UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
For The Quarterly Period Ended June 30, 2012
OR
Commission File Number: 814-00702
HERCULES TECHNOLOGY GROWTH
CAPITAL, INC.
(Exact Name of Registrant as Specified in its Charter)
(State or Jurisdiction of
Incorporation or Organization)
(IRS Employer
Identification No.)
400 Hamilton Ave., Suite 310
Palo Alto, California
(650) 289-3060
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this Chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
On August 1, 2012, there were 49,748,903 shares outstanding of the Registrant’s common stock, $0.001 par value.
HERCULES TECHNOLOGY GROWTH CAPITAL, INC.
FORM 10-Q TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1.
Consolidated Statement of Operations for the three and six month periods ended June 30, 2012 and 2011 (unaudited)
Consolidated Statement of Changes in Net Assets for the six month periods ended June 30, 2012 and 2011 (unaudited)
Item 2.
Item 3.
Item 4.
PART II. OTHER INFORMATION
Item 1A.
Item 5.
Item 6.
2
PART I: FINANCIAL INFORMATION
In this Quarterly Report, the “Company,” “Hercules,” “we,” “us” and “our” refer to Hercules Technology Growth Capital, Inc. and its wholly owned subsidiaries and its affiliated securitization trusts unless the context otherwise requires.
CONSOLIDATED STATEMENT OF ASSETS AND LIABILITIES
(unaudited)
(dollars in thousands, except per share data)
Assets
Investments:
Non-control/Non-affiliate investments (cost of $724,952 and $642,038, respectively)
Affiliate investments (cost of $8,065 and $3,236, respectively)
Control investments (cost of $10,696 and $11,266, respectively)
Total investments, at value (cost of $743,713 and $656,540, respectively)
Cash and cash equivalents
Interest receivable
Other assets
Total assets
Liabilities
Accounts payable and accrued liabilities
Wells Fargo Loan
2019 Notes
Long-term Liabilities (Convertible Debt)
Long-term SBA Debentures
Total liabilities
Commitments and Contingencies (Note 10)
Net assets consist of:
Common stock, par value
Capital in excess of par value
Unrealized depreciation on investments
Accumulated realized losses on investments
Distributions in excess of investment income
Total net assets
Total liabilities and net assets
Shares of common stock outstanding ($0.001 par value, 100,000,000 authorized)
Net asset value per share
See notes to consolidated financial statements (unaudited)
3
CONSOLIDATED SCHEDULE OF INVESTMENTS
June 30, 2012
(dollars in thousands)
Portfolio Company
Industry
Type of Investment(1)
Series
Anthera Pharmaceuticals Inc.(3)
Senior Debt
Matures December 2014
Interest rate Prime + 7.30% or
Floor rate of 10.55%
Aveo Pharmaceuticals, Inc.(3)
Matures September 2015
Interest rate Prime + 7.15% or
Floor rate of 11.90%
Cempra, Inc.(3)
Matures December 2015
Interest rate Prime + 6.30% or
Floor rate of 9.55%
Chroma Therapeutics, Ltd.(5)(10)
Matures November 2013
Interest rate Prime + 7.75% or
Floor rate of 12.00%
Concert Pharmaceuticals, Inc.(4)
Matures October 2015
Interest rate Prime + 3.25% or
Floor rate of 8.50%
Dicerna Pharmaceuticals, Inc.
Matures January 2015
Interest rate Prime + 5.75% or
Floor rate of 10.15%
Insmed, Incorporated(3)
Matures January 2016
Interest rate Prime + 4.75% or
Floor rate of 9.25%
NeurogesX, Inc.(3)
Matures February 2015
Interest rate Prime + 6.25% or
Floor rate of 9.50%
NextWave Pharmaceuticals, Inc.(4)
Matures June 2015
Interest rate Prime + 4.30% or
Paratek, Pharmaceuticals, Inc.
Senior Debt(9)
Matures upon liquidation
Interest rate Fixed 10.00%
Total Debt Drug Discovery & Development (26.39%)*
4
CONSOLIDATED SCHEDULE OF INVESTMENTS—(Continued)
Bridgewave Communications
Matures March 2016
Interest rate Prime + 8.75% or
OpenPeak, Inc.(4)
Matures July 2015
Interest rate Prime + 8.75%
Pac-West Telecomm, Inc.
Matures October 2013
Interest rate Prime + 7.50% or
PeerApp, Inc.(4)
Matures April 2013
Floor rate of 11.50%
PointOne, Inc.
Matures April 2015
Interest rate Libor + 9.00% or
Total PointOne, Inc.
Total Debt Communications & Networking (7.14%)*
5
Box.net, Inc.(4)
Matures March 2015
Interest rate Prime + 3.75% or
Floor rate of 7.50%
Matures July 2014
Interest rate Prime + 5.25% or
Matures July 2016
Interest rate Prime + 5.13% or
Floor rate of 8.88%
Total Box.net, Inc.
Caplinked
Matures May 2015
Interest rate Fixed 5.00%
Central Desktop, Inc.
Matures April 2014
Interest rate Prime + 6.75% or
Floor rate of 10.50%
Clickfox, Inc.
Matures July 2013
Interest rate Prime + 6.00% or
Floor rate of 11.25%
Matures December 2012
Total Clickfox, Inc.
Hillcrest Laboratories, Inc
Floor rate of 10.75%
Kxen, Inc.(4)
Interest rate Prime + 5.08% or
Floor rate of 8.33%
Tada Innovations, Inc.
Matures August 2012
Interest rate Fixed 8.00%
Tectura
Revolving Line of Credit
Interest rate Fixed 11.00%
Interest rate Fixed 13.00%
Total Tectura
White Sky, Inc.
Matures June 2014
Interest rate Prime + 7.00% or
Floor rate of 10.25%
Total Debt Software (15.37%)*
6
Maxvision Holding, LLC.(7)(8)
Matures December 2013
Interest rate Prime + 8.25% or
Floor rate of 12.00%, PIK
interest 5.00%
Floor rate of 10.00%, PIK
interest 2.00%
Floor rate of 10.00%
Total Maxvision Holding, LLC
Total Debt Electronics & Computer Hardware (0.04%)*
Althea Technologies, Inc.
Interest rate Prime + 7.70% or
Floor rate of 10.95%
Quatrx Pharmaceuticals Company
Matures March 2014
Total Debt Specialty Pharmaceuticals (2.43%)*
Achronix Semiconductor Corporation
Interest rate Prime + 10.60% or
Floor rate of 13.85%
Kovio Inc.
Interest rate Prime + 5.50% or
Interest rate Prime - 3.75% or
Floor rate of 9.75%
Total Kovio Inc.
Total Debt Semiconductors (1.29%)*
7
AcelRX Pharmaceuticals, Inc.(3)
Total AcelRX Pharmaceuticals, Inc.
Alexza Pharmaceuticals, Inc.(3)(4)
Interest rate Prime + 6.5% or
BIND Biosciences, Inc.
Interest rate Prime + 7.45% or
Floor rate of 10.70%
Intelliject, Inc.(4)
Floor rate of 11.00%
Revance Therapeutics, Inc.
Interest rate Prime + 6.60% or
Floor rate of 9.85%
Total Debt Drug Delivery (14.03%)*
Gelesis, Inc.(6)
Gynesonics, Inc.
Matures November 2012
Total Gynesonics, Inc.
Oraya Therapeutics, Inc.(4)
Novasys Medical, Inc.
Matures January 2013
Total Debt Therapeutic (3.43%)*
8
Ahhha, Inc.
Blurb, Inc.
Floor rate 8.50%
Just.Me
Interest rate Prime + 2.50% or
Floor rate 5.75%
NetPlenish
Reply! Inc.(4)
Interest rate Prime + 6.875% or
Floor rate of 10.125%
Interest rate Prime + 7.25% or
Second Rotation
Matures August 2015
Interest rate Prime + 6.50% or
Floor rate of 10.25%, PIK
Interest 2.50%
Trulia, Inc.(4)
Interest rate Prime + 2.75% or
Floor rate of 6.00%
Floor rate of 8.75%
Total Trulia, Inc.
9
Vaultlogix, Inc.
Matures September 2016
Interest rate LIBOR + 8.50% or
interest 2.50%
Interest rate LIBOR + 7.00% or
Interest rate Libor + 6.00% or
Total Vaultlogix, Inc.
Votizen
Matures February 2013
Wavemarket, Inc.(4)
Total Debt Internet Consumer & Business Services (13.90%)*
Cha Cha Search, Inc.
Eccentex Corporation
InXpo, Inc.
Jab Wireless, Inc.
Matures August 2016
Floor rate of 6.75%
RichRelevance, Inc.
Total Debt Information Services (6.85%)*
Optiscan Biomedical, Corp.
Interest rate Prime + 8.20% or
Floor rate of 11.45%
Total Debt Medical Device & Equipment (2.20%)*
Navidea Biopharmaceuticals, Inc. (pka Neoprobe)(3)
Tethys Bioscience Inc.
Interest rate Prime + 8.40% or
Floor rate of 11.65%
Total Debt Diagnostic (3.49%)*
10
deCODE genetics ehf.(5)(10)
Matures September 2014
Interest rate Prime + 10.25% or
Floor rate of 13.50%, PIK interest 2.00%
Labcyte, Inc.
Matures May 2013
Interest rate Prime + 8.60% or
Floor rate of 11.85%
Matures June 2016
Interest rate Prime + 6.70% or
Floor rate of 9.95%
Total Debt Biotechnology Tools (2.28%)*
ScriptSave (Medical Security Card Company, LLC)
Matures February 2016
Interest rate LIBOR + 8.75% or
MedCall
Interest rate 7.79% or
Interest rate LIBOR + 8.00% or
Pacific Child & Family Associates, LLC
Interest rate LIBOR + 6.50% or
Floor rate of 9.00%
Interest rate LIBOR + 10.50% or
Floor rate of 13.00%, PIK interest 3.75%
Total Pacific Child & Family Associates, LLC
Total Debt Health Services, Other (8.11%)*
Entrigue Surgical, Inc.
Interest rate Prime + 5.90% or
Floor rate of 9.65%
Transmedics, Inc.(4)
Matures February 2014
Interest rate Prime + 9.70% or
Floor rate of 12.95%
Total Debt Surgical Devices (2.44%)*
11
Women’s Marketing, Inc.
Media/
Content/ Info
Matures May 2016
Interest rate Libor + 9.50% or
Floor rate of 12.00%, PIK interest 3.00%
Matures November 2015
Interest rate Libor + 7.50% or
Total Women’s Marketing, Inc.
Westwood One Communications
Media/Content/
Info
Matures October 2016
Floor rate of 8.00%
Total Debt Media/Content/Info (9.88%)*
Alphabet Energy, Inc.
American Superconductor Corporation(3)
BrightSource Energy, Inc.
EcoMotors, Inc.
Interest rate Prime + 6.10% or
Floor rate of 9.35%
Enphase Energy, Inc.(3)
Interest rate Prime + 4.40% or
Glori Energy, Inc.
Integrated Photovoltaics, Inc.
Interest rate Prime + 7.38% or
Floor rate of 10.63%
Propel Biofuels, Inc.
Matures September 2013
Interest rate of 11.00%
SCIenergy, Inc.
Matures October 2014
Interest rate 6.25%
Interest rate Prime + 4.90% or
Floor rate of 8.15%
Total SCIenergy, Inc.
12
Solexel, Inc.
Matures June 2013
Total Solexel, Inc.
Stion Corporation(4)
Total Debt Clean Tech (17.02%)*
Total Debt (136.29%)
13
Atrenta, Inc.
Total Atrenta, Inc.
Braxton Technologies, LLC.
Daegis Inc. (pka Unify Corporation)(3)
Forescout Technologies, Inc.
HighRoads, Inc.
Hillcrest Laboratories, Inc.
Rockyou, Inc.
SugarSync Inc.
Total SugarSync Inc.
Tectura Corporation
WildTangent, Inc.
Total Warrants Software (1.34%)*
Luminous Devices, Inc.
Shocking Technologies, Inc.
Total Warrant Electronics & Computer Hardware (0.01%)*
Pacira Pharmaceuticals, Inc.(3)
Total Warrants Specialty Pharmaceuticals (0.35%)*
IPA Holdings, LLC
Market Force Information, Inc.
Seven Networks, Inc.
Wageworks, Inc.(3)
Total Warrant Consumer & Business Products (0.43%)*
14
Enpirion, Inc.
iWatt, Inc.
Total iWatt, Inc.
Quartics, Inc.
Total Warrants Semiconductors (0.13%)*
Merrion Pharma, Plc.(3)(5)(10)
Transcept Pharmaceuticals, Inc.(3)
Total Warrant Drug Delivery (0.43%)*
EKOS Corporation
Light Science Oncology, Inc.
Total Warrants Therapeutic (0.07%)*
Total Blurb, Inc.
Cozi Group, Inc.
Invoke Solutions, Inc.
Prism Education Group, Inc.
RazorGator Interactive Group, Inc.
Total Warrants Internet Consumer & Business Services (0.52%)*
15
Buzznet, Inc.
Series F
Intelligent Beauty, Inc.
Total InXpo, Inc.
Magi.com (pka Hi5 Networks, Inc.)
Solutionary, Inc.
Zeta Interactive Corporation
Total Warrants Information Services (0.19%)*
Total Optiscan Biomedical, Corp.
Total Warrants Medical Device & Equipment (0.16%)*
Tethys Bioscience, Inc.
Total Warrants Diagnostic (0.15%)
NuGEN Technologies, Inc.
Total NuGEN Technologies, Inc.
Total Warrants Biotechnology Tools (0.20%)*
Total Warrants Surgical Devices (0.07%)*
Everyday Health, Inc. (pka Waterfront Media, Inc.)
Glam Media, Inc.
Total Warrants Media/Content/Info (0.05%)*
American Supercondutor Corporation(3)
Calera, Inc.
GreatPoint Energy, Inc.
Lilliputian Systems, Inc.
Total Lilliputian Systems, Inc.
SCIenergy, Inc.(4)
Trilliant, Inc.
Total Warrants Clean Tech (0.63%)*
Total Warrants (5.92%)
16
Aegerion Pharmaceuticals, Inc.(3)
Inotek Pharmaceuticals Corp.
Merrimack Pharmaceuticals, Inc.(3)
Paratek Pharmaceuticals, Inc.
Total Equity Drug Discovery & Development (1.68%)*
Acceleron Pharmaceuticals, Inc.
Total Acceleron Pharmaceuticals, Inc.
Total Equity Drug Delivery (0.32%)*
E-band Communications, Corp.(6)
Total E-band Communications, Corp.
Neonova Holding Company
Peerless Network, Inc.
Stoke, Inc.
Total Equity Communications & Networking (1.13%)*
Total Equity Software (1.83%)*
Total Maxvision Holding, LLC.
Spatial Photonics, Inc.
Virident Systems
Total Equity Electronics & Computer Hardware (1.05%)*
Total Equity Specialty Pharmaceuticals (0.00%)*
17
Caivis Acquisition Corporation
Facebook, Inc.(3)
Total Equity Consumer & Business Products (2.34%)*
Total Equity Semiconductors (0.26%)*
Total Gelesis, Inc.
Total Equity Therapeutic (0.54%)*
Total Equity Internet Consumer & Business Services (0.00%)*
Good Technologies, Inc. (pka Visto Corporation)
Total Solutionary, Inc.
Total Equity Information Services (0.13%)*
Total Equity Medical Device & Equipment (0.44%)*
Total Equity Biotechnology Tools (0.11%)*
Total Transmedics, Inc.
Total Equity Surgical Devices (0.08%)*
18
Total Equity Media/Content/Info (0.12%)*
Total Equity (10.03%)
Total Investments (152.24%)
19
December 31, 2011
Anthera Pharmaceuticals Inc.
Matures September 2014Interest rate Prime + 7.3% orFloor rate of 10.55%
Aveo Pharmaceuticals, Inc.
Matures June 2014Interest rate Prime + 7.15% orFloor rate of 11.9%
Matures January 2015Interest rate Prime + 4.40% orFloor rate of 10.15%
NextWave Pharmaceuticals, Inc.
Matures June 2015Interest rate Prime + 4.3% orFloor rate of 9.55%
Concert Pharmaceuticals
Matures July 2015Interest rate Prime + 3.25% orFloor rate of 8.25%
PolyMedix, Inc.
Matures September 2013Interest rate Prime + 7.1% orFloor rate of 12.35%
Aegerion Pharmaceuticals, Inc.
Matures September 2014Interest rate Prime + 5.65% orFloor rate of 10.40%
Chroma Therapeutics, Ltd.(5)
Matures September 2013Interest rate Prime + 7.75% orFloor rate of 12.00%
NeurogesX, Inc.
Matures February 2015Interest rate Prime + 6.25% orFloor rate of 9.50%
Total Debt Drug Discovery & Development (26.79%)*
Convertible SeniorDebt Due on demandInterest rate Fixed 6.00%
Intelepeer, Inc.
Senior DebtMatures May 2013Interest rate Prime + 8.12% orFloor rate of 11.37%
Matures May 2012
Interest rate Prime + 4.25%
Total Intelepeer, Inc.
Senior DebtMatures October 2014Interest rate Prime + 7.50% orFloor rate of 12.00%
PeerApp, Inc.
Senior DebtMatures April 2013Interest rate Prime + 7.5% orFloor rate of 11.50%
Senior DebtMatures April 2013Interest rate Libor + 9.0% orFloor rate of 11.50%
Stoke, Inc(4)
Senior DebtMatures May 2013Interest rate Prime + 7.0% orFloor rate of 10.25%
Total Debt Communications & Networking (5.71%)*
See notes to consolidated financial statements.
20
Senior DebtMatures April 2014Interest rate Prime + 6.75% orFloor rate of 10.50%
Senior DebtMatures July 2013Interest rate Prime + 6.00% orFloor rate of 11.25%
Kxen, Inc.
Senior DebtMatures January 2015Interest rate Prime + 5.08% orFloor rate of 8.33%
Senior DebtMatures January 2015Interest rate Prime + 3.25% orFloor rate of 7.50%
Blurb, Inc
Senior DebtMatures December 2015Interest rate Prime +5.25% orFloor rate 8.5%
Senior DebtMatures April 2015Interest rate Prime + 4.50% orFloor rate of 8.25%
Senior DebtMatures June 2014Interest rate Prime + 7.00% orFloor rate of 10.25%
Senior DebtMatures August 2012Interest rate Prime + 3.25% orFloor rate of 6.50%
Total Debt Software (5.34%)*
21
Maxvision Holding, LLC.(7)
Senior DebtMatures December 2013Interest rate Prime + 8.25% orFloor rate of 12.00%, PIK interest 5.00%
Senior DebtMatures December 2013Interest rate Prime + 6.25% orFloor rate of 10.00%, PIK interest 2.00%
Revolving Line of CreditMatures December 2013Interest rate Prime +5.00% orFloor rate of 8.50%
Total Debt Electronics & Computer Hardware (0.24%)*
Senior DebtMatures October 2013Interest rate Prime + 7.70% orFloor rate of 10.95%
Pacira Pharmaceuticals, Inc.
Senior DebtMatures August 2014Interest rate Prime + 6.25% orFloor rate of 10.25%
Senior DebtMatures August 2014Interest rate Prime + 8.65% orFloor rate of 12.65%
Total Pacira Pharmaceuticals, Inc.
Convertible Senior DebtMatures March 2012Interest rate Fixed 8.00%
Total Debt Specialty Pharmaceuticals (8.92%)*
Senior DebtMatures January 2015Interest rate Prime + 7.75% orFloor rate of 11.00%
Senior DebtMatures March 2015Interest rate Prime + 5.50% orFloor rate of 9.25%
Senior DebtMatures March 2015Interest rate Prime + 6.00% orFloor rate of 9.75%
Total Debt Semiconductors (1.50%)*
22
AcelRX Pharmaceuticals, Inc.
Senior DebtMatures December 2014Interest rate Prime + 3.25% orFloor rate of 8.50%
Alexza Pharmaceuticals, Inc. (4)
Senior DebtMatures October 2013Interest rate Prime + 6.5% orFloor rate of 10.75%
Senior DebtMatures July 2014Interest rate Prime + 7.45% orFloor rate of 10.70%
Total BIND Biosciences, Inc.
Merrion Pharma, Plc.(5)
Senior DebtMatures January 2015Interest rate Prime + 9.20% orFloor rate of 12.45%
Senior DebtMatures March 2015Interest rate Prime + 6.60% orFloor rate of 9.85%
Total Debt Drug Delivery (13.90%)*
Gelesis, Inc. (8)
Senior DebtMatures April 2013Interest rate Prime + 8.75% orFloor rate of 12.00%
Senior DebtMatures October 2013Interest rate Prime + 8.25% orFloor rate of 11.50%
Oraya Therapeutics, Inc.
Senior DebtMatures March 2015Interest rate Prime + 4.75% orFloor rate of 9.50%
Senior DebtMatures January 2015Interest rate LIBOR + 8.0% orFloor rate of 10.50%
Revolving Line of CreditMatures January 2015Interest rate LIBOR + 6.5% orFloor rate of 9.00%
Senior DebtMatures January 2015Interest rate LIBOR + 10.50% orFloor rate of 13.0%, PIK interest 3.75%
Total Debt Therapeutic (6.68%)*
23
Business Services
Senior DebtMatures March 2014Interest rate Prime + 7.5% orFloor rate of 10.75%
Senior DebtMatures October 2016Interest rate LIBOR + 6.50% orFloor rate of 8.00%
Senior DebtMatures June 2015Interest rate Prime + 6.87% orFloor rate of 10.12%
Senior DebtMatures January 2016Interest rate LIBOR + 7.79% orFloor rate of 9.50%
ScriptSave
(Medical Security Card Company, LLC)
Senior DebtMatures February 2016Interest rate LIBOR + 8.75%
Senior DebtMatures March 2015Interest rate Prime + 2.75% orFloor rate of 6.00%
Senior DebtMatures March 2015Interest rate Prime + 5.50% orFloor rate of 8.75%
Senior DebtMatures September 2016Interest rate Libor + 8.50% orFloor rate of 10.00%, PIK interest 2.50%
Revolving Line of CreditMatures September 2015Interest rate Libor + 6.00% orFloor rate of 7.50%
Senior DebtMatures December 2012Interest rate 11%
Revolving Line of CreditSenior DebtMatures August 2012Interest rate 11%
Revolving Line of CreditMatures July 2012Interest rate 11%,PIK interest 1.00%
Total Tectura Corporation
Total Debt Internet Consumer & Business Services (27.06%)
24
Box.net, Inc.
Senior DebtMatures March 2015Interest rate Prime + 3.75% orFloor rate of 7.50%
Senior DebtMatures July 2014Interest rate Prime + 5.25% orFloor rate of 8.50%
Senior DebtMatures February 2015Interest rate Prime + 6.25% orFloor rate of 9.50%
Senior DebtMatures August 2016Interest rate Prime + 6.25% orFloor rate of 6.75%
Total Debt Information Services (7.88%)
Senior DebtMatures December 2013Interest rate Prime + 8.20% orFloor rate of 11.45%
Total Debt Diagnostic (2.59%)*
deCODE genetics ehf.
Senior DebtMatures September 2014Interest rate Prime + 10.25% orFloor rate of 13.50%, PIK interest 2.00%
Senior DebtMatures May 2013Interest rate Prime + 8.6% orFloor rate of 11.85%
Cempra Holdings LLC
Senior DebtMatures December 2015Interest rate Prime + 7.05% orFloor rate of 10.30%
Total Debt Biotechnology Tools (3.91%)*
Senior DebtMatures December 2014Interest rate Prime + 5.90% orFloor rate of 9.65%
Senior DebtMatures February 2014Interest rate Prime + 9.70% orFloor rate of 12.95%
Total Debt Surgical Devices (2.66%)*
25
Neoprobe Corporation
Senior DebtMatures December 2014Interest rate Prime + 6.75% orFloor rate of 10.00%
Senior DebtMatures May 2016Interest rate Libor + 9.50% orFloor rate of 12.00%, PIK interest 3.00%
Senior DebtMatures November 2015Interest rate Libor + 7.50% orFloor rate of 10.0%
Total Debt Media/Content/Info (8.47%)*
BrightSource Energy, Inc.(4)
Senior DebtMatures December 2011Interest rate Prime + 7.75% orFloor rate of 11.0%
Senior DebtMatures December 2012Interest rate Prime + 9.55% orFloor rate of 12.8%
Total BrightSource Energy, Inc.
Senior DebtMatures February 2014Interest rate Prime + 6.1% orFloor rate of 9.35%
Enphase Energy, Inc.
Senior DebtMatures June 2014Interest rate Prime + 5.75% orFloor rate of 9.0%
NanoSolar, Inc.
Senior DebtMatures September 2014Interest rate Prime + 7.75% orFloor rate of 11.0%
Integrated Photovoltaics
Senior DebtMatures February 2015Interest rate Prime + 7.375% orFloor rate of 10.625%
Senior DebtMatures September 2013Interest rate of 11.0%
Senior DebtMatures October 2014Interest rate 6.25%
Senior DebtMatures August 2015Interest rate 8.15%
Senior DebtMatures June 2013Interest rate Prime + 8.25% orFloor rate of 11.50%
Senior DebtMatures June 2013Interest rate Prime + 7.25% orFloor rate of 10.50%
Total Debt Clean Tech (14.24%)*
Total Debt (135.90%)
26
& Development
Common Stock Warrants
Preferred Stock Warrants
Total Warrants Acceleron Pharmaceuticals, Inc.
Total Warrants Anthera Pharmaceuticals Inc.
Total Warrants Dicerna Pharmaceuticals, Inc.
EpiCept Corporation(5)
Concert Pharmaceuticals, Inc.
Horizon Pharma, Inc.
Merrimack Pharmaceuticals, Inc.
Portola Pharmaceuticals, Inc.
Total Warrants Drug Discovery & Development (1.17%)*
27
Affinity Videonet, Inc.
& Networking
IKANO Communications, Inc.
Total IKANO Communications, Inc.
Ping Identity Corporation
Purcell Systems, Inc.
Total Stoke, Inc.
Total Warrants Communications & Networking (0.23%)*
Bullhorn, Inc.
Sportvision, Inc.
Daegis Inc. (pka Unify Corporation)
Total Warrants Software (1.01%)*
28
Luminus Devices, Inc.
Total Luminus Devices, Inc.
Total Warrant Electronics & Computer Hardware (0.05%)*
Total Warrants Specialty Pharmaceuticals (0.22%)*
Annie’s, Inc.
Wageworks, Inc.
Total Warrant Consumer & Business Products (0.68%)*
NEXX Systems, Inc.
Total Warrants Semiconductors (0.35%)*
Alexza Pharmaceuticals, Inc.(4)
Transcept Pharmaceuticals, Inc.
Total Transcept Pharmaceuticals, Inc.
Total Warrant Drug Delivery (0.35%)*
29
Gelesis, Inc.
BARRX Medical, Inc.
Total Warrants Therapeutic (0.25%)*
Total Invoke Solutions, Inc.
Trulia, Inc.
Total Warrants Internet Consumer & Business Services (0.21%)
Total Warrants Energy (0.00%)*
Total Warrants Information Services (1.10%)
Total Warrants Diagnostic (0.20%)*
Total Warrants Biotechnology Tools (0.23%)*
30
Total Warrants Surgical Devices (0.02%)*
Everyday Health, Inc. (Waterfront Media, Inc.)
Total Warrants Media/Content/Info (0.17%)*
Total EcoMotors, Inc.
Total Warrants Clean Tech (0.74%)*
Total Warrants (6.97%)
Aveo Pharmaceuticals
Total Equity Drug Discovery & Development (2.49%)*
Total Equity Drug Delivery (0.33%)*
Total Equity Communications & Networking (0.70%)*
Total Equity Software (0.11%)*
31
Spatial Photonics, Inc.(8)
Total Equity Electronics & Computer Hardware (0.00%)*
Total Equity Consumer & Business Products (0.29%)*
Total Equity Semiconductors (0.41%)*
Total Equity Therapeutic (1.40%)*
Total Equity Internet Consumer & Business Services (0.01%)
Total Equity Information Services (1.66%)
Novadaq Technologies, Inc.(5)
Total Equity Diagnostic (0.73%)*
32
Kamada, LTD.
Biotechnology Tools
Total Equity Biotechnology Tools (0.20%)*
Surgical Devices
Total Equity Surgical Devices (0.00%)*
Media/Content/ Info
Total Equity Media/Content/Info (0.28%)*
Total Equity (8.60%)
Total Investments (151.47%)
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CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Investment Income:
Interest income
Non Control/Non Affiliate investments
Affiliate investments
Control investments
Total interest income
Fees
Total fees
Total investment income
Operating expenses:
Interest
Loan fees
General and administrative
Employee Compensation:
Compensation and benefits
Stock-based compensation
Total employee compensation
Total operating expenses
Net investment income
Net realized gains (loss) on investments
Total net realized gain (loss) on investments
Net increase (decrease) in unrealized appreciation (depreciation) on investments
Total net unrealized (depreciation) appreciation on investments
Total net realized and unrealized gain (loss)
Net increase (decrease) in net assets resulting from operations
Net investment income before provision for income taxes and investment gains and losses per common share:
Basic
Net increase in net assets resulting from operations per common share
Diluted
Weighted average shares outstanding
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CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS
(dollars and shares in thousands)
Balance at December 31, 2010
Net increase in net assets resulting from operations
Issuance of common stock
Issuance of common stock under restricted stock plan
Issuance of common stock as stock dividend
Retired shares from net issuance
Issuance of the Convertible Senior Notes
Dividends declared
Balance at June 30, 2011
Balance at December 31, 2011
Public Offering
Balance at June 30, 2012
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CONSOLIDATED STATEMENT OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net increase in net assets resulting from operations to net cash provided by (used in) operating activities:
Purchase of investments
Principal payments received on investments
Conversion of investment assets to other current assets
Proceeds from sale of investments
Net unrealized appreciation (depreciation) on investments
Net realized (gain) loss on investments
Accretion of paid-in-kind principal
Accretion of loan discounts
Accretion of loan exit fees
Change in deferred loan origination revenue
Unearned fees related to unfunded commitments
Accretion of loan discount on Convertible Senior Notes
Amortization of debt fees and issuance costs
Depreciation
Stock-based compensation and amortization of restricted stock grants
Change in operating assets and liabilities:
Interest and fees receivable
Prepaid expenses and other assets
Accounts payable
Accrued liabilities
Net cash provided by (used in) operating activities
Cash flows from investing activities:
Purchases of capital equipment
Other long-term assets
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from issuance of common stock, net
Dividends paid
Issuance of 2019 Notes
Borrowings of credit facilities
Repayments of credit facilities
Cash paid for debt issuance costs
Fees paid for credit facilities and debentures
Net cash provided by financing activities
Net decrease in cash
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
See notes to consolidated financial statements (audited)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business and Unaudited Interim Consolidated Financial Statements Basis of Presentation
Hercules Technology Growth Capital, Inc. (the “Company”) is a specialty finance company that provides debt and equity growth capital to technology-related companies at various stages of development, from seed and emerging growth to expansion and established stages of development, which include select publicly listed companies and select lower middle market technology companies. The Company sources its investments through its principal office located in Silicon Valley, as well as through its additional offices in Boston, MA, Boulder, CO and McLean, VA. The Company was incorporated under the General Corporation Law of the State of Maryland in December 2003.
The Company is an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). From incorporation through December 31, 2005, the Company was taxed as a corporation under Subchapter C of the Internal Revenue Code of 1986, (the “Code”). Effective January 1, 2006, the Company has elected to be treated for tax purposes as a regulated investment company, or RIC, under the Code (see Note 5).
Hercules Technology II, L.P. (“HT II”), Hercules Technology III, LP (“HT III”), and Hercules Technology IV, L.P. (“HT IV”), are Delaware limited partnerships that were formed in January 2005, September 2009 and December 2010, respectively. HT II and HT III were licensed to operate as small business investment companies (“SBICs”), under the authority of the Small Business Administration (“SBA”), on September 27, 2006 and May 26, 2010, respectively. As SBICs, HT II and HT III are subject to a variety of regulations concerning, among other things, the size and nature of the companies in which they may invest and the structure of those investments. The Company also formed Hercules Technology SBIC Management, LLC, or HTM, a limited liability company in November 2003. HTM is a wholly owned subsidiary of the Company and serves as the limited partner and general partner of HT II and HT III (see Note 4).
HT II and HT III hold approximately $203.8 million and $185.1 million in assets, respectively, and accounted for approximately 19.1% and 17.3% of our total assets prior to consolidation at June 30, 2012.
The Company also established wholly owned subsidiaries, all of which are structured as Delaware corporations and limited liability companies, to hold portfolio companies organized as limited liability companies, or LLCs (or other forms of pass-through entities). The Company currently qualifies as a RIC for federal income tax purposes, which allows the Company to avoid paying corporate income taxes on any income or gains that the Company distributes to our stockholders. The purpose of establishing these entities is to satisfy the RIC tax requirement that at least 90% of the Company’s gross income for income tax purposes is investment income.
The consolidated financial statements include the accounts of the Company and its subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. In accordance with Article 6 of Regulation S-X under the Securities Act of 1933 and the Securities and Exchange Act of 1934, the Company does not consolidate portfolio company investments. The accompanying consolidated interim financial statements are presented in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information, and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X under the Securities Act of 1933 and the Securities Exchange Act of 1934. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with U.S. GAAP are omitted. In the opinion of management, all adjustments consisting solely of normal recurring accruals considered necessary for the fair presentation of consolidated financial statements for the interim periods have been included. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year. Therefore, the interim unaudited consolidated financial statements and notes should be read in conjunction with the audited consolidated financial statements and notes thereto for the period ended December 31, 2011. The year-end consolidated statement of assets and liabilities data was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. Financial statements prepared on a U.S. GAAP basis require management to make estimates and assumptions that affect the amounts and disclosures reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
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2. Valuation of Investments
The Company’s investments are carried at fair value in accordance with the 1940 Act and Accounting Standards Codification (“ASC”) topic 820 Fair Value Measurements and Disclosures (formerly known as SFAS No. 157, Fair Value Measurements). At June 30, 2012, 90.1% of the Company’s total assets represented investments in portfolio companies that are valued at fair value by the Board of Directors. Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the Board of Directors. The Company’s debt securities are primarily invested in equity sponsored technology-related companies including life science, clean technology and select lower middle market technology companies. Given the nature of lending to these types of businesses, the Company’s investments in these portfolio companies are considered Level 3 assets under ASC 820 because there is no known or accessible market or market indexes for these investment securities to be traded or exchanged. As such, the Company values substantially all of its investments at fair value as determined in good faith pursuant to a consistent valuation policy and the Company’s Board of Directors in accordance with the provisions of ASC 820 and the 1940 Act. Due to the inherent uncertainty in determining the fair value of investments that do not have a readily available market value, the fair value of the Company’s investments determined in good faith by its Board may differ significantly from the value that would have been used had a readily available market existed for such investments, and the differences could be material.
Our Board of Directors may from time to time engage an independent valuation firm to provide the Company with valuation assistance with respect to certain of the Company’s portfolio investments on a quarterly basis. The Company intends to continue to engage an independent valuation firm to provide management with assistance regarding the Company’s determination of the fair value of selected portfolio investments each quarter unless directed by the Board of Directors to cancel such valuation services. The scope of services rendered by an independent valuation firm is at the discretion of the Board of Directors. The Company’s Board of Directors is ultimately and solely responsible for determining the fair value of the Company’s investments in good faith.
With respect to investments for which market quotations are not readily available or when such market quotations are deemed not to represent fair value, the Company’s Board of Directors has approved a multi-step valuation process each quarter, as described below:
(1) the Company’s quarterly valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment;
(2) preliminary valuation conclusions are then documented and business based assumptions are discussed with the Company’s investment committee;
(3) the valuation committee of the Board of Directors reviews the preliminary valuation of the investment committee which incorporates the results of the independent valuation firm as appropriate;
(4) the Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith based on the input of, where applicable, the respective independent valuation firm and the valuation committee.
The Company adopted ASC 820 on January 1, 2008. ASC 820 establishes a framework for measuring the fair value of the assets and liabilities and outlines a fair value hierarchy which prioritizes the inputs used to measure fair value and the effect of fair value measures on earnings. ASC 820 also enhances disclosure requirements for fair value measurements based on the level within the hierarchy of the information used in the valuation. ASC 820 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The Company has categorized all investments recorded at fair value in accordance with ASC 820 based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by ASC 820 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:
Level 1—Inputs are unadjusted, quoted prices in active markets for identical assets at the measurement date. The types of assets carried at Level 1 fair value generally are equities listed in active markets.
Level 2—Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset in connection with market data at the measurement date and for the extent of the instrument’s anticipated life. Fair valued assets that are generally included in this category are warrants held in a public company.
Level 3—Inputs reflect management’s best estimate of what market participants would use in pricing the asset at the measurement date. It includes prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. Generally, assets carried at fair value and included in this category are the debt investments and warrants and equities held in a private company.
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In accordance with ASU 2011-04, the following table provides quantitative information about the Company’s Level 3 fair value measurements of the Company’s investments as of June 30, 2012. In addition to the techniques and inputs noted in the table below, according to the Company’s valuation policy the Company may also use other valuation techniques and methodologies when determining the Company’s fair value measurements. The below table is not intended to be all-inclusive, but rather provides information on the significant Level 3 inputs as they relate to the Company’s fair value measurements.
Quantitative Information about Level 3 Fair Value Measurements of Debt Investments
Investment Type - Level Three Debt Investments
Valuation Techniques/
Methodologies
Unobservable Input(a)
Pharmaceuticals - Debt
(2.0%) - 3.0%
Option Pricing Model(b)
Average Industry Volatility(c)
Risk Free Interest Rate Estimated Time to Exit (in months)
61.54%
0.27%
21.3
Medical Devices - Debt
Technology - Debt
Clean Tech - Debt
Lower Middle Market - Debt
Broker Quote(d)
Price Quotes
93.5% - 99% of par
Liquidation
Investment Collateral
$50 - $293
Total Level Three Debt Investments
Pharmaceuticals, above, is comprised of debt investments in the Therapeutic, Specialty Pharmaceuticals, Drug Discovery and Development, Drug Delivery, Diagnostic and Biotechnology Tools industries in the Schedule of Investments.
Medical Devices, above, is comprised of debt investments in the Therapeutic, Surgical Devices, Medical Devices and Equipment and Biotechnology Tools industries in the Schedule of Investments.
Technology, above, is comprised of debt investments in the Software, Semiconductors, Internet Consumer and Business Services, Information Services, and Communications and Networking industries in the Schedule of Investments.
Lower Middle Market, above, is comprised of debt investments in the Communications and Networking, Electronics and Computer Hardware, Healthcare Services - Other, Information Services, Internet Consumer and Business Services, Media/Content/Info, and Specialty Pharmaceuticals industries in the Schedule of Investments.
Clean Tech, above, aligns with the Clean Tech industry in the Schedule of Investments.
Quantitative Information about Level 3 Fair Value Measurements of Warrants and Equity Investments
Investment Type -
Level Three Warrant and Equity Investments
Warrant positions additionally subject to:
Total Level Three Warrant and Equity Investments
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Debt Investments
The Company’s debt securities are primarily invested in equity sponsored technology-related companies including life science, clean technology and select lower middle market technology companies. Given the nature of lending to these types of businesses, the Company’s investments in these portfolio companies are considered Level 3 assets under ASC 820 because there is no known or accessible market or market indexes for these investment securities to be traded or exchanged.
The Company applies a procedure that assumes a sale of investment in a hypothetical market to a hypothetical market participant where buyers and sellers are willing participants. The hypothetical market does not include scenarios where the underlying security was simply repaid or extinguished, but includes an exit concept. Under this process, the Company also evaluates the collateral for recoverability of the debt investments as well as applies all of its historical fair value analysis. The Company uses pricing on recently issued comparable debt securities to determine the baseline hypothetical market yields as of the measurement date. The Company considers each portfolio company’s credit rating, security liens and other characteristics of the investment to adjust the baseline yield to derive a hypothetical yield for each investment as of the measurement date. The anticipated future cash flows from each investment are then discounted at the hypothetical yield to estimate each investment’s fair value as of the measurement date.
The Company’s process includes, among other things, the underlying investment performance, the current portfolio company’s financial condition and market changing events that impact valuation, estimated remaining life, current market yield and interest rate spreads of similar securities as of the measurement date. If there is a significant deterioration of the credit quality of a debt investment, the Company may consider other factors to estimate fair value, including the proceeds that would be received in a liquidation analysis.
The Company records unrealized depreciation on investments when it believes that an investment has decreased in value, including where collection of a loan is doubtful or if under the in exchange premise when the value of a debt security was to be less than amortized cost of the investment. Conversely, where appropriate, the Company records unrealized appreciation if it believes that the underlying portfolio company has appreciated in value and, therefore, that its investment has also appreciated in value or if under the in exchange premise the value of a debt security were to be greater than amortized cost.
When originating a debt instrument, the Company generally receives warrants or other equity-related securities from the borrower. The Company determines the cost basis of the warrants or other equity-related securities received based upon their respective fair values on the date of receipt in proportion to the total fair value of the debt and warrants or other equity-related securities received. Any resulting discount on the loan from recordation of the warrant or other equity instruments is accreted into interest income over the life of the loan.
Equity-Related Securities and Warrants
Securities that are traded in the over-the-counter markets or on a stock exchange will be valued at the prevailing bid price at period end. We have a limited number of equity securities in public companies. In accordance with the 1940 Act, unrestricted publicly traded securities for which market quotations are readily available are valued at the closing market quote on the measurement date.
The Company estimates the fair value of warrants using a Black Scholes pricing model. At each reporting date, privately held warrant and equity-related securities are valued based on an analysis of various factors including, but not limited to, the portfolio company’s operating performance and financial condition and general market conditions, price to enterprise value or price to equity ratios, discounted cash flow, valuation comparisons to comparable public companies or other industry benchmarks. When an external event occurs, such as a purchase transaction, public offering, or subsequent equity sale, the pricing indicated by that external event is utilized to corroborate the Company’s valuation of the warrant and equity-related securities. The Company periodically reviews the valuation of its portfolio companies that have not been involved in a qualifying external event to determine if the enterprise value of the portfolio company may have increased or decreased since the last valuation measurement date.
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Investments measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations as of June 30, 2012 (unaudited) and as of December 31, 2011. We transfer investments in and out of Level 1, 2 and 3 securities as of the beginning balance sheet date, based on changes in the use of observable and unobservable inputs utilized to perform the valuation for the period. During the six month period ended June 30, 2012, there were no transfers in between Levels 1 or 2.
(in thousands)
Description
Senior secured debt
Preferred stock
Common stock
Warrants
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The table below presents reconciliation for all financial assets and liabilities measured at fair value on a recurring basis, excluding accrued interest components, using significant unobservable inputs (Level 3) for the six months ended June 30, 2012 (unaudited) and for the year ended December 31, 2011.
Preferred Stock
Common Stock
Total
Subordinated debt
Includes net realized gains (losses) recorded as realized gains or losses in the accompanying consolidated statements of operations.
Included in change in net unrealized appreciation or depreciation in the accompanying consolidated statements of operations.
Transfers in to Level 3 relate to the conversion of E-Band Communications, Inc. debt to equity. Transfers out of Level 3 relate to the respective initial public offerings of Annie’s, Inc., Cempra, Inc., Enphase Energy, Inc. Merrimack Pharmaceuticals, Inc. and WageWorks, Inc. to level 1 and of Facebook, Inc. to level 2.
For the six months ended June 30, 2012, approximately $1.6 million in unrealized appreciation and approximately $861,000 in unrealized depreciation was recorded for equity and warrant Level 3 investments, respectively, relating to assets still held at the reporting date. For the same period, approximately $10.7 million in unrealized depreciation was recorded for Level 3 debt investments relating to assets still held at the reporting date.
For the year ended December 31, 2011, approximately $9.1 million and $3.8 million in unrealized appreciation was recorded for debt and warrant Level 3 investments, respectively, relating to assets still held at the reporting date. For the same period, approximately $480,000 in unrealized depreciation was recorded for equity Level 3 investments relating to assets still held at the reporting date.
As required by the 1940 Act, the Company classifies its investments by level of control. “Control investments” are defined in the 1940 Act as investments in those companies that the Company is deemed to “control”. Generally, under the 1940 Act, the Company is deemed to “control” a company in which it has invested if it owns 25% or more of the voting securities of such company or has greater than 50% representation on its board. “Affiliate investments” are investments in those companies that are “affiliated companies” of the Company, as defined in the 1940 Act, which are not control investments. The Company is deemed to be an “affiliate” of a company in which it has invested if it owns 5% or more but less than 25% of the voting securities of such company. “Non-control/non-affiliate investments” are investments that are neither control investments nor affiliate investments.
The following table summarizes our realized and unrealized gain and loss and changes in our unrealized appreciation and depreciation on control and affiliate investments for the three and six months ended June 30, 2012 and June 30, 2011:
Three months ended June 30, 2012
Type
MaxVision Holding, LLC.
E-Band Communications, Corp.
Gelesis
Three months ended June 30, 2011
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A summary of the composition of the Company’s investment portfolio as of June 30, 2012 (unaudited) and December 31, 2011 at fair value is shown as follows:
Senior secured debt with warrants
A summary of the Company’s investment portfolio, at value, by geographic location as of June 30, 2012 (unaudited) and as of December 31, 2011 is shown as follows:
United States
England
Iceland
Ireland
Canada
Israel
The following table shows the fair value the Company’s portfolio by industry sector at June 30, 2012 (unaudited) and December 31, 2011:
Drug Discovery & Development
Software
Clean Tech
Drug Delivery
Internet Consumer & Business Services
Media/Content/Info
Communications & Networking
Healthcare Services, Other
Information Services
Therapeutic
Diagnostic
Medical Device & Equipment
Specialty Pharma
Consumer & Business Products
Semiconductors
Electronics & Computer Hardware
During the three and six-month periods ended June 30, 2012, the Company funded investments in debt securities, totaling approximately $106.9 million and $169.8 million, respectively. During the three and six-month periods ended June 30, 2012, the Company funded equity investments of approximately $5.0 million and $7.1 million respectively. During the six-month period ended June 30, 2012, the Company converted approximately $356,000 of debt to equity in one portfolio company. In addition, in December 2011, Hercules entered into an agreement to acquire shares of Facebook, Inc. common stock for approximately $9.6 million through a secondary marketplace. The investments were subject to a Facebook, Inc. right of first refusal, which expired thirty days after the date of investment. At December 31, 2011 these assets were held as Other Assets. In February 2012, Hercules was notified that Facebook Inc. had not exercised its repurchase right with respect to any of the shares and had executed all documents necessary to fully transfer the ownership of the shares to Hercules. Accordingly, during the six-month period ended June 30, 2012, the investment in Facebook, Inc. was transferred from Other Assets to Investments.
During the three and six-month periods ended June 30, 2011 the Company made investments in debt securities, totaling approximately $105.2 million and $189.3 million, respectively. The Company funded equity investments of approximately $500,000 in the three month period and approximately $500,000 in the six-month period ended June 30, 2011.
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During the three and six-months ended June 30, 2012, the Company recognized net realized gains of approximately $8.3 million and $11.1 million on the portfolio, respectively. During the quarter ended June 30, 2012, we recorded approximately $5.3 million, $2.4 million and $862,000 of realized gains from the sale of equity and warrant investments in NEXX Systems, Inc., Annie’s, Inc. and Bullhorn, Inc., respectively. These gains were partially offset by realized losses due to the expiration of warrants in three private portfolio companies that had a total cost basis of approximately $222,000.
During the three and six-months ended June 30, 2011 the Company recognized total net realized gains of approximately $497,000 for the sale of equity in Aegerion Pharmaceuticals, Inc. and $10.1 million from the sale of common stock in its public portfolio companies and realized gains of approximately $162,000 and realized losses of approximately $5.1 million from equity, loan, and warrant investments in portfolio companies that have been liquidated.
Loan origination and commitment fees received in full at the inception of a loan are deferred and amortized into fee income as an enhancement to the related loan’s yield over the contractual life of the loan. Loan exit fees to be paid at the termination of the loan are accreted into interest income over the contractual life of the loan. The Company had approximately $2.9 million and $4.5 million of unamortized fees at June 30, 2012 and December 31, 2011, respectively, and approximately $4.8 million and $4.4 million in exit fees receivable at June 30, 2012 and December 31, 2011, respectively.
The Company has loans in its portfolio that contain a payment-in-kind (“PIK”) provision. The PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain the Company’s status as a RIC, this non-cash source of income must be paid out to stockholders in the form of dividends even though the Company has not yet collected the cash. Amounts necessary to pay these dividends may come from available cash or the liquidation of certain investments. The Company recorded approximately $271,000 and $569,000 in PIK income in the three and six-month periods ended June 30, 2012. The Company recorded approximately $524,000 and $1.1 million in PIK income in the same periods ended June 30, 2011, respectively.
In certain investment transactions, the Company may provide advisory services. For services that are separately identifiable and external evidence exists to substantiate fair value, income is recognized as earned, which is generally when the investment transaction closes. The Company had no income from advisory services in the three and six-month periods ended June 30, 2012.
In some cases, the Company collateralizes its investments by obtaining a first priority security interest in a portfolio company’s assets, which may include their intellectual property. In other cases, the Company may obtain a negative pledge covering a company’s intellectual property. At June 30, 2012, approximately 63.1% of the Company’s portfolio company loans were secured by a first priority security in all of the assets of the portfolio company (including their intellectual property), 33.8% of portfolio company loans were to portfolio companies that were prohibited from pledging or encumbering their intellectual property, 2.3% of portfolio company loans had a first priority security in only their intellectual property, and 0.8% of portfolio company loans had an equipment only lien.
3. Fair Value of Financial Instruments
Fair value estimates are made at discrete points in time based on relevant information. These estimates may be subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. The Company believes that the carrying amounts of its financial instruments, consisting of cash and cash equivalents, receivables, accounts payable and accrued liabilities approximate the fair values of such items due to the short maturity of such instruments. The Convertible Senior Notes, 2019 Notes and the SBA debentures as sources of liquidity remain a strategic advantage due to their flexible structure, long-term duration, and low fixed interest rates. At June 30, 2012, the 2019 Notes were trading on the New York Stock Exchange for $1.014 per dollar at par value. Based on market quotations on or around June 30, 2012, the Convertible Senior Notes were trading for $1.0375 per dollar at par value. Calculated based on the net present value of payments over the term of the notes using estimated market rates for similar notes and remaining terms, the fair value of the SBA debentures would be approximately $216.0 million, compared to the carrying amount of $200.7 million as of June 30, 2012.
The liabilities of the Company below are recorded at amortized cost and not at fair value on the balance sheet. The following table provides additional information about the level in the fair value hierarchy of our liabilities:
(in thousands)Description
Convertible Senior Notes
SBA Debentures
See the accompanying Consolidated Schedule of Investments for the fair value of the Company’s investments. The methodology for the determination of the fair value of the Company’s investments is discussed in Note 1.
4. Borrowings
On September 27, 2006, HT II received a license to operate as a SBIC under the SBIC program and is able to borrow funds from the SBA against eligible investments and regulatory capital. Under the Small Business Investment Company Act and current SBA policy applicable to SBICs, a SBIC can have outstanding at any time SBA guaranteed debentures up to twice the amount of its regulatory capital. The Company’s net investment of $75.0 million in HT II as of June 30, 2012 fully funds the required regulatory capital for HT II. HT II has a total of $100.7 million of SBA guaranteed debentures outstanding as of June 30, 2012 and has paid the SBA commitment fees of approximately $1.5 million. As of June 30, 2012, the Company held investments in HT II in 52 companies with a fair value of approximately $179.7 million, accounting for approximately 24.9% of the Company’s total portfolio.
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On May 26, 2010, HT III received a license to operate as a SBIC under the SBIC program and is able to borrow funds from the SBA against eligible investments and additional contributions to regulatory capital. With the Company’s net investment of $62.3 million in HT III as of June 30, 2012, HT III has the capacity to issue a total of $124.3 million of SBA guaranteed debentures, subject to SBA approval, of which $100.0 million was outstanding as of June 30, 2012. As of June 30, 2012, HT III has paid commitment fees of approximately $1.2 million. As of June 30, 2012, the Company held investments in HT III in 27 companies with a fair value of approximately $140.3 million, accounting for approximately 19.4% of the Company’s total portfolio.
There is no assurance that HT II or HT III will be able to draw to the maximum limit available under the SBIC program.
SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18.0 million and have average annual fully taxed net income not exceeding $6.0 million for the two most recent fiscal years. In addition, SBICs must devote 25.0% of its investment activity to “smaller” concerns as defined by the SBA.
A smaller concern is one that has a tangible net worth not exceeding $6.0 million and has average annual fully taxed net income not exceeding $2.0 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services. Through its wholly-owned subsidiaries HT II and HT III, the Company plans to provide long-term loans to qualifying small businesses, and in connection therewith, make equity investments.
HT II and HT III are periodically examined and audited by the SBA’s staff to determine their compliance with SBA regulations. If HT II or HT III fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit HT II’s or HT III’s use of debentures, declare outstanding debentures immediately due and payable, and/or limit HT II or HT III from making new investments. In addition, HT II or HT III may also be limited in their ability to make distributions to the Company if they do not have sufficient capital in accordance with SBA regulations. Such actions by the SBA would, in turn, negatively affect the Company because HT II and III are the Company’s wholly owned subsidiaries. HT II and HT III were in compliance with the terms of the SBIC’s leverage as of June 30, 2012 as a result of having sufficient capital as defined under the SBA regulations.
The rates of borrowings under various draws from the SBA beginning in April 2007 are set semiannually in March and September and range from 2.77% to 5.73%. Interest payments on SBA debentures are payable semi-annually. There are no principal payments required on these issues prior to maturity and no prepayment penalties. Debentures under the SBA generally mature ten years after being borrowed. Based on the initial draw down date of April 2007, the initial maturity of SBA debentures will occur in April 2017. In addition, the SBA charges a fee that is set annually, depending on the Federal fiscal year the leverage commitment was delegated by the SBA, regardless of the date that the leverage was drawn by the SBIC. The annual fees related to HT II debentures that pooled on September 22, 2010 were 0.406% and 0.285%, depending upon the year in which the underlying commitment was closed. The annual fees related to HT III debentures that pooled on March 21, 2012 were 0.285% and 0.515% depending upon the year in which the underlying commitment was closed. The annual fees on other debentures have been set at 0.906%. The average amount of debentures outstanding for the quarter ended June 30, 2012 for HT II was approximately $100.7 million with an average interest rate of approximately 6.3%. The average amount of debentures outstanding for the quarter ended June 30, 2012 for HT III was approximately $100.0 million with an average interest rate of approximately 3.6%.
HT II and HT III hold approximately $203.8 million and $185.1 million in assets, respectively, and accounted for approximately 19.1% and 17.3% of the Company’s total assets prior to consolidation at June 30, 2012.
In January 2011, the Company repaid $25.0 million of SBA debentures under HT II, priced at approximately 6.63%, including annual fees. In April 2011, the SBA approved a $25.0 million dollar commitment for HT III bringing the total available borrowings to $225.0 million, of which $125.0 million was available in HT II and $100.0 million was available in HT III.
In February 2012, the Company repaid $24.3 million of SBA debentures under HT II, priced at 6.63%, including annual fees. In June 2012, the SBA approved a $24.3 million dollar commitment for HT III bringing the total available borrowings to $225.0 million, of which $100.7 million was available in HT II and $124.3 million was available in HT III.
As of June 30, 2012, the maximum statutory limit on the dollar amount of outstanding SBA guaranteed debentures issued by a single SBIC is $150.0 million, subject to periodic adjustments by the SBA, and a maximum amount of $225.0 million for funds under common control, subject to periodic adjustments by the SBA. In the aggregate, at June 30, 2012 there was $200.7 million principal amount of indebtedness outstanding incurred by our SBIC subsidiaries, and in June 2012 the SBA approved an additional $24.3 million under HT III, bringing us to the maximum statutory limit on the dollar amount of SBA guaranteed debentures under the SBIC program.
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The Company reported the following SBA debentures outstanding on its Consolidated Statement of Assets and Liabilities as of June 30, 2012 (unaudited) and December 31, 2011:
Issuance/Pooling Date
SBA Debentures:
September 26, 2007
March 26, 2008
September 24, 2008
March 25, 2009
September 23, 2009
September 22, 2010
March 29, 2011
September 21, 2011
March 21, 2012
Total SBA Debentures
Interest rate includes annual charge
Wells Facility
In August 2008, the Company entered into a $50.0 million two-year revolving senior secured credit facility with Wells Fargo Capital Finance (the “Wells Facility”). On June 20, 2011, the Company renewed the Wells Facility. Under this three-year senior secured facility, Wells Fargo Capital Finance has made commitments of $75.0 million. The facility contains an accordion feature, in which we can increase the credit line up to an aggregate of $300.0 million, funded by additional lenders and with the agreement of Wells Fargo Capital Finance and subject to other customary conditions. We expect to continue discussions with various other potential lenders to join the new facility; however, there can be no assurances that additional lenders will join the Wells Facility.
Borrowings under the Wells Facility will generally bear interest at a rate per annum equal to LIBOR plus 3.50%, with a floor of 5.00% and an advance rate of 50% against eligible loans. The Wells Facility is secured by loans in the borrowing base. The Wells Facility requires the monthly payment of a non-use fee of 0.3% for each payment date on or before September 1, 2011. The monthly payment of a non-use fee thereafter shall depend on the average balance that was outstanding on a scale between 0.0% and 0.75%. For the three-month period ended June 30, 2012, this non-use fee was approximately $140,000. On June 20, 2011 we paid an additional $1.1 million in structuring fees in connection with the Wells Facility which is being amortized through June 2014. At June 30, 2012, there was approximately $3.1 million outstanding under the Wells Facility.
The Wells Facility includes various financial and operating covenants applicable to us and our subsidiaries, in addition to those applicable to Hercules Funding II, LLC. These covenants require us to maintain certain financial ratios and a minimum tangible net worth in an amount, when added to outstanding subordinated indebtedness, that is in excess of $314.0 million plus 90% of the cumulative amount of equity raised after March 31, 2011. In addition, the tangible net worth covenant will increase by 90 cents on the dollar for every dollar of equity capital subsequently raised by the Company. As of June 30, 2012, the minimum tangible net worth covenant has increased to $357.2 million as a result of the January 2012 follow-on public offering of 5.0 million shares of common stock for proceeds of approximately $48.05 million. The Wells Facility provides for customary events of default, including, but not limited to, payment defaults, breach of representations or covenants, bankruptcy events and change of control. We were in compliance with all covenants at June 30, 2012.
Union Bank Facility
On February 10, 2010, the Company entered a $20.0 million one-year revolving senior secured credit facility with Union Bank (the “Union Bank Facility”). On November 2, 2011, the Company renewed and amended the Union Bank Facility and added a new lender under the Union Bank Facility. Union Bank and RBC Capital Markets have made commitments of $30.0 million and $25.0 million, respectively. The Union Bank Facility contains an accordion feature, in which we can increase the credit line up to an aggregate of $150.0 million, funded by additional lenders and with the agreement of Union Bank and subject to other customary conditions. We expect to continue discussions with various other potential lenders to join the new facility; however, there can be no assurances that additional lenders will join the Union Bank Facility.
Borrowings under the Union Bank Facility will generally bear interest at a rate per annum equal to LIBOR plus 2.25% with a floor of 4.0%. At June 30, 2012, there were no borrowings outstanding on this facility. The Union Bank Facility requires the payment of a non-use fee of 0.50% annually. For the three-month period ended June 30, 2012, this non-use fee was approximately $70,000. The Union Bank Facility is collateralized by debt investments in our portfolio companies, and includes an advance rate equal to 50.0% of eligible loans placed in the collateral pool. The Union Bank Facility generally requires payment of interest on a monthly basis. All outstanding principal is due upon maturity.
The Union Bank Facility requires various financial and operating covenants. These covenants require us to maintain certain financial ratios and a minimum tangible net worth in an amount, when added to outstanding subordinated indebtedness, that is in excess of $314.0 million plus 90% of the amount of net cash proceeds received from the sale of common stock after March 31, 2011. As of June 30, 2012, the minimum tangible net worth covenant has increased to $356.5 million as a result of the January 2012 follow-on public offering of 5.0 million shares of common stock for net proceeds of approximately $47.2 million. The Union Bank Facility will mature on November 2, 2014, approximately three years from the date of issuance, revolving through the first 24 months with a term out provision for the remaining 12 months. Union Bank Facility also provides for customary events of default, including, but not limited to, payment defaults, breach of representations or covenants, bankruptcy events and change of control. On March 30, 2012 the Company entered into an amendment to the Union Bank Facility which permitted the Company to issue additional senior notes relating to the offer and sale of the Company’s 2019 Notes. We were in compliance with all covenants at June 30, 2012.
Citibank Credit Facility
The Company, through Hercules Funding Trust I, an affiliated statutory trust, had a securitized credit facility (the “Citibank Credit Facility”) with Citigroup Global Markets Realty Corp. which expired under normal terms. During the first quarter of 2009, the Company paid off all principal and interest owed under the Citibank Credit Facility. Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants collateralized under the Citibank Credit Facility. Pursuant to the warrant participation agreement, the Company granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants were included in collateral subsequent to the facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equal $3,750,000 (the “Maximum Participation Limit”). The obligations under the warrant participation agreement continue even after the Citibank Credit Facility was terminated until the Maximum Participation Limit has been reached. The value of their participation right on unrealized gains in the related equity investments was approximately $606,000 as of June 30, 2012 and is included in accrued liabilities. There can be no assurances that the unrealized appreciation of the warrants will not be higher or lower in future periods due to fluctuations in the value of the warrants. Since inception of the agreement, the Company has paid Citigroup approximately $1.1 million under the warrant participation agreement thereby reducing its realized gains by this amount. The Company will continue to pay Citigroup under the warrant participation agreement until the Maximum Participation Limit is reached or the warrants expire. Warrants subject to the Citigroup participation agreement are set to expire between July 2012 and January 2017.
In April 2011, the Company issued $75.0 million in aggregate principal amount of its 6.00% convertible senior notes (the “Convertible Senior Notes”) due 2016.
The Convertible Senior Notes mature on April 15, 2016 (the “Maturity Date”), unless previously converted or repurchased in accordance with their terms. The Convertible Senior Notes bear interest at a rate of 6.00% per year payable semiannually in arrears on April 15 and October 15 of each year, commencing on October 15, 2011. The Convertible Senior Notes are the Company’s senior unsecured obligations and rank senior in right of payment to the Company’s existing and future indebtedness that is expressly subordinated in right of payment to the Convertible Senior Notes; equal in right of payment to the Company’s existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of the Company’s secured indebtedness (including unsecured indebtedness that the Company later secures) to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred by the Company’s subsidiaries, financing vehicles or similar facilities.
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Prior to the close of business on the business day immediately preceding October 15, 2015, holders may convert their Convertible Senior Notes only under certain circumstances set forth in the Indenture. On or after October 15, 2015 until the close of business on the scheduled trading day immediately preceding the Maturity Date, holders may convert their Convertible Senior Notes at any time. Upon conversion, the Company will pay or deliver, as the case may be, at its election, cash, shares of its common stock or a combination of cash and shares of its common stock. The conversion rate will initially be 84.0972 shares of common stock per $1,000 principal amount of Convertible Senior Notes (equivalent to an initial conversion price of approximately $11.89 per share of common stock). The conversion rate will be subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. In addition, if certain corporate events occur prior to the Maturity Date, the conversion rate will be increased for converting holders.
The Company may not redeem the Convertible Senior Notes prior to maturity. No sinking fund is provided for the Convertible Senior Notes. In addition, if certain corporate events occur, holders of the Convertible Senior Notes may require the Company to repurchase for cash all or part of their Convertible Senior Notes at a repurchase price equal to 100% of the principal amount of the Convertible Senior Notes to be repurchased, plus accrued and unpaid interest through, but excluding, the required repurchase date.
The Convertible Senior Notes are accounted for in accordance with ASC 470-20 (previously FASB Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)”). In accounting for the Convertible Senior Notes, we estimated at the time of issuance that the values of the debt and the embedded conversion feature of the Convertible Senior Notes were approximately 92.8% and 7.2%, respectively. The original issue discount of 7.2% attributable to the conversion feature of the Convertible Senior Notes was recorded in “capital in excess of par value” in the accompanying consolidated statement of assets and liabilities. As a result, the Company records interest expense comprised of both stated interest expense as well as accretion of the original issue discount. Additionally, the issuance costs associated with the Convertible Senior Notes were allocated to the debt and equity components in proportion to the allocation of the proceeds and accounted for as debt issuance costs and equity issuance costs, respectively. At the time of issuance, the debt issuance costs and equity issuance costs were approximately $2.9 million and $224,000, respectively. At the time of issuance and as of June 30, 2012, the equity component, net of issuance costs, as recorded in the “capital in excess of par value” in the balance sheet was approximately $5.2 million.
As of June 30, 2012, the components of the carrying value of the Convertible Senior Notes were as follows:
Principal amount of debt
Original issue discount, net of accretion
Carrying value of debt
For the three month and six months ended June 30, 2012, the components of interest expense, fees and cash paid for interest expense for the Convertible Senior Notes were as follows:
Stated interest expense
Accretion of original issue discount
Amortization of debt issuance cost
Total interest expense
Cash paid for interest expense
The estimated effective interest rate of the debt component of the Convertible Senior Notes, equal to the stated interest of 6.0% plus the accretion of the original issue discount, was approximately 8.2% for the three and six-months ended June 30, 2012. As of June 30, 2012, we are in compliance with the terms of the indentures governing the Convertible Senior Notes.
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On April 17, 2012, the Company and U.S. Bank, N.A. (the “Trustee”), entered into the First Supplemental Indenture (the “First Supplemental Indenture”) to the Indenture (the “Indenture”) between the Company and the Trustee, dated April 17, 2012, relating to the Company’s issuance, offer and sale of $43.0 million aggregate principal amount of 7.00% senior notes due 2019 (the “2019 Notes”). The sale of the Notes generated net proceeds, before expenses, of approximately $41.7 million.
The 2019 Notes will mature on April 30, 2019 and may be redeemed in whole or in part at the Company’s option at any time or from time to time on or after April 30, 2015, upon not less than 30 days nor more than 60 days written notice by mail prior to the date fixed for redemption thereof, at a redemption price of 100% of the outstanding principal amount thereof plus accrued and unpaid interest payments otherwise payable for the then-current quarterly interest period accrued to but not including the date fixed for redemption. The 2019 Notes bear interest at a rate of 7.00% per year payable quarterly on January 30, April 30, July 30 and October 30 of each year, commencing on July 30, 2012, and trade on the New York Stock Exchange under the trading symbol “HTGZ.”
The 2019 Notes will be the Company’s direct unsecured obligations and will rank: (i) pari passu with our other outstanding and future senior unsecured indebtedness, including without limitation, the $75 million in aggregate principal amount of the Convertible Senior Notes; (ii) senior to any of our future indebtedness that expressly provides it is subordinated to the 2019 Notes; (iii) effectively subordinated to all our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, borrowings under our credit facilities; (iv) structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Hercules Technology II, L.P. and Hercules Technology III, L.P. and borrowings under our revolving senior secured credit facility with Wells Fargo Capital Finance.
The Indenture, as supplemented by the First Supplemental Indenture, contains certain covenants including covenants requiring the Company to comply with (regardless of whether it is subject to) the asset coverage requirements set forth in Section 18(a)(1)(A) as modified by Section 61(a)(1) of the Investment Company Act of 1940, as amended, to comply with the restrictions on dividends, distributions and purchase of capital stock set forth in Section 18(a)(1)(B) as modified by Section 61(a)(1) of the Investment Company Act of 1940, as amended, and to provide financial information to the holders of the 2019 Notes and the Trustee if the Company should no longer be subject to the reporting requirements under the Securities Exchange Act of 1934. These covenants are subject to important limitations and exceptions that are described in the Indenture, as supplemented by the First Supplemental Indenture. The Indenture provides for customary events of default and further provides that the Trustee or the holders of 25% in aggregate principal amount of the outstanding 2019 Notes in a series may declare such 2019 Notes immediately due and payable upon the occurrence of any event of default after expiration of any applicable grace period.
The 2019 Notes were sold pursuant to an underwriting agreement dated April 11, 2012 among the Company and Stifel, Nicolaus & Company, Incorporated, as representative of the several underwriters named in the underwriting agreement.
In July 2012, we re-opened our 2019 Notes and issued an additional amount of approximately $41.5 million in aggregate principal amount of 2019 Notes, which includes exercise of an over-allotment option, bringing the total amount of the 2019 Notes issued to approximately $84.5 million in aggregate principal amount. See “Subsequent Events” below.
For the three months and six months ended June 30, 2012, the components of interest expense and related fees and cash paid for interest expense for the 2019 Notes are as follows:
Total interest expense and fees
At June 30, 2012 (unaudited) and December 31, 2011, the Company had the following borrowing capacity and outstanding borrowings:
2019 Notes(2)
Convertible Senior Notes(3)
SBA Debentures(4)
Except for the Convertible Senior Notes (as defined below), all carrying values are the same as the principal amount outstanding.
In July 2012, the Company re-opened its 2019 Notes and issued an additional approximate $41.5 million in aggregate principal amount, which includes exercise of an over-allotment option, bringing the total amount of 2019 Notes issued to approximately $84.5 million in aggregate principal amount.
Represents the aggregate principal amount outstanding of the Convertible Senior Notes (as defined below) less the unaccreted discount initially recorded upon issuance of the Convertible Senior Notes. The total unaccreted discount for the Convertible Senior Notes was $4,106 at June 30, 2012.
In February 2012, the Company repaid $24.3 million of SBA debentures under HT II, priced at approximately 6.63%, including annual fees. In June 2012, the SBA approved a $24.3 million dollar commitment for HT III bringing the total available borrowings to $225.0 million, of which $100.7 million was available in HT II and $124.3 million was available in HT III.
5. Income taxes
The Company has elected to be taxed as a RIC under Subchapter M of the Code and intends to continue operate so as to qualify to be taxed as a RIC under Subchapter M of the Code and, as such, will not be subject to federal income tax on the portion of taxable income and gains distributed to stockholders.
To qualify as a RIC, the Company is required to meet certain income and asset diversification tests in addition to distributing at least 90% of its investment company taxable income, as defined by the Code. The amount to be paid out as a dividend is determined by the Board of Directors each quarter and is based upon the annual earnings estimated by the management of the Company. To the extent that the Company’s earnings fall below the amount of dividends declared, however, a portion of the total amount of the Company’s dividends for the fiscal year may be deemed a return of capital for tax purposes to the Company’s stockholders.
Taxable income includes the Company’s taxable interest, dividend and fee income, as well as taxable net capital gains. Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation, as gains or losses are not included in taxable income until they are realized.
Taxable income includes non-cash income, such as changes in accrued and reinvested interest and dividends, which includes contractual payment-in-kind interest, and the amortization of discounts and fees. Cash collections of income resulting from contractual PIK interest or the amortization of discounts and fees generally occur upon the repayment of the loans or debt securities that include such items. Non-cash taxable income is reduced by non-cash expenses, such as realized losses and depreciation and amortization expense.
During the quarter ended June 30, 2012, the Company declared a distribution of $0.24 per share. The determination of the tax attributes of the Company’s distributions is made annually as of the end of the Company’s fiscal year based upon its taxable income for the full year and distributions paid for the full year. As a result, a determination made on a quarterly basis may not be representative of the actual tax attributes of the Company’s distributions for a full year. If we had determined the tax attributes of our distributions year-to-date as of June 30, 2012, approximately 98% would be from ordinary income and spillover earnings from 2011, and 2% would be a return of capital. However there can be no certainty to shareholders that this determination is representative of what the tax attributes of its 2012 distributions to shareholders will actually be.
As a RIC, the Company will be subject to a 4% nondeductible federal excise tax on certain undistributed income unless the Company distributes in a timely manner an amount at least equal to the sum of (1) 98% of its ordinary income for each calendar year, (2) 98.2% of its capital gain net income for the 1-year period ending October 31 in that calendar year and (3) any income realized, but not distributed, in the preceding year (the “Excise Tax Avoidance Requirements”). The Company will not be subject to excise taxes on amounts on which the Company is required to pay corporate income tax (such as retained net capital gains). Depending on the level of taxable income earned in a tax year, the Company may choose to carry over taxable income in excess of current year distributions from such taxable income into the next tax year and pay a 4% excise tax on such income, as required. The maximum amount of excess taxable income that may be carried over for distribution in the next year under the Code is the total amount of dividends paid in the following year, subject to certain declaration and payment guidelines. To the extent the Company chooses to carry over taxable income into the next tax year, dividends declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income, the distribution of prior year taxable income carried over into and distributed in the current year, or returns of capital.
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Taxable income for the six month period ended June 30, 2012 was approximately $22.1 million or $0.47 per share. Taxable net realized gains for the same period were $15.3 million or approximately $0.32 per share. Taxable income for the six-month period ended June 30, 2011 was approximately $18.5 million or $0.43 per share. Taxable net realized gains for the same period were $8.8 million or approximately $0.21 per share.
6. Shareholders’ Equity
On January 20, 2012, the Company raised approximately $47.7 million, net of issuance costs, in a public offering of 5,000,000 shares of its common stock.
On July 25, 2012, the Company approved the extension of the stock repurchase plan under the same terms and conditions that allows the Company to repurchase up to $35.0 million of its common stock as previously approved and extended for an additional six month period set to expire on February 26, 2013. During the six month period ended June 30, 2012, the Company did not repurchase any common stock.
At June 30, 2012, the Company was authorized to issue 100,000,000 shares of common stock with a par value of $0.001. Each share of common stock entitles the holder to one vote.
The Company has issued stock options for common stock subject to future issuance, of which 2,637,654 and 4,231,444 were outstanding at June 30, 2012 and December 31, 2011, respectively.
7. Equity Incentive Plan
The Company and its stockholders have authorized and adopted the 2004 Equity Incentive Plan (the “2004 Plan”) for purposes of attracting and retaining the services of its executive officers and key employees. Under the 2004 Plan, the Company is authorized to issue 7,000,000 shares of common stock. On June 1, 2011, stockholders approved an increase of 1,000,000 shares, authorizing the Company to issue 8,000,000 shares of common stock under the 2004 Plan. Unless terminated earlier by the Company’s Board of Directors, the 2004 Plan will terminate on June 9, 2014, and no additional awards may be made under the 2004 Plan after that date.
The Company and its stockholders have authorized and adopted the 2006 Non-Employee Director Plan (the “2006 Plan” and, together with the 2004 Plan, the “Plans”) for purposes of attracting and retaining the services of its Board of Directors. Under the 2006 Plan, the Company is authorized to issue 1,000,000 shares of common stock. Unless terminated earlier by the Company’s Board of Directors, the 2006 Plan will terminate on May 29, 2016 and no additional awards may be made under the 2006 Plan after that date. The Company filed an exemptive relief request with the Securities and Exchange Commission (“SEC”) to allow options to be issued under the 2006 Plan which was approved on October 10, 2007.
On June 21, 2007, the stockholders approved amendments to the 2004 Plan and the 2006 Plan allowing for the grant of restricted stock. The amended Plans limit the combined maximum amount of restricted stock that may be issued under both Plans to 10% of the outstanding shares of the Company’s stock on the effective date of the Plans plus 10% of the number of shares of stock issued or delivered by the Company during the terms of the Plans. The amendments further specify that no one person shall be granted awards of restricted stock relating to more than 25% of the shares available for issuance under the 2004 Plan. Further, the amount of voting securities that would result from the exercise of all of the Company’s outstanding warrants, options and rights, together with any restricted stock issued pursuant to the Plans, at the time of issuance shall not exceed 25% of its outstanding voting securities, except that if the amount of voting securities that would result from such exercise of all of the Company’s outstanding warrants, options and rights issued to the Company’s directors, officers and employees, together with any restricted stock issued pursuant to the Plans, would exceed 15% of the Company’s outstanding voting securities, then the total amount of voting securities that would result from the exercise of all outstanding warrants, options and rights, together with any restricted stock issued pursuant to the Plans, at the time of issuance shall not exceed 20% of our outstanding voting securities.
In conjunction with the amendment and in accordance with the exemptive order, on June 21, 2007 the Company made an automatic grant of shares of restricted common stock to Messrs. Badavas, Chow and Woodward, the independent members of its Board of Directors, in the amounts of 1,667, 1,667 and 3,334 shares, respectively. In May 2008, the Company issued restricted shares to Messrs. Badavas and Chow in the amount of 5,000 shares each. In June 2009, the Company issued 5,000 restricted stock shares to Mr. Woodward. The shares were issued pursuant to the 2006 Plan and vest 33% on an annual basis from the date of grant and deferred compensation cost will be recognized ratably over the three year vesting period.
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A summary of common stock options activity under the Company’s 2006 and 2004 Plans for the six months ended June 30, 2012 and 2011 is as follows:
Outstanding at Beginning of Period
Granted
Exercised
Cancelled
Outstanding at End of Period
Weighted-average exercise price
Options generally vest 33% one year after the date of grant and ratably over the succeeding 24 months. All options may be exercised for a period ending seven years after the date of grant. At June 30, 2012, options for approximately 2.2 million shares were exercisable at a weighted average exercise price of approximately $12.25 per share with a weighted average remaining contractual term of 2.38 years.
The Company determined that the fair value of options granted under the 2006 and 2004 Plans during the six-month periods ended June 30, 2012 and 2011 was approximately $67,000 and $930,000 respectively. During the three-month periods ended June 30, 2012 and 2011, approximately $116,000 and $187,000 of share-based cost due to stock option grants was expensed, respectively. During the six-month periods ended June 30, 2012 and 2011, approximately $220,000 and $354,000 of share-based cost due to stock option grants was expensed, respectively. As of June 30, 2012, there was approximately $603,000 of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 1.9 years. The fair value of options granted is based upon a Black Scholes option pricing model using the assumptions in the following table for each of the six-month periods ended June 30, 2012 and 2011:
Expected Volatility
Expected Dividends
Expected term (in years)
Risk-free rate
The following table summarizes stock options outstanding and exercisable at June 30, 2012.
(Dollars in thousands, except exercise price)
Range of exercise prices
$4.21 - $8.49
$8.67 - $13.40
$13.87 - $14.02
$4.21 - $14.02
During the six months ended June 30, 2012 and 2011, respectively, the Company granted approximately 677,000 and 306,600 shares of restricted stock pursuant to the Plans. Each restricted stock award granted in 2012 and 2011 is subject to lapse as to 25% of the award one year after the date of grant and ratably over the succeeding 36 months subject to a four year forfeiture schedule. The restricted stock awarded in 2008 vests 25% annually on the anniversary date of the award. Share based compensation cost will be recognized ratably over the four year vesting period. No restricted stock was granted pursuant to the 2004 Plan prior to 2008.
The Company determined that the fair value of restricted stock granted under the 2006 and 2004 Plans during the six-month periods ended June 30, 2012 and 2011, was approximately $7.3 million and $3.4 million, respectively. During the three-month periods ended June 30, 2012 and 2011, the Company expensed approximately $1.1 million and $756,000 of compensation expense related to restricted stock, respectively. During the six-month periods ended June 30, 2012 and 2011, the Company expensed approximately $1.8 million and $1.3 million of compensation expense related to restricted stock, respectively. As of June 30, 2012, there was approximately $10.5 million of total unrecognized compensation costs related to restricted stock. These costs are expected to be recognized over a weighted average period of 3.04 years.
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The SEC, through an exemptive order granted on June 22, 2010, approved amendments to the Plans which allow participants to elect to have the Company withhold shares of the Company’s common stock to pay for the exercise price and applicable taxes with respect to an option exercise (“net issuance exercise”). The exemptive order also permits the holders of restricted stock to elect to have the Company withhold shares of Hercules stock to pay the applicable taxes due on restricted stock at the time of vesting. Each individual can make, and does not preclude the participant from electing to make, a cash payment at the time of option exercise or to pay taxes on restricted stock.
8. Earnings Per Share
Shares used in the computation of the Company’s basic and diluted earnings per share are as follows:
Numerator
Less: Dividends declared-common and restricted shares
Undistributed earnings
Undistributed earnings-common shares
Add: Dividend declared-common shares
Numerator for basic and diluted change in net assets per common share
Denominator
Basic weighted average common shares outstanding
Common shares issuable
Weighted average common shares outstanding assuming dilution
Change in net assets per common share
The calculation of change in net assets per common share—assuming dilution, excludes all anti-dilutive shares. For the three and six-month periods ended June 30, 2012 and 2011, the number of anti-dilutive shares, as calculated based on the weighted average closing price of the Company’s common stock for the periods, were approximately 2.6 million and 2.5 million shares, respectively.
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9. Financial Highlights
Following is a schedule of financial highlights for the six months ended June 30, 2012 and 2011:
FINANCIAL HIGHLIGHTS
(dollars in thousands, except per share amounts)
Per share data:
Net asset value at beginning of period
Net realized gain (loss) on investments
Total from investment operations
Net increase/(decrease) in net assets from capital share transactions
Distributions
Stock-based compensation expense included in investment income(1)
Net asset value at end of period
Ratios and supplemental data:
Per share market value at end of period
Total return(2)
Shares outstanding at end of period
Weighted average number of common shares outstanding
Net assets at end of period
Ratio of operating expense to average net assets
Ratio of net investment income before provision for income tax expense and investment gains and losses to average net assets
Average debt outstanding
Weighted average debt per common share
Stock option expense is a non-cash expense that has no effect on net asset value. Pursuant to ASC 718, net investment loss includes the expense associated with the granting of stock options which is offset by a corresponding increase in paid-in capital. The total return equals the change in the ending market value over the beginning of period price per share plus dividends paid per share during the period, divided by the beginning price.
The total return equals the increase or decrease of ending market value over beginning market value, plus distributions, dividend by the beginning market value, assuming dividend reinvestment prices obtained under the Company’s dividend reinvestment plan.
10. Commitments and Contingencies
In the normal course of business, the Company is party to financial instruments with off-balance sheet risk. These instruments consist primarily of unused commitments to extend credit, in the form of loans to the Company’s portfolio companies. The balance of unfunded commitments to extend credit at June 30, 2012 totaled approximately $92.7 million. Approximately $32.6 million of these unfunded commitments are dependent upon the portfolio company reaching certain milestones before the Company’s debt commitment becomes available. Since a portion of these commitments may expire without being drawn, unfunded commitments do not necessarily represent future cash requirements. In addition, the Company had approximately $48.0 million of non-binding term sheets outstanding to six new and existing companies at June 30, 2012. Non-binding outstanding term sheets are subject to completion of the Company’s due diligence and final approval process, as well as the negotiation of definitive documentation with the prospective portfolio companies. Not all non-binding term sheets are expected to close and do not necessarily represent future cash requirements.
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Certain premises are leased under agreements which expire at various dates through October 2018. Total rent expense amounted to approximately $288,000 and $573,000 during the three and six-month period ended June 30, 2012 respectively. There was approximately $277,000 and $553,000 recorded in the same periods ended June 30, 2011.
Future commitments under operating leases as of June 30, 2012 were as follows:
Contractual Obligations(1)(2)
Borrowings(3) (4)
Operating Lease Obligations(5)
Excludes commitments to extend credit to our portfolio companies.
The Company also has a warrant participation agreement with Citigroup. See Note 4.
Includes $200,750 in borrowings under the SBA debentures, $3.1 million of outstanding borrowings under the Wells Facility, and $43.0 million in aggregate principal amount of the 2019 Notes issued in April 2012. In July 2012, the Company re-opened its 2019 Notes and issued an additional $41.5 million in aggregate principal amount of 2019 Notes, which includes exercise of an over-allotment option, bringing the total amount of 2019 Notes issued to approximately $84.5 million in aggregate principal amount. See “Subsequent Events” below.
Except for the Convertible Senior Notes, all carrying values are the same as the principal amount outstanding. The aggregate principal amount outstanding of the Convertible Senior Notes less the unaccreted discount initially recorded upon issuance of the Convertible Senior Notes was $4,106 at June 30, 2012.
Long-term facility leases.
The Company and its executives and directors are covered by Directors and Officers Insurance, with the directors and officers being indemnified by the Company to the maximum extent permitted by Maryland law subject to the restrictions in the 1940 Act.
11. Recent Accounting Pronouncements
In May 2011, the FASB issuedAccounting Standards Update No. 2011-04—Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, or ASU 2011-04. ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes the application of some requirements for measuring fair value and requires additional disclosure for fair value measurements. The highest and best use valuation premise is only applicable to non-financial assets. In addition, the disclosure requirements are expanded to include for fair value measurements categorized in Level 3 of the fair value hierarchy: (1) a quantitative disclosure of the unobservable inputs and assumptions used in the measurement; (2) a description of the valuation processes in place; and (3) a narrative description of the sensitivity of the fair value to changes in unobservable inputs and interrelationships between those inputs. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011, for public entities and as such the Company has adopted this ASU beginning with the quarter ended March 31, 2012. The Company has increased the disclosures related to Level 3 fair value measurement, in addition to other required disclosures. There were no related impacts on our financial position or results of operations.
12. Subsequent Events
Liquidity and Capital Resources
7.00% Senior Notes Due 2019
On July 6, 2012 the Company re-opened its 2019 Notes and issued approximately $38.8 million in aggregate principal amount of the 2019 Notes pursuant to an underwriting agreement among the Company and Stifel, Nicolaus & Company, Incorporated, as representative of the several underwriters named therein, relating to the issuance, offer and sale of the additional 2019 Notes. The Company granted the underwriters an option to purchase up to an additional $5.8 million in aggregate principal amount of the 2019 Notes to cover overallotments, if any. Pursuant to this option, approximately $2.7 million in aggregate principal amount of the additional 2019 Notes were issued and sold on July 12, 2012. The sale of the additional 2019 Notes generated net proceeds to the Company, before expenses and excluding accrued interest, of approximately $40.2 million.
The 2019 Notes are a further issuance of, rank equally in right of payment with, and form a single series for all purposes under the Indenture (as defined below) including, without limitation, waivers, amendments, consents, redemptions and other offers to purchase and voting, with the $43.0 million aggregate principal amount of its 2019 Notes initially issued by the Company on April 17, 2012.
On April 17, 2012, the Company and U.S. Bank National Association, as Trustee (the “Trustee”) entered into the First Supplemental Indenture (the “First Supplemental Indenture”) to the Indenture (the “Base Indenture,” and together with the First Supplemental Indenture, the “Indenture”), between the Company and U.S. Bank National Association, as Trustee (the “Trustee”), dated March 6, 2012, relating to the issuance, offer and sale of the 2019 Notes. The additional 2019 Notes were offered under the same Indenture.
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The 2019 Notes will mature on April 30, 2019 and may be redeemed in whole or in part at the Company’s option at any time or from time to time on or after April 30, 2015, upon not less than 30 days nor more than 60 days written notice by mail prior to the date fixed for redemption thereof, at a redemption price of 100% of the outstanding principal amount thereof plus accrued and unpaid interest payments otherwise payable for the then-current quarterly interest period accrued to but not including the date fixed for redemption. The notes bear interest at a rate of 7.00% per year payable quarterly on January 30, April 30, July 30 and October 30 of each year, commencing on July 30, 2012.
The 2019 Notes will be the Company’s direct unsecured obligations and will rank: (i) pari passu with the Company’s other outstanding and future senior unsecured indebtedness, including without limitation, the $75.0 million of Convertible Senior Notes; (ii) senior to any of the Company’s future indebtedness that expressly provides it is subordinated to the 2019 Notes; (iii) effectively subordinated to all of the Company’s existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, borrowings under the Company’s credit facilities; (iv) structurally subordinated to all existing and future indebtedness and other obligations of any of the Company’s subsidiaries, including without limitation, the indebtedness of Hercules Technology II, L.P. and Hercules Technology III, L.P. and borrowings under the Company’s revolving senior secured credit facility with Wells Fargo Capital Finance, LLC.
Wells Fargo Credit Facility
In August 2012 the Company amended its credit facility with Wells Fargo Capital Finance, LLC (“WFCF”) under which WFCF has committed $75.0 million in initial credit capacity under a $300.0 million accordion credit facility. The Company can increase the credit line up to an aggregate of $300.0 million, funded by additional lenders who may join the facility and with the agreement of WFCF and RBC Capital Markets and subject to other customary conditions. There can be no assurances that additional lenders will join the new credit facility.
The credit facility has an advance rate equal to 50% of eligible loans placed in the collateral pool. The credit facility generally requires payment of interest on a monthly basis. The Company paid an amendment fee of $375,000.
Borrowings under the credit facility will continue to be at an interest rate per annum equal to LIBOR plus 3.50%, consistent with prior facilities while the floor has been lowered from 5.00% to 4.25%, a 75 basis point reduction. Additionally, an amortization period of 12 months was added to pay down the principal balance as of the maturity date, the maturity date was extended by one year to August 2015, and the unused line fee was reduced. The amendment also increased the minimum tangible net worth when added to outstanding subordinated indebtedness from in excess of $314.0 million plus 90% of the cumulative amount of equity raised after March 31, 2011 to in excess of $362.0 million plus 90% of the cumulative amount of equity raised after June 30, 2012. The amendment is effective as of August 1, 2012.
The Company has various financial and operating covenants required by the credit facility. These covenants require the Company to maintain certain financial ratios and a minimum tangible net worth. The credit facility provides for customary events of default, including, but not limited to, payment defaults, breach of representations or covenants, bankruptcy events and change of control.
Dividend Declaration
On July 30, 2012 the Board of Directors declared a cash dividend of $0.24 per share that will be payable on August 24, 2012 to shareholders of record as of August 17, 2012. This dividend represents the Company’s twenty-eighth consecutive dividend declaration since its initial public offering, bringing the total cumulative dividend declared to date to $7.40 per share.
Renewal of Stock Repurchase Plan
On July 25, 2012, the Company approved the extension of the stock repurchase plan as previously approved under the same terms and conditions that allows the Company to repurchase up to $35.0 million of its common stock. Unless renewed, the stock repurchase plan will expire on February 26, 2013.
Portfolio Company Developments
On July 31, 2012, the Company received payment of $2.0 million for its total debt investments in Maxvision Holding, L.L.C. As of June 30, 2012 the Company valued these debt investments, which had a total cost basis of approximately $7.1 million, at a fair value of approximately $169,000. These investments were accounted for on a non-accrual basis. In the third quarter of 2012, the Company will record a realized loss of approximately $5.1 million and a reversal of previously recorded unrealized depreciation of $6.9 million for the Maxvision debt investments.
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Forward-Looking Statements
The matters discussed in this report, as well as in future oral and written statements by management of Hercules Technology Growth Capital, Inc., that are forward-looking statements are based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. Important assumptions include our ability to originate new investments, achieve certain margins and levels of profitability, the availability of additional capital, and the ability to maintain certain debt to asset ratios. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this report should not be regarded as a representation by us that our plans or objectives will be achieved. The forward-looking statements contained in this report include statements as to:
our future operating results;
our business prospects and the prospects of our prospective portfolio companies;
the impact of investments that we expect to make;
the impact of a protracted decline in the liquidity of credit markets on our business;
our informal relationships with third parties including in the venture capital industry;
the expected market for venture capital investments and our addressable market;
the dependence of our future success on the general economy and its impact on the industries in which we invest;
our ability to access debt markets and equity markets;
the ability of our portfolio companies to achieve their objectives;
our expected financings and investments;
our regulatory structure and tax status;
our ability to operate as a BDC, a SBIC and a RIC;
the adequacy of our cash resources and working capital;
the timing of cash flows, if any, from the operations of our portfolio companies;
the timing, form and amount of any dividend distributions;
the impact of fluctuations in interest rates on our business;
the valuation of any investments in portfolio companies, particularly those having no liquid trading market; and
our ability to recover unrealized losses.
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For a discussion of factors that could cause our actual results to differ from forward-looking statements contained in this report, please see the discussion under Item 1A—“Risk Factors” of Part II of this quarterly report on Form 10-Q as well as Item 1A—“Risk Factors” of our annual report on Form 10-K. You should not place undue reliance on these forward-looking statements. The forward-looking statements made in this report relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this report.
The following discussion should be read in conjunction with our consolidated financial statements and related notes and other financial information appearing elsewhere in this report. In addition to historical information, the following discussion and other parts of this report contain forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated by such forward-looking information due to the factors discussed under Item 1A—“Risk Factors” of Part II of this quarterly report on Form 10-Q, Item 1A—“Risk Factors” of our annual report on Form 10-K, and “Forward-Looking Statements” of this Item 2.
Overview
We are a specialty finance firm providing customized loans to public and private technology-related companies, including clean technology, life science and select lower middle market technology companies at all stages of development. We primarily finance privately-held companies backed by leading venture capital and private equity firms, and also may finance certain publicly-traded companies that lack access to public capital or are sensitive to equity ownership dilution. We source our investments through our principal office located in Silicon Valley, as well as through additional offices in Boston, MA, Boulder, CO, and McLean, VA.
Our goal is to be the leading structured debt financing provider of choice for venture capital and private equity backed technology-related companies requiring sophisticated and customized financing solutions. Our strategy is to evaluate and invest in a broad range of technology-related companies including clean technology, life science and select lower middle market technology companies and to offer a full suite of growth capital products up and down the capital structure. We invest primarily in structured debt with warrants and, to a lesser extent, in senior debt and equity investments. We use the term “structured debt with warrants” to refer to any debt investment, such as a senior or subordinated secured loan, that is coupled with an equity component, including warrants, options or rights to purchase common or preferred stock. Our structured debt with warrants investments will typically be secured by some or all of the assets of the portfolio companies.
Our investment objective is to maximize our portfolio total return by generating current income from our debt investments and capital appreciation from our equity-related investments. Our primary business objectives are to increase our net income, net operating income and net asset value by investing in structured debt with warrants and equity of venture capital and private equity backed technology-related companies with attractive current yields and the potential for equity appreciation and realized gains. Our structured debt investments typically include warrants or other equity interests, giving us the potential to realize equity-like returns on a portion of our investments. Our equity ownership in our portfolio companies may represent a controlling interest. In some cases, we receive the right to make additional equity investments in our portfolio companies in connection with future equity financing rounds. Capital that we provide directly to venture capital and private equity backed technology-related companies is generally used for growth and general working capital purposes as well as in select cases for acquisitions or recapitalizations.
We are an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company under the 1940 Act. As a business development company, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in “qualifying assets,” including securities of private U.S. companies, cash, cash equivalents, and high-quality debt investments that mature in one year or less.
From incorporation through December 31, 2005, we were taxed as a corporation under Subchapter C of the Internal Revenue Code, or the Code. As of January 1, 2006, we have elected to be treated for federal income tax purposes as a regulated investment company, or a RIC, under Subchapter M of the Code. Pursuant to this election, we generally will not have to pay corporate-level taxes on any income that we distribute to our stockholders. However, such an election and qualification to be treated as a RIC requires that we comply with certain requirements contained in Subchapter M of the Code. For example, a RIC must meet certain requirements, including source-of income, asset diversification and income distribution requirements. The income source requirement mandates that we receive 90% or more of our income from qualified earnings, typically referred to as “good income.” Qualified earnings may exclude such income as management fees received in connection with our SBIC or other potential outside managed funds and certain other fees.
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Our portfolio is comprised of, and we anticipate that our portfolio will continue to be comprised of, investments primarily in technology-related companies at various stages of their development. Consistent with regulatory requirements, we invest primarily in United States based companies and to a lesser extent in foreign companies. Our investing emphasis has been primarily on private companies following or in connection with a subsequent institutional round of equity financing, which we refer to as expansion-stage companies and private companies in later rounds of financing and certain public companies, which we refer to as established-stage companies and select lower middle market technology companies. We have focused our investment activities in private companies following or in connection with the first institutional round of financing, which we refer to as emerging-growth companies.
Portfolio and Investment Activity
The total value of our investment portfolio was $722.8 million at June 30, 2012 as compared to $652.9 million at December 31, 2011.
During the six-month period ended June 30, 2012 we made debt and equity commitments to new and existing portfolio companies, including restructured loans, totaling $223.4 million and $16.9 million, respectively. Debt commitments for the six-month period ended June 30, 2012 included commitments of approximately $134.7 million to 17 new portfolio companies and $88.7 million, including restructured loans, to 11 existing companies. Equity commitments for the six-month period ended June 30, 2012 included commitments of approximately $14.6 million to two new portfolio companies and $2.3 million to two existing companies.
During the three and six-month periods ended June 30, 2012, we funded investments in debt securities, totaling approximately $106.9 million and $169.8 million, respectively. During the three and six-month periods ended June 30, 2012, we funded equity investments of approximately $5.0 million and $7.1 million, respectively. During the six-month period ended June 30, 2012, the Company converted approximately $356,000 of debt to equity in one portfolio company, and the investment in Facebook, Inc. of approximately $9.6 million was transferred from Other Assets to Investments.
At June 30, 2012, we had unfunded contractual commitments of approximately $92.7 million to 22 new and existing companies. Approximately $32.6 million of these unfunded origination activity commitments are dependent upon the portfolio company reaching certain milestones before the Hercules debt commitment becomes available.
These commitments will be subject to the same underwriting and ongoing portfolio maintenance as the on-balance sheet financial instruments that we hold. Since these commitments may expire without being drawn, unfunded commitments do not necessarily represent future cash requirements. In addition, we have approximately $48.0 million of non-binding term sheets outstanding to six new and existing companies at June 30, 2012. Non-binding outstanding term sheets are subject to completion of our due diligence and final approval process, as well as the negotiation of definitive documentation with the prospective portfolio companies. Not all non-binding term sheets are expected to close and do not necessarily represent future cash requirements.
The fair value of the loan portfolio at June 30, 2012 was approximately $647.1 million, compared to a fair value of approximately $411.6 million at June 30, 2011. The fair value of the equity portfolio at June 30, 2012 and 2011 was approximately $47.6 million and $31.1 million, respectively. The fair value of our warrant portfolio at June 30, 2012 and 2011 was approximately $28.1 million and $32.5 million, respectively.
We receive payments in our loan portfolio based on scheduled amortization of the outstanding balances. In addition, we receive repayments of some of our loans prior to their scheduled maturity date. The frequency or volume of these repayments may fluctuate significantly from period to period. During the six month period ended June 30, 2012, we received approximately $99.6 million of principal repayments, including normal principal amortization repayments of approximately $37.1 million, and early repayments and of approximately $62.5 million. During the six month period ended June 30, 2012, we restructured our debt investments in two portfolio companies for approximately $49.1 million and converted $356,000 of debt to equity.
During the three-month period ended June 30, 2012, two of our portfolio companies completed initial public offerings. On May 10, 2012, WageWorks, Inc. completed its initial public offering of 6,500,000 shares of common stock at a price to the public of $9.00 per share, and on May 18, 2012, Facebook Inc. completed its initial public offering of 421,233,615 shares of common stock at a price to the public of $38.00 per share.
As of June 30, 2012, we held warrants or equity positions in three companies which filed registration statements on Form S-1 with the SEC in contemplation of potential initial public offerings, including Glori Energy, Inc., iWatt, Inc., and one company that filed a registration statement confidentially under the JOBS Act. During the second quarter of 2012, BrightSource Energy, Inc. withdrew its registration statement for its initial public offering. There can be no assurance that these companies will complete their initial public offerings in a timely manner or at all.
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Total portfolio investment activity as of June 30, 2012 (unaudited) and for the year ended December 31, 2011 is as follows:
Beginning Portfolio
Purchase of debt investments
Equity Investments
Sale of Investments
Early pay-offs and recoveries
Accretion of loan discounts and paid-in-kind principal
Net change in unrealized depreciation in investments
Net change in unrealized appreciation (depreciation) in Citigroup participation
0.1
(0.2
)
Conversion of Other Assets to Equity
Restructure fundings
Restructure payoffs
Ending Portfolio
The following table shows the fair value of our portfolio of investments by asset class as of June 30, 2012 (unaudited) and December 31, 2011 (excluding unearned income).
A summary of our investment portfolio at value by geographic location is as follows:
Our portfolio companies are primarily privately held expansion-and established-stage companies in the drug discovery, internet consumer and business services, clean technology, drug delivery, media/content/info, software, specialty pharmaceuticals, healthcare services, communications and networking, information services, consumer and business products, therapeutic, medical device and equipment, semiconductors, surgical devices, biotechnology tools, diagnostic, and electronics and computer hardware industry sectors. These sectors are characterized by high margins, high growth rates, consolidation and product and market extension opportunities. Value is often vested in intangible assets and intellectual property.
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The following table shows the fair value of our portfolio by industry sector at June 30, 2012 (unaudited) and December 31, 2011:
Energy
The largest portfolio companies vary as new loans are recorded and loans pay off. Loan revenue, consisting of interest, fees, and recognition of gains on equity interests, can fluctuate dramatically when a loan is paid off or a related equity interest is sold. Revenue recognition in any given year can be highly concentrated among several portfolio companies. As of June 30, 2012 and December 31, 2011, our ten largest portfolio companies represented approximately 37.1% and 37.9%, respectively, of the total fair value of our investments in portfolio companies. At June 30, 2012 and December 31, 2011, we had six and seven investments, respectively, that represented 5% or more of our net assets. At June 30, 2012, we had five equity investments representing approximately 61.7% of the total fair value of our equity investments, and each represented 5% or more of the total fair value of our equity investments. At December 31, 2011, we had seven equity investments which represented approximately 63.8% of the total fair value of our equity investments, and each represented 5% or more of the total fair value of such investments.
As of June 30, 2012, approximately 61.9% of the fair value of our portfolio was composed of investments in five industries: 18.9% was composed of investments in the drug discovery and development industry, 12.2% was composed of investments in the software industry, 11.6% was composed of investments in the clean technology industry, 9.7% was composed of investments in the internet drug delivery industry; and 9.5% was composed of investments in the internet consumer and business services industry.
As of June 30, 2012, over 99.0% of our debt investments were in a senior secured first lien position, and more than 94.9% of the debt investment portfolio was priced at floating interest rates or floating interest rates with a Prime or LIBOR based interest rate floor. Our investments in senior secured debt with warrants have equity enhancement features, typically in the form of warrants or other equity-related securities designed to provide us with an opportunity for capital appreciation. Our warrant coverage generally ranges from 3% to 20% of the principal amount invested in a portfolio company, with a strike price equal to the most recent equity financing round at the time of issuance. As of June 30, 2012, we held warrants in 115 portfolio companies, with a fair value of approximately $28.1 million. The fair value of the warrant portfolio has decreased by approximately 6.3% as compared to the fair value of $30.0 million at December 31, 2011. The decrease was primarily driven by the realized gain and exit from two of our portfolio companies during the second quarter of 2012. These warrant holdings would require us to invest approximately $74.6 million to exercise such warrants.
Warrants may appreciate or depreciate in value depending largely upon the underlying portfolio company’s performance and overall market conditions. Of the warrants which have monetized since inception, we have realized warrant and equity gain multiples in the range of approximately 1.04x to 10.17x based on the historical rate of return on our investments. However, our current warrants may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our warrant interests. The value of our senior secured debt (without warrants) at June 30, 2012 was approximately $104.6 million compared to approximately $133.5 million at December 31, 2011. The increase in 2011 was primarily attributable to two new investments in lower middle market technology companies, which typically do not have equity enhancement features.
As required by the 1940 Act, we classify our investments by level of control. “Control investments” are defined in the 1940 Act as investments in those companies that we are deemed to “control.” Generally, under the 1940 Act, we are deemed to “control” a company in which we have invested if we own 25% or more of the voting securities of such company or have greater than 50% representation on its board. “Affiliate investments” are investments in those companies that are “affiliated companies” of us, as defined in the 1940 Act, which are not control investments. We are deemed to be an “affiliate” of a company in which we have invested if we own 5% or more but less than 25% of the voting securities of such company. “Non-control/ non-affiliate investments” are investments that are neither control investments nor affiliate investments.
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The following table summarizes our realized and unrealized gain and loss and changes in our unrealized appreciation and depreciation on control and affiliate investments for the three and six-months ended June 30, 2012 and June 30, 2011:
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We use an investment grading system, which grades each debt investment on a scale of 1 to 5, to characterize and monitor our expected level of risk on the debt investments in our portfolio with 1 being the highest quality. The following table shows the distribution of our outstanding debt investments on the 1 to 5 investment grading scale at fair value as of June 30, 2012 (unaudited) and December 31, 2011, respectively.
Investment Grading
1
As of June 30, 2012, our investments had a weighted average investment grading of 2.08 as compared to 2.01 at December 31, 2011. The downgrade in investment grading is primarily attributable to eight companies being downgraded from a 2 to a 3, one company being downgraded from a 3 to a 4, one company being downgraded from a 1 to a 3 and one company being downgraded from a 2 to a 4. This overall downgrade was partially offset by four companies being upgraded from a 3 to a 2, four companies being upgraded from a 2 to a 1 and the complete payoffs of one rated 1, four rated 2, one rated 3 and one rated 4 as of June 30, 2012. Our policy is to lower the grading on our portfolio companies as they approach the point in time when they will require additional equity capital. Additionally, we may downgrade our portfolio companies if they are not meeting our financing criteria and their respective business plans. Various companies in our portfolio will require additional funding in the near term or have not met their business plans and have therefore been downgraded until their funding is complete or their operations improve. At June 30, 2012, 46 portfolio companies were graded 2, 18 portfolio companies were graded 3, three portfolio companies were graded 4, and one portfolio company was graded 5 as compared to 43 portfolio companies that were graded 2, 12 portfolio companies that were graded 3, two portfolio companies that were grade 4, and two portfolio companies that were graded 5 at December 31, 2011.
At June 30, 2012, there was one portfolio company on non-accrual status with a fair value of $169,000. There was one portfolio company on non-accrual status as of December 31, 2011 with a fair value of approximately $1.0 million.
We generate revenue in the form of interest income, primarily from our investments in debt securities, and commitment and facility fees. Fees generated in connection with our debt investments are recognized over the life of the loan or, in some cases, recognized as earned. In addition, we generate revenue in the form of capital gains, if any, on warrants or other equity-related securities that we acquire from our portfolio companies. Our investments generally range from $1.0 million to $25.0 million. Our debt investments have a term of between two and seven years and typically bear interest at a rate ranging from Prime to approximately 13.9% as of June 30, 2012. In addition to the cash yields received on our loans, in some instances, our loans may also include any of the following: end-of-term payments, exit fees, balloon payment fees, commitment fees, success fees, PIK provisions or prepayment fees which may be required to be included in income prior to receipt.
Loan origination and commitment fees received in full at the inception of a loan are deferred and amortized into fee income as an enhancement to the related loan’s yield over the contractual life of the loan. We recognize nonrecurring fees amortized over the remaining term of the loan commencing in the quarter relating to specific loan modifications. Loan exit fees to be paid at the termination of the loan are accreted into interest income over the contractual life of the loan. We had approximately $2.9 million and $4.5 million of
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unamortized fees at June 30, 2012 and December 31, 2011, respectively, and approximately $4.8 million and $4.4 million in exit fees receivable at June 30, 2012 and December 31, 2011, respectively. We recognize nonrecurring fees amortized over the remaining term of the loan relating to specific loan modifications. Certain fees may still be recognized as one-time fees, including prepayment penalties, fees related to select covenant default waiver fees and acceleration of previously deferred loan fees and original issue discount (“OID”) related to early loan pay-off or material modification of the specific debt outstanding.
We have loans in our portfolio that contain a PIK provision. The PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain our status as a RIC, this non-cash source of income must be paid out to stockholders in the form of dividends even though we have not yet collected the cash. Amounts necessary to pay these dividends may come from available cash or the liquidation of certain investments. We recorded approximately $569,000 and $1.1 million in PIK income in the six month periods ended June 30, 2012 and 2011. In certain investment transactions, we may provide advisory services. For services that are separately identifiable and external evidence exists to substantiate fair value, income is recognized as earned, which is generally when the investment transaction closes. We had no income from advisory services in the six month period ended June 30, 2012.
In some cases, we collateralize our investments by obtaining a first priority security interest in a portfolio company’s assets, which may include their intellectual property. In other cases, we may obtain a negative pledge covering a company’s intellectual property. At June 30, 2012, approximately 63.1% our portfolio company loans were secured by a first priority security in all of the assets of the portfolio company (including their intellectual property), 33.8% of portfolio company loans were to portfolio companies that were prohibited from pledging or encumbering their intellectual property, 2.3% of portfolio company loans had a first priority security in only their intellectual property, and 0.8% of portfolio company loans had an equipment only lien.
Interest on debt securities is generally payable monthly, with amortization of principal typically occurring over the term of the security for emerging-growth, expansion-stage and established-stage companies. In addition, certain loans may include an interest-only period ranging from three to eighteen months for emerging-growth and expansion-stage companies and longer for established-stage companies. In limited instances in which we choose to defer amortization of the loan for a period of time from the date of the initial investment, the principal amount of the debt securities and any accrued but unpaid interest become due at the maturity date.
The effective yield on our debt investments for the three-month periods ended June 30, 2012 and 2011 was 15.2% and 18.4%, respectively. This yield was lower period over period due to fewer fee accelerations attributed to early payoffs and one-time events during the current year as compared to the prior year. The effective yield excluding payoffs on our debt investments for the three month periods ended June 30, 2012 and 2011 was 13.3% and 15.7%, respectively. The decline in this rate is due primarily to the repayments of debt investments that had higher effective yields than the debt investments made in the past three to four quarters.
The overall weighted average yield to maturity of our loan investments was approximately 12.6% at both June 30, 2012 and December 31, 2011. The weighted average yield to maturity is computed using the interest rates in effect at the inception of each of the loans, and includes amortization of the loan facility fees, commitment fees and market premiums or discounts over the expected life of the debt investments, weighted by their respective costs when averaged and based on the assumption that all contractual loan commitments have been fully funded and held to maturity.
Results of Operations
Comparison of the three and six month periods ended June 30, 2012 and 2011
Investment Income
Total investment income for the three and six-month periods ended June 30, 2012 totaled approximately $23.9 million and $46.2 million, respectively, compared to $20.8 million and $40.0 million for the three and six-month periods ended June 30, 2011, respectively.
Interest income for the three and six-month periods ended June 30, 2012 totaled approximately $21.1 million and $41.4 million, respectively, compared to $18.1 million and $34.5 million for the three and six-month periods ended June 30, 2011, respectively. The increase in interest income is attributable to an increase of loan interest income and back end interest income of approximately $4.0 million and $8.5 million for the three and six-month periods ended June 30, 2012, respectively, partially offset by decreases in default interest income, OID interest income and PIK interest income of approximately $849,000 and $1.4 million for the three and six-month periods ended June 30, 2012, respectively.
Income from commitment, facility and loan related fees for the three and six-month periods ended June 30, 2012 totaled approximately $2.7 million and $4.8 million, respectively, compared to $2.8 million and $5.4 million for the three and six-month periods ended June 30, 2011, respectively. The decrease in income from commitment, facility and loan related fees is primarily the result of a decrease in facility fees, one time fees and amendment revenue of approximately $319,000 and $1.0 million for the three and six-month periods ended June 30, 2012, respectively, partially offset by an increase in commitment fees of approximately $216,000 and $327,000 for the three and six-month periods ended June 30, 2012, respectively.
The following table shows the PIK-related activity for the six months ended June 30, 2012 and 2011, at cost:
Beginning PIK loan balance
PIK interest capitalized during the period
Payments received from PIK loans
PIK converted to other securities
Realized Loss
Ending PIK loan balance
The decrease in payments received from PIK loans and PIK interest capitalized during the six months ended June 30, 2012 is due to approximately $1.4 million, $894,000, $207,000 and $166,000 of PIK collected in conjunction with the sale of our investment in Infologix, Inc. and the early payoffs of IPA Holdings, LLC., Unify Corporation and Velocity Technology Solutions, Inc., respectively, in the six-months ended June 30, 2011. The decrease in PIK converted to other securities during the six months June 30, 2012 is due to approximately $440,000 related to the conversion of MaxVision Holding, LLC. debt to equity in six months period ended June 30, 2011.
In certain investment transactions, we may provide advisory services. For services that are separately identifiable and external evidence exists to substantiate fair value, income is recognized as earned, which is generally when the investment transaction closes. We had no income from advisory services in the three and six-month periods ended June 30, 2012 and 2011, respectively.
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Operating Expenses
Operating expenses, which are comprised of interest and fees on borrowings, general and administrative and employee compensation, totaled approximately $11.5 million and $10.5 million during the three month periods ended June 30, 2012 and 2011, respectively. Operating expenses totaled approximately $22.5 million and $19.8 million during the six month periods ended June 30, 2012 and 2011, respectively.
Interest and fees on borrowings totaled approximately $5.2 million and $10.2 million during the three and six-month periods ended June 30, 2012, respectively, and approximately $3.8 million and $7.0 million during the three and six months periods ended June 30, 2011, respectively. The increase is primarily attributed to interest and fee expenses of $1.1 million and $2.3 million during the three and six-month periods ended June 30, 2012, respectively, related to the $75.0 million of Convertible Senior Notes issued on April 15, 2011 and approximately $668,000 related to the $43.0 million of 2019 Notes issued on April 17, 2012. Additionally, we incurred approximately $271,000 and $541,000 of non cash interest expense during the three and six-month periods ended June 30, 2012, respectively, and $225,000 during both the three and six-month periods ended June 30, 2011 attributed to the accretion of the fair value of the conversion feature on the Convertible Senior Notes. Additionally, we recognized an acceleration of approximately $457,000 of unamortized fees in connection with the pay down of $24.3 million SBA debentures in February 2012.
We had a weighted average cost of debt comprised of interest and fees of approximately 6.7% at June 30, 2012, as compared to 6.6% during the second quarter of 2011. The increase was primarily attributed to the weighted average cost of debt on the 2019 Notes of 7.6%, which closed in April 2012, offset by a lower weighted average cost of debt on outstanding SBA debentures of 4.9% in the second quarter of 2012 versus 5.6% in the second quarter of 2011.
General and administrative expenses include legal fees, consulting fees, accounting fees, printer fees, insurance premiums, rent, workout and various other expenses. Expenses decreased to $1.9 million from $2.3 million for the three month periods ended June 30, 2012 and 2011, respectively. These decreases were primarily due to decreases of approximately $222,000, $162,000 and $132,000 in outside services, SEC printing expenses and legal disbursements, respectively, partially offset by an increase in public relations expenses of approximately $118,000 for the three month period ended June 30, 2012.
Expenses decreased to $3.7 million from $4.5 million for the six month periods ended June 30, 2012 and 2011, respectively. These decreases were primarily due to decreases of approximately $241,000, $187,000, $185,000, $141,000 and $134,000 in auditing fees, outside services, legal disbursements, workout related expenses and SEC printing expenses, respectively, partially offset by an increase in public relations expenses of approximately $183,000 for the six month period ended June 30, 2012.
Employee compensation and benefits totaled approximately $3.3 million and $6.6 million during the three and six-month periods ended June 30, 2012, respectively. Employee compensation and benefits totaled approximately $3.4 million and $6.6 million during the three and six-month periods ended June 30, 2011, respectively. Stock-based compensation totaled approximately $1.2 million and $927,000 during the three-month periods ended June 30, 2012 and 2011, respectively, and approximately $2.0 million and $1.6 million during the six-month periods ended June 30, 2012 and 2011, respectively. These increases were due primarily to the expense on restricted stock grants of approximately 672,000 shares issued in the first quarter of 2012. See “Financial Condition, Liquidity, and Capital Resources” for disclosure of additional expenses.
Net Investment Income Before Investment Gains and Losses
Net investment income per share was $0.25 for the quarter ended June 30, 2012 compared to $0.24 per share in the quarter ended June 30, 2011, based on 48,615,780 and 42,970,747 weighted average shares outstanding, respectively. Net investment income before investment gains and losses for the three and six-month periods ended June 30, 2012 totaled approximately $12.3 million and $23.7 million, respectively, as compared to $10.4 million and $20.2 million in the three and six-month periods ended June 30, 2011, respectively. The changes are made up of the items described above under “Investment Income” and “Operating Expenses.”
Net Investment Realized Gains and Losses and Unrealized Appreciation and Depreciation
Realized gains or losses are measured by the difference between the net proceeds from the repayment or sale and the cost basis of the investment without regard to unrealized appreciation or depreciation previously recognized, and includes investments charged off during the period, net of recoveries. Net change in unrealized appreciation or depreciation primarily reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.
During the three and six month periods ended June 30, 2012, we recognized net realized gains of approximately $8.3 million and $11.1 million on the portfolio, respectively. During the quarter ended June 30, 2012, we recorded approximately $5.3 million, $2.4 million and $862,000 of realized gains from the sale of equity in NEXX Systems, Inc., Annie’s, Inc. and Bullhorn, Inc., respectively. These gains were partially offset by realized losses due to the expiration of warrants in three private portfolio companies that had a cost basis of approximately $222,000.
During the three and six-months ended June 30, 2011 we recognized total net realized gains of approximately $497,000 for the sale of equity in Aegerion Pharmaceuticals, Inc. and $10.1 million from the sale of common stock in its public portfolio companies and realized gains of approximately $162,000 and realized losses of approximately $5.1 million from equity, loan, and warrant investments in portfolio companies that have been liquidated.
A summary of realized gains and losses for the three and six month periods ended June 30, 2012 and 2011 is as follows:
Realized gains
Realized losses
Net realized gains (losses)
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The net unrealized appreciation and depreciation of our investments is based on fair value of each investment determined in good faith by our Board of Directors.
The following table itemizes the change in net unrealized appreciation/depreciation of investments for the three and six-month periods ended June 30, 2012 and 2011:
Gross unrealized appreciation on portfolio investments
Gross unrealized depreciation on portfolio investments
Reversal of prior period net unrealized appreciation upon a realization
Reversal of prior period net unrealized depreciation upon a realization
Citigroup Warrant Participation
Net unrealized appreciation (depreciation) on portfolio investments
During the three month period ended June 30, 2012, we recorded approximately $20.5 million of net unrealized depreciation from our loans, warrant and equity investments. Approximately $5.0 million and $5.8 million is attributed to net unrealized depreciation on equity and warrants, respectively, of which approximately $5.2 million and $1.7 million is due to the reversal of prior period net unrealized appreciation upon being realized as a gain. Additionally, we recorded approximately $500,000 of unrealized depreciation attributed to reduced expectations of escrow proceeds previously anticipated to be collected.
We recorded approximately $9.2 million net unrealized depreciation on our debt investments related to decreases in fair value adjustments made as a result of an increase in current quarter effective yield.
The following table itemizes the change in net unrealized appreciation/(depreciation) in the investment portfolio by category for the three month period ended June 30, 2012.
(in millions)
Collateral based impairments
Reversals due to Loan Payoffs & Warrant/Equity sales
Fair Value Market/Yield Adjustments*
Level 1 & 2 Assets
Level 3 Assets
Total Fair Value Market/Yield Adjustments
Total Unrealized Appreciation/(Depreciation)
During the six month period ended June 30, 2012, we recorded approximately $17.7 million of net unrealized depreciation from our loans, warrant and equity investments. Approximately $2.3 million and $4.2 million is attributed to net unrealized depreciation on equity and warrants, respectively, of which approximately $6.4 million and $4.6 million is due to the reversal of prior period net unrealized appreciation upon being realized as a gain. Additionally, we recorded approximately $500,000 of unrealized depreciation attributed to reduced expectations of escrow proceeds previously anticipated to be collected.
We recorded approximately $10.7 million net unrealized depreciation on our debt investments related to fluctuations in current market interest rates.
The following table itemizes the change in net unrealized appreciation/(depreciation) in the investment portfolio by category for the six month period ended June 30, 2012.
As of June 30, 2012, the net unrealized depreciation recognized by us was increased by approximately $108,000 due to the warrant participation agreement with Citigroup. For a more detailed discussion of the warrant participation agreement, see the discussion set forth under Note 4 to the Consolidated Financial Statements.
During the three month period ended June 30, 2011, we recorded approximately $13.3 million of net unrealized appreciation from our loans, warrant and equity investments. During the six month period ended June 30, 2011, we recorded approximately $2.1 million of net unrealized depreciation from our loans, warrant and equity investments.
Income and Excise Taxes
We account for income taxes in accordance with the provisions of ASC 740, Income Taxes, which requires that deferred income taxes be determined based upon the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax law. Valuation allowances are used to reduce deferred tax assets to the amount likely to be realized.
Net Increase in Net Assets Resulting from Operations and Change in Net Assets per Share
For the three and six months ended June 30, 2012, the net increase in net assets resulting from operations totaled approximately $48,000 and $17.2 million, respectively. For the three and six months ended June 30, 2011, the net decrease in net assets resulting from operations totaled approximately $24.3 million and $23.1 million, respectively. These changes are made up of the items previously described.
There was no net change in net assets per common share for the three month period ended June 30, 2012 and basic and fully diluted net change in net assets per common share for the six-month period ended June 30, 2012 was $0.35. The basic and fully diluted net change in net assets per common share was $0.56 and $0.53, respectively, for the three and six-month periods ended June 30, 2011.
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Financial Condition, Liquidity, and Capital Resources
Our liquidity and capital resources are derived from our credit facilities, SBA debentures, Convertible Senior Notes, 2019 Notes and cash flows from operations, including investment sales and repayments, and income earned. Our primary use of funds from operations includes investments in portfolio companies and payments of fees and other operating expenses we incur. We have used, and expect to continue to use, our borrowings and the proceeds from the rotation of our portfolio and from public and private offerings of securities to finance our investment objectives. We may raise additional equity or debt capital through both registered offerings off a shelf registration and private offerings of securities, by securitizing a portion of our investments or borrowing, including from the SBA through our SBIC subsidiaries.
At June 30, 2012, we had $75.0 million of Convertible Senior Notes payable, $43.0 million of 2019 Notes and approximately $200.7 million of SBA debentures payable. We had approximately $3.1 million outstanding to the Wells Facility and no borrowings outstanding under the Union Bank Facility. In July 2012, we re-opened our 2019 Notes, and issued an additional amount of approximately $41.5 million in aggregate principal amount, which includes exercise of an over-allotment option, bringing the total amount of 2019 Notes issued to approximately $84.5 million in aggregate principal amount.
During the six months ended June 30, 2012, our operating activities used $42.7 million of cash and cash equivalents, compared to $20.3 million provided during the six months ended June 30, 2011. The $63.0 million decrease in cash provided by operating activities resulted primarily from a reduction of principal payments received on investments of approximately $78.4 million, partially offset by an increase in net unrealized appreciation of $15.6 million and a decrease in purchase of investments of $12.1 million during the six month period ended June 30, 2012. During the six months ended June 30, 2012, our financing activities provided $34.4 million of cash, compared to $70.9 million provided during the six months ended June 30, 2011. This $36.5 million decrease in cash provided by financing activities was primarily attributed to net proceeds from the issuance of common stock of $46.7 million, offset by the repayments of borrowings of approximately $46.3 million and by cash dividend payments of $22.1 million.
As of June 30, 2012, net assets totaled $474.8 million, with a net asset value per share of $9.54. We intend to generate additional cash primarily from cash flows from operations, including income earned from investments in our portfolio companies and, to a lesser extent, from the temporary investment of cash in other high-quality debt investments that mature in one year or less as well as from future borrowings as required to meet our lending activities. Our primary use of funds will be investments in portfolio companies and cash distributions to holders of our common stock.
In January 2012, we completed a follow-on public offering of 5.0 million shares of common stock for proceeds of approximately $48.05 million, before deducting offering expenses, to us. Additionally, we expect to raise additional capital to support our future growth through future equity and debt offerings, and/or future borrowings, to the extent permitted by the 1940 Act. To the extent we determine to raise additional equity through an offering of our common stock at a price below net asset value, existing investors will experience dilution. During our 2012 Annual Shareholder Meeting held on May 30, 2012, our stockholders authorized us, with the approval of our Board of Directors, to sell up to 20% of our outstanding common stock at a price below our then current net asset value per share and to offer and issue debt with warrants or debt convertible into shares of our common stock at an exercise or conversion price that will not be less than the fair market value per share but may be below the then current net asset value per share. There can be no assurance that these capital resources will be available.
As required by the 1940 Act, our asset coverage must be at least 200% after each issuance of senior securities. As of June 30, 2012 our asset coverage ratio under our regulatory requirements as a business development company was 654.3%, excluding our SBA debentures as a result of our exemptive order from the SEC which allows us to exclude all SBA leverage from our asset coverage ratio. Total leverage when including our SBA debentures was 246.2% at June 30, 2012. As a result of the SEC exemptive order, our ratio of total assets on a consolidated basis to outstanding indebtedness may be less than 200%, which while providing increased investment flexibility, also may increase our exposure to risks associated with leverage.
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At June 30, 2012 (unaudited) and December 31, 2011, we had the following borrowing capacity and outstanding amounts:
Except for the Convertible Senior Notes, all carrying values are the same as the principal amount outstanding.
In July 2012, we re-opened our 2019 Notes and issued an additional $41.5 million in aggregate principal amount of 2019 Notes, which includes exercise of an over-allotment option, bringing the total amount of 2019 Notes issued to approximately $84.5 million in aggregate principal amount.
Represents the aggregate principal amount outstanding of the Convertible Senior Notes less the unaccreted discount initially recorded upon issuance of the Convertible Senior Notes. The total unaccreted discount for the Convertible Senior Notes was $4,106 at June 30, 2012.
In February 2012, we repaid $24.3 million of SBA debentures under HT II, priced at approximately 6.63%, including annual fees. In June 2012, the SBA approved a $24.3 million dollar commitment for HT III bringing the total available borrowings to $225.0 million, of which $100.7 million was available in HT II and $124.3 million was available in HT III.
On September 27, 2006, HT II received a license and on May 26, 2010 HT III received a license to operate as SBICs under the SBIC program and are able to borrow funds from the SBA against eligible investments. As of June 30, 2012, all required contributed capital from the Company has been invested into HT II and HT III. We are the sole limited partner of HT II and HT III and HTM is the general partner. HTM is our wholly-owned subsidiary. If HT II or HT III fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit HT II’s or HT III’s use of debentures, declare outstanding debentures immediately due and payable, and/or limit HT II or HT III from making new investments. In addition, HT II or HT III may also be limited in their ability to make distributions to us if they do not have sufficient capital in accordance with SBA regulations. Such actions by the SBA would, in turn, negatively affect us because HT II and HT III are our wholly owned subsidiaries. HT II and HT III were in compliance with the terms of the SBIC’s leverage as of June 30, 2012 as a result of having sufficient capital as defined under the SBA regulations. HT II and HT III hold approximately $203.8 million and $185.1 million in assets, respectively, and accounted for approximately 19.1% and 17.3% of our total assets prior to consolidation at June 30, 2012.
With our net investment of $75.0 million in HT II as of June 30, 2012, HT II has the capacity to issue a total of $100.7 million of SBA guaranteed debentures, of which $100.7 million was outstanding at June 30, 2012. As of June 30, 2012, HT II has paid the SBA commitment fees of approximately $1.5 million. As of June 30, 2012, we held investments in HT II in 52 companies with a fair value of approximately $179.7 million, accounting for approximately 24.9% of our total portfolio at June 30, 2012.
As of June 30, 2012, HT III had the potential to borrow up to $124.3 million of SBA-guaranteed debentures under the SBIC program. With our net investment of $62.3 million in HT III as of June 30, 2012, HT III has the capacity to issue a total of $124.3 million of SBA guaranteed debentures, subject to SBA approval, of which $100.0 million was outstanding at June 30, 2012. As of June 30, 2012, HT III has paid the SBA commitment fees of approximately $1.2 million. As of June 30, 2012, we held investments in HT III in 27 companies with a fair value of approximately $140.3 million accounting for approximately 19.4% of our total portfolio at June 30, 2012.
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We believe that our current cash and cash equivalents, cash generated from operations, and funds available from the credit facilities will be sufficient to meet our working capital and capital expenditure commitments for at least the next 12 months.
Commitments
In the normal course of business, we are party to financial instruments with off-balance sheet risk. These consist primarily of unfunded commitments to extend credit, in the form of loans, to our portfolio companies. Unfunded commitments to provide funds to portfolio companies are not reflected on our balance sheet. Our unfunded commitments may be significant from time to time. As of June 30, 2012, we had unfunded commitments of approximately $92.7 million. Approximately $32.6 million of these unfunded debt commitments are dependent upon the portfolio company reaching certain milestones before the debt commitment becomes available. These commitments will be subject to the same underwriting and ongoing portfolio maintenance as are the on-balance sheet financial instruments that we hold. Since these commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Closed commitments generally fund 70-80% of the committed amount in aggregate over the life of the commitment. We intend to use cash flow from normal and early principal repayments, and proceeds from borrowings and notes to fund these commitments. However, there can be no assurance that we will have sufficient capital available to fund these commitments as they come due.
In addition, we had approximately $48.0 million of non-binding term sheets outstanding to six new and existing companies, which generally convert to contractual commitments within approximately 45 to 60 days of signing. Non-binding outstanding term sheets are subject to completion of our due diligence and final approval process, as well as the negotiation of definitive documentation with the prospective portfolio companies. Not all non-binding term sheets are expected to close and do not necessarily represent future cash requirements.
Contractual Obligations
The following table shows our contractual obligations as of June 30, 2012:
Borrowings(3)(4)
We also have a warrant participation agreement with Citigroup. See Note 4 to our consolidated financial statements.
Includes $200,750 in borrowings under the SBA debentures, $3.1 million outstanding under the Wells Facility and $43.0 million in aggregate principal amount of the 2019 Notes issued in April 2012. In July 2012, the Company re-opened its 2019 Notes, and issued an additional $41.5 million in aggregate principal amount of 2019 Notes, which included exercise of an over-allotment option, bringing the total amount of 2019 Notes issued to approximately $84.5 million in aggregate principal amount. See “Subsequent Events” below.
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We and our executives and directors are covered by Directors and Officers Insurance, with the directors and officers being indemnified by us to the maximum extent permitted by Maryland law subject to the restrictions in the 1940 Act.
Borrowings
On September 27, 2006, HT II received a license to operate as a SBIC under the SBIC program and is able to borrow funds from the SBA against eligible investments and regulatory capital. Under the Small Business Investment Company Act and current SBA policy applicable to SBICs, a SBIC can have outstanding at any time SBA guaranteed debentures up to twice the amount of its regulatory capital. HT II has a total of $100.7 million of SBA guaranteed debentures outstanding as of June 30, 2012 and has paid the SBA commitment fees of approximately $1.5 million. As of June 30, 2012, the Company held investments in HT II in 52 companies with a fair value of approximately $179.7 million, accounting for approximately 24.9% of our total portfolio at June 30, 2012.
On May 26, 2010, HT III received a license to operate as a SBIC under the SBIC program and is able to borrow funds from the SBA against eligible investments and additional contributions to regulatory capital. With our net investment of $62.3 million in HT III as of June 30, 2012, HT III has the capacity to issue a total of $124.3 million of SBA guaranteed debentures, subject to SBA approval, of which $100.0 million was outstanding as of June 30, 2012. As of June 30, 2012, HT III has paid commitment fees of approximately $1.2 million. As of June 30, 2012, we held investments in HT III in 27 companies with a fair value of approximately $140.3 million accounting for approximately 19.4% of our total portfolio at June 30, 2012.
There is no assurance that HT II or HT III will be able to draw up to the maximum limit available under the SBIC program.
SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18.0 million and have average annual fully taxed net income not exceeding $6.0 million for the two most recent fiscal years. In addition, SBICs must devote 25.0% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6.0 million and has average annual fully taxed net income not exceeding $2.0 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services. Through its wholly-owned subsidiaries HT II and HT III, we plan to provide long-term loans to qualifying small businesses, and in connection therewith, make equity investments.
HT II and HT III are periodically examined and audited by the SBA’s staff to determine their compliance with SBA regulations. If HT II or HT III fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit HT II’s or HT III’s use of debentures, declare outstanding debentures immediately due and payable, and/or limit HT II or HT III from making new investments. In addition, HT II or HT III may also be limited in their ability to make distributions to us if they do not have sufficient capital in accordance with SBA regulations. Such actions by the SBA would, in turn, negatively affect us because HT II and III are our wholly owned subsidiaries. HT II and HT III were in compliance with the terms of the SBIC’s leverage as of June 30, 2012 as a result of having sufficient capital as defined under the SBA regulations.
In January 2011, we repaid $25.0 million of SBA debentures under HT II, priced at approximately 6.63%, including annual fees. In April 2011, the SBA approved a $25.0 million dollar commitment for HT III bringing the total available borrowings to $225.0 million, of which $125.0 million was available in HT II and $100.0 million was available in HT III.
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In February 2012, we repaid $24.3 million of SBA debentures under HT II, priced at 6.63%, including annual fees. In June 2012, the SBA approved a $24.3 million dollar commitment for HT III bringing the total available borrowings to $225.0 million, of which $100.7 million was available in HT II and $124.3 million was available in HT III.
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In August 2008, we entered into a $50.0 million two-year revolving senior secured credit facility with Wells Fargo Capital Finance (the “Wells Facility”). On June 20, 2011, we renewed the Wells Facility. Under this three-year senior secured facility, Wells Fargo Capital Finance has made commitments of $75.0 million. The facility contains an accordion feature, in which we can increase the credit line up to an aggregate of $300.0 million, funded by additional lenders and with the agreement of Wells Fargo Capital Finance and subject to other customary conditions. We expect to continue discussions with various other potential lenders to join the new facility; however, there can be no assurances that additional lenders will join the Wells Facility.
The Wells Facility includes various financial and operating covenants applicable to us and our subsidiaries, in addition to those applicable to Hercules Funding II, LLC. These covenants require us to maintain certain financial ratios and a minimum tangible net worth in an amount, when added to outstanding subordinated indebtedness, that is in excess of $314.0 million plus 90% of the cumulative amount of equity raised after March 31, 2011. In addition, the tangible net worth covenant will increase by 90 cents on the dollar for every dollar of equity capital that we subsequently raise. As of June 30, 2012, the minimum tangible net worth covenant has increased to $357.2 million as a result of the January 2012 follow-on public offering of 5.0 million shares of common stock for proceeds of approximately $48.05 million. The Wells Facility provides for customary events of default, including, but not limited to, payment defaults, breach of representations or covenants, bankruptcy events and change of control. We were in compliance with all covenants at June 30, 2012. See “Subsequent Events” for a discussion of an amendment to the Wells Facility.
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On February 10, 2010, we entered a $20.0 million one-year revolving senior secured credit facility with Union Bank (the “Union Bank Facility”). On November 2, 2011, we renewed and amended the Union Bank Facility and added a new lender under the Union Bank Facility. Union Bank and RBC Capital Markets have made commitments of $30.0 million and $25.0 million, respectively. The Union Bank Facility contains an accordion feature, in which we can increase the credit line up to an aggregate of $150.0 million, funded by additional lenders and with the agreement of Union Bank and subject to other customary conditions. We expect to continue discussions with various other potential lenders to join the new facility; however, there can be no assurances that additional lenders will join the Union Bank Facility.
Borrowings under the Union Bank Facility will generally bear interest at a rate per annum equal to LIBOR plus 2.25% with a floor of 4.0%. The Union Bank Facility requires the payment of a non-use fee of 0.50% annually. For the three-month period ended June 30, 2012, this nonuse fee was approximately $70,000. The Union Bank Facility is collateralized by debt investments in our portfolio companies, and includes an advance rate equal to 50.0% of eligible loans placed in the collateral pool. The Union Bank Facility generally requires payment of interest on a monthly basis. All outstanding principal is due upon maturity. At June 30, 2012, there were no borrowings outstanding on this facility.
We, through Hercules Funding Trust I, an affiliated statutory trust, had a securitized credit facility (the “Citibank Credit Facility”) with Citigroup Global Markets Realty Corp. which expired under normal terms. During the first quarter of 2009, we paid off all principal and interest owed under the Citibank Credit Facility. Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants collateralized under the Citibank Credit Facility. Pursuant to the warrant participation agreement, we granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants were included in collateral subsequent to the facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equal $3,750,000 (the “Maximum Participation Limit”). The obligations under the warrant participation agreement continue even after the Citibank Credit Facility is terminated until the Maximum Participation Limit has been reached. The value of their participation right on unrealized gains in the related equity investments was approximately $606,000 as of June 30, 2012 and is included in accrued liabilities. There can be no assurances that the unrealized appreciation of the warrants will not be higher or lower in future periods due to fluctuations in the value of the warrants, thereby increasing or reducing the effect on the cost of borrowing. Since inception of the agreement, we have paid Citigroup approximately $1.1 million under the warrant participation agreement thereby reducing our realized gains by this amount. We will continue to pay Citigroup under the warrant participation agreement until the Maximum Participation Limit is reached or the warrants expire. Warrants subject to the Citigroup participation agreement are set to expire between July 2012 and January 2017.
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In April 2011, we issued $75.0 million in aggregate principal amount of 6.00% convertible senior notes (the “Convertible Senior Notes”) due 2016. As of June 30, 2012, the carrying value of the Convertible Senior Notes, comprised of the aggregate principal amount outstanding less the unaccreted discount initially recorded upon issuance of the Convertible Senior Notes, is approximately $70.9 million.
The Convertible Senior Notes mature on April 15, 2016 (the “Maturity Date”), unless previously converted or repurchased in accordance with their terms. The Convertible Senior Notes bear interest at a rate of 6.00% per year payable semiannually in arrears on April 15 and October 15 of each year, commencing on October 15, 2011. The Convertible Senior Notes are our senior unsecured obligations and rank senior in right of payment to our existing and future indebtedness that is expressly subordinated in right of payment to the Convertible Senior Notes; equal in right of payment to our existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness (including unsecured indebtedness that we later secure) to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred by our subsidiaries, financing vehicles or similar facilities.
Prior to the close of business on the business day immediately preceding October 15, 2015, holders may convert their Convertible Senior Notes only under certain circumstances set forth in the Indenture. On or after October 15, 2015 until the close of business on the scheduled trading day immediately preceding the Maturity Date, holders may convert their Convertible Senior Notes at any time. Upon conversion, we will pay or deliver, as the case may be, at our election, cash, shares of our common stock or a combination of cash and shares of our common stock. The conversion rate will initially be 84.0972 shares of common stock per $1,000 principal amount of Convertible Senior Notes (equivalent to an initial conversion price of approximately $11.89 per share of common stock). The conversion rate will be subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. In addition, if certain corporate events occur prior to the Maturity Date, the conversion rate will be increased for converting holders.
We may not redeem the Convertible Senior Notes prior to maturity. No sinking fund is provided for the Convertible Senior Notes. In addition, if certain corporate events occur, holders of the Convertible Senior Notes may require us to repurchase for cash all or part of their Convertible Senior Notes at a repurchase price equal to 100% of the principal amount of the Convertible Senior Notes to be repurchased, plus accrued and unpaid interest through, but excluding, the required repurchase date.
In accounting for the Convertible Senior Notes, we estimated that the values of the debt and the embedded conversion feature of the Convertible Senior Notes were approximately 92.8% and 7.2%, respectively. The original issue discount of 7.2% attributable to the conversion feature of the Convertible Senior Notes has initially been recorded in “capital in excess of par value” in the consolidated statement of assets and liabilities. As a result, we record interest expense comprised of both stated interest expense as well as accretion of the original issue discount resulting in an estimated effective interest rate of approximately 7.9%.
For the three and six months ended June 30, 2012, the components of interest expense, fees and cash paid for interest expense for the Convertible Senior Notes were as follows:
As of June 30, 2012, we are in compliance with the terms of the indentures governing the Convertible Senior Notes. See Note to our consolidated financial statements for more detail on the Convertible Senior Notes.
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On April 17, 2012, we and U.S. Bank, N.A. (the “Trustee”), entered into the First Supplemental Indenture (the “First Supplemental Indenture”) to the Indenture (the “Indenture”) between us and the Trustee, dated April 17, 2012, relating to our issuance, offer and sale of $43.0 million aggregate principal amount of 7.00% senior notes due 2019 (the “2019 Notes”). The sale of the 2019 Notes generated net proceeds, before expenses, of approximately $41.7 million.
The 2019 Notes will mature on April 30, 2019 and may be redeemed in whole or in part at our option at any time or from time to time on or after April 30, 2015, upon not less than 30 days nor more than 60 days written notice by mail prior to the date fixed for redemption thereof, at a redemption price of 100% of the outstanding principal amount thereof plus accrued and unpaid interest payments otherwise payable for the then-current quarterly interest period accrued to but not including the date fixed for redemption. The 2019 Notes bear interest at a rate of 7.00% per year payable quarterly on January 30, April 30, July 30 and October 30 of each year, commencing on July 30, 2012, and trade on the New York Stock Exchange under the trading symbol “HTGZ.”
The 2019 Notes will be our direct unsecured obligations and will rank: (i) pari passu with our other outstanding and future senior unsecured indebtedness, including without limitation, the $75.0 million in aggregate principal amount of the Convertible Senior Notes; (ii) senior to any of our future indebtedness that expressly provides it is subordinated to the 2019 Notes; (iii) effectively subordinated to all our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, borrowings under our credit facilities; (iv) structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Hercules Technology II, L.P. and Hercules Technology III, L.P. and borrowings under our revolving senior secured credit facility with Wells Fargo Capital Finance, LLC.
The Indenture, as supplemented by the First Supplemental Indenture, contains certain covenants including covenants requiring our compliance with (regardless of whether it is subject to) the asset coverage requirements set forth in Section 18(a)(1)(A) as modified by Section 61(a)(1) of the Investment Company Act of 1940, as amended, to comply with the restrictions on dividends, distributions and purchase of capital stock set forth in Section 18(a)(1)(B) as modified by Section 61(a)(1) of the Investment Company Act of 1940, as amended, and to provide financial information to the holders of the 2019 Notes and the Trustee if the Company should no longer be subject to the reporting requirements under the Securities Exchange Act of 1934. These covenants are subject to important limitations and exceptions that are described in the Indenture, as supplemented by the First Supplemental Indenture. The Indenture provides for customary events of default and further provides that the Trustee or the holders of 25% in aggregate principal amount of the outstanding 2019 Notes in a series may declare such 2019 Notes immediately due and payable upon the occurrence of any event of default after expiration of any applicable grace period.
The 2019 Notes were sold pursuant to an underwriting agreement dated April 11, 2012 among us and Stifel, Nicolaus & Company, Incorporated, as representative of the several underwriters named in the underwriting agreement. In July 2012, we re-opened our 2019 Notes and issued an additional $41.5 million in aggregate principal amount of 2019 Notes, which includes exercise of an over-allotment option, bringing the total amount of the 2019 Notes issued to approximately $84.5 million in aggregate principal amount.
For the three months and six months ended June 30, 2012, the components of interest expense and cash paid for interest expense for the 2019 Notes are as follows:
As of June 30, 2012, we are in compliance with the terms of the indenture governing the 2019 Notes. See Note 4 to our consolidated financial statements for more detail on the 2019 Notes.
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Outstanding Borrowings
At June 30, 2012 (unaudited) and December 31, 2011, we had the following borrowing capacity and outstanding borrowings:
In July 2012, we re-opened our 2019 Notes and issued an additional $41.5 million in aggregate principal amount, which includes exercise of an over-allotment option, bringing the total amount of 2019 Notes issued to approximately $84.5 million in aggregate principal amount.
In February 2012, we repaid $24.3 million of SBA debentures under HT II, priced at approximately 6.63%, including annual fees. In June 2012, the SBA approved a $24.3 million dollar commitment for HT III, bringing the total available borrowings to $225.0 million, of which $100.7 million was available in HT II and $124.3 million was available in HT III.
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Dividends
The following table summarizes our dividends declared and paid or to be paid on all shares, including restricted stock, to date:
Date Declared
Record Date
Payment Date
October 27, 2005
December 9, 2005
April 3, 2006
July 19, 2006
October 16, 2006
February 7, 2007
May 3, 2007
August 2, 2007
November 1, 2007
February 7, 2008
May 8, 2008
August 7, 2008
November 6, 2008
February 12, 2009
May 7, 2009
August 6, 2009
October 15, 2009
December 16, 2009
February 11, 2010
May 3, 2010
August 2, 2010
November 4, 2010
March 1, 2011
May 5, 2011
August 4, 2011
November 3, 2011
February 27, 2012
April 30, 2012
July 30, 2012
On July 30, 2012 the Board of Directors declared a cash dividend of $0.24 per share to be paid on August 24, 2012 to shareholders of record as of August 17, 2012. This dividend represents the Company’s twenty-eighth consecutive quarterly dividend declaration since its initial public offering, and will bring the total cumulative dividend declared to date to $7.40 per share.
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Our Board of Directors maintains a variable dividend policy with the objective of distributing four quarterly distributions in an amount that approximates 90 - 100% of our taxable quarterly income or potential annual income for a particular year. In addition, at the end of the year, we may also pay an additional special dividend or fifth dividend, such that we may distribute approximately all of our annual taxable income in the year it was earned, while maintaining the option to spill over our excess taxable income.
Distributions in excess of our current and accumulated earnings and profits would generally be treated first as a return of capital to the extent of the stockholder’s tax basis, and any remaining distributions would be treated as a capital gain. The determination of the tax attributes of our distributions is made annually as of the end of our fiscal year based upon our taxable income for the full year and distributions paid for the full year, therefore a determination made on a quarterly basis may not be representative of the tax attributes of our 2012 distributions to stockholders. If we had determined the tax attributes of our distributions year-to-date as of June 30, 2012, approximately 98% would be from ordinary income and spillover earnings from 2011, and 2% would be a return of capital.
Each year a statement on Form 1099-DIV identifying the source of the distribution (i.e., paid from ordinary income, paid from net capital gains on the sale of securities, and/or a return of paid-in-capital surplus which is a nontaxable distribution) is mailed to our stockholders. To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a tax return of capital to our stockholders.
We operate to qualify to be taxed as a RIC under the Code. Generally, a RIC is entitled to deduct dividends it pays to its shareholders from its income to determine “taxable income.” Taxable income includes our taxable interest, dividend and fee income, as well as taxable net capital gains. Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation, as gains or losses are not included in taxable income until they are realized. In addition, gains realized for financial reporting purposes may differ from gains included in taxable income as a result of our election to recognize gains using installment sale treatment, which generally results in the deferment of gains for tax purposes until notes or other amounts, including amounts held in escrow, received as consideration from the sale of investments are collected in cash. Taxable income includes non-cash income, such as changes in accrued and reinvested interest and dividends, which includes contractual payment-in-kind interest, and the amortization of discounts and fees. Cash collections of income resulting from contractual PIK interest or the amortization of discounts and fees generally occur upon the repayment of the loans or debt securities that include such items. Non-cash taxable income is reduced by non-cash expenses, such as realized losses and depreciation and amortization expense.
We intend to distribute quarterly dividends to our stockholders. In order to avoid certain excise taxes imposed on RICs, we currently intend to distribute during each calendar year an amount at least equal to the sum of (1) 98% of our ordinary income for the calendar year, (2) 98.2% of our capital gains in excess of capital losses for the one year period ending on October 31 of the calendar year, and (3) any ordinary income and net capital gains for the preceding year that were not distributed during such year. We will not be subject to excise taxes on amounts on which we are required to pay corporate income tax (such as retained net capital gains). In order to obtain the tax benefits applicable to RICs, we will be required to distribute to our stockholders with respect to each taxable year at least 90% of our ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses.
We can offer no assurance that we will achieve results that will permit the payment of any cash distributions and, if we issue senior securities, we will be prohibited from making distributions if doing so causes us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or if distributions are limited by the terms of any of our borrowings. See “Regulation.”
We maintain an “opt-out” dividend reinvestment plan for our common stockholders. As a result, if we declare a dividend, cash dividends will be automatically reinvested in additional shares of our common stock unless the stockholder specifically “opts out” of the dividend reinvestment plan and chooses to receive cash dividends. See “Dividend Reinvestment Plan.”
Our ability to make distributions will be limited by the asset coverage requirements under the 1940 Act.
Critical Accounting Policies
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and revenues and expenses during the period reported. On an ongoing basis, our management evaluates its estimates and assumptions, which are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. Changes in our estimates and assumptions could materially impact our results of operations and financial condition.
Valuation of Portfolio Investments. The most significant estimate inherent in the preparation of our consolidated financial statements is the valuation of investments and the related amounts of unrealized appreciation and depreciation of investments recorded.
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Our investments are carried at fair value in accordance with the 1940 Act and Accounting Standards Codification (“ASC”) topic 820 Fair Value Measurements and Disclosures (formerly known as SFAS No. 157, Fair Value Measurements). At June 30, 2012, approximately 90.1% of the Company’s total assets represented investments in portfolio companies that are valued at fair value by the Board of Directors. Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the Board of Directors. Our debt securities are primarily invested in equity sponsored technology-related companies including life science, clean technology and select lower middle market technology companies. Given the nature of lending to these types of businesses, our investments in these portfolio companies are generally considered Level 3 assets under ASC 820 because there is no known or accessible market or market indexes for these investment securities to be traded or exchanged. As such, it values substantially all of its investments at fair value as determined in good faith pursuant to a consistent valuation policy and our Board of Directors in accordance with the provisions of ASC 820 and the 1940 Act. Due to the inherent uncertainty in determining the fair value of investments that do not have a readily available market value, the fair value of our investments determined in good faith by our Board may differ significantly from the value that would have been used had a readily available market existed for such investments, and the differences could be material.
Our Board of Directors may from time to time engage an independent valuation firm to provide us with valuation assistance with respect to certain of our portfolio investments on a quarterly basis. We intend to continue to engage an independent valuation firm to provide us with assistance regarding our determination of the fair value of selected portfolio investments each quarter unless directed by the Board of Directors to cancel such valuation services. The scope of the services rendered by an independent valuation firm is at the discretion of the Board of Directors. Our Board of Directors is ultimately and solely responsible for determining the fair value of our investments in good faith.
With respect to investments for which market quotations are not readily available or when such market quotations are deemed not to represent fair value, our Board of Directors has approved a multi-step valuation process each quarter, as described below:
(1) our quarterly valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment;
(2) preliminary valuation conclusions are then documented and business based assumptions are discussed with our investment committee;
(3) the valuation committee of the Board of Directors reviews the preliminary valuation of the investment committee which incorporates the results of the independent valuation firm as appropriate.
We adopted ASC 820 on January 1, 2008. ASC 820 establishes a framework for measuring the fair value of the assets and liabilities and outlines a fair value hierarchy which prioritizes the inputs used to measure fair value and the effect of fair value measures on earnings. ASC 820 also enhances disclosure requirements for fair value measurements based on the level within the hierarchy of the information used in the valuation. ASC 820 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
We have categorized all investments recorded at fair value in accordance with ASC 820 based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by ASC 820 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:
Level 3—Inputs reflect management’s best estimate of what market participants would use in pricing the asset at the measurement date. It includes prices or valuations that require inputs that are both significant to the fair value measurement and
unobservable. Generally, assets carried at fair value and included in this category are the debt investments and warrants and equities held in a private company.
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In accordance with ASU 2011-04, the following table provides quantitative information about our Level 3 fair value measurements of our investments as of June 30, 2012. In addition to the techniques and inputs noted in the table below, according to our valuation policy we may also use other valuation techniques and methodologies when determining our fair value measurements. The below table is not intended to be all-inclusive, but rather provides information on the significant Level 3 inputs as they relate to our fair value measurements.
Valuation Techniques/Methodologies
Pharmaceuticals, above, is comprised of debt investments in the Therapeutic, Specialty Pharmaceuticals, Drug Discovery and Development, Drug Delivery, and Diagnostics and Biotechnology industries in the Schedule of Investments.
Clean Tech, above, aligns with the Clean Tech Industry in the Schedule of Investments.
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Our debt securities are primarily invested in equity sponsored technology-related companies including life science, clean technology and select lower middle market technology companies. Given the nature of lending to these types of businesses, our investments in these portfolio companies are considered Level 3 assets under ASC 820 because there is no known or accessible market or market indexes for these investment securities to be traded or exchanged.
We apply a procedure for debt investments that assumes a sale of investment in a hypothetical market to a hypothetical market participant where buyers and sellers are willing participants. The hypothetical market does not include scenarios where the underlying security was simply repaid or extinguished, but includes an exit concept. Under this process, we also evaluate the collateral for recoverability of the debt investments as well as apply all of its historical fair value analysis. We use pricing on recently issued comparable debt securities to determine the baseline hypothetical market yields as of the measurement date. We consider each portfolio company’s credit rating, security liens and other characteristics of the investment to adjust the baseline yield to derive a hypothetical yield for each investment as of the measurement date. The anticipated future cash flows from each investment are then discounted at the hypothetical yield to estimate each investment’s fair value as of the measurement date.
Our process includes, among other things, the underlying investment performance, the current portfolio company’s financial condition and market changing events that impact valuation, estimated remaining life, current market yield and interest rate spreads of similar securities as of the measurement date. If there is a significant deterioration of the credit quality of a debt investment, we may consider other factors than those a hypothetical market participant would use to estimate fair value, including the proceeds that would be received in a liquidation analysis.
We record unrealized depreciation on investments when we believe that an investment has decreased in value, including where collection of a loan is doubtful or if under the in exchange premise when the value of a debt security were to be less than amortized cost of the investment. Conversely, where appropriate, we record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and, therefore, that our investment has also appreciated in value or if under the in exchange premise the value of a debt security were to be greater than amortized cost.
When originating a debt instrument, we generally receive warrants or other equity-related securities from the borrower. We determine the cost basis of the warrants or other equity-related securities received based upon their respective fair values on the date of receipt in proportion to the total fair value of the debt and warrants or other equity-related securities received. Any resulting discount on the loan from recordation of the warrant or other equity instruments is accreted into interest income over the life of the loan.
We estimate the fair value of warrants using a Black Scholes pricing model. At each reporting date, privately held warrant and equity-related securities are valued based on an analysis of various factors including, but not limited to, the portfolio company’s operating performance and financial condition and general market conditions, price to enterprise value or price to equity ratios, discounted cash flow, valuation comparisons to comparable public companies or other industry benchmarks. When an external event occurs, such as a purchase transaction, public offering, or subsequent equity sale, the pricing indicated by that external event is utilized to corroborate our valuation of the warrant and equity-related securities. We periodically review the valuation of our portfolio companies that have not been involved in a qualifying external event to determine if the enterprise value of the portfolio company may have increased or decreased since the last valuation measurement date.
Income Recognition.
We record interest income on the accrual basis and we recognize it as earned in accordance with the contractual terms of the loan agreement to the extent that such amounts are expected to be collected. Original Issue Discount (“OID”) initially represents the value of detachable equity warrants obtained in conjunction with the acquisition of debt securities and is accreted into interest income over the term of the loan as a yield enhancement. When a loan becomes 90 days or more past due, or if management otherwise does not expect the portfolio company to be able to service its debt and other obligations, we will generally place the loan on non-accrual status
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and cease recognizing interest income on that loan until all principal has been paid. Any uncollected interest related to prior periods is reversed from income in the period that collection of the interest receivable is determined to be doubtful. However, we may make exceptions to this policy if the investment has sufficient collateral value and is in the process of collection. As of June 30, 2012, we had one portfolio company on non-accrual status with an approximate cost of $7.1 million and a fair value of approximately $169,000. There was one portfolio company on non-accrual status with an approximate cost of $7.7 million and a fair value of approximately $1.0 million as of December 31, 2011.
Paid-In-Kind and End of Term Income.
Contractual paid-in-kind (“PIK”) interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. We will generally cease accruing PIK interest if there is insufficient value to support the accrual or we do not expect the portfolio company to be able to pay all principal and interest due. In addition, we may also be entitled to an end-of-term payment that we amortize into income over the life of the loan. To maintain our status as a RIC, PIK and end-of-term income must be paid out to stockholders in the form of dividends even though we have not yet collected the cash. Amounts necessary to pay these dividends may come from available cash or the liquidation of certain investments. We recorded approximately $271,000 and $569,000 in PIK income in the three and six-month periods ended June 30, 2012, respectively. We recorded approximately $524,000 and $1.1 million in the same periods ended June 30, 2011, respectively.
Fee Income.
Fee income, generally collected in advance, includes loan commitment and facility fees for due diligence and structuring, as well as fees for transaction services and management services rendered by us to portfolio companies and other third parties. Loan and commitment fees are amortized into income over the contractual life of the loan. Management fees are generally recognized as income when the services are rendered. Loan origination fees are capitalized and then amortized into interest income using the effective interest rate method. In certain loan arrangements, warrants or other equity interests are received from the borrower as additional origination fees.
We recognize nonrecurring fees amortized over the remaining term of the loan commencing in the quarter relating to specific loan modifications. Certain fees may still be recognized as one-time fees, including prepayment penalties, fees related to select covenant default waiver fees and acceleration of previously deferred loan fees and original issue discount (OID) related to early loan pay-off or material modification of the specific debt outstanding.
Equity Offering Expenses
Our offering costs are charged against the proceeds from equity offerings when received.
Debt Issuance Costs
Debt issuance costs are being amortized over the life of the related debt instrument using the straight line method, which closely approximates the effective yield method.
Stock-Based Compensation.
We have issued and may, from time to time, issue additional stock options and restricted stock to employees under our 2004 Equity Incentive Plan and Board members under our 2006 Equity Incentive Plan. We follow ASC 718, formally known as FAS 123R “Share-Based Payments” to account for stock options granted. Under ASC 718, compensation expense associated with stock-based compensation is measured at the grant date based on the fair value of the award and is recognized over the vesting period.
Federal Income Taxes.
We intend to operate so as to qualify to be taxed as a RIC under Subchapter M of the Code and, as such, will not be subject to federal income tax on the portion of our taxable income and gains distributed to stockholders. To qualify as a RIC, we are required to distribute at least 90% of our investment company taxable income, as defined by the Code. We are subject to a non-deductible federal excise tax if we do not distribute at least 98% of our taxable income and 98.2% of our capital gain net income for each one year period ending on October 31. At December 31, 2011, 2010 and 2009, no excise tax was recorded. At December 31, 2008, we recorded a liability for excise tax of approximately $203,000 on income and capital gains of approximately $5.0 million which was distributed in 2009. Because federal income tax regulations differ from accounting principles generally accepted in the United States, distributions in accordance with tax regulations may differ from net investment income and realized gains recognized for financial reporting
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purposes. Differences may be permanent or temporary. Permanent differences are reclassified among capital accounts in the financial statement to reflect their tax character. Temporary differences arise when certain items of income, expense, gain or loss are recognized at some time in the future. Differences in classification may also result from the treatment of short-term gains as ordinary income for tax purposes.
Recent Accounting Pronouncement
In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2011-04—Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, or ASU 2011-04. ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes the application of some requirements for measuring fair value and requires additional disclosure for fair value measurements. The highest and best use valuation premise is only applicable to non-financial assets. In addition, the disclosure requirements are expanded to include for fair value measurements categorized in Level 3 of the fair value hierarchy: (1) a quantitative disclosure of the unobservable inputs and assumptions used in the measurement; (2) a description of the valuation processes in place; and (3) a narrative description of the sensitivity of the fair value to changes in unobservable inputs and interrelationships between those inputs. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011, for public entities and as such we have adopted this ASU beginning with our quarter ended March 31, 2012. We have increased our disclosures related to Level 3 fair value measurement, in addition to other required disclosures. There were no related impacts on our financial position or results of operations.
Subsequent Events
On July 6, 2012, we re-opened our 2019 Notes and issued approximately $38.8 million in aggregate principal amount of the 2019 Notes pursuant to an underwriting agreement among us and Stifel, Nicolaus & Company, Incorporated, as representative of the several underwriters named therein, relating to the issuance, offer and sale of the 2019 Notes. We granted the underwriters an option to purchase up to an additional $5.8 million in aggregate principal amount of the 2019 Notes to cover overallotments, if any. Pursuant to this option, approximately $2.7 million in aggregate principal amount of the 2019 Notes were issued and sold on July 12, 2012. The sale of the 2019 Notes generated net proceeds to us, before expenses and excluding accrued interest, of approximately $40.2 million.
The 2019 Notes are a further issuance of, rank equally in right of payment with, and form a single series for all purposes under the Indenture (as defined below) including, without limitation, waivers, amendments, consents, redemptions and other offers to purchase and voting, with the $43.0 million aggregate principal amount initially issued by us on April 17, 2012.
On April 17, 2012, we and U.S. Bank National Association, as Trustee (the “Trustee”) entered into the First Supplemental Indenture (the “First Supplemental Indenture”) to the Indenture (the “Base Indenture,” and together with the First Supplemental Indenture, the “Indenture”), between us and U.S. Bank National Association, as Trustee (the “Trustee”), dated March 6, 2012, relating to the issuance, offer and sale of the additional 2019 Notes were offered under the same Indenture.
The 2019 Notes will mature on April 30, 2019 and may be redeemed in whole or in part at our option at any time or from time to time on or after April 30, 2015, upon not less than 30 days nor more than 60 days written notice by mail prior to the date fixed for redemption thereof, at a redemption price of 100% of the outstanding principal amount thereof plus accrued and unpaid interest payments otherwise payable for the then-current quarterly interest period accrued to but not including the date fixed for redemption. The 2019 Notes bear interest at a rate of 7.00% per year payable quarterly on January 30, April 30, July 30 and October 30 of each year, commencing on July 30, 2012.
The 2019 Notes will be our direct unsecured obligations and will rank: (i) pari passu with our other outstanding and future senior unsecured indebtedness, including without limitation, the $75.0 million Convertible Senior Notes; (ii) senior to any of our future indebtedness that expressly provides it is subordinated to the 2019 Notes (iii) effectively subordinated to all of our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, borrowings under our credit facilities; (iv) structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Hercules Technology II, L.P. and Hercules Technology III, L.P. and borrowings under our revolving senior secured credit facility with Wells Fargo Capital Finance.
The Base Indenture, as supplemented by the First Supplemental Indenture, contains certain covenants including covenants requiring us to comply with (regardless of whether it is subject to) the asset coverage requirements set forth in Section 18(a)(1)(A) as modified by Section 61(a)(1) of the Investment Company Act of 1940, as amended, to comply with the restrictions on dividends, distributions and purchase of capital stock set forth in Section 18(a)(1)(B) as modified by Section 61(a)(1) of the Investment Company Act of 1940, as amended, and to provide financial information to the holders of the 2019 Notes and the Trustee if the Company should no longer be subject to the reporting requirements under the Securities Exchange Act of 1934. These covenants are subject to important limitations and exceptions that are described in the Base Indenture, as supplemented by the First Supplemental Indenture. The Base Indenture provides for customary events of default and further provides that the Trustee or the holders of 25% in aggregate principal amount of the outstanding 2019 Notes in a series may declare such 2019 Notes immediately due and payable upon the occurrence of any event of default after expiration of any applicable grace period.
Wells Credit Facility
In August 2012 we amended our credit facility with Wells Fargo Capital Finance, LLC (“WFCF”) under which WFCF has committed $75.0 million in initial credit capacity under a $300.0 million accordion credit facility. We can increase the credit line up to an aggregate of $300.0 million, funded by additional lenders who may join the facility and with the agreement of WFCF and RBC Capital Markets and subject to other customary conditions. There can be no assurances that additional lenders will join the new credit facility.
The credit facility has an advance rate equal to 50% of eligible loans placed in the collateral pool. The credit facility generally requires payment of interest on a monthly basis. We paid an amendment fee of $375,000.
We have various financial and operating covenants required by the credit facility. These covenants require us to maintain certain financial ratios and a minimum tangible net worth. The credit facility provides for customary events of default, including, but not limited to, payment defaults, breach of representations or covenants, bankruptcy events and change of control.
On July 25, 2012, we approved the extension of the stock repurchase plan as previously approved under the same terms and conditions that allows the Company to repurchase up to $35.0 million of its common stock. Unless renewed, the stock repurchase plan will expire on February 26, 2013.
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On July 31, 2012, we received payment of $2.0 million for our total debt investments in Maxvision Holding, L.L.C. As of June 30, 2012 we valued these debt investments, which had a total cost basis of approximately $7.1 million, at a fair value of approximately $169,000. These investments were accounted for on a non-accrual basis. In the third quarter of 2012, we will record a realized loss of approximately $5.1 million and a reversal of previously recorded unrealized depreciation of $6.9 million for our Maxvision debt investments.
Closed and Pending Commitments
As of August 2, 2012, we have:
The table below summarizes our year-to-date closed and pending commitments as follows:
Closed Commitments and Pending Commitments (in millions)
January 1- June 30, 2012 Closed Commitments
Q3-12 Closed Commitments (as of August 2, 2012)
Total 2012 Closed Commitments(a)
Pending Commitments (as of August 2, 2012)(b)
Notes:
We are subject to financial market risks, including changes in interest rates. Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread relationships, the difference in re-pricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows. Changes in the general level of interest rates can affect our net investment income, which is the difference between the interest income earned on interest earning assets and our interest expense incurred in connection with our interest bearing debt and liabilities. Changes in interest rates can also affect, among other things, our ability to acquire and originate loans and securities and the value of our investment portfolio.
As of June 30, 2012, approximately 94.9% of our portfolio loans were at variable rates or variable rates with a floor and 5.1% of our loans were at fixed rates. Over time additional investments may be at variable rates. We do not currently engage in any hedging activities. However, we may, in the future, hedge against interest rate fluctuations by using standard hedging instruments such as futures, options, and forward contracts. While hedging activities may insulate us against changes in interest rates, they may also limit our ability to participate in the benefits of lower interest rates with respect to our borrowed funds and higher interest rates with respect to our portfolio of investments. Interest rates on our borrowings are based primarily on LIBOR. Borrowings under our SBA program are fixed at the ten year treasury rate every March and September for borrowings of the preceding six months. Borrowings under the program are charged interest based on ten year treasury rates plus a spread and the rates are generally set for a pool of debentures issued by the SBA in six-month periods. The rates of borrowings under the various draws from the SBA beginning in April 2007 and set semiannually in March and September range from 2.77% to 5.73%. In addition, the SBA charges a fee that is set annually, depending on the Federal fiscal year the leverage commitment was delegated by the SBA, regardless of the date that the leverage was drawn by the SBIC. The annual fees related to HT II debentures that pooled on September 22, 2010 were 0.406% and 0.285%, depending upon the year in which the underlying commitment was closed. The annual fees related to HT III debentures that pooled on March 21, 2012 were 0.285% and 0.515% depending upon the year in which the underlying commitment was closed. The annual fees on other debentures have been set at 0.906%. The average amount of debentures outstanding for the quarter ended June 30, 2012 for HT II was approximately $100.7 million with an average interest rate of approximately 6.3%. The average amount of debentures outstanding for the quarter ended June 30, 2012 for HT III was approximately $100.0 million with an average interest rate of approximately 3.6%. Interest is payable semiannually and there are no principal payments required on these issues prior to maturity. Debentures under the SBA generally mature ten years after being borrowed. Based on the initial draw down date of April 2007, the initial maturity of SBA debentures will occur in April 2017.
Borrowings under the Union Bank Facility will generally bear interest at a rate per annum equal to LIBOR plus 2.25% with a floor of 4.0%. The Union Bank Facility required the payment of an unused fee of 0.50% annually. For the three-month period ended June 30, 2012, this non-use fee was approximately $70,000. The Union Bank Facility is collateralized by debt investments in our portfolio companies, and includes an advance rate equal to 50% of eligible loans placed in the collateral pool. The Union Bank Facility generally requires payment of interest on a monthly basis. All outstanding principal is due upon maturity. There were no outstanding borrowings under this facility at June 30, 2012. On November 2, 2011, we renewed and amended the Union Bank Facility. The other terms of the Union Bank Facility generally remain unchanged, including the stated interest rate. The Union Bank Facility will mature on November 2, 2014, revolving through the first 24 months with a term out provision for the remaining 12 months.
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Borrowings under the Convertible Senior Notes mature on April 15, 2016 (the “Maturity Date”), unless previously converted or repurchased in accordance with their terms. The Convertible Senior Notes bear interest at a rate of 6.00% per year payable semiannually in arrears on April 15 and October 15 of each year, commencing on October 15, 2011. The Convertible Senior Notes are our senior unsecured obligations and rank senior in right of payment to the our existing and future indebtedness that is expressly subordinated in right of payment to the Convertible Senior Notes; equal in right of payment to our existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness (including unsecured indebtedness that we later secure) to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred by our subsidiaries, financing vehicles or similar facilities.
The 2019 Notes will be our direct unsecured obligations and will rank: (i) pari passu with our other outstanding and future senior unsecured indebtedness, including without limitation, the $75 million in aggregate principal amount of the Convertible Senior Notes; (ii) senior to any of our future indebtedness that expressly provides it is subordinated to the Notes; (iii) effectively subordinated to all our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, borrowings under our credit facilities; (iv) structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Hercules Technology II, L.P. and Hercules Technology III, L.P. and borrowings under our revolving senior secured credit facility with Wells Fargo Capital Finance.
Because we currently borrow, and plan to borrow in the future, money to make investments, our net investment income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest the funds borrowed. Accordingly, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds would increase, which could reduce our net investment income if there is not a corresponding increase in interest income generated by variable rate assets in our investment portfolio.
Disclosure Controls and Procedures
Our chief executive and chief financial officers, under the supervision and with the participation of our management, conducted an evaluation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of the end of the period covered by this quarterly report on Form 10-Q, our chief executive and chief financial officers have concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that information required to be disclosed by us in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the company’s management, including its chief executive and chief financial officers, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There have been no other changes in our internal control over financing reporting, as defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, that occurred during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II: OTHER INFORMATION
At June 30, 2012, we were not a party to any legal proceedings. However, from time to time, we may be party to certain legal proceedings incidental to the normal course of our business including the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations and cash flows.
In addition to the risks discussed below, important risk factors that could cause results or events to differ from current expectations are described in Part I, Item 1A “Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
It is likely that the terms of any current or future borrowings, long-term or revolving credit or warehouse facility we may enter into may constrain our ability to grow our business.
Under our borrowings and credit facilities, including our Union Bank and Wells credit facilities, current lenders have, and any future lender or lenders may have, fixed dollar claims on our assets that are senior to the claims of our stockholders and, thus, will have a preference over our stockholders with respect to our assets in the collateral pool. Our current credit facilities and borrowings also subject us to various financial and operating covenants, including, but not limited to, maintaining certain financial ratios and minimum tangible net worth amounts. Future credit facilities and borrowings will likely subject us to similar or additional covenants. In addition, we may grant a securities interest in our assets in connection with any such credit facilities and borrowings.
Our current credit facilities generally contain customary default provisions such as a minimum net worth amount, a profitability test, and a restriction on changing our business and loan quality standards. In addition, such credit facilities require or are expected to require the repayment of all outstanding debt on the maturity which may disrupt our business and potentially the business of our portfolio companies that are financed through the facilities. An event of default under these facilities would likely result, among other things, in termination of the availability of further funds under the facilities and accelerated maturity dates for all amounts outstanding under the facilities, which would likely disrupt our business and, potentially, the business of the portfolio companies whose loans we finance through the facilities. This could reduce our revenues and, by delaying any cash payment allowed to us under our facilities until the lender has been paid in full, reduce our liquidity and cash flow and impair our ability to grow our business and maintain our status as a RIC.
The terms of future available financing may place limits on our financial and operation flexibility. If we are unable to obtain sufficient capital in the future, we may be forced to reduce or discontinue our operations, not be able to make new investments, or otherwise respond to changing business conditions or competitive pressures.
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On September 27, 2006, HT II received a license to operate as a SBIC under the SBIC program and is able to borrow funds from the SBA against eligible investments and additional contributions to regulatory capital. As of June 30, 2012, HT II had the potential to borrow up to $125.0 million of SBA-guaranteed debentures under the SBIC program. With our net investment of $75.0 million in HT II as of June 30, 2012, HT II has the capacity to issue a total of $100.7 million of SBA guaranteed debentures, subject to SBA approval, of which $100.7 million is outstanding as of June 30, 2012.
On May 26, 2010, HT III received a license to operate as a SBIC under the SBIC program and is able to borrow funds from the SBA against eligible investments and additional contributions to regulatory capital. As of June 30, 2012, HT III had the potential to borrow up to $100.0 million of SBA-guaranteed debentures under the SBIC program. With our net investment of $62.3 million in HT III as of June 30, 2012, HT III has the capacity to issue a total of $124.3 million of SBA guaranteed debentures, subject to SBA approval, of which $100.0 million was outstanding as of June 30, 2012.
As of June 30, 2012, there was $200.7 million principal amount of indebtedness outstanding incurred by our SBIC subsidiaries. Access to the remaining leverage is subject to SBA approval and compliance with SBA regulations.
In addition to regulatory restrictions that restrict our ability to raise capital, the Wells Facility, the Union Bank Facility, the Convertible Senior Notes, and the 2019 Notes contain various covenants which, if not complied with, could accelerate repayment under the facility or require us to repurchase the Convertible Senior Notes or 2019 Notes, thereby materially and adversely affecting our liquidity, financial condition, results of operations and ability to pay dividends.
The credit agreements governing the Wells Facility, the Union Bank Facility, the Convertible Senior Notes and 2019 Notes require us to comply with certain financial and operational covenants. These covenants require us to, among other things, maintain certain financial ratios, including asset coverage, debt to equity and interest coverage. Our ability to continue to comply with these covenants in the future depends on many factors, some of which are beyond our control. There are no assurances that we will be able to comply with these covenants. Failure to comply with these covenants would result in a default which, if we were unable to obtain a waiver from the lenders under the Wells Facility and the Union Bank facility or the trustee or holders under the Convertible Senior Notes or 2019 Notes, could accelerate repayment under the facilities or the Convertible Senior Notes or 2019 Notes and thereby have a material adverse impact on our liquidity, financial condition, results of operations and ability to pay dividends. In addition, holders of the Convertible Senior Notes will have the right to require us to repurchase the Convertible Senior Notes upon the occurrence of a fundamental change at a repurchase price equal to 100% of their principal amount, plus accrued and unpaid interest, if any. We may not have enough available cash or be able to obtain financing at the time we are required to make repurchases. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition—Borrowings.”
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Depending on funding requirements, we may need to raise additional capital to meet our unfunded commitments either through equity offerings or through additional borrowings.
As of June 30, 2012, we had unfunded commitments of approximately $92.7 million. Approximately $32.6 million of these unfunded debt commitments are dependent upon the portfolio company reaching certain milestones before the debt commitment becomes available. These commitments will be subject to the same underwriting and ongoing portfolio maintenance. Since these commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Closed commitments generally fund 70-80% of the committed amount in aggregate over the life of the commitment. We intend to use cash flow from normal and early principal repayments, and proceeds from borrowings and notes to fund these commitments. However, there can be no assurance that we will have sufficient capital available to fund these commitments as they come due.
Pending legislation may allow us to incur additional leverage.
As a business development company, under the 1940 Act generally we are not permitted to incur indebtedness unless immediately after such borrowing we have an asset coverage for total borrowings of at least 200% (i.e., the amount of debt may not exceed 50% of the value of our assets). Recent legislation introduced in the U.S. House of Representatives, if passed, would modify this section of the 1940 Act and increase the amount of debt that business development companies may incur by modifying the percentage from 200% to 150%. As a result, we may be able to incur additional indebtedness in the future and therefore your risk of an investment in us may increase.
Our financial results could be negatively affected if a significant portfolio investment fails to perform as expected.
Our total investment in companies may be significant individually or in the aggregate. As a result, if a significant investment in one or more companies fails to perform as expected, our financial results could be more negatively affected and the magnitude of the loss could be more significant than if we had made smaller investments in more companies. The following table shows the fair value of the totals of investments held in portfolio companies at June 30, 2012 that represent greater than 5% of net assets:
Anthera Pharmaceuticals, Inc.
Box.net Inc. is an online storage and sharing service that gives users access to their files from anywhere.
Brightsource Energy, Inc. designs, develops and sells solar thermal power systems that deliver reliable, clean energy to utilities and industrial companies.
Aveo Pharmaceuticals, Inc. is a biopharmaceutical company dedicated to the discovery and development of new, targeted cancer therapeutics.
Women’s Marketing, Inc. is a media solutions company, delivering premium media at value pricing across all platforms.
Tectura Corporation is an IT services firm that specializes in Microsoft Business Solutions applications.
Anthera Pharmaceuticals, Inc. is a biopharmaceutical company focused on developing and commercializing products to treat serious diseases, including cardiovascular and autoimmune diseases.
Our financial results could be negatively affected if these portfolio companies or any of our other significant portfolio companies encounter financial difficulty and fail to repay their obligations or to perform as expected.
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Our quarterly and annual operating results are subject to fluctuation as a result of the nature of our business, and if we fail to achieve our investment objective, the net asset value of our common stock may decline.
We could experience fluctuations in our quarterly and annual operating results due to a number of factors, some of which are beyond our control, including, but not limited to, the interest rate payable on the debt securities that we acquire, the default rate on such securities, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, changes in our portfolio composition, the degree to which we encounter competition in our markets, market volatility in our publicly traded securities and the securities of our portfolio companies, and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods. In addition, any of these factors could negatively impact our ability to achieve our investment objectives, which may cause our net asset value of our common stock to decline.
Our investments may be in portfolio companies which may have limited operating histories and financial resources.
We expect that our portfolio will continue to consist of investments that may have relatively limited operating histories. These companies may be particularly vulnerable to U.S. and foreign economic downturns such as the current recession and European financial crisis may have more limited access to capital and higher funding costs, may have a weaker financial position and may need more capital to expand or compete. These businesses also may experience substantial variations in operating results. They may face intense competition, including from companies with greater financial, technical and marketing resources. Furthermore, some of these companies do business in regulated industries and could be affected by changes in government regulation. Accordingly, these factors could impair their cash flow or result in other events, such as bankruptcy, which could limit their ability to repay their obligations to us, and may adversely affect the return on, or the recovery of, our investment in these companies. We cannot assure you that any of our investments in our portfolio companies will be successful. Our portfolio companies compete with larger, more established companies with greater access to, and resources for, further development in these new technologies. We may lose our entire investment in any or all of our portfolio companies.
Our investment strategy focuses on technology-related companies, which are subject to many risks, including volatility, intense competition, shortened product life cycles and changes in regulatory and governmental programs, periodic downturns, and you could lose all or part of your investment.
We have invested and will continue investing primarily in technology-related companies, many of which may have narrow product lines and small market shares, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as to general economic downturns. The revenues, income (or losses), and valuations of technology-related companies can and often do fluctuate suddenly and dramatically. In addition, technology-related markets are generally characterized by abrupt business cycles and intense competition. Overcapacity in technology-related industries, together with cyclical economic downturns, may result in substantial decreases in the market capitalization of many technology-related companies. While such valuations have recovered to some extent, such decreases in market capitalization may occur again, and any future decreases in technology-related company valuations may be substantial and may not be temporary in nature. Therefore, our portfolio companies may face considerably more risk of loss than do companies in other industry sectors.
Because of rapid technological change, the average selling prices of products and some services provided by technology-related companies have historically decreased over their productive lives. As a result, the average selling prices of products and services offered by technology-related companies may decrease over time, which could adversely affect their operating results, their ability to meet obligations under their debt securities and the value of their equity securities. This could, in turn, materially adversely affect our business, financial condition and results of operations.
A natural disaster may also impact the operations of our portfolio companies, including our technology- related portfolio companies. The nature and level of natural disasters cannot be predicted and may be exacerbated by global climate change. A portion of our technology-related portfolio companies rely on items assembled or produced in areas susceptible to natural disasters, and may sell finished goods into markets susceptible to natural disasters. A major disaster, such as an earthquake, tsunami, flood or other catastrophic event could result in disruption to the business and operations of our technology-related portfolio companies.
We will invest in technology-related companies that are reliant on U.S. and foreign regulatory and governmental programs. Any material changes or discontinuation, due to change in administration or U.S. Congress or otherwise could have a material adverse affect on the operations of a portfolio company in these industries and, in turn, impair our ability to timely collect principal and interest payments owed to us to the extent applicable.
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Cleantech companies are subject to extensive government regulation and certain other risks particular to the sectors in which they operate and our business and growth strategy could be adversely affected if government regulations, priorities and resources impacting such sectors change or if our portfolio companies fail to comply with such regulations.
As part of our investment strategy, we plan to invest in portfolio companies in Cleantech sectors that may be subject to extensive regulation by foreign, U.S. federal, state and/or local agencies. Changes in existing laws, rules or regulations, or judicial or administrative interpretations thereof, or new laws, rules or regulations could have an adverse impact on the business and industries of our portfolio companies. In addition, changes in government priorities or limitations on government resources could also adversely impact our portfolio companies. We are unable to predict whether any such changes in laws, rules or regulations will occur and, if they do occur, the impact of these changes on our portfolio companies and our investment returns. Furthermore, if any of our portfolio companies fail to comply with applicable regulations, they could be subject to significant penalties and claims that could materially and adversely affect their operations. Our portfolio companies may be subject to the expense, delay and uncertainty of the regulatory approval process for their products and, even if approved, these products may not be accepted in the marketplace.
In addition, there is considerable uncertainty about whether foreign, U.S., state and/or local governmental entities will enact or maintain legislation or regulatory programs that mandate reductions in greenhouse gas emissions or provide incentives for Cleantech companies. Without such regulatory policies, investments in Cleantech companies may not be economical and financing for Cleantech companies may become unavailable, which could materially adversely affect the ability of our portfolio companies to repay the debt they owe to us. Any of these factors could materially and adversely affect the operations and financial condition of a portfolio company and, in turn, the ability of the portfolio company to repay the debt they owe to us.
Our investments in the life science industry are subject to extensive government regulation, litigation risk and certain other risks particular to that industry.
We have invested and plan to continue investing in companies in the life science industry that are subject to extensive regulation by the Food and Drug Administration (the “FDA”) and to a lesser extent, other federal, state and other foreign agencies. If any of these portfolio companies fail to comply with applicable regulations, they could be subject to significant penalties and claims that could materially and adversely affect their operations. Portfolio companies that produce medical devices or drugs are subject to the expense, delay and uncertainty of the regulatory approval process for their products and, even if approved, these products may not be accepted in the marketplace. In addition, governmental budgetary constraints effecting the regulatory approval process, new laws, regulations or judicial interpretations of existing laws and regulations might adversely affect a portfolio company in this industry. Portfolio companies in the life science industry may also have a limited number of suppliers of necessary components or a limited number of manufacturers for their products, and therefore face a risk of disruption to their manufacturing process if they are unable to find alternative suppliers when needed. Any of these factors could materially and adversely affect the operations of a portfolio company in this industry and, in turn, impair our ability to timely collect principal and interest payments owed to us.
Our investments in the drug discovery industry are subject to numerous risks, including competition, extensive government regulation, product liability and commercial difficulties.
Our investments in the drug discovery industry are subject to numerous risks. The successful and timely implementation of the business model of our drug discovery portfolio companies depends on their ability to adapt to changing technologies and introduce new products. As competitors continue to introduce competitive products, the development and acquisition of innovative products and technologies that improve efficacy, safety, patient’s and clinician’s ease of use and cost-effectiveness are important to the success of such portfolio companies. The success of new product offerings will depend on many factors, including the ability to properly anticipate and satisfy customer needs, obtain regulatory approvals on a timely basis, develop and manufacture products in an economic and timely manner, obtain or maintain advantageous positions with respect to intellectual property, and differentiate products from those of competitors. Failure by our portfolio companies to introduce planned products or other new products or to introduce products on schedule could have a material adverse effect on our business, financial condition and results of operations.
Further, the development of products by drug discovery companies requires significant research and development, clinical trials and regulatory approvals. The results of product development efforts may be affected by a number of factors, including the ability to innovate, develop and manufacture new products, complete clinical trials, obtain regulatory approvals and reimbursement in the US and abroad, or gain and maintain market approval of products. In addition, regulatory review processes by U.S. and foreign agencies may extend longer than anticipated as a result of decreased funding and tighter fiscal budgets. Further, patents attained by others can preclude or delay the commercialization of a product. There can be no assurance that any products now in development will achieve technological feasibility, obtain regulatory approval, or gain market acceptance. Failure can occur at any point in the development process, including after significant funds have been invested. Products may fail to reach the market or may have only limited commercial success because of efficacy or safety concerns, failure to achieve positive clinical outcomes, inability to obtain necessary regulatory approvals, failure to achieve market adoption, limited scope of approved uses, excessive costs to manufacture, the failure to establish or maintain intellectual property rights, or the infringement of intellectual property rights of others.
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Future legislation, and/or regulations and policies adopted by the FDA or other U.S. or foreign regulatory authorities may increase the time and cost required by some of our portfolio companies to conduct and complete clinical trials for the product candidates that they develop, and there is no assurance that these companies will obtain regulatory approval to market and commercialize their products in the U.S. and in foreign countries
The FDA has established regulations, guidelines and policies to govern the drug development and approval process, as have foreign regulatory authorities, which affect some of our portfolio companies. Any change in regulatory requirements due to the adoption by the FDA and/or foreign regulatory authorities of new legislation, regulations, or policies may require some of our portfolio companies to amend existing clinical trial protocols or add new clinical trials to comply with these changes. Such amendments to existing protocols and/or clinical trial applications or the need for new ones, may significantly impact the cost, timing and completion of the clinical trials.
In addition, increased scrutiny by the U.S. Congress of the FDA’s and other authorities approval processes may significantly delay or prevent regulatory approval, as well as impose more stringent product labeling and post-marketing testing and other requirements. Foreign regulatory authorities may also increase their scrutiny of approval processes resulting in similar delays. Increased scrutiny and approvals processes may limit the ability of our portfolio companies to market and commercialize their products in the U.S. and in foreign countries.
Changes in healthcare laws and other regulations applicable to some of our portfolio companies’ businesses may constrain their ability to offer their products and services.
Changes in healthcare or other laws and regulations applicable to the businesses of some of our portfolio companies may occur that could increase their compliance and other costs of doing business, require significant systems enhancements, or render their products or services less profitable or obsolete, any of which could have a material adverse effect on their results of operations. There has also been an increased political and regulatory focus on healthcare laws in recent years, and new legislation could have a material affect on the business and operations of some of our portfolio companies.
Economic recessions or downturns could impair the ability of our portfolio companies to repay loans, which, in turn, could increase our non-performing assets, decrease the value of our portfolio, reduce our volume of new loans and have a material adverse effect on our results of operations.
Many of our portfolio companies may be susceptible to economic slowdowns or recessions in both the U.S. and foreign countries and may be unable to repay our loans during such periods. In such periods, our non-performing assets are likely to increase and the value of our portfolio is likely to decrease. Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments. Economic slowdowns or recessions could lead to financial losses in our portfolio and a decrease in revenues, net income and assets. Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us.
A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of the portfolio company’s loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize the portfolio company’s ability to meet its obligations under the debt securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company. In addition, if a portfolio company goes bankrupt, even though we may have structured our investment as senior debt or secured debt, depending on the facts and circumstances, including the extent to which we actually provided significant “managerial assistance,” if any, to that portfolio company, a bankruptcy court might re-characterize our debt holding and subordinate all or a portion of our claim to that of other creditors. These events could materially adversely affect our financial condition and operating results.
Generally, we do not control our portfolio companies. These portfolio companies may face intense competition, including competition from companies with greater financial resources, more extensive research and development, manufacturing, marketing and service capabilities and greater number of qualified and experienced managerial and technical personnel. They may need additional financing which they are unable to secure and which we are unable or unwilling to provide, or they may be subject to adverse developments unrelated to the technologies they acquire.
The business, financial condition and results of operations of our portfolio companies could be adversely affected by worldwide economic conditions, as well as political and economic conditions in the countries in which they conduct business.
The business and operating results of our portfolio companies may be impacted by worldwide economic conditions. Although the U.S. economy has in recent quarters shown signs of recovery from the 2008–2009 global recession, the strength and duration of any economic recovery will be impacted by worldwide economic growth. For instance, a number of recent reports indicate that growth in China and other emerging markets may be slowing relative to historical growth rates. The significant debt in U.S. and European countries is expected to hinder growth in those countries for the foreseeable future. Multiple factors relating to the international operations of some of our portfolio companies and to particular countries in which they operate could negatively impact their business, financial condition and results of operations.
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Some of the products of our portfolio companies are developed, manufactured, assembled, tested or marketed outside the U.S. Any conflict or uncertainty in these countries, including due to natural disasters, public health concerns, political unrest or safety concerns, could harm their business, financial condition and results of operations. In addition, if the government of any country in which their products are developed, manufactured or sold sets technical or regulatory standards for products developed or manufactured in or imported into their country that are not widely shared, it may lead some of their customers to suspend imports of their products into that country, require manufacturers or developers in that country to manufacture or develop products with different technical or regulatory standards and disrupt cross-border manufacturing, marketing or business relationships which, in each case, could harm their businesses.
Some of our portfolio companies may need additional capital, which may not be readily available and may be needed if necessary regulatory review processes are extended or approvals not obtained.
Our portfolio companies will often require substantial additional equity financing to satisfy their continuing working capital and other requirements, and in most instances to service the interest and principal payments on our investments. Each round of venture financing is typically intended to provide a company with only enough capital to reach the next stage of development. We cannot predict the circumstances or market conditions under which our portfolio companies will seek additional capital. It is possible that one or more of our portfolio companies will not be able to raise additional financing or may be able to do so only at a price or on terms unfavorable to us, either of which would negatively impact our investment returns. Some of these companies may be unable to obtain sufficient financing from private investors, public capital markets or traditional lenders. This may have a significant impact if the companies are unable to obtain certain federal, state or foreign agency approval for their products or the marketing thereof, of if regulatory review processes extend longer than anticipated, and the companies need continued funding for their operations during these times. Accordingly, financing these types of companies may entail a higher risk of loss than would financing companies that are able to utilize traditional credit sources.
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Not Applicable
ExhibitNumber
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SIGNATURES
Pursuant to the requirements of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/S/ MANUEL A. HENRIQUEZ
/S/ JESSICABARON
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EXHIBIT INDEX
93