Hercules Capital, Inc. (HTGC) Q4 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Hercules Capital Q4 2019 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. Michael Hara, Managing Director of Investor Relations. Please go ahead, sir.

Thank you, Grace. Good afternoon, everyone, and welcome to Hercules' conference call for the fourth quarter and full year 2019. With us on the call today from Hercules are Scott Bluestein, Chief Executive Officer and Chief Investment Officer; and Seth Meyer, Chief Financial Officer. Hercules' fourth quarter and full year 2019 financial results were released just after today's market close and can be accessed from Hercules' Investor Relations section at htgc.com. We have arranged for a replay of the call at Hercules' web page or by using the telephone number and passcode provided in today's earnings release. During this call, we may make forward-looking statements based on current expectations. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein due to timing delays between the date of this release and in the confirmation and final audit results. In addition, the statements contained in this release that are not purely historical are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements, including and without limitation the risks and uncertainties including the uncertainties surrounding the current market turbulence and other factors we identify from time to time in our filings with the SEC. Although we believe that the assumptions on which these forward-looking statements are reasonable, any of those assumptions can prove to be inaccurate. And as a result, the forward-looking statements based on those assumptions also can be incorrect. You should not place undue reliance upon these forward-looking statements. The forward-looking statements contained in this release are made as of the date hereof, and Hercules assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of related SEC filings, please visit our website. With that, I'll turn the call over to Scott.

Thank you, Michael, and thank you all for joining us today. Our strong finish in Q4 capped off a record year, where our key competitive advantages and our differentiated lending model were once again reflected in our results. We delivered strong new debt and equity commitments and total gross fundings, while continuing to deliver superior and consistent credit performance and operating results. Our overall performance throughout 2019 put us in a strong position to declare record shareholder distributions for 2019. And more importantly, we continue to believe that we are well positioned at this particular juncture of the credit and economic cycle. The continued strength of our originations platform, robust liquidity and strong balance sheet delivered another year of outstanding growth, profitability and credit quality, with records on multiple fronts, including: total investment income of $267.9 million, up 29%; net investment income of $143.3 million, up 32%; new debt and equity commitments of $1.47 billion, up 22%; total gross fundings of $1.03 billion, up 7%; debt investment portfolio of $2.17 billion at cost, up 24%; total portfolio investments of $2.4 billion at cost, up 21%; total assets of $2.46 billion, up 24%; total declared shareholder distributions of $1.42 per share; and undistributed earnings spillover of $68 million or $0.67 per share based on weighted average shares outstanding. In Q4, we originated new debt and equity commitments of $283.9 million, an increase of nearly 14% from the same period last year. Our strong performance in Q4 allowed us to achieve record new debt and equity commitments in 2019 of $1.47 billion. In addition, our current pipeline remains strong with approximately $1 billion in potential transactions. In Q4, our investment-related activity continued to reflect our focus on 3 key themes: first, diversification, where our objectives are centered on building and maintaining a broadly diversified portfolio and avoiding concentrated or binary risk; second, delivering controlled growth without sacrificing our credit and underwriting standards and discipline; and third, positioning the portfolio best for where we believe we are in the credit cycle. During the quarter, we were successful in each of these 3 areas of focus, and I am incredibly proud of the entire Hercules investment team and broader organization for our achievements in 2019. We have chosen to build and grow our business with an emphasis on diversification and risk management. During the fourth quarter, we funded 10 new and 11 existing portfolio companies. Consistent with what we saw throughout 2019, the majority of the 11 existing portfolio companies that we funded during Q4 were situations where our portfolio companies achieved specific performance milestones or growth targets that unlocked additional capital availability. As our debt portfolio has continued to grow and our portfolio companies have continued to perform, we are seeing more opportunities to expand and enhance our funding relationships with existing borrowers, who chose Hercules Capital in part because of our unique ability to grow and scale with them as their funding needs increase. We ended the year with a total of 97 debt portfolio companies. The profile of the 10 new companies that we made debt commitments to was consistent with our focus on quality, diversification and differentiation. We saw strong performance from both our technology and life sciences teams with respect to new debt commitments to both new and existing companies. Our total fundings in Q4 were split nearly evenly between technology and life sciences companies, as we continue to emphasize diversification across our investment portfolio. At the end of Q4, our top 5 and top 10 debt positions made up 17% and 29% of our total debt portfolio at cost, respectively. We funded $240.9 million in Q4 and a record $1.03 billion for the year, the first time in our history that we have managed to fund in excess of $1 billion in a year. As noted in our earnings release, early payoffs remained at a higher level, but did not produce a commensurate level of accelerated fee income due to the vintage of some of the paydowns. Seth will provide more detail in his comments. In Q4, we had $161 million of early payoffs, which was up from $140 million in Q3. Consistent with what we have seen in each of the last 3 years, in 2019 we had $527 million in early payoffs compared to $487 million in 2018 and $506 million in 2017. As we continue to emphasize prudent risk management and portfolio quality, approximately 50% of the Q4 payoffs were attributable to either M&A-related events or prudent credit management. With the growth of our debt investment portfolio and an increase in the average size of our loans, we expect quarterly payoffs throughout 2020 to remain elevated and lumpy. Our focus will remain on sustainable long-term performance and total shareholder returns. Net debt portfolio growth of $68.8 million in Q4 drove our debt investment portfolio to a record $2.17 billion at cost. We had record net debt investment growth for 2019 of $417.2 million, which exceeded the high end of our debt investment portfolio growth targets for 2019. Credit quality on the debt investment portfolio improved slightly in Q4 with a weighted average internal credit rating of 2.15 as compared to 2.17 in Q3. Our rated 1 credits as a percentage of our overall investment portfolio increased to 18% in Q4 from 11.4% in Q3, largely driven by a handful of companies continuing to perform above our initial expectations. Our rated 2 credits as a percentage of our investment portfolio decreased to 55% in Q4 from 64% in Q3. And our rated 4 and rated 5 credits continue to make up less than 3.5% of our entire debt portfolio. Nonaccruals remained low with 3 debt investments on nonaccrual with a cumulative investment cost and fair value of approximately $9 million and $1 million, respectively, or 0.4% and 0% as a percentage of the company's total investment portfolio at cost and value, respectively. During 2019, we had $16.5 million of net realized gains across our investment portfolio, largely driven by M&A activity and several public market dispositions. Our diverse and well-structured balance sheet is designed to provide a long-term focused and sustainable investment platform and give us the flexibility to drive growth when we feel prudent. We ended Q4 with over $235 million of liquidity, which was further strengthened by our $120 million private placement of unsecured bonds in early February, our Q1 quarter-to-date ATM issuances of $35 million as well as the $400 million expanded and enhanced credit facility that we announced earlier today. Seth will provide greater details in his remarks. We have made substantial progress in Q1 towards our goals of reducing our cost of capital, strengthening our liquidity position and improving our balance sheet flexibility. We continue to see strong loan demand and transaction deal flow, driven partly by the continued strong pace of U.S. venture capital investment activities, which ended the year with more than $103 billion invested and over $46 billion raised, according to Dow Jones and PitchBook's Q4 Venture Monitor, respectively. Assuming market conditions remain favorable, we are anticipating all exit activity to continue at a steady pace. In 2019, 882 exits represented over $256 billion in exit value according to Venture Monitor. Evidencing our team's ability to pick the right companies to partner with, in 2019 Hercules Capital had 12 companies complete their IPOs and 13 companies complete M&A events. Although we are very early in 2020, and we expect election year market volatility as we approach November, we remain optimistic by what we believe lies ahead. Our focus in the first half of this year will be centered on 3 specific items. First, enhancing and strengthening our balance sheet and liquidity position, both of which we believe differentiate Hercules from others in the space and provide us with a unique ability to fund our companies across numerous value inflection points without the need for them to seek debt capital elsewhere. We have taken several steps to not only enhance our liquidity position, but also drive down our cost of capital, and these steps remain active and ongoing. Being long liquidity is something that we believe will position us well to be aggressive and opportunistic moving forward. Second, remaining disciplined underwriters of credit, where we underwrite each deal based on its specific credit attributes and not on what others may be doing to gain market share or a portfolio of assets. The competitive landscape remains heated, and in certain instances, we would rather slow growth than chase deals, where we do not believe the underwriting is warranted from a credit perspective. We have recently been passing on a higher number of the opportunities we are evaluating, largely based on our credit screens. Using our scale and -- sorry, third, using our scale and platform more aggressively for the right opportunities and to expand our product set. I would now like to spend a few minutes discussing our shareholder distributions. With our debt investment portfolio at $2.17 billion at cost, our NII per share in Q4 generated 119% coverage above our quarterly base distribution of $0.32 per share. In addition to our quarterly base distribution of $0.32 per share in Q4, we also declared a supplemental distribution of $0.08 per share. In the aggregate, this brings our total declared distributions to shareholders for 2019 to $1.42, representing an increase of nearly 13% compared to 2018. This also represents the fourth consecutive quarter where the company's strong performance has allowed us to deliver an increased distribution to our shareholders. In addition to our quarterly income exceeding our base distribution, we are also fortunate to have been able to grow our undistributed spillover to an estimated $68 million or $0.67 per share based on weighted average shares outstanding, subject to final tax filings for 2019. This provides us with tremendous flexibility with respect to our variable base dividend going forward and the ability to continue to invest in our team and platform as we discussed during 2019, while at the same time optimizing total shareholder return. In closing, our performance in Q4 and the full year 2019 was impressive on many fronts, but would -- it would not have been possible without the tremendous work and effort demonstrated by each of our talented employees across this organization. In January of this year, we announced another record-breaking milestone when we crossed $10 billion in cumulative debt commitments since inception. I would like to close by acknowledging and thanking the nearly 500 different companies and management teams that have been a part of the Hercules story since 2004, and their incredible VC and sponsor investors who have all contributed to our success by choosing to make Hercules Capital their preferred partner of choice. Thank you very much, and I will now turn the call over to Seth.

Thanks, Scott, and good afternoon, ladies and gentlemen. This was another strong quarter for Hercules, capping off a record year with over $1 billion in fundings. Credit remained strong in Q4 with nonaccruals remaining below 0.5% of total investments on a cost basis. To support our growth in 2019, we successfully raised more than $130 million in equity and $350 million in debt, ending the year with a stronger and more diversified balance sheet. Subsequent to year-end, we have made further substantial progress on both of these fronts. We have continued prudently using leverage to improve our returns to shareholders. Our ROAE or NII over average equity increased to 15.4% for the fourth quarter, and our ROAA or NII over average total assets was 7.3%, above our average of 7% for the full year. The year was a testament to the strength of our franchise ability to scale the platform and access the capital markets on an as-needed basis and grow where and when we saw the right opportunities. Today, we announced a further increase to our MUFG syndicated credit facility capacity to $400 million, in line with the growth of our balance sheet. The facility is larger in size, has improved pricing and offers improved flexibility. Every lender in our existing MUFG facility participated in the expanded facility, in addition to several new lenders being added. We are grateful for their partnership and support. The further strengthening of our capital and liquidity position will ensure that we're well positioned in 2020. Today, I'll focus on the following areas: income statement performance and highlights; NAV unrealized and realized activity; leverage; and finally, outlook. With that, let's turn our attention to the income statement performance and highlights. Net investment income was a record $40.1 million or $0.38 per share in Q4, a quarter-over-quarter increase from $0.37 per share in Q3. Total investment income increased by 1.9% to $70.6 million compared to the prior quarter, supported by a 2.9% increase in total invest -- interest income due to portfolio growth in the fourth quarter. Fee income decreased in the quarter despite higher payoffs, largely due to the vintage and size of the onetime and unamortized fees associated with the loans that paid off. I would emphasize again this quarter that the growth we have in the portfolio over the full year has created a baseline at which we can cover the base dividend without depending on non-reoccurring or non-core income. For context, compared to the full year 2018, core interest -- investment income has increased 30.2%. Our effective and core yields in the fourth quarter were 13% and 12.3%, respectively, compared to 13.4% and 12.4% in the third quarter. The primary driver for the decrease in the effective yield was, again, related to the size of the onetime and unamortized fees associated with the loans that paid off. The core yield reduced slightly due to the fed rate cut in October. However, the average coupon rate across our debt portfolio remained above 10% in Q4. Net investment income margin further increased to 56.8% in the fourth quarter compared to 56.1% in the prior quarter. The reason for the increase was primarily due to the higher levels of core income due to the portfolio growth while maintaining our operating expenses. Turning to expenses. Our total operating expenses for the fourth quarter remained flat at $30.5 million compared to $30.4 million in the third quarter. Interest expense and fees increased to $16 million from $15 million in the prior quarter, commensurate with the increased fundings. SG&A expenses decreased to $14.5 million from $15.4 million in the prior quarter. The main driver for the decrease was the lower legal cost compared to the third quarter, which was partially offset by increased discretionary and variable compensation as a result of the company's increased debt fundings and strong performance in the quarter. As a reminder, our discretionary and variable compensation will fluctuate on a quarterly basis depending on our funding and related activity, as well as our overall performance against key corporate goals and objectives. Finally, our weighted average cost of debt was 5%, a small reduction compared to 5.1% in the prior quarter. Now let's switch the focus to the NAV unrealized and realized activity. During the quarter, our NAV increased by $47.4 million or $0.17 per share to $10.55 per share. The main drivers for the increase were $37.4 million of new equity raised at an average premium of 33% to the year-end NAV through our ATM program and earnings in the quarter exceeding the dividend paid. Our $1.7 million of unrealized gains were largely driven by improvements in the biotech sector. The key drivers of unrealized gains were approximately $1.8 million of mark-to-market appreciation in the equity and warrant portfolio, offset by approximately $0.1 million of depreciation on the loan portfolio. The $2.9 million of realized gains were comprised of $3.2 million of gains from the disposal of 3 publicly traded equity positions, offset by losses from the expiration of certain legacy warrants. Next, I'd like to discuss our leverage. At the end of the quarter, our GAAP and regulatory leverage was 115% and 101.8%, respectively, which increased compared to the third quarter due to the funding growth in the quarter, partially with the credit facilities. We continued to manage the business to ensure that we remain below our communicated leverage point of approximately 125%. Consistent with this, we've raised an additional $35.2 million of new equity capital under the ATM program quarter-to-date in Q1. And at the current time, we do not see a need to raise equity capital in the short-to-medium term above and beyond what we were able to raise using our ATM. Earlier this month, we announced the successful issuance of $50 million of 5-year dated notes in a private placement with a fixed coupon of 4.28%, which is well below our current cost of debt. At the same time, we announced the commitment to draw an additional $70 million for a total of $120 million in June with a fixed coupon of 4.31% on the later tranche. This offering done with institutional investors, together with the increase in the credit facility announced today, further strengthens our balance sheet and liquidity position and demonstrates our ability to attractively tap the capital markets when we feel it's prudent to do so. As a reminder, our early payoffs and normal amortization provide us with significant monthly inflows that we can use to delever when and as needed. We will closely monitor macro, political and market conditions in determining future potential debt and equity capital timing. Finally, let's address our expectations on outlook points. As a result of the multiple rate reductions by the Fed in 2019, we are updating our core yield guidance to 11.5% to 12.5% for 2020. As a reminder, the majority of our loans are issued with a floor, which mitigates some of the potential downside. As a result, the impact of rate decreases is not linear when compared to the impact of rate increases. As of year-end, approximately 63% of our portfolio is at the contractual floor. For the first quarter, we expect SG&A expenses of $15.5 million to $16.5 million. We expect our borrowing costs to increase slightly due to the increased activity in the quarter and greater use of our credit facilities. Finally, although always difficult to predict, we expect a $100 million to $150 million in prepayment activity for the quarter. In closing, as we put our record-breaking year behind us, we believe Hercules Capital is well positioned to prudently grow and further scale our platform and deliver strong shareholder returns in 2020. I will now turn the call over to the operator to begin the Q&A part of our call. Grace, over to you.

[Operator Instructions] Your first question comes from the line of Tim Hayes from B. Riley FBR.

Congrats on a really strong quarter and year. My first question, and I'm going to start with the dividend here, as I did last quarter. It's the third consecutive quarter of covering the dividend with NII, and this quarter was especially healthy. I understand that there is some pressure on core yields, but it sounds like your outlook is fairly positive, and you have a very strong liquidity position, a nice spillover buffer. So can you just explain your decision to -- or -- I know it's a Board decision, but maybe give us some context around why the quarterly dividend is being held flat at $0.32 right now? And if either the impact from the coronavirus outbreak and/or the uncertainty around the November election played into that?

Sure. So thanks for the comments, Tim. With respect to the dividend specifically, I think we're in a very fortunate position. You referenced a couple of points there. We have a $68 million spillover, roughly $0.67 per share on a weighted average shares outstanding basis. We had NII in the quarter that covered that base distribution by 119%, and we have a fairly optimistic outlook per our comments. When we think about the dividend, we're really focused on total shareholder distributions. We're very proud of the fact that our total declared distributions in 2019 were $1.42, up over 13% from where they were in the year prior period. Our base dividends we look at, as we always have, on a variable basis, and it's something that we evaluate together with our Board on a quarterly basis. We are very grateful for the fact that we're in a unique position where we have tremendous flexibility on a go-forward basis. Once we get a little bit more visibility into Q1, we'll sit down with our Board, and we'll discuss what we believe makes the most sense for our business going forward. We will obviously evaluate whether or not we think an increase to the base distribution is appropriate. We also have the flexibility to the extent we think it's prudent to do so to continue to deliver supplemental distributions on a quarterly basis, and we're going to look at both of those things in conjunction with market conditions and then make the determination in Q1 that we think is most prudent with respect to our business.

Okay, got it. Yes, that's helpful. I appreciate the context around that. And I guess, just the latter part of that question was, I guess, it was more relating to the dividend, but whether the impact from the coronavirus outbreak or the uncertainty around the November election played into that. Are you -- with the election less than 9 months away and obviously, the coronavirus outbreak still very much present, have you shifted -- I mean, do you expect any direct impact on your portfolio companies from coronavirus? Or are you shifting your behavior at all to, I guess, reflect these events?

So specifically with respect to coronavirus, the answer is no. We have very little if any exposure, outside of one portfolio company, directly to the Asian and Hong Kong markets. So we really don't expect to see any direct impact with respect to the virus specifically. We do see a scenario where the virus will create some increased overall market or macro volatility over the next quarter or so, and that's something that we're certainly watching. But that really doesn't play into our thinking at the current time with respect to the dividend. I think the thing that I would probably focus on a little bit more so would be, and we've talked about this on the last few calls, when we think about our base dividend, we're really focused on our business's core income. So the income that our portfolio generates excluding any impact from nonrecurring or onetime events. So when we look at what we think is the most prudent base distribution, we are excluding, for internal purposes, any impact from prepayment penalties, which is sort of reflected on our income statement in the fee income line. And that number, if you look at it with respect to Q4, is in that sort of $0.33, $0.34, so still exceeding the base distribution; but that's the number that we're more focused on relative to the $0.38 of overall NII in the quarter.

Okay. Got it. That's helpful. And one more for me. The -- I guess the third point of focus you mentioned for 2020 was using your scale and your platform to more aggressively, I guess, expand the product set. And please correct me if I misquoted you there. But I know that you've talked about some new lending initiatives to help expand the pipeline. Maybe in the context of that third point, if you could expand on that and how that's helped your pipeline over the past 3 to 6 months?

Sure. So I think a couple of things there. So one, as an organization, we've done a great job at enhancing and strengthening our balance sheet. We've taken several steps to lower our cost of capital. We've taken several steps to increase the overall flexibility that we have with respect to the funding of our loans. And you saw that throughout 2019 in our growth: over $415 million of growth on the debt investment portfolio; our asset base now is approaching $2.5 billion; our debt portfolio is approaching $2.2 billion; and we're going to use the fact that we've achieved scale a little bit more aggressively on a go-forward basis in the market. There are a number of deals historically that we saw that we thought were very strong credits and largely driven on pricing concerns, we chose to let those go. We now have the ability, given that we've achieved scale and given that we've significantly lowered our overall cost of capital, to go after those deals a little bit more aggressively. And that's something that I think you're going to see from us in both Q1 and in Q2. The second thing is, now that we have again achieved that sort of point of scale, there are some things that we're going to continue to do on the product side that we think will add to our growth objectives for 2020. We talked throughout 2019 about some of the tweaks that we made from a product perspective that enhanced and accelerated our growth. There are some continued ongoing efforts that we're going to continue to roll out in the market in Q1 and Q2 that we think will have a similar effect with respect to growth on a go-forward basis.

Understood. And probably are limited in what you can say, but can you just elaborate on those efforts a little bit?

Yes. Unfortunately, we're not -- because when we tend to talk about things publicly, others start to copy and mimic us. So we're going to stay away from that. But once we get through a couple of quarters, I think it will be fairly clear what we're doing and how we're trying to take advantage of that in the market.

And your second question comes from the line of Aaron Deer from Piper Sandler.

Just, Chris, my audio cut out briefly, so I might have missed this in your growth or your outlook commentary, but any specific guidance in terms of your expectations for growth this year?

So we're going to give some guidance with respect to growth expectations on the Q1 call. Still relatively early in Q1. We're off to a very strong start. If you look at the release that we put out, we gave some disclosure in the subsequent events section. Through the middle of February, we've already closed $172 million of new commitments. We have another $72 million or so of signed commitments, so about $250 million of commitments through the February 14 date. So off to a fairly strong start, and we're continuing to be optimistic with respect to what we're seeing in the market, but we're going to wait to see how Q1 plays out, and then we'll provide some overall growth targets on the Q1 call.

Okay. And then it sounds like you're doing more with your existing customers, and maybe that plays into the growth outlook. I think you mentioned that your top 5 and 10 customers represented 17% and 29% of the portfolio. I guess, I'd suggest larger credit sizes. Can you maybe give us a sense of what -- how large you're willing to let some of these bigger relationships become?

Sure. So the average funded loan for us in 2019 was approximately $20 million. That's up slightly, but not materially from where it was a year ago; so I think it was about $18.5 million, $19 million in 2018. It was a little bit north of $20 million on an average basis in 2019. So you've seen the average size creep up a little bit. The largest deal that we did in 2019 was $150 million commitment. We believe that our platform and our balance sheet today gives us the ability to do that on a more frequent basis, subject to the underlying credit warranting that size of commitment. When we've gone that aggressive or that large in the past, it's largely been a tranche or milestone-based facility. And we've seen, and we are continuing to see, a number of opportunities across our portfolio for the better-performing credits that have achieved scale or achieved significant value inflection points to structure larger, more custom-tailored, longer-term financing solutions that would allow us to stay long those credits longer than we historically were able to do so.

Okay. And then maybe one for Seth. Given -- it sounds like you're continuing to make investments in the platform and people. I guess when you look at your noninterest expenses, either as a percentage of investment income or assets, how do you think about operating leverage going forward, given the investments that you might still be looking to make? Can you extract better operating leverage as we head into 2020? Or how should we think about that?

Yes, that's a great question. So we actually improved as we moved throughout the year. We did have the spike in the middle of the year at 3.3%, and we ended the year down around 2.5%, 2.6%. So we would expect that we'll be at that level for the year 2020. And we are continuing to invest. If you look at our long-term average back to 2016, we're at 2.6%. So we're operating a little bit below that. And the investment in the platform that we flagged at the end of Q3 and expect to continue to get ready for $3 billion, that certainly will be impacting that. It will keep you -- it up. But I would say that you should expect it to be around where we ended for the year.

Okay. And just a reminder, any separation costs coming here in the next quarter or 2?

So we fully disclosed the separation agreement, there was a delayed payment, 2 of them. We're amortizing that in, but they are not material to our expenses.

And your next question comes from the line of Chris York from JMP Securities.

Only have 2 of them. Scott, it's been about maybe a year since you were named interim CEO, I think, close to 7 months since you were named CEO. So now that you are cemented here as the leader of Hercules, and your stock is close to an all-time high, you may be in a position to be more offensive. So could you update us on any growth priorities for the company strategically over, say, the next 12 months?

Sure. So look, I think you're going to continue to see us be aggressive when and where it makes sense. Our focus with respect to our investment business on a stand-alone basis is really going to be on those 3 things that I mentioned. Number one, we are going to continue to do things to enhance and strengthen our liquidity position. The entire management team here is very focused on being long liquidity, given what we expect to be some increased market volatility and turbulence in the second half of the year. The second thing that we are going to continue to be laser-focused on will be maintaining our disciplined underwriting standards. We think that we are unique, given that we are singularly focused on underwriting and structural integrity versus sort of a growth-at-all-costs mentality. And we're going to continue to make sure that that's a priority for us with respect to the base business. And then third, we're going to continue to use, I think a little bit more aggressively, the scale that we've been able to achieve. I would add to that that we're now in a fortunate position where we do have, obviously, some advantages. And I think you will see us look a little bit more aggressively at some strategic initiatives and strategic alternatives. We're currently looking at a couple of things in the market. We're going to be very picky and choosy and selective with respect to what we will do in that regard. But we are, as you pointed out, in a little bit of a unique position given our stock position, given the performance of our business and given our liquidity position, where if we see something that we think makes sense, we are in a position to take advantage of it. And I think we'll be a little bit more willing to do that on a go-forward basis than we were last year.

That's great color. I know you're limited from what you can kind of say there, but just trying to get a sense of your willingness. And then second question is, looking back in the rearview mirror again, it's been 2 years since you acquired Gibraltar, and noticed that the preferred equity investment continues to gradually grow. So could you just update us on the growth at Gibraltar? And then any expectations for income potential on that preferred investment maybe in 2020 or in 2021?

Sure. I'll handle the first part and then Seth can speak to the second part. On the first part, it's a portfolio company of ours, so we don't disclose any specific information about their performance that they don't disclose specifically on their own. But I can tell you at a high level, that business has continued to perform very well, and it is certainly meeting our expectations across the board. That company announced on their own that in 2019 they crossed the $100 million mark from a portfolio perspective for the first time, and that's something that was a significant achievement and milestone that we're very proud of, and we're proud to be partnered with that team, both historically and on a go-forward basis. The company continues to perform well. We have no intention at the current time to do anything in terms of the monetization of that investment. And then I'll ask Seth to provide color on any potential dividend or distribution discussions.

Yes. So currently, there aren't any distribution discussions. We're certainly glad that they continue to grow, generate income and are able to reinvest that into their platform. We do have the loan arrangement that we disclosed in the SOI related to that. So there is income that comes into Hercules related to that, but no dividend planned at the moment.

And your next question comes from the line of Casey Alexander from Compass Point.

A couple of questions. One, the -- you converted a pretty high percentage in the quarter of your gross -- of your commitments into fundings, around 84%, and generally that has been running in the 70% area. Is -- are we working towards a new norm on that in the way that you're structuring investments?

No. So great point with respect to Q4, but that's really just specific to the quarter. If you look at our business historically over the last several years on a quarterly basis, on the low end, we've been at about 60%, on the high end, we've been at about 85%. This quarter, we happen to be at the higher end of that, largely driven by the number of investments that we had to existing portfolio companies. Overall, from a per annum perspective in 2019, $1.5 billion of commitments, $1 billion of funding. So that ratio is very consistent with what it was in each of the last 2 years.

Okay, great. Secondly, you did call out some, let's call it, less-than-rational competitive behavior as it relates to deals. Are there new pockets of capital and new competitors that have entered the market that are creating some of this less-than-stellar behavior?

Yes. We're not going to mention or discuss names. But the answer to the question is largely yes. I think you've seen a little bit of a bifurcation in the market over the last quarter or so. The legacy players in both the venture space and the growth cap space, I think, have continued to be fairly prudent, given that most of us that have been in this space for some time understand what it takes to run a portfolio of cash flow-negative growth-stage investments. And so you haven't seen sort of the same irrationality with respect to the legacy or incumbent players. There are some newer players in the market who have raised some pools of capital that are being incredibly aggressive with respect to the structuring of deals. We're seeing every one of those deals. And what we've told our investment team is, if the deal doesn't make sense for us on a credit perspective, we're happy to let someone else do it. We've been through that story before. We know how that story ends, and we've got a strong enough portfolio, and we've got strong enough demand that makes sense for us where we don't need to chase those types of deals at this time.

All right, great. And one last question. For those of us who have been covering the company for a while, we remember that at the last election, essentially, Hercules sort of shut down for a short period of time around the election. And you discussed your expectations for volatility later in the year. Would you think that perhaps deal opportunities might pull forward to the first half, or the first half might be more active than the second half, simply because BCs and sponsors want to get things done before the electional period arises?

Yes. I think based on what we're seeing now, we expect more opportunities in the first half than we do in the second half, but it's early in the year. So it's difficult to predict and sort of foreshadow how that's going to play out. We do expect, as a company, there to be increased market volatility as we get towards the second half of the year. How it plays out, I don't think anybody here on this call can tell you. But we do expect it to be fairly volatile. So it would be -- I mean, it would make sense from our perspective for demand and interest to decrease slightly. I would counterbalance that, though, with -- and you've been following us for a while, so you know this, one of the bigger competitive threats that we tend to lose deals to happens to be, right, the equity markets. When the equity markets either on the public side or the private side are strong, that's something that we compete with, with respect to the deployment of capital. And so if the market gets more volatile towards the second half of the year, the equity markets become a little bit more turbulent, public capital raises, particularly on the biotech side, become a little bit more difficult, we actually could see a case where demand for our product actually increases. So we're going to wait and see how it plays out. But I think intuitively, we would expect the first half to be a little bit stronger than the second half, just given what we're looking at today.

And your next question comes from the line of Ryan Carr from Jefferies.

This is Ryan Carr on for John Hecht. Congratulations on the great quarter.

Thanks, Ryan.

Yes. So my first question is related to your balance sheet. Obviously, you've done a very good job at optimizing that over the past several quarters, and we saw the renewal of the facility up to $400 million and new ABS debt and very enhanced use of your ATM program. Just curious in the context of all of that, where do you see your near-term leverage goals going over the next several quarters. This quarter, you saw debt-to-equity above 100%. And so what are the immediate impacts of that? And any additional capital raises or debt raises in the near term?

So not in the near term. Thanks for the question, Ryan. But I think for our balance sheet, we will continue to try to optimize liquidity, manage the overall leverage position. We've communicated that our leverage point that we're trying to be approximately below is 125%. We'll continue to do that. So that's why you're going to continue to see a balanced strategy of a little bit of equity, a little bit of debt, when we need it. But what we really wanted to do by announcing and working with union on the announced credit facility expansion today was really make it so that we don't need to rush to the market every time that we need additional capital. Our core activity is, obviously, the business activity on the front side, and we want to have enough liquidity and capital available to conduct the business when we want to do it. And so, what we're trying to do is make sure that we're focused on that core activity. We're not racing to market every moment. And we have the ability to draw a deeper -- with the size of our balance sheet, Scott mentioned the larger loan average that continues to go up. And so that's what our strategy is about, is one, managing it to stay at a reasonable level of leverage; two, having superior liquidity compared to our competitors; and three, tapping the equity markets when we need to, but on a very deliberate basis and opportunistically.

And my second question is related to your rate sensitivity, especially given the impending rate outlook. You noted that about 63% of your loans now have LIBOR floors incorporated. Moving forward, are you -- are all of your loans being originated with those LIBOR floors? And then can you maybe quantify the upwards and downwards effect to NIM when those rates move?

Sure. So Ryan, about 85-plus percent of our investment book on the debt side is actually prime-based. It's not LIBOR-based. So LIBOR-based sensitivity is a fairly insignificant, immaterial part of our business. With respect to the prime-based portion of our business, which again, is about 85% of our $2.2 billion debt investment portfolio, 97-plus percent of those loans are structured with a contractual floor in place. And that's why if you look at our press release, you'll see the downside that we have with respect to further rate cuts is not linear with respect to what we would see -- to the extent that rates moved in a different direction. 63% on or about of our current debt investment portfolio book is now at its contractual floor. Every time we do an amendment or a restructuring, we're looking for ways to continue to increase that, and that's something that we'll continue to do on a go-forward basis.

And then last question for me. You've been consistently outearning the distribution, you definitely saw great performance on that in this quarter. You noted earlier that you look every -- you look quarter-to-quarter at what you're going to do, whether it's respect to paying out a special or potentially raising the quarterly distribution? I mean what are the characteristics for what your decisions are going to be either -- on either side? And what would make you ultimately raise that -- the quarter-to-quarter distribution?

Yes, I think it's a combination of the 2 things that we spoke about a little bit earlier. Number one, it's just our outlook on both macro and our specific investment business. And secondly, we tend to really focus on the portfolio's ability to generate core income that sustainably covers that base distribution. If you look at our business throughout 2018 and in the early parts of 2019, and you isolate NII per share to core versus noncore, there were periods during those times where core income was not at the $0.32 or the $0.31 historical base distribution. This is really the first time in the last 2 quarters where our core income on a per-share basis is either meeting or exceeding that base distribution. And that's something that we're going to spend a lot of time looking at in Q1. And when you look at that, combined with the fact that we have the $68 million of spillover, it really puts us in a great position with respect to driving total shareholder returns this year, because we have the flexibility to look at both the base distribution as well as the supplemental quarterly distribution.

And your next question comes from the line of Ryan Lynch from KBW.

First question, I wanted to follow-up on a question regarding the dividend. That was helpful color around your guys' thoughts around the core dividend, but I wanted to talk about the supplemental dividend a little bit. This is the fourth quarter in a row that you guys have paid a supplemental dividend out. There are some other BDCs out there who have a little bit more of a formula-based approach, where they'll [ pad ] x percentage of earnings above kind of their core dividend. I'm trying to get a sense of -- your guys' last 4 supplementals have been $0.01, $0.02, $0.03 and now $0.08. Can you talk about what framework you and the Board use to decide whether to pay a supplemental dividend, and really more particularly, the size of the supplemental dividend that you guys are paying on a quarterly basis?

Sure. So we've certainly looked at -- there's obviously a bunch of different ways to deal with distributions with respect to the spillover. You can distribute all of it, you can distribute some of it. It can be formulaic, it can be variable. You can use it, once you pay the excise tax, to reinvest in the business and in the platform. And those are all things that we've looked at and thought about. We are going to think about potentially a more formulaic approach, but our view historically and our view currently is that maintaining a variable policy, both with respect to the base distribution and any potential supplemental distribution, gives us the maximum flexibility with respect to the growth -- prudent growth of our business. Our focus is on driving total shareholder returns, and that's what the Board and the management team and all of our 78 employees will continue to be focused on throughout 2020. And once we get through Q1, we'll have the discussions with our Board to figure out what we think makes the most sense with respect to driving total shareholder distributions in 2020, but also maintaining maximum flexibility to be able to continue to invest in our platform and take advantage of market opportunities that we think will be out there.

Okay. That's helpful color. And then your investment in Gibraltar, the fair value has increased by about $10 million in the past year. Can you provide some context of what drove that increase? Is it because it's retaining earnings? Is the profitability of the business -- I know you mentioned that it had grown meaningfully -- is the profitability of the business increasing as such where it warrants a better valuation? Can you just kind of walk through the puts and takes of what drove that $10 million increase in the fair value over the last year?

Sure. So I'd point to 2 things. One, as I mentioned, we continually see them reinvesting the profits that they're generating into their business, and that drives up the valuation in itself. And then, of course, there's the market comparative. So operations like Gibraltar, the valuations are going up comparatively. So we continually look at the overall benchmark in that market, do an evaluation, send it externally for a second opinion on what the valuation would be. And we see that industry, that sector, improving over time.

And I'll just add to that, Ryan, without giving anything that -- we can't disclose in terms of the specific numbers -- in each of the key metrics that we evaluate for Gibraltar and that that management team evaluates for their own business, each metric was a record result for that company in 2019. So substantial growth in all key areas of that business, FY '19 over FY '18. And that certainly contributed to the growth of our valuation.

And your next question comes from the line of Fin O'Shea from Wells Fargo.

Most have been asked and answered. One comment on the Q&A, Scott, you mentioned lower-cost debt affording you the ability to lean in a little more on something that's lower priced, lower risk, lower priced. Just thinking about that. It's been over time a little bit of a trend for you, but you've generally -- the platform's maintained its core yields. And beyond the lower cost debt that allows you to do this, I can think of bigger things like lower G&A or a higher stock price. So you've probably had the ability to do this anyway, if you really wanted to go lower in core yields. So I'll just leave it there for you to comment. Am I thinking too much here? Or does -- should we see a late-cycle, more defensive market push for the Hercules platform?

Sure. So Fin, if we gave the impression that we're materially driving down core yields, we're certainly not. You're correct that historically we have always maintained a core yield somewhere between 11.5% and 13%. Obviously, prior to the Fed rate increases throughout 2017, 2018, we were on the lower end of that. And then as the Fed increased, we drove our core yields up to 12.8%, 12.9%. And then with the 3 Fed cuts in 2019, the core yield has now come back to 12.3%. We are very confident that on a portfolio level, we can continue to maintain core yields inside of our target range, which is 11.5% to 12.5%. Based on what we're seeing right now in the first half of the year, we expect to be pretty close to the midpoint of that range, both with respect to Q1 and Q2. We've done a lot of things, as you pointed out and as we highlighted on the call, to really drive down our overall cost of capital and the operating efficiency of our business. The unsecured bond offering that we did in February was done at -- $50 million of it was done at 4.28%, $70 million of it was done at 4.31%. The $400 million credit facility that we announced this morning is a reduction from a cost perspective. This is being done at L 250 versus the legacy union facility that we had that was at 270. So we've made a lot of progress with respect to driving down our cost of capital and we're going to use that reduction in the cost of capital to be a little bit more aggressive on select higher profile, later stage, more stable credits. We don't think that's going to have a material impact on our ability, on a portfolio level, to continue to deliver core yields inside of that range of 11.5% to 12.5%.

Appreciate that context. And then just more higher level one on the venture capital ecosystem that's obviously been very strong, and you've been well positioned for that. But seeing the money come in there, I think, toward -- on the core middle market, private equity side, where there's more money being raised than good deal flow, would you say that that applies as much to -- are VCs -- is there all the money they want to be raised and scarcity and deal flow out there? Or do you think they have still a good return proposition, still abundant investment opportunities?

Yes, we're pretty optimistic about the overall ecosystem, particularly the way 2019 wrapped up. 2019 was the second consecutive year where when you exclude strategic investments, so if you're just looking at pure VC firm invested equity dollars, the number exceeded $100 billion for the second year in a row. Fundraising activity also continued to be very strong in 2018. VC firms within our addressable market raised about $56 billion. The final 2019 numbers have the amount raised at right around $50 billion. So continuing to see a very healthy, robust ecosystem. We've seen no slowdown with respect to the number of deals that we are looking at and evaluating. Our current pipeline is sitting at about $1 billion, as I mentioned. But one thing that we have seen, as we noted, is that on certain of the deals there are certain lenders that are doing something structurally that we don't think are defensible or sustainable. And with respect to those specific opportunities, we're going to let them go and continue to pick and choose the deals that we think make sense for our shareholders and stakeholders.

Very well, that's all for me, and I'll congratulate you all as well for the quarter and year.

Thanks, Fin.

And I'm showing no further questions at this time. I would now like to turn the conference back to our presenters for any closing remarks.

Thank you, operator, and thanks to everyone for joining our call today. We look forward to reporting our progress on our Q1 2020 earnings call. Thank you.

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