Hercules Capital(HTGC) - 2020 Q3 - Quarterly Report

PART I. FINANCIAL INFORMATION ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS Presents Hercules Capital, Inc.'s unaudited consolidated financial statements, covering financial position, performance, cash flows, and detailed notes Consolidated Statements of Assets and Liabilities Shows Hercules Capital, Inc.'s increased total assets and net assets, with higher investments and a slight rise in liabilities Consolidated Statements of Assets and Liabilities (in thousands) | Metric | September 30, 2020 (in thousands) | December 31, 2019 (in thousands) | | :------------------------------------------------- | :-------------------------------- | :-------------------------------- | | Assets | | | | Total investments in securities, at value | $2,420,827 | $2,314,526 | | Cash and cash equivalents | $27,554 | $64,393 | | Restricted cash | $20,507 | $50,603 | | Total assets | $2,504,001 | $2,461,968 | | Liabilities | | | | Total liabilities | $1,330,921 | $1,328,919 | | Net Assets | | | | Total net assets | $1,173,080 | $1,133,049 | | Shares of common stock outstanding | 114,317 | 107,364 | | Net asset value per share | $10.26 | $10.55 | - The company's consolidated securitization trusts for the 2027 and 2028 Asset-Backed Notes, which are variable interest entities (VIEs), had total assets of $685.9 million and total liabilities of $445.1 million as of September 30, 2020[13][14] Consolidated Statements of Operations Shows increased investment income and net investment income, offset by substantial net realized losses on investments Metric (in thousands) | Metric (in thousands) | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :------------------------------------ | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Total investment income | $70,339 | $69,238 | $211,926 | $197,297 | | Total operating expenses | $31,625 | $30,365 | $96,948 | $94,124 | | Net investment income | $38,714 | $38,873 | $114,978 | $103,173 | | Net realized gain (loss) on investments | $(48,501) | $4,807 | $(41,393) | $13,633 | | Net change in unrealized appreciation (depreciation) on investments | $52,834 | $(24,409) | $2,504 | $12,181 | | Net increase (decrease) in net assets resulting from operations | $43,047 | $19,271 | $76,089 | $128,987 | | Basic EPS | $0.38 | $0.18 | $0.68 | $1.29 | Consolidated Statements of Changes in Net Assets Illustrates equity movements, driven by operations, public offerings, stock issuances, and shareholder distributions Metric (in thousands) | Metric (in thousands) | 3 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2019 | | :------------------------------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Balance at beginning of period | $1,164,030 | $1,133,049 | $1,104,684 | $955,444 | | Net increase (decrease) in net assets from operations | $43,047 | $76,089 | $19,271 | $128,987 | | Public offering, net of offering expenses | $(96) | $73,566 | $(331) | $95,092 | | Distributions | $(36,557) | $(116,782) | $(35,555) | $(97,606) | | Stock-based compensation | $2,124 | $6,332 | $1,239 | $7,094 | | Balance at end of period | $1,173,080 | $1,173,080 | $1,085,681 | $1,085,681 | Consolidated Statements of Cash Flows Indicates a shift from cash provided by financing activities in 2019 to cash used in 2020, with reduced operating cash Metric (in thousands) | Metric (in thousands) | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :------------------------------------------------- | :-------------------------- | :-------------------------- | | Net cash used in operating activities | $(24,015) | $(226,752) | | Net cash used in investing activities | $(115) | $(484) | | Net cash (used in) provided by financing activities | $(42,805) | $217,310 | | Net increase (decrease) in cash, cash equivalents, and restricted cash | $(66,935) | $(9,926) | | Cash, cash equivalents, and restricted cash at end of period | $48,061 | $35,931 | - Supplemental disclosures show interest paid of $46.2 million in 2020 (vs. $41.0 million in 2019) and income tax paid of $2.5 million in 2020 (vs. $1.4 million in 2019) for the nine months ended September 30[23] Consolidated Schedule of Investments Details Hercules Capital, Inc.'s portfolio by type, maturity, interest rate, and sub-industry, primarily debt in Drug Discovery & Development and Software Total Investments in Securities (in thousands) | Investment Type | September 30, 2020 (Value) | December 31, 2019 (Value) | | :---------------------- | :--------------------------- | :-------------------------- | | Debt Investments | $2,264,447 | $2,148,592 | | Equity Investments | $133,849 | $145,053 | | Warrant Investments | $22,531 | $20,881 | | Total | $2,420,827 | $2,314,526 | Investment Portfolio by Industry Sector (in thousands) | Industry Sector | September 30, 2020 (Fair Value) | Percentage of Total Portfolio | | :------------------------------ | :------------------------------ | :---------------------------- | | Drug Discovery & Development | $859,371 | 35.6% | | Software | $755,010 | 31.2% | | Internet Consumer & Business Services | $492,696 | 20.4% | | Sustainable and Renewable Technology | $61,297 | 2.5% | | Information Services | $53,363 | 2.2% | | Diversified Financial Services | $46,797 | 1.9% | | Drug Delivery | $45,481 | 1.9% | | Medical Devices & Equipment | $38,543 | 1.6% | | Healthcare Services, Other | $27,271 | 1.1% | | Media/Content/Info | $21,308 | 0.9% | | Communications & Networking | $12,534 | 0.5% | | Surgical Devices | $3,190 | 0.1% | | Electronics & Computer Hardware | $2,809 | 0.1% | | Consumer & Business Products | $708 | 0.0% | | Semiconductors | $432 | 0.0% | | Specialty Pharmaceuticals | $17 | 0.0% | | Biotechnology Tools | $0 | 0.0% | | Total | $2,420,827 | 100.0% | - As of September 30, 2020, approximately 92.4% of the investment portfolio by fair value was located in the United States, with smaller percentages in the United Kingdom (2.5%), Australia (2.2%), and Netherlands (1.5%)[149] Notes to Consolidated Financial Statements Provides detailed explanations for financial statements, covering business, accounting policies, fair value, borrowings, income tax, equity, and subsequent events 1. Description of Business and Basis of Presentation Hercules Capital, Inc. is a specialty finance company providing senior secured loans to high-growth, venture capital-backed companies, operating as an internally managed BDC and RIC - Hercules Capital, Inc. is a specialty finance company focused on providing senior secured loans to high-growth, innovative venture capital-backed companies in technology, life sciences, and sustainable and renewable technology industries[87] - The company operates as an internally managed, non-diversified closed-end investment company and has elected to be regulated as a Business Development Company (BDC) under the 1940 Act, and as a Regulated Investment Company (RIC) for tax purposes effective January 1, 2006[88] - The consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries (including SBIC subsidiaries like HT III), and affiliated securitization trusts (VIEs) where the Company is the primary beneficiary[96][100] 2. Summary of Significant Accounting Policies Details significant accounting policies, including consolidation, investment valuation (primarily Level 3), income recognition, and treatment of cash and other assets Valuation of Investments The company values approximately 96.7% of its total assets at fair value, primarily Level 3 assets, determined by the Board due to lack of market quotations - Approximately 96.7% of the Company's total assets at September 30, 2020, were investments in portfolio companies whose fair value is determined in good faith by the Board of Directors, primarily classified as Level 3 assets under ASC Topic 820[103] Fair Value Hierarchy of Investments (in thousands) | Description | September 30, 2020 (Level 1) | September 30, 2020 (Level 2) | September 30, 2020 (Level 3) | | :------------------ | :--------------------------- | :--------------------------- | :--------------------------- | | Senior Secured Debt | — | — | $2,249,500 | | Unsecured Debt | — | — | $14,947 | | Preferred Stock | — | — | $50,283 | | Common Stock | $41,646 | — | $41,920 | | Warrants | — | $6,963 | $15,568 | | Escrow Receivable | — | — | $417 | | Total | $41,646 | $6,963 | $2,372,635 | - The valuation process for debt investments involves determining a hypothetical market yield and applying premiums/discounts based on credit quality, security liens, and other investment characteristics[119] - For equity and warrant investments, valuation uses market comparable multiples (EBITDA, Revenue, Tangible Book Value), market equity adjustment factors, and discounts for lack of marketability, often employing a Black Scholes Option Pricing Model (OPM)[124] Portfolio Composition Investments are classified by control level, primarily senior secured debt concentrated in Drug Discovery & Development and Software, with 85.5% in a first lien position Investment Portfolio by Asset Class (in thousands) | Asset Class | September 30, 2020 (Fair Value) | Percentage of Total Portfolio | | :------------------------- | :------------------------------ | :---------------------------- | | Senior Secured Debt | $1,317,224 | 54.4% | | Senior Secured Debt with Warrants | $954,807 | 39.4% | | Unsecured Debt | $14,947 | 0.6% | | Preferred Stock | $50,283 | 2.1% | | Common Stock | $83,566 | 3.5% | | Total | $2,420,827 | 100.0% | - As of September 30, 2020, approximately 85.5% of the Company's debt investments were in a senior secured first lien position, with 43.3% secured by a first priority security in all assets (including intellectual property) and 34.2% secured by a first priority security in all assets except intellectual property (which was prohibited from pledging)[151] - The largest industry concentrations as of September 30, 2020, were Drug Discovery & Development (35.6%), Software (31.2%), and Internet Consumer & Business Services (20.4%)[150] Income Recognition Accrues interest income on loans (OID, PIK), places 90+ day past due loans on non-accrual, and amortizes or recognizes fee income as earned - Interest income is recognized on an accrual basis, including OID and PIK interest, as long as collection is expected[154] - Loans 90 days or more past due are typically placed on non-accrual status[154] - Fee income includes loan commitment, facility, and origination fees amortized over the loan life, and one-time fees for specific events like prepayment penalties or covenant defaults[155][156][157] - Exit fees are also accreted into interest income over the loan's contractual life[157] - PIK interest income was approximately $2.3 million and $6.5 million for the three and nine months ended September 30, 2020, respectively[158] - To maintain RIC tax status, PIK and exit fee income must be accrued and distributed as dividends, even if cash has not yet been collected[159] 3. Fair Value of Financial Instruments Fair value of financial instruments approximates carrying amounts for short-maturity items, with borrowings based on market prices or estimated rates - The carrying amounts of cash, cash equivalents, receivables, accounts payable, and accrued liabilities approximate their fair values due to their short maturity[161] Fair Value of Outstanding Borrowings (in thousands) | Description | September 30, 2020 (Fair Value) | December 31, 2019 (Fair Value) | | :---------------------- | :------------------------------ | :------------------------------ | | SBA Debentures | $102,815 | $152,963 | | 2022 Notes | $151,844 | $151,215 | | July 2024 Notes | $106,294 | $107,028 | | February 2025 Notes | $49,730 | — | | June 2025 Notes | $69,681 | — | | 2025 Notes | $76,380 | $77,430 | | 2033 Notes | $42,560 | $42,160 | | 2027 Asset-Backed Notes | $200,219 | $200,750 | | 2028 Asset-Backed Notes | $251,475 | $251,094 | | 2022 Convertible Notes | $230,874 | $234,922 | | Union Bank Facility | $37,492 | $103,919 | | Total | $1,319,364 | $1,321,481 | - The fair value of outstanding borrowings is categorized into Level 2 (observable market trading prices/quotations for 2022, 2025, 2033, 2027, 2028 Notes, and 2022 Convertible Notes) and Level 3 (unobservable market rates for SBA Debentures, July 2024, February 2025, June 2025 Notes, and Union Bank Facility)[162][163] 4. Borrowings Details various outstanding borrowings, including SBA Debentures, Notes, Asset-Backed Notes, Convertible Notes, and Credit Facilities, with principal amounts, rates, and maturities Outstanding Borrowings (in thousands) | Borrowing Type | Total Available (Sep 30, 2020) | Principal (Sep 30, 2020) | Carrying Value (Sep 30, 2020) | Total Available (Dec 31, 2019) | Principal (Dec 31, 2019) | Carrying Value (Dec 31, 2019) | | :---------------------- | :----------------------------- | :----------------------- | :---------------------------- | :----------------------------- | :----------------------- | :---------------------------- | | SBA Debentures | $99,000 | $99,000 | $98,668 | $149,000 | $149,000 | $148,165 | | 2022 Notes | $150,000 | $150,000 | $148,907 | $150,000 | $150,000 | $148,514 | | 2025 Notes | $75,000 | $75,000 | $73,256 | $75,000 | $75,000 | $72,970 | | 2033 Notes | $40,000 | $40,000 | $38,582 | $40,000 | $40,000 | $38,501 | | July 2024 Notes | $105,000 | $105,000 | $103,869 | $105,000 | $105,000 | $103,685 | | February 2025 Notes | $50,000 | $50,000 | $49,493 | — | — | — | | June 2025 Notes | $70,000 | $70,000 | $69,233 | — | — | — | | 2027 Asset-Backed Notes | $200,000 | $200,000 | $197,521 | $200,000 | $200,000 | $197,312 | | 2028 Asset-Backed Notes | $250,000 | $250,000 | $247,579 | $250,000 | $250,000 | $247,395 | | 2022 Convertible Notes | $230,000 | $230,000 | $227,786 | $230,000 | $230,000 | $226,614 | | Wells Facility | $75,000 | — | — | $75,000 | — | — | | Union Bank Facility | $400,000 | $37,492 | $37,492 | $200,000 | $103,919 | $103,919 | | Total | $1,744,000 | $1,306,492 | $1,292,386 | $1,474,000 | $1,302,919 | $1,287,075 | - The company repaid $50.0 million of SBA debentures during the nine months ended September 30, 2020[168] - New debt issuances in 2020 included $50.0 million of February 2025 Notes and $70.0 million of June 2025 Notes[184][187] - The Wells Facility and Union Bank Facility are credit lines with accordion features, allowing for increased capacity[215][221] - As of September 30, 2020, there were no outstanding borrowings under the Wells Facility, but $37.5 million was outstanding under the Union Bank Facility[224] 5. Income Taxes Operates as a RIC, aiming to distribute taxable income to avoid corporate taxes, but subject to a 4% federal excise tax on undistributed income - The Company operates as a Regulated Investment Company (RIC) under Subchapter M of the Code, aiming to avoid U.S. federal income tax on distributed taxable income by meeting income, asset diversification, and distribution tests (generally 90% of investment company taxable income)[226][227] - A 4% nondeductible U.S. federal excise tax applies to certain undistributed income unless timely distributions are made, generally 98% of ordinary income and 98.2% of capital gain net income[229][230] Taxable Income and Taxes Paid (in thousands) | Metric | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :----------------------------------- | :-------------------------- | :-------------------------- | | Taxable income | $112,800 | $110,000 | | Taxable net realized gains | $14,200 | $15,600 | | Income tax, including excise tax, paid | $2,478 | $1,371 | 6. Stockholders' Equity Manages equity through ATM agreements and public offerings, selling 6.0 million shares for $73.9 million net proceeds in 2020, with a new ATM for 16.5 million shares - The company terminated the 2019 Equity Distribution Agreement and entered into a new 2020 Equity Distribution Agreement on July 2, 2020, allowing for the sale of up to 16.5 million shares of common stock through JMP as its sales agent[238] - During the nine months ended September 30, 2020, the company sold approximately 6.0 million shares of common stock under the 2019 Equity Distribution Agreement, generating total accumulated net proceeds of approximately $73.9 million[239] - As of September 30, 2020, there were 456,484 stock options outstanding and 16.5 million shares available for issuance under the 2020 Equity Distribution Agreement[241][243] 7. Equity Incentive Plans Utilizes 2018 Equity Incentive Plan and Director Plan for stock options, restricted stock, and units, recognizing compensation expense over vesting periods - The company uses the 2018 Equity Incentive Plan and the Director Plan to grant stock options, restricted stock awards, and restricted stock units to employees and non-employee directors[245][246] Unrecognized Compensation Costs (in thousands) | Award Type | Unrecognized Compensation Costs (Sep 30, 2020) | | :---------------------- | :--------------------------------------------- | | Stock Options | $32 | | Restricted Stock Awards | $8,300 | | Restricted Stock Units | $2,800 | | Retention PSUs | $2,700 | | Cash Awards | $2,500 | - Retention Performance Stock Unit (PSU) awards and Cash Awards were granted to senior personnel in May 2018, designed to incentivize based on total shareholder return (TSR) and vesting on the fourth anniversary of the grant date[254] 8. Earnings Per Share Basic and diluted EPS calculated based on net assets from operations and weighted average shares. 2022 Convertible Notes were anti-dilutive and excluded Earnings Per Share (EPS) Data | Metric | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :----------------------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Net increase (decrease) in net assets from operations (in thousands) | $43,047 | $19,271 | $76,089 | $128,987 | | Basic weighted average common shares outstanding (in thousands) | 113,489 | 104,314 | 111,342 | 99,615 | | Diluted weighted average common shares outstanding (in thousands) | 113,744 | 104,655 | 111,590 | 100,043 | | Basic EPS | $0.38 | $0.18 | $0.68 | $1.29 | | Diluted EPS | $0.38 | $0.18 | $0.67 | $1.29 | - The 2022 Convertible Notes were anti-dilutive for both the three and nine months ended September 30, 2020 and 2019, and thus excluded from the calculation of diluted earnings per share, as the share price was less than the conversion price[258][259] 9. Financial Highlights Highlights for nine months ended September 30, 2020, show NAV per share of $10.26, total return of (10.19%), and net investment income of $1.03 per share Financial Highlights (9 Months Ended September 30) | Metric | 2020 | 2019 | | :------------------------------------------------ | :---------- | :---------- | | Net asset value at beginning of period | $10.55 | $9.90 | | Net investment income (per share) | $1.03 | $1.03 | | Net realized gain (loss) on investments (per share) | $(0.37) | $0.14 | | Net unrealized appreciation (depreciation) on investments (per share) | $0.02 | $0.12 | | Total from investment operations (per share) | $0.68 | $1.29 | | Net asset value at end of period | $10.26 | $10.38 | | Per share market value at end of period | $11.57 | $13.37 | | Total return | (10.19%) | 29.94% | | Shares outstanding at end of period (in thousands) | 114,317 | 104,636 | | Ratio of total expense to average net assets | 11.29% | 12.25% | | Ratio of net investment income before investment gains and losses to average net assets | 13.39% | 13.43% | | Portfolio turnover rate | 23.86% | 22.82% | | Weighted average debt outstanding (in thousands) | $1,302,048 | $1,145,027 | 10. Commitments and Contingencies Unfunded contractual commitments totaled $242.5 million, with $97.9 million in non-binding term sheets. Lease obligations totaled $11.1 million - As of September 30, 2020, the company had approximately $242.5 million in unfunded contractual commitments, including undrawn revolving facilities, available at the request of portfolio companies and unencumbered by milestones[267][270] - The company also had approximately $97.9 million of non-binding term sheets outstanding, which are subject to due diligence and final approval and do not necessarily represent future cash requirements[268] Contractual Obligations (in thousands) | Contractual Obligations | Total | Less than 1 year | 1 - 3 years | 3 - 5 years | After 5 years | | :---------------------- | :------------ | :--------------- | :---------- | :---------- | :------------ | | Borrowings | $1,306,492 | $25,000 | $454,000 | $337,492 | $490,000 | | Lease and License Obligations | $11,135 | $3,000 | $5,776 | $1,581 | $778 | | Total | $1,317,627 | $28,000 | $459,776 | $339,073 | $490,778 | 11. Recent Accounting Pronouncements Adopted ASU 2018-13 and 2020-04 with no material impact, assessing ASU 2020-6, and early implemented SEC's revised 'significant subsidiary' definition - The company fully adopted ASU 2018-13, 'Fair Value Measurement,' effective January 1, 2020, and ASU 2020-04, 'Reference Rate Reform,' effective March 12, 2020, neither of which had a material impact on its consolidated financial statements[279][280] - The company is assessing the impact of ASU 2020-6, 'Debt with Conversion and Other Options,' effective after December 15, 2021, and does not intend to early adopt it[281] - The company elected to implement the SEC's revised 'significant subsidiary' rule (May 2020) effective June 30, 2020, expecting it to reduce future requirements for separate audited financial statements and summarized financial information for controlled portfolio companies[282] 12. Subsequent Events Sold 306,401 shares under 2020 Equity Distribution Agreement, declared $0.32 cash and $0.02 supplemental distributions, and HT IV received an SBIC license for $175.0 million capital - As of October 26, 2020, the company sold 306,401 shares of common stock under the 2020 Equity Distribution Agreement, with 16.2 million shares remaining available[284] - On October 21, 2020, the Board of Directors declared a cash distribution of $0.32 per share and a supplemental cash distribution of $0.02 per share, both payable on November 16, 2020[285] - On October 27, 2020, Hercules Technology IV, L.P. (HT IV) received an SBIC license, granting access to $175.0 million of capital through the SBA debenture program, in addition to a regulatory capital contribution of $87.5 million[286] ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management discusses financial performance, condition, operations, COVID-19 impact, portfolio activities, liquidity, capital, and critical accounting policies COVID-19 Developments COVID-19 negatively impacted net assets from operations but increased investment income, with long-term impacts remaining uncertain due to fluidity - COVID-19 negatively impacted net assets from operations for the nine months ended September 30, 2020, but total investment income and net investment income increased[291] - The long-term impact of COVID-19 on the business, future results, financial position, or cash flows cannot be estimated due to the fluidity of the situation, potential resurgence, and government actions[291] - The company is maintaining close communications with portfolio companies and increasing oversight of credits in vulnerable industries to manage potential risks[324] Overview Hercules Capital, Inc. provides structured debt with warrants, senior debt, and equity to venture capital-backed tech companies, aiming for total return - The company's primary business is providing structured debt with warrants, senior debt, and equity investments to high-growth, venture capital-backed companies in technology-related industries[293] - The investment objective is to maximize total portfolio return by generating current income from debt and capital appreciation from warrant and equity-related investments[295] - The company operates as an internally managed BDC and has elected RIC tax treatment, requiring it to invest at least 70% of total assets in 'qualifying assets' and distribute 90% or more of its taxable income[297][298] Portfolio and Investment Activity Investment portfolio increased to $2.4 billion, with $1,035.3 million in debt commitments and $480.7 million in principal repayments for the nine months - The total fair value of the investment portfolio was approximately $2.4 billion at September 30, 2020, an increase from $2.3 billion at December 31, 2019[301] Portfolio Activity (in millions) | Metric | 9 Months Ended Sep 30, 2020 | Year Ended Dec 31, 2019 | | :----------------------------------- | :-------------------------- | :---------------------- | | Debt Commitments (Total) | $1,035.3 | $1,457.1 | | Funded and Restructured Debt Investments (Total) | $629.4 | $1,007.9 | | Funded Equity Investments (Total) | $2.0 | $17.8 | | Unfunded Contractual Commitments | $242.5 | $133.7 | | Non-Binding Term Sheets (Total) | $97.9 | $194.0 | - During the nine months ended September 30, 2020, the company received approximately $480.7 million in aggregate principal repayments, of which $426.7 million were early principal repayments from 27 portfolio companies[307] Changes in Portfolio Revenue from interest, fees, and capital gains. Debt terms are 2-5 years with 6.9% to 11.5% interest, concentrated in Drug Discovery & Development, Software, and Internet Consumer & Business Services - Debt investments generally have a term of two to five years and typically bear interest at a rate ranging from approximately 6.9% to 11.5%[309] Yields on Debt Investments | Metric | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | | :------------ | :-------------------------- | :-------------------------- | | Core Yield | 11.3% | 12.4% | | Effective Yield | 12.6% | 13.4% | | Total Yield | 11.5% | 12.1% | - As of September 30, 2020, approximately 91.9% of the portfolio's fair value was concentrated in five industries: Drug Discovery & Development (35.6%), Software (31.2%), Internet Consumer & Business Services (20.4%), Sustainable and Renewable Technology (2.5%), and Information Services (2.2%)[316] - Approximately 97.9% of the debt investment portfolio was priced at floating interest rates or floating interest rates with a Prime- or LIBOR-based interest rate floor as of September 30, 2020[319] Portfolio Grading Uses a 1-to-5 grading system for debt investment risk, with a weighted average of 2.22. Increased oversight for vulnerable industries due to COVID-19 Debt Investment Portfolio Grading (Fair Value, in thousands) | Investment Grading | Number of Companies (Sep 30, 2020) | Debt Investments at Fair Value (Sep 30, 2020) | Percentage of Total Portfolio (Sep 30, 2020) | | :----------------- | :--------------------------------- | :-------------------------------------------- | :------------------------------------------- | | 1 | 17 | $406,502 | 17.9% | | 2 | 50 | $1,053,112 | 46.5% | | 3 | 33 | $772,269 | 34.1% | | 4 | 4 | $26,663 | 1.2% | | 5 | 2 | $5,901 | 0.3% | | Total | 106 | $2,264,447 | 100.0% | - The weighted average investment grading for debt investments was 2.22 on a cost basis as of September 30, 2020, compared to 2.15 at December 31, 2019[323] - The company proactively assesses and manages potential risks across its debt investment portfolio due to COVID-19, increasing oversight and analysis of credits in vulnerable industries[324] Results of Operations Shows increased total investment income and net investment income, but significant net realized losses. Operating expenses rose due to higher interest and fees on borrowings Investment Income Total investment income increased to $70.3 million (three months) and $211.9 million (nine months), driven by higher recurring interest and accelerated income from early repayments Investment Income (in thousands) | Metric (in thousands) | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :-------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Total investment income | $70,339 | $69,238 | $211,926 | $197,297 | | Total interest income | $65,375 | $64,244 | $195,134 | $181,427 | | Total fee income | $4,964 | $4,994 | $16,792 | $15,870 | - The increase in interest income for both periods in 2020 was primarily due to an increase in the weighted average principal outstanding of loans and accelerated income from early loan repayments[327] - PIK interest income slightly decreased for the nine months ended September 30, 2020, to $6.5 million from $6.6 million in 2019, due to a decrease in the weighted average principal outstanding for loans bearing PIK interest[326][330] Operating Expenses Total operating expenses increased to $31.6 million (three months) and $96.9 million (nine months), primarily due to higher interest and fees on borrowings Operating Expenses (in thousands) | Metric (in thousands) | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :-------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Total operating expenses | $31,625 | $30,365 | $96,948 | $94,124 | | Interest and fees on borrowings | $16,631 | $14,995 | $49,683 | $45,720 | | General and administrative | $5,291 | $6,368 | $17,213 | $16,316 | | Employee compensation | $7,181 | $7,559 | $22,575 | $23,372 | | Stock-based compensation | $2,522 | $1,443 | $7,477 | $8,716 | - The weighted average cost of debt was approximately 5.1% for both three-month periods, and 5.1% for the nine months ended September 30, 2020, down from 5.4% in 2019, primarily due to a reduction in weighted average principal outstanding on higher-yielding debt instruments[337] Net Investment Realized Gains and Losses and Net Unrealized Appreciation and Depreciation Recognized significant net realized losses of $48.5 million (three months) and $41.4 million (nine months), offset by $52.8 million net unrealized appreciation in Q3 2020 Net Realized Gains (Losses) (in thousands) | Metric (in thousands) | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :-------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Realized gains | $1,463 | $9,015 | $16,182 | $23,957 | | Realized losses | $(49,964) | $(4,208) | $(57,575) | $(10,324) | | Net realized gains (losses) | $(48,501) | $4,807 | $(41,393) | $13,633 | Net Unrealized Appreciation (Depreciation) on Investments (in thousands) | Metric (in thousands) | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :-------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Total net unrealized appreciation (depreciation) on investments | $52,834 | $(24,409) | $2,504 | $12,181 | - For the three months ended September 30, 2020, net unrealized appreciation of $52.8 million was recorded, primarily from $43.3 million on debt investments (including $35.9 million reversal of depreciation upon write-off/pay-off) and $9.5 million on equity and warrant investments[346][347] Income and Excise Taxes Accounts for income taxes under ASC Topic 740, aiming to distribute taxable income as a RIC to avoid corporate taxes, but subject to a 4% federal excise tax - The company provides for income taxes based on current and deferred amounts, with valuation allowances used to reduce deferred tax assets to the amount likely to be realized[354] - As a RIC, the company intends to distribute substantially all annual taxable income to stockholders to avoid corporate-level U.S. federal income taxes, but is subject to a 4% nondeductible federal excise tax on certain undistributed income if excise tax avoidance requirements are not met[354][355] - Taxable income for the nine months ended September 30, 2020, was approximately $112.8 million, with taxable net realized gains of $14.2 million[233] Net Change in Net Assets Resulting from Operations and Earnings Per Share Net increase in net assets from operations was $43.0 million (three months) and $76.1 million (nine months), with 2022 Convertible Notes being anti-dilutive Net Change in Net Assets and EPS | Metric | 3 Months Ended Sep 30, 2020 | 3 Months Ended Sep 30, 2019 | 9 Months Ended Sep 30, 2020 | 9 Months Ended Sep 30, 2019 | | :----------------------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | :-------------------------- | | Net increase (decrease) in net assets from operations (in thousands) | $43,047 | $19,271 | $76,089 | $128,987 | | Basic EPS | $0.38 | $0.18 | $0.68 | $1.29 | | Diluted EPS | $0.38 | $0.18 | $0.67 | $1.29 | - The 2022 Convertible Notes were anti-dilutive and excluded from diluted EPS calculations for both the three and nine months ended September 30, 2020 and 2019, as the share price was less than the conversion price[358] Financial Condition, Liquidity, and Capital Resources Available liquidity of $465.1 million, net assets of $1.2 billion, and a NAV per share of $10.26, with an asset coverage ratio of 197.0% (excluding SBA debentures) - As of September 30, 2020, the company had $465.1 million in available liquidity, including $27.6 million in cash and cash equivalents, and available borrowing capacity of $75.0 million under the Wells Facility and $362.5 million under the Union Bank Facility[384] - Net assets totaled $1.2 billion, with a NAV per share of $10.26, as of September 30, 2020[391] - The company's asset coverage ratio under BDC regulatory requirements was 197.0% (excluding SBA debentures) and 189.7% (including SBA debentures) as of September 30, 2020, operating under the 150% minimum asset coverage ratio approved by stockholders[393] Critical Accounting Policies Significant estimates in investment valuation (predominantly Level 3 assets), income recognition, and stock-based compensation, requiring Board and independent firm judgment - The most significant estimate in financial statements is the valuation of investments, with approximately 96.7% of total assets at September 30, 2020, being Level 3 investments whose fair value is determined in good faith by the Board of Directors[416] - The company engages independent valuation firms to assist in valuing selected portfolio investments quarterly, based on factors like potential for material fluctuations, size, credit quality, and time since last valuation[417] - Stock-based compensation expense for options and restricted stock is measured at grant date fair value and recognized over the vesting period, requiring judgment in estimating volatility, forfeiture rates, and expected option life[420] Subsequent Events Sold 306,401 shares under 2020 Equity Distribution Agreement, declared $0.32 cash and $0.02 supplemental distributions, and HT IV received an SBIC license for $175.0 million capital - As of October 26, 2020, the company sold 306,401 shares of common stock under the 2020 Equity Distribution Agreement, with 16.2 million shares remaining available[421] - On October 21, 2020, the Board of Directors declared a cash distribution of $0.32 per share and a supplemental cash distribution of $0.02 per share, both payable on November 16, 2020[422] - On October 27, 2020, HT IV was licensed as an SBIC, gaining access to $175.0 million of capital through the SBA debenture program, in addition to an $87.5 million regulatory capital contribution[423] COVID-19 The company continues to closely monitor the COVID-19 pandemic and its broader impact on the U.S. and global economy, with no reportable subsequent events as of October 29, 2020 - The company continues to closely monitor the COVID-19 pandemic and its broader impact on the U.S. and global economy[424] - As of October 29, 2020, there is no indication of a reportable subsequent event impacting the financial statements for the three and nine months ended September 30, 2020[424] ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Exposed to interest rate risk, affecting funding costs and investment income, with 97.9% of loans at variable rates and most borrowings at fixed rates - The company is subject to financial market risks, primarily interest rate risk, which affects both its cost of funding and interest income from portfolio investments[425] - As of September 30, 2020, approximately 97.9% of the loans in the portfolio had variable rates based on floating LIBOR or Prime rates with a floor, while most borrowings (SBA debentures, 2022, July 2024, February 2025, June 2025, 2025, 2033, 2027, 2028 Asset-Backed Notes, and 2022 Convertible Notes) bear interest at a fixed rate[425] Annualized Impact of Hypothetical Interest Rate Changes (in thousands) | Basis Point Change | Interest Income | Interest Expense | Net Income | EPS | | :----------------- | :-------------- | :--------------- | :--------- | :---- | | (75) | $(53) | $(45) | $(8) | $(0.00) | | (50) | $(53) | $(30) | $(23) | $(0.00) | | (25) | $(53) | $(15) | $(38) | $(0.00) | | 25 | $2,197 | $15 | $2,182 | $0.02 | | 50 | $4,581 | $30 | $4,551 | $0.04 | | 75 | $6,964 | $45 | $6,919 | $0.06 | | 100 | $9,471 | $60 | $9,411 | $0.08 | | 200 | $21,622 | $121 | $21,501 | $0.19 | ITEM 4. CONTROLS AND PROCEDURES Disclosure controls and procedures were effective as of September 30, 2020, with no material changes in internal control over financial reporting during the quarter - As of September 30, 2020, the company's disclosure controls and procedures were deemed effective by its chief executive and chief financial officers[430] - No material changes in internal control over financial reporting occurred during the most recently completed fiscal quarter[431] PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS May be involved in litigation, but current proceedings are not expected to materially affect financial condition or results of operations - The company may be involved in litigation arising from its operations, but does not expect current matters to materially affect its financial condition or results of operations[434] ITEM 1A. RISK FACTORS COVID-19 poses significant risks, stock price volatility may limit equity raising, and underperforming portfolio investments could adversely affect financial results - The COVID-19 pandemic poses significant risks, including disruption to operations, impaired ability of portfolio companies to fulfill obligations, increased delinquencies, declining collateral values, and reduced demand for loans, which could materially adversely affect the business[436][437] - The common stock price may be volatile or trade below its NAV per share, which could limit the company's ability to raise additional equity capital and cause dilution to stockholders if shares are issued at a discount[438][439][441] - Failure of significant portfolio investments to perform as expected could negatively affect financial results, given that several companies represent greater than 5% of net assets, including BridgeBio Pharma LLC (7.2%), EverFi, Inc. (7.1%), and Tricida, Inc. (6.7%)[442][443] ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Issued 198,393 shares of common stock, valued at approximately $2.4 million, to stockholders through its dividend reinvestment plan, not subject to SEC registration - During the nine months ended September 30, 2020, the company issued 198,393 shares of common stock to stockholders via its dividend reinvestment plan[444] - The aggregate value of these shares was approximately $2.4 million, and they were not subject to the registration requirements of the Securities Act[444] ITEM 3. DEFAULTS UPON SENIOR SECURITIES This item is not applicable to the current report ITEM 4. MINE SAFETY DISCLOSURES This item is not applicable to the current report ITEM 5. OTHER INFORMATION This item is not applicable to the current report ITEM 6. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES Lists exhibits filed with Form 10-Q, including CEO/CFO certifications and Schedule of Investments in and Advances to Affiliates, detailing control and affiliate investments - The exhibits include CEO and CFO certifications (31.1, 31.2, 32.1, 32.2) as required by the Sarbanes-Oxley Act of 2002[448] Total Control and Affiliate Investments (in thousands) | Metric | As of Dec 31, 2019 (Fair Value) | As of Sep 30, 2020 (Fair Value) | | :----------------------------------- | :------------------------------ | :------------------------------ | | Total Control Investments | $59,746 | $55,092 | | Total Affiliate Investments | $21,808 | $9,800 | | Total Control and Affiliate Investments | $81,554 | $64,892 | - All control and affiliate investments are classified as Level 3 investments, valued using significant unobservable inputs[457] SIGNATURES Report duly signed by Scott Bluestein (President, CEO, CIO) and Seth H. Meyer (CFO, CAO) on behalf of Hercules Capital, Inc. on October 29, 2020 - The report was signed by Scott Bluestein, President, Chief Executive Officer, and Chief Investment Officer, and Seth H. Meyer, Chief Financial Officer, and Chief Accounting Officer, on October 29, 2020[461]