing pretty steady ad consistent opportunities. We remain very yield stingy, if you will, when we underwrite.

But we're seeing encouraging signs and when we look a - for example, in Aries, willing to sell us their portfolio, I think that gives you some indications of what we think that the broader industry is doing, where venture lending is a very complex and a very difficult asset class to originate.

And if you don't have that brand and that deal flow, the amount of early repayments can actually bury you quickly.

And so we're beginning to see signs where a lot of these players who are coming into venture lending flirting with the asset class is not working out as they anticipated and they're beginning to show signs of leaving it, which is why we're beginning to see a nice gradual increase in yields that I think will come into full force probably in Q2 of '18..

Your next question comes from the line of Ryan Lynch, from KBW..

First one, just wanted to get a clarification on exactly when do you anticipate the Aries transaction closing.

I know you guys announced it today, but do you guys expect it to close very soon? Or is that going to close later in the quarter?.

It literally closed this morning, I think it is. So the ink and the paint is still wet. But everything was papered and closed this morning. I have to give credit to both teams, Aries and our team it officially closed this morning.

We now have the process of onboarding all the loans and getting all the terms and conditions in our systems and getting all that done. So until it's all in the system to really have a strong forecast on yields is difficult to do. Of course, we can compute them mathematically but until it's in the system.

Conversely, we expect the portfolio to be accretive immediately commencing in November 1. We expect the portfolio to be about $0.02 accretive in earnings and I think that as we look forward to that we probably may be able to get a little bit more than $0.02 accretion out of it.

But I think that right now $0.02 per quarter on the acquisition is something that we feel pretty confident about with what we know right now..

Okay. Great. And then when you gave the guidance of about $75 million to $125 million of kind of net growth in the fourth quarter including the transaction, it looks like that could potentially be pretty conservative. If I look at the commitments you guys have closed quarter-to-date through October, it's about $60 million.

With the Aries transaction, that's $125 million. Add those together, that's $185 million in the first month of the quarter. And if I look at early repayoffs payment of $75 million to $100 million, it feels like net growth of $75 million to $125 million could be pretty conservative.

Is that kind of a conservative number in your mind?.

It is. And the reason why it is that I've been burdened once already trying to give a good indication of what early payoff activities are. And for 3 quarters, I have not been able to get it nailed down appropriately and it's a plus or minus - these days $50 million swing. So maybe I'm just burned by trying to be conservative.

So, yes, I think it's conservative..

Sure.

What is, I know it's difficult to predict early prepayments that can fluctuate pretty wildly quarter -to-quarter, but what is generally driving the slowdown that you guys are expecting in early repayments?.

So as I indicated, and I've done this a million times [indiscernible], there are 4 components of early payoff activities. The first one, we can't control, M&A. We're picking great companies. Those companies are being acquired. That's a positive outcome of good portfolio selection. So, M&A is one of the events.

Number two is some encouraging signs, if you will, of our companies being quite successful, they're maturing and eventually migrating to more traditional bank financing that they can achieve when they're operating an EBITDA positive. So there's a natural sequencing of our companies maturing and eventually migrating off the books.

The element where we're seeing an ebbing begin to occur is that we're seeing hedge funds and other non-sophisticated non-experienced financial lenders who went into the asset class and they started taking on losses and realizing that venture lending is much more difficult than they anticipated.

And we're beginning to see signs of them pulling back and pulling out of the industry, causing us to be encouraged by those signs. Are kind of the three high-level items that I would share with you that give us that confidence that we're seeing in the marketplace..

Okay. That's all for me. I just did want to say I appreciate the discussions you had around the externalization and also appreciate your guys' decision to stay internal..

Thank you very much. And I will say that your forum, as difficult as it was, was actually a very, very helpful in that process. So I'm very thankful to KBW and that forum with all those investors. That was a very good forum. So thank you for that..

Your next question comes from the line of Jonathan Bock, from Wells Fargo Securities..

So 1 quick item I want to put out, Manuel. There were 2 points as it relates to externalization that had people worried. One, if you did it, it relates to compensation for handing over something of value without receiving compensation for it. You absolutely appreciate the decision you made.

But the second one was that if we didn't do it, I think the comment was we can't necessarily guarantee key personnel being kept around.

And so this solidifies it probably one last time, Manuel, do you believe that under the current compensation scheme that you'll likely be able to maintain and continue to build the best-in-class venture platform that you've built and would like to continue to do so in the future?.

So as I've said many, many times, every individual in this earth is free to go as they please and we hire and we work with some of the most talented, highly skilled individuals in our organization. It is up to every organization to work hard to keep those people motivated and incentivized.

Specific to your question, I do believe that in Fiscal 2018 that, and we're still running our models now, I do believe that we're going to see an increase in SG&A. I don't know what that level is, but I would probably if pushed for a number, I probably would think that SG&A will probably rise anywhere between $500,000 to maybe $1 million a quarter.

I don't think it has to go to that level, but there's clearly a need to retain and encourage and motivate our key personnel responsible for this outstanding performance that we have accomplished over the years.

So, yes, I do believe that they'll be a slight increase in SG&A; it's not going to go through the rood, but I do believe that probably a modest increase in SG&A in Fiscal 2018. What exactly that is, until I rerun the forecast for 2018 our models, I don't know.

But I think that if you want to walking around number $500,000 to $1 million a quarter is probably a good number..

Sure. Appreciate that. And while the detail is certainly helpful, I think folks weren't necessarily afraid of compensating employees more for good performance as you've delivered, it was the fear that one wouldn't be able to retain employees.

And so is it your belief that you'll be able to retain key employees over time?.

Jonathan, as you know, our employees are very important to me. They are the bedrock of this organization and a critical, critical component. The decision on compensation ultimately does not just rest on me; it rests on our independent board of directors.

I think that they're highly aware and attuned the need to make sure that we incentivize and retain our key employees.

So at this point, I believe that with our focus on remaining internally managed with the acquisition of the Aries portfolio, with our strong access to the capital markets for liquidity, we are the platform of choice that have the ability for them to execute and deliver on what they want to be doing, which is a venture lending.

And because we are that platform with that scale, I hope and believe that those key employee flight risk may be contained. But again, I say as I always say, everyone is a free agent. But I believe that our key employees will stick around, but I cannot give you that assurances because everyone has the ability to make their decisions..

Understand. Appreciate that. Next question just relates to the use of the ATM. Walk us through why one would choose to even in very small amounts access that market relative to the cash balance, et cetera, that you have over the past quarter.

And what's your view on its use, going forward?.

So the ATM is an extremely accretive and beneficial product to sue. It's actually probably one of the greatest tools that a CEO can have at their disposal, not the single equity raise and to dial in modest equity capital raises that are highly accretive to net asset value for our shareholders.

As to the second part of your question, I'm not going to get into our strategy behind ATM, because that is a proprietary strategy that we use and it's been very beneficial and very effective for our balance sheet and balance sheet management. The third element of your question is very critical.

The ATM as an example, we just turned it on in late Q3 when we started to have the realization of the possibility of an Aries transaction. So to put that in context, I have $140 million of cash and I'm going to deploy $125 million of that to buy the Aries portfolio.

I have my bank lines available to me, but why would I want to have a negative spread on cash on the balance sheet when I can actually deploy that cash and make it immediately accretive by doing the acquisition, which we did.

And when you actually do your models, you will see the conversion of $125 million of cash into interest-earning assets becomes a pretty spectacular accretive benefit for the shareholders and our company.

So because of that, I will always dial in a set number of capital dollars that I plan to raise over an ATM over a 6- to 9-month period of time and then gradually do that without adversely impacting the stock by doing it at a very accretive way..

Appreciate that. Appreciate your comments, the work that went around your decision and also likely the returns that can be generated by your key team employed with you heretofore and for quite a while from now..

Your next question comes from the line of Timothy Hayes, from BRB Riley FBR..

Back to the Aries portfolio, can you just talk a little about the characteristics of the portfolio and why you decided to pull the trigger on this acquisition versus maybe some others you vetted over the past several quarters? And then you gave some color around the yield profile.

Can you also just give us an indication of kind of how the maturity profile stacks up versus your portfolio? And also just the types of industries of the portfolio companies, as well?.

Sure. As I said, the reason why we transacted is that Aries did a great job of underwriting. It's not often you see a great quality book come available. And I have a very strong belief that Aires is a good shop and a great underwriter and that certainly was proven true when we bought their portfolio.

So the portfolio is heavily tech orientated and , in fact, I think it has little to no life sciences exposure in it. So it's a heavily tech orientated portfolio where I can point to you that our tech book is about 32%, 35% of our exposure and by augmenting our book with the Aries we start getting a better balance of tech to life sciences.

So that's one of the reasons. Number two, on duration, let me try it - well, I don't remember exact duration, but I remember we have approximately 11 [indiscernible] , I think it is, that we acquired. So 11 unique portfolio companies on the lending side.

We have a smattering of warrants and equity positions that make up about $4.5 million, $5 million of that transaction. But the vast majority, $120 million of it, is interest-earning loans that we believe when we put them in our system will have a yield somewhere in the neighbourhood of an 11% , 11.2%.

The average duration, if I remember correctly, I think it has about 18 to 22 months left in the portfolio. And most have a maturity somewhere in the neighbourhood of about 2020, if I remember correctly. But apologies. I don't have specific all the obligores there in front of me. But it's about 11 of them with a yield 11%, 11.2% mostly all tech..

Great. That's really helpful. Thank you.

And then just a follow-up from me, given the infrastructure that you have built out today, how large do you see the portfolio growing to kind of over time? And then can you just give us an idea the type of operating leverage you can achieve as you , I guess, surpass new milestones, whether it's $1.5 billion to $2 billion marks, et cetera?.

If the competitive trends that we're seeing continue to come in our direction, I think that you can look at Fiscal 2018 a loan portfolio on the debt side, not including our equity and warrant positions, that can probably be between $1.7 billion and $1.8 billion on the debt side.

And I reserve a little bit on that because if the broader macroeconomics continues to improve as we expect, obviously, we'll be giving guidance to our investor community, our shareholder community and analysts later on in early part of '18, but if the trends continue rising yields and early payoff begin to truly ebb, then it translates into significant portfolio growth and accretion by having those loan runoff that we've been experiencing stay on the books and continue to earn interest income.

That is all highly favorable for our shareholders in the process. Right now I guess I would tell you we're being a little bit more guarded because we like what we're seeing. It is encouraging. We have the liquidity to capitalize on it. And to your macro question, prior to the acquisition of the Aries portfolio, my net leverage position was only 50%.

Post the Aries acquisition, I believe it's about 65% leverage when I exclude my cash back from my leverage on that. So I still have plenty of room to grow the book. We've given our deal teams the authority and the latitude to be a bit more aggressive right now.

And so we intend to make a very strong message to the market that we intend to grow our credit book, going forward, in 2018..

And just to clarify, when you say be more aggressive, you again you're not talking about chasing yields down or sacrificing anything that's outside of the traditional Hercules credit box, right?.

I'm an old-school Boston guy. I don't like taking credit risk. I'm an old Yankee lender. So I like to put money out and get it back. So , no, we are not chasing yields and we're not doing silly underwriting. I refuse to do that. And I'd rather miss earnings than go down the balance sheet.

I think we've seen that witnessed - that strategy play out recently in the last few quarter's earnings calls. Not a very good strategy to pursue..

Your next question comes from the line of Henry Coffey, from Wedbush..

So I'm trying to make some sense out of this discussion around core yields. I know the number was at 12.1% in the second quarter. There was a lot of expressed anxiety that it would break below that as recently even as a few weeks ago and now we're at 12.6%.

And I think I may have misheard you, but were you talking about an 11% to an 11.2% kind of number? Or how does that fit into the dialogue?.

No, we expected when we first indicated our conversation in Q2, we thought that our core yields will continue the pace of competitive environment, and we though that they would leg down as much as potentially 11.7%. And potentially 12.2% was I think the range that we had given.

So we were pleasantly surprised when we actually ended up realizing 40 basis points on the higher end higher than we anticipated.

But I will tell you most of it is driven probably by portfolio rotations, meaning that we had some early payoff activities on companies that had lower yield than we had anticipated would be paying off, and as those lower yields once off they actually make the broader portfolio rise in doing so.

So that's some of the things that we had not anticipated with the type of companies that paid us off. The normal profile of that is somewhat shifted in Q3. So we had lower yielding loans actually pay us off earlier than anticipated.

And then of course the inverse of that is we also onboarded some newer loans that had higher yields than we anticipated, but also we began to eat away at the negative cash drag. So as we convert that cash into interest-earning assets, that's also another accretive component of the process..

The 11.7% that you were referring to was yields on new investments?.

No, it was the expected overall weighting of the core portfolio that given the trend line that we experienced, to give you some context, we went from 12.9% in Q4 to 12.2% in Q1 to 12.1% in Q2 of '17. So we extrapolated that given what we realized and we thought we were going to break through 12% in Q3.

And in fact, the deal tea did a phenomenal job of finding alternative credits that were able to get yields slightly higher than that.

So our new loans onboarding were actually higher yields than we anticipated, coupled with what I said a minute ago of lower-margin loans at lower-yielding loans actually paid us off sooner than we anticipated, and that helped us increase our yields..

Could you give us some insight into what the core yields on the newly originated product was like?.

Henry, I don't have that in front of me, but if I remember a ballpark is somewhere in the mid to low 12%s I think it was is what we're looking at, but I'm happy to kind of follow up. But I believe it was somewhere in the neighbourhood around 12% to 12.2% was the new loans..

Going to this issue of externalization and I know it must have been a pretty dramatic thing for you because in the past you've been very adamant about being internally managed, but is there a vehicle by which you could, in essence, create your own legal entity that's the manager and that that manager could then sponsor funds, et cetera, outside of the BDC world?.

So don't take my comments the wrong way. I am so done with externalization that I am happily remaining internally managed for quite some time.

I think that we have explored with our independent advisers and our boards the broad range of options and permutations and I believe that the decision that we've made is actually the right one for now, for the foreseeable future.

And I think this is the right decision and I'm telling you that with unbelievable conviction that this is the right decision, to remain internally managed for quite some time..

And you don't see Hercules , for example, originating a third-party lease portfolio or a third-party asset-based facility or something for someone else?.

There's a lot of issues when it comes to the '40 Act regarding internally managed and joint transactions and affiliated transactions. Clearly, the investment community and the shoulder community is very much aware that I fully support an ABL relationship. I fully support and equivalent leasing company.

It only makes our platform more competitive and more dynamic. I think that down the road if there's a way of finding a scalable solution at an internally managed BDC that I truly bears fruit, I think that we'll explore that. But right now I just want to focus on what I know best, and that is internally managing and deliver strong shareholder value.

But right now I do not want to even flirt with anything in externalization in any permutation. That has become a third rail for me. So I just want to go forward and build the franchise and the company that I know we can build and we should have as Hercules Capital, internally managed..

Excellent. And then looking at your sort of capital liquidity debt equation, you obviously - you have about $200 million of commitments from the redemption of the existing notes as well as the Aries portfolio.

Is that the way to think about it?.

No. to be very clear and maybe we - and it's a good question for clarifications. Because of the strong demand for loan volume that we're seeing, the original $150 million of the new investment-grade bond offering that we did, we had anticipated that we would be retiring $150 million of our old legacy bonds.

But not for the fact that we're now seeing a pretty robust pipeline, we have now chosen to only retire $75 million of our legacy 6.25% bonds. So at least for right now, we're only going to announce and retire $75 million and we're retaining $75 million of proceeds of that new bond offering to be redeployed immediately into new investments.

So that kind of gives you a little bit of confidence that what we're seeing in our pipeline that we're not retiring fully the initial bond offering because of demand for capital that we're seeing..

So you have more than enough cash sitting around to do all this.

What is the thought process in 2018 about becoming a regular issuer of investment-grade debt? Do you think there's a market for it? Is that going to be a new source of capital and asset growth for Hercules? Or was this more of a one-and-done opportunity?.

No. I will tell you that since this is our first inaugural debut, I thought that we had had an outstanding series of conversations and presentations with investors, many of which had not been exposed to prior to the investment-grade market.

I can give you with absolute assurances the transaction was already upsized from $100 million to $150 million and we still was oversubscribed on a very healthy level. There's no question that we intend to access the investment-grade market in early 2018, and if things continue we could actually even do it sooner.

But most likely, we probably access the investment-grade market again in 2018 and continue to do that, given the terrific terms that we received for our inaugural offering. We expect to obviously subsequent offerings to be tighter, of course..

And our final question comes from the line of Casey Alexander, from Compass Point Research..

Obviously, at this stage of the ballgame most of my questions have been asked and answered.

But you did - first of all, in the how did you go about credit underwriting the Aries portfolio? And were these assets that you had bid on in a competitive process when they were originally underwritten?.

Without sounding arrogant, the answer is, yes. Almost every one of the transactions that we ended up purchasing from Aries we were on the opposing side competing with Aries in some of those deals on yield. So that gives us significant leg up.

But I would tell you that our outstanding credit team took an amazing process of literally reunderwriting these credits. We had very strong confirmatory data from Aries. Aries has done a great job of underwriting. So that really made this process a lot easier. But we went through a typical Hercules underwriting confirmatory process.

We knew those credits most of them, quite well. And that's what we did. So we're very comfortable in the underwriting and the methodical process. This is not done in 30 days. I think the whole process cradle to grave probably took on almost over 9 days to get it done.

So this was not something that was done overnight and it had to go through our investment committee and our very methodical process of underwriting..

That's really interesting. So what you're saying then is that not only did you buy a portfolio that you know well, but there is a competitor that has been directly competing with you and decreasing yields as a result of that competition who is now leaving the market.

Is that correct?.

Well, certainly I can't speak to what Aries' strategy is, if they're leaving the market or not..

Well, they said on their conference call that they are..

Okay. Well, I wasn't part of that conference call. So first of all, then I'm grateful for that announcement. So I'm encouraged by that announcement.

So, yes, your extrapolations of the facts are critical and, yes, the conclusion is correct, whereby a competitor of mine which was doing loans at a lower yield is now leaving the market and now you're beginning to see the consolidation that I believe will continue, especially in the venture lending.

And we have the liquidity and the wherewithal and the scale to start taking advantage of those opportunities as they surface..

Well, that leads me to my last question, which is you seemed to sort of headbob towards the fact that you think there's going to be more portfolios like this to buy.

Did I read that right?.

I'll be very clear, we are evaluating two of them right now..

There are no further questions at this time. I turn the call back over to Manuel..

Thank you. Thank you, Operator, and thank you, everybody, for joining us today and for our call. As I said, we are very proud of our decision to remain internally managed. I think and our board of directors think deeply that is the right decision for the shareholders long term.

We will be participating at the Jefferies second annual London BDC summit in London, Zurich, and Frankfurt next week, along with four other BDCs that we're touring Europe with the Jefferies team. I'm looking forward to meeting our European shareholders and bondholders.

In addition, we will be presenting at the Wells Fargo Thought Leadership Forum on December 6 and 7. We will have both David and Gerard with us in New York presenting at the conference along with us.

If anybody has an interest in meeting with the Hercules team, please contact Jefferies for the European portion of the trip or Wells Fargo for the New York or Michael Hara doing our trip to New York, as well. With that, I'd like to say thank you everybody and thank you for your time this evening..

That concludes today's conference call. You may disconnect..