Sep 21, 2008
Executives
Manuel A. Henriquez - Chairman of the Board, President, Chief Executive Officer David M.
Lund - Chief Financial Officer, Principal Financial and Accounting Officer [Dee Dee Shield - F.D. Ash Partners - Investor Relations Counsel for Hercules]
Analysts
Troy Ward - Stifel Nicolaus & Company Greg Mason - Stifel Nicolaus & Company John Hecht - JMP Securities Jon G. Arfstrom - RBC Capital Markets Robert Napoli - Piper Jaffray [Brandon Wohl] - Lehman Brothers Quinton Maynard - Morehead Capital
Operator
Welcome to the Hercules Technology Growth Capital, Inc. second quarter 2008 financial results conference call.
(Operator Instructions) I’ll now turn the call over to Dee Dee Shield of F.D. Ash & Partners, Investor Relations Counsel to Hercules.
Dee Dee Shield
On the call today are Manuel Henriquez, Hercules’ Co-Founder, Chairman and CEO, and David Lund, CFO. Our second quarter 2008 financial results were released just after today’s market closed.
They can be accessed from the company’s website at www.herculestech.com or www.htgc.com. We have arranged for a taped replay of today’s call which will be available through our website or by using the telephone numbers and pass codes provided in today’s earnings release.
I would like to call your attention to the Safe Harbor disclosure in our earnings release regarding forward-looking information. Today’s conference call may include forward-looking statements and projections.
We ask that you refer to our most recent filings with the SEC for important risk factors that could cause actual results to differ materially from these projections. We do not take any obligation to update our forward-looking statements unless required by law.
To obtain copies of our latest SEC filings please visit www.sec.gov or visit our website at www.herculestech.com. I would now like to turn the call over to Manuel Henriquez, Hercules’ Co-Founder, Chairman and CEO.
Manuel A. Henriquez
Good afternoon and thank you everybody for joining us today. I want to start by reminding everyone that Hercules is a highly specialized business development company and we specialize and focus exclusively on the venture capital and private equity technology in life sciences companies.
On today’s call I would like to discuss four key items: Our second quarter performance, our current liquidity position, our credit performance and credit quality of our portfolio, and of course the current venture capital environment and our portfolio exits. I will then turn the call over to David Lund who will discuss our financial results in more detail.
After that, I will be happy to answer any of your questions along with David. Now to summarize our second quarter results.
We had continued growth and commitments for a record of $236 million and $161 million in fundings and loan renewals during the quarter. This was primarily driven by a robust venture capital market and the hard work of our organization and our investment professionals.
During that period of time we also maintained our historical solid credit performance. We continued to build upon the diversity and strength of our investor portfolio with continued focus on and towards more later-stage EBITDA positive type companies as we continued to build our portfolio.
We finished the quarter with approximately $602 million of investment assets on our balance sheet and an unfunded backlog of $193 million giving us visibility for the next two to three quarters out of additional investment activities, which David will discuss further during his portion of the presentation. We also achieved a weighted average yield for the quarter of 12.67% compared to a 12.64% during the first quarter all while short term LIBOR rates were declining.
Our effective yield however during the same period of time went up quite significantly to 14.3%, which David will also discuss during his portion of the presentation. I’m happy to report that we’ve also surpassed our goal which we outlined during our fourth quarter and reiterated during our first quarter of this year on a number of exits that we expect to realize during fiscal 2008 of eight to 10 exits.
I’m happy to report that as of the end of the June period we’ve now achieved 11 exits in our portfolio already surpassing our goal of eight to 10 exit events during the year. Now turning to liquidity, we are confident that our current liquidity position will allow us to continue to fund our operations for the next couple of quarters while the addition of our new credit facility will allow us to continue to fund the operations well into 2009.
I will expand further about our credit facility during our Q&A session to discuss the impending credit facility that we expect to have in place here shortly. Continuing on, during the quarter we continued to deploy capital from our new credit facility thanks to our partners who with both Deutsche Bank and Citibank which we continue to draw capital from those credit facilities which renewed in the middle of the second quarter.
And again, David will speak further about the costs of credit on those two facilities. We currently are only leveraged on 53% of our portfolio and I’d like to remind everybody that we have an [SPIC] exemption from the SEC which allows Hercules to leverage above and beyond the 1 to 1 debt equity ratio to an optimal leverage point of 130% or 1.3 to 1 leverage ratio.
So we have a significant amount of liquidity that we can actually continue to leverage our balance sheet to fund our existing operations for the next few quarters. Now let me take a moment and turn to credit quality.
I am very proud of our achievement of our organization in maintaining our high credit standards especially during this current credit environment and credit crisis that we seem to be experiencing in the broader markets and certainly many of our commercial bank partners out there as well. We continue to remain very disciplined in our selecting process of new investment opportunities and we remain extremely vigilant in monitoring and tracking our existing portfolio for the first signs of trouble which has allowed us to navigate these difficult credit times by avoiding any significant credit losses as evidenced in our portfolio’s performance so far.
In terms of a weighted average loan grade in our portfolio, I’m happy to report that that weighted average loan grade has also improved during the quarter to 2.1% compared to 2.2% in the previous quarter. Given the current environment we remain very selective in our investments and we seek to make strategic decisions and emphasize in the near term a way for early stage investing and migrating more towards later-stage more established EBITDA positive companies.
You will continue to see us migrate more towards mature companies in the proceeding two to three quarters as we continue to see the market spill-out that we’re experiencing today. Further, as we focus on more mature companies we’re looking to continue to enhance our investments in more EBITDA positive companies which we believe is a very attractive market opportunity for us to pursue realizing very attractive yield at historically low EBITDA multiple levels today.
While we believe there are many great opportunities from an investment perspective, we have elongated our due diligence process and extended out our initial fundings of companies where we have purposely increased our due diligence timeframe anywhere from two to three weeks above our historical norm in order to continue to ensure that we’re getting the proper investment opportunities as we make our final investment selection process. This has enabled us to both garner meaningful terms and conditions on our new credit facilities with our portfolio companies as well as ensure that we complete a very thorough and continued deep due diligence process as we’ve done historically to ensure a continued preservation of our credit performance.
We continue to believe these actions are prudent in order to maintain our high quality standards which we do not expect to deviate very significantly from if at all as we continue to build our assets over the proceeding two to four quarters in the future. Now let me turn to portfolio exists.
As I said earlier on, we have now exceeded our exits of eight to 10 events now achieving 11. This was achieved by having five of our companies achieve exists during the second quarter, all of which achieved positive IRRs for Hercules.
We have successfully worked out and received payoffs of an additional two to three companies during the quarter as well as part of our continued effort to ensure principal preservation as we work through difficult credit situations with our companies in conjunction with the venture capital partners. Now let me turn to our warrant portfolio and potential future of liquidity opportunities to our portfolio derived from those existing warrant positions.
Today our warrant portfolio has consistently provided us with realized gains which we will distribute to our shareholders in the form of additional dividends or retain for future investments by paying the appropriate corporate tax and retaining those earnings in order to fund our future operations. We continued to build our warrant positions during the quarter and I’m happy to report that at the end of the second quarter Hercules now holds warrants in 96 venture backed life sciences and technology companies which we carry on a fair value basis of approximately $25 million.
In contrast, if we were to exercise all 96 warrant positions we would have a cash outlay of approximately $60 million representing the full exercised price of those warrants. As I’ve done historically I want to caution our investors and remind our investors that you should not expect nor do we expect to see full realization for our warrant portfolio and we continue to say that you should only model approximately 50% or less of that warrant portfolio will ever monetize into any upside.
And we will expand that further in our Q&A session as well. The increase in our warrant position from the second quarter to the first quarter represents approximately a 70% increase in our warrant portfolio position.
This is important as we continue to build our warrant portfolio in hopes of in the future harvesting those gains for additional capital gains and create a self-funding mechanism for the Hercules model. As I have now seen and heard many of the other [inaudible] calls out there, Hercules is certainly one of the most unique business models out there where we generally receive warrant positions in all of our venture-backed companies allowing us the potential for future upside for our shareholders in the event these warrants were to monetize.
This is important as our warrant portfolio does allow or should allow Hercules to provide a venture capital type return towards shareholders with limited downside risks. In conclusion, we believe Hercules Technology Growth Capital in this current market environment has continued to navigate very difficult waters and continued to perform quite well for our shareholders while avoiding any significant hardships from realized loans losses in our portfolio.
It is frankly a testimony to the quality and integrity of our business professional people we have here, the vast majority of which all have significant credit trading programs and to a lesser extent business development. It is certainly a critical differentiating factor for Hercules that its investment professional staff has a significant credit training background which has afforded us the ability to scrutinize and evaluate some investment opportunities as we’ve done historically in these current times.
We believe our short-term strategy of shifting to later-stage companies, mature EBITDA positive companies, continued with and coupled with a vigilance on our credit quality and credit performance will allow us to continue to build our portfolio and to continue to build shareholder value for our underlying shareholders. I’d like to remind the audience on today’s call that the third quarter is traditionally our slowest quarter in terms of both originations and fundings.
The third quarter traditionally represents anywhere between 10% to 15% of our investment activities for the year during the third quarter. Given the current economic times we are certainly expecting that the third quarter will probably be on a seasonally low end of the expected originations given the current environment that we’re in.
Overall I am extremely pleased with the continued performance of our investment portfolio, the dedication and commitment of our investment professionals in [inaudible] their absolute vigilance and hawkish approach to our credit position ensuring that we maintain the solid credit performance that we’ve done. Our success is clearly attributed to their dedication and their performance on behalf of our shareholders.
I would now like to turn the call over to David Lund who will elaborate on our quarterly financial performance.
David M. Lund
Today I will provide more details on our commitments and fundings, income statement, key portfolio metrics, balance sheet and also provide an update on our credit facility. With our record level of commitments and fundings this period, our commitments since inception have exceeded $1.3 billion and our fundings approaches $950 million.
Turning to the income statement, total investment income which is comprised of interest and fee income was $19 million which was in increase of approximately 43% over the second quarter of 2007 investment income of $13.3 million. This increase reflects an above-average level of income from event driven fees and acceleration of deferred revenue.
The effective yield on our debt investments during the quarter was 14.3%. The increase from last quarter’s effective yield of 12.6% was due to the acceleration of the event driven fees.
Interest expense and loan fees on borrowings were $3.5 million for the second quarter of 2008 as compared to $2 million in the second quarter of 2007. The change was attributed to higher average loan balances outstanding and fees related to the SBA draw-downs.
During the quarter our average loan balance outstanding was $181 million of which $98 million was attributed to our credit facility and $83 million was attributed to our SBA facility. The effective cost of debt during the quarter was approximately 7.7% compared to 6.4% in the first quarter.
This increase reflects the higher costs under our credit facility. I would like to remind our investors that the credit facility was renewed on May 10, 2008 and this cost only reflects a half quarter of increase.
During March 2008 Hercules secured its borrowing rate on $58 million of borrowings under the SBA program at a rate of 6.37% which is comprised of interest rate of 5.47% and an annual fee of approximately 0.9%. Subsequent SBA borrowings will bear interest at an interim rate of LIBOR plus the spread of approximately 30 basis points until fixed at the semi-annual meeting of the SBA in September.
As a reminder, the rate becomes fixed at the time of the SBA pooling which generally occurs in September and March each year and is set to the 10-year Treasury rate at that time plus a spread and an annual SBA charge. Operating expenses for the quarter excluding interest expense and loan fees were $5.6 million as compared to $4 million during the same period last year.
The increase as compared to the second quarter of 2007 was primarily attributable to an increase in the number of employees as well as increased legal and workout related expenses. Net investment income for the quarter was $10 million or $0.30 per share based on 32.8 million basic shares outstanding.
This is compared to $7.2 million or $0.29 per share in the second quarter of 2007 based on 25.2 million shares outstanding representing an increase of 3.4% on a per share basis. Taxable income for the quarter was $0.39 per share including realized gains and tax timing differences totaling $2.5 million or approximately $0.08 per share.
During the second quarter we also recognized realized gains of $1.9 million. These gains were primarily attributed to the gain on sale of our warrants and Sirtris Pharmaceuticals.
Net unrealized depreciation on investments in the second quarter was $3.5 million compared with unrealized depreciation of $1.4 million in the second quarter of 2007. I’d like now to briefly address credit quality.
We continued our high credit quality standards and discipline of loan monitoring during the quarter. The weighted average loan rating of our portfolio improved to 2.1 as compared to 2.21 at the end of the prior quarter.
As a reminder, most of our portfolio companies are dependent on future events of venture capital investments and we downgrade our portfolio companies as they approach a period in which they will need to close additional rounds of financing. I would like to note that the makeup of the companies in the various grading categories will change period-to-period based on operating results and funding activities.
Also, as we had identified in our earnings release today we continue to diversify our investment portfolio which mitigates investment risk in any single industry subsector. Now turning to the balance sheet, effective January 1, 2008 the company adopted FAS 157.
There was no material effect on the investment valuations as a result of the adoption of this accounting principle. During the quarter we also reviewed certain warrant valuations with our consults, Houlihan & Lokey.
In the second quarter we placed two of our loans with an aggregate value of approximately $5 million representing only 1% of our total investment portfolio on a nonaccrual basis, $4 million of which is currently in receivership and is being sold. During the quarter we borrowed $46 million under our warehouse credit facility.
The debt balance under the facility was $119 million at June 30, 2008. We also drew an additional $25 million from the SBA bringing the SBA debenture total to $95 million at the end of the quarter.
$16 million remains available under the Citibank credit facility and $32 million remains available under the SBA program as of the end of June. Turning to our liquidity, as Manuel mentioned we expect to announce later during the month of August a new revolving credit facility for potentially up to $300 million providing the ability to add additional lenders to the credit facility over its term as needed.
The facility is expected to be structured as a two-year committed facility with a one-year optional extension. The initial facility is expected to close with commitment of $50 million and possibly expanding to $100 million with the addition of one to two potential lenders.
We are currently in the process of finalizing the loan and security agreements. However until this transaction’s fully closed I would like to remind everyone that it is still a pending transaction and subject to closure.
I would like to point out that based on our existing stockholders’ equity and our SEC exemptive relief for borrowings available under the SBA debenture program, the company has the potential to leverage its balance sheet in excess of $500 million. We had approximately $180 million in debt outstanding as of June 30, 2008 representing a leverage ratio of approximately 53%.
Turning to our dividend, our Board of Directors declared a dividend of $0.34 per share representing a 13% increase over the second quarter dividend of 2007. The dividend will be payable on September 15, 2008 to shareholders of record as of August 15, 2008.
This is our 12th consecutive quarterly dividend declaration bringing the total cumulative dividend declared to date to $3.41 per share. Operator, we are now ready to open the call for questions.
Operator
(Operator Instructions) Our first question comes from Troy Ward - Stifel Nicolaus & Company.
Troy Ward - Stifel Nicolaus & Company
The obvious question that comes to mind unless I just missed this, did you speak to the potential cost of the facility that you’re in process of getting?
Manuel A. Henriquez
The answer is we haven’t because until a deal is done, we don’t feel as comfortable saying that. I will say the following however, that all the terms and conditions of the credit facility are and have been fully negotiated and complete.
We are literally within probably five, maybe at worse 10 days away from finalizing the loan and security agreement with the lender. I can say the following however, that the borrowing costs of the facility is materially less than the current Deutsche Bank/Citibank credit facility that is in place today.
Troy Ward - Stifel Nicolaus & Company
So it’s at least L plus 499 then?
Manuel A. Henriquez
No, I think that our credit performance which we’ve emphasized very strongly has allowed us to significantly show a difference between us and other specialty finance companies, so we have received what I consider to be the proper partner that we have found to provide the credit facility and we think that the credit facility terms reflect our ability to continue to perform in this current market condition. So we’re very happy with our arrangement that we’re soon to have in place with this particular lender.
Troy Ward - Stifel Nicolaus & Company
That’s fantastic especially in light of hearing that one of the peer BDCs had one pulled in the 11th hour. Hopefully that won’t happen here.
Quickly; not much; it seems to be a very clean quarter. Moving on to the income statement, was there something in the G&A this quarter that was a one-time?
It looked like that was higher than normal.
David M. Lund
Yes. We had some slightly higher legal fees; we had some workout related expenses for one deal that has been resolved and one that’s in process.
So it’s been more related to SEC filings and things of that nature. Troy, there’s probably about $250,000 of one-time fees that we expect or will be getting reimbursed on when this particular workout transaction we just identified is completed later on in the third quarter and that overrides some reimbursement.
The accounting rules are as we incur these expenses they must be expensed in the quarter recognized.
Greg Mason - Stifel Nicolaus & Company
Gentlemen, this is Greg Mason, can you talk a little bit more about just the overall venture capital environment particularly on the debt side? What kind of competition’s out there, opportunities that are presenting themselves for new investments, and exit opportunities; obviously the IPO market is slow, M&A, can you just give us a little overview there?
Manuel A. Henriquez
Let me first talk on the macro level which frankly surprised me on how favorable the numbers are that came out. As you may look at the transcripts from Q4 of last year and Q1 of this year, I’ve always said all along that I expected 2008 to be slightly lower than the investment activities in 2007 which to remind everybody did about $30 billion in investment activities.
In Q2 the venture capital community invested approximately $7.4 billion into 990 different transactions as compared to $7.5 billion in Q1 giving a run rate of investment activities close to $16 billion year-to-date or $32 billion for the year, which is surprisingly strong. That’s important because that venture capital investment into technology life sciences companies is one of our primary sources of repayment.
So unlike every other BDC out there we’re experiencing a very robust and a very good market in the venture capital sector. Another important leading indicator to the health of our industry is the amount of capital that the venture funds themselves raise from limited partners, and that number absolutely surprised me on how strong it was in the second quarter.
The venture capitalists themselves raised $9.1 billion into 71 new venture funds. That is compared to $7.1 billion in Q108 to 70 funds making the year-to-date number exactly matching their outflows of $16.2 billion.
And just to remind everybody, venture capitalists typically invest their funds between three to five years and they take on investment horizons for their portfolio companies anywhere between eight to 10 years for liquidity. So even though we may be experiencing some difficult times in this current market place, the venture capitalists take a longer term perspective in supporting investing in their companies which again has allowed us to have and select the proper companies which is reflected in our credit performance.
Now in terms of competition, the one thing is that because we’re such a specialty investment practice very few people either have the franchise, the knowledge or the experience to work with and deal with early-stage, mid-stage, late-stage venture capital-backed companies. It’s a highly specialized practice of lending and traditional asset-based lenders aren’t necessarily able to do that.
Because of that we’ve seen a significant curtailment or abatement in competition from many of our competitors some of which were doing what we considered to be extremely silly deals by doing very, very large dollar size deals with no warrant coverage or significantly very, very low cost capital. Hercules is not a low-cost capital provider.
We’re highly selective in our portfolio. And as such we’ve seen our competition who went out and did a lot of deals now suddenly running into significant credit problems.
And more importantly, they’re significantly underperforming on a P&L basis when somebody compares them to Hercules. And they’re running into capital fund raising problems today.
So we’re seeing the competitive landscape shifting quite a bit. We’re still seeing pretty significant healthy competition on the other hand from the venture banks who are more focused on giving away loans in order to secure deposits as a source of funding to support their real estate efforts or their middle market efforts today.
Operator
Our next question comes from John Hecht - JMP Securities.
John Hecht - JMP Securities
Forgive me; I have been jumping from conference call to conference call. Manuel, it looks like you may have addressed this on the call too.
It looks like your yields on your loans as we calculated just interest income divided by the average portfolio size jumped pretty nicely in the quarter yet you’re talking about going after larger deals, later-stage companies with lower multiples. Is this a factor that you’re entering a market that either has less competition and you’re able to get better spreads on it or is there something else going on with the yield that is enabling you to pass off the increased credit spreads to your customer base at a more rapid rate?
Manuel A. Henriquez
Let me answer the first part. We’re absolutely going upstream into more established later-stage companies.
And some of these companies we may forego a warrant coverage for example because of the more stability nature of the company but garner current higher cash yields, some of which have some [PIC] component to it but our [PIC] exposure still is very minimal even to this date. So it’s a much, much healthier stronger current cash income and a higher yield spread.
And certainly we have seen and continue to see a declining level of competition on assets below the $30 million range.
John Hecht - JMP Securities
So it’s a little bit of getting higher current income without warrants in the bigger deals along with the higher yields in the smaller deals. Is that a combination of what we’re seeing in your portfolio yields?
Manuel A. Henriquez
It is certainly a combination of both of those items, yes.
David M. Lund
And just to be clear, we had some acceleration of interest income, some event driven fees where people paid off that boosted the current quarter’s interest income as well.
John Hecht - JMP Securities
And I missed that. Did you divulge what the prepayment fees were in the quarter?
Manuel A. Henriquez
Prepayment fees, and this is strictly dollars, in the quarter were $236,000. That’s not necessarily increased quarter-over-quarter but just within the quarter.
And we had one-time fees of $1.1 million. Now that’s slightly higher than the previous periods as well so we are seeing some additional fees this quarter obviously.
David M. Lund
And John, we’re going to start shifting the terminologies. I’m not particularly a fan of one-time fees.
The better and more appropriate terminology I think is event driven fees such as a company paying off early, a company being acquired, a company going public and they have excess proceeds, they pay down a loan which will cause either an acceleration of unrecognized deferred revenues that gets accelerated or coupled with any loan amendment fees or frankly any prepayment penalties are then recognized because it’s an event driven situation.
John Hecht - JMP Securities
Manuel if you have a comment on it, I’d like to hear your update on what industries are more enticing to you right now where you’re seeing better investment opportunities and from a regional perspective if you’re seeing any activity in Israel still and maybe where you’re seeing it in the US relatively speaking?
Manuel A. Henriquez
Certainly. The investors who have been following us all along have probably heard me say this now for about six to nine quarters, maybe longer, that we had historically de-emphasized software investment.
We then said at the beginning of Q1 of this year that we have now begun to relook at software investment activities and you’re seeing us shift some of our focus back into software companies today. And you see the portfolio basically jumped from 6.5% in software investments in Q1 to approximately 11% software investments in Q2.
So that’s been a material shift for us in the short term. We have continued to cautiously reduce our exposure in the life sciences area, not because we don’t like life sciences; we think that the market is going through a little bit of an adjustment period right now so our life sciences as a percent of our portfolio exposure declined from a 37.5% portfolio concentration in the first quarter to about 32.5% portfolio concentration in the second quarter.
And that’s something that we did consciously; however I think that the life sciences concentration is not going to dip below much more than a 30% level and you’ll start seeing that increase probably in the fourth quarter. If you don’t follow the technology area, semiconductors is going through a fairly significant rough patch right now.
We are somewhat net neutral to that exposure now. We do have some exposure to semiconductor.
We’re watching some of our companies very, very closely. They’re going through a fairly significant sector recession if you will for lack of a better word.
And you’re seeing some additional hiccups going on right now in our comm exposure but we’re continuing to monitor that quite well and we think we’re well positioned in that area. But comm is going through a little bit of an adjustment period right now which represents about 20% of our portfolio today.
Operator
Our next question comes from Jon G. Arfstrom - RBC Capital Markets.
Jon G. Arfstrom - RBC Capital Markets
Just a clarification on the event driven fees; I just want to make sure I understand it. The typical run rate has been about $1.5 million a quarter and Manuel I understand what you’re saying about how they’re event driven and not necessarily one-time, but would you characterize any of that that might have been pulled in some what would have occurred in the third quarter that was pulled into the second quarter or do we expect that to drop back to the typical run rate?
Manuel A. Henriquez
It’s going to drop back to the more typical run rate. Our increase in the interest income was about $1.8 million over the quarter.
About $1.2 million of that was event driven and it’s event driven that would have been longer term out because we had deals that paid off or more matured companies paid off, we had some back-end fees that paid off, so I expect it to go to the more normal run rate.
David M. Lund
And John, let me clarify it further. As much as people may believe, we can’t affect any event in our company.
These are M&A activities. Some companies are doing so well that they raise even higher amounts of equity capital at significantly higher valuations and they decide they don’t need the debt anymore.
And it’s a combination of many different things of that nature but nothing of which we can pull forward at all.
Jon G. Arfstrom - RBC Capital Markets
And just a follow up on the shift to more mature companies. I just want to make sure I understand that you do expect some rising investment yields over time as you continue to recycle the portfolio and move into more mature companies?
Did I understand that correctly?
Manuel A. Henriquez
Absolutely. One thing we haven’t done I guess a very good job on is discussing the micro-level analyses we do in our portfolio.
We have probably anywhere between conservatively $60 million to $100 million of loans that are ostensibly below what our new yield requirements would be for example that are maturing and as those portfolios run off, you’ll actually start seeing us redeploy that capital into new investments. And again, another very important distinction between Hercules and almost every other BDC out there is because we rely so heavily upon rapidly amortizing credit investments, we receive anywhere between $30 million to $50 million a quarter in cash flows back that we’re able to redeploy or looked at differently allowing us to delever ourselves and redeploy that capital very effectively thereby getting new fees and new warrants in our deals.
Jon G. Arfstrom - RBC Capital Markets
I understand your comments on Q3 originations but assuming your new debt facilities closes as planned, can you comment a little bit on your appetite for overall balance sheet growth? Do you feel like the environment supports an opportunity to grow the balance sheet faster maybe after the third quarter or would you say regardless of the size of your facility you’re still a bit cautious on growth?
Manuel A. Henriquez
Our credit facility does not drive originations. We could have zero leverage in our balance sheet and an inordinate amount of liquidity and that doesn’t mean that we simply accelerate originations.
We are very true to what we do and that is if the opportunities are not there that we feel fit from a credit risk profile, potential economic upside in the warrants and repayment of our principal, we’re not going to make the investment irregardless of having liquidity. So I don’t think liquidity’s going to change our positioning for the third quarter or its materially going to change our investment activities for the fourth quarter.
Liquidity aside, we’re going to go slow and steady as we’ve done and continue to build our portfolio with the right quality assets if we see them. Now that said, we are seeing a disproportionate amount of very good solid deal flows coming in but even then it does not make the reason to go out and overrun your liquidity position today.
Jon G. Arfstrom - RBC Capital Markets
On your nonaccrual, David you said $4 million of it is being sold. Can you give us a little clarification on that?
Does that mean it’s in the process of being sold right now or you’re planning on selling it eventually?
David M. Lund
It’s in the process of being closed. I would anticipate that we would actually see that deal close in this third quarter here.
Manuel A. Henriquez
In that transaction the buyer’s already been identified and it’s like a credit facility in the final throes of finalizing the purchase and sell agreement.
Operator
Our next question comes from Robert Napoli - Piper Jaffray.
Robert Napoli - Piper Jaffray
Nice to see strong numbers out of at last one company this quarter. I mean you guys are in a different sector that should be a lot less affected by what’s going on in the economy so we’re not too surprised by what we see.
I have another call going on too so I missed a little bit of your call so I apologize if the question was asked. What type of pricing do you expect on the $300 million facility that you hope to get by the end of this month?
Manuel A. Henriquez
We expect to see improvement but we’ve not disclosed or discussed that. We think it would be too premature to do that at this point.
We’ve nailed down the terms, we’ve discussed those, we’re in the final throes of the actual agreement itself, but we will disclose that in the next couple weeks.
David M. Lund
And I can assure you that it’s lower than the current facility today. Across the board.
Robert Napoli - Piper Jaffray
If for some reason that transaction does not happen in the timeframe you’re expecting, how much can you invest?
Manuel A. Henriquez
As you can imagine in this current environment, we have run an inordinate amount of scenarios on originations and fundings in our business. We can actually make it all throughout 2008 without having to raise any additional capital whatsoever.
Another important point though I think that we should emphasize, and I’ll take this opportunity to do it, is our dividend basically for the year is pretty much already baked in-house done. Between our spill-over, our realized gains on our warrant positions and our continuing economic NII performance in our portfolio, our dividend is more than covered already by all the operations and the spill-over of 2007.
So there’s actually no risk whatsoever to the dividend unless we some unforeseen losses that we’re not aware of or don’t anticipate right now; the dividend’s fully covered. With that we can also modulate downward if we need to the originations in the third quarter and fourth quarter and make it throughout all calendar 2008 without any additional capital raised because as we said earlier a minute ago, we’re throwing off now anywhere between $30 million to $50 million of normalized principal repayment and in this quarter alone I think we had $70 million of principal repays.
So we’re having a very healthy return of capital back that we like and that allows us to continue to fund our business for the next two quarters easily.
Robert Napoli - Piper Jaffray
You said Manuel you had 11 takeouts in the first six months?
Manuel A. Henriquez
We’ve had 11 exists that are both repayments in full of the principal amounts whether in M&A activity, an IPO or an event driven event such as liquidation where they repaid the loan.
Robert Napoli - Piper Jaffray
Can you break it down by which event it was? How many were M&As?
How many were full repays?
Manuel A. Henriquez
Let me take a quick shot at it for you. We had four repayment events in the quarter and then we M&A we had three M&A events in the quarter.
I apologize. Add two more to the first column I said earlier.
And then we had one IPO of that such as Sirtris.
David M. Lund
That’s actually for the six months, not the quarter.
Robert Napoli - Piper Jaffray
I just wondered. With the IP market so bad, do you know of a number of your companies that are just biding their time waiting for the IPO markets to open?
Manuel A. Henriquez
I want to emphasize what we’ve said all along. We’re not dependent at all on the IPO market.
The IPO market if and when it opens up again will be highly accretive but the venture industry buying spar does not rely upon the IPO market. And the M&A despite what the broader media is saying, we’re not seeing any abatement in our portfolio of M&A activity.
I mean we’re seeing an incredible amount of M&A going on in our portfolio. Maybe it’s because we’re fortunate enough to picking the right companies but we’re not seeing any downward trend in M&A activities whatsoever.
Robert Napoli - Piper Jaffray
I understand that. We need IPOs more than you do probably.
I just wondered what you were seeing from an economic standpoint, if what your companies are telling you, the ones that may be looking to go to the IPO route if they feel like they’re going to go that direction sooner rather than later or just any color you had on that.
Manuel A. Henriquez
We all know and different sectors play differently, oftentimes companies in the life sciences sector will pursue an S1 filing to go public as a way of triggering an M&A event that may be looming. And I don’t think that’s going to change at all.
I think we’re going to be seeing probably two or three additional IPO filings in our portfolio the second half of this year.
Robert Napoli - Piper Jaffray
Let me ask a question about the structure of your company. Being a BDC is not an easy thing to do because you’re reliant on raising equity capital for growth and you’ve done a good job of raising more capital than what you need when you seem like you don’t need it, which is a nice way from a long-term perspective.
And your assets I understand are not traditional bank assets but you keep pretty low leverage. There’ve got to be more unfortunately bank depositories out there that have had problems that could be available.
I’m sure you’re aware of what Capital Source did on a much grander scale, but I just wondered what your thoughts were on long term, on capital structure and if you’ve thought about or you do have venture banks out there, if that’s a direction that you should go with this company long term or if you’re just totally comfortable with the BDC structure?
Manuel A. Henriquez
That’s a meaty question. The answer is clearly our Board of Directors and the management team of this company are constantly evaluating alternative sources of capital to grow one in particular that you just mentioned is the depository relationship whether as an affiliate relationship or even the possibility of somewhere down the road structuring a venture with a bank.
It’s certainly something that we will be and are looking at long term especially after Capital Source did what it did as a source of funding. So that’s certainly on the table and we’re evaluating that opportunity.
We’re also looking at, and we talked about this historically, somewhere as the market improves establishing the possibility of having affiliate funds that we manage on behalf of our shareholders where we have a source of capital to invest in specialty practices such as for example venture leasing where we actually have a leasing product that is derived with the pool of capital that we manage, because as a BDC there’s really no tax player benefit for leasing assets inside a BDC because of the [RIC] status. But we’re seeing a marketing opportunity that is emerging there that we will probably look to capitalize sometime in the next two to six quarters out, maybe longer, it’s all depending on the market.
But we are certainly actively looking at alternatives strategic directions to continue to grow the company. We’re fine with the BDC veneer.
We don’t have much problem with the BDC structure because as you said we tend to manage it on a much more conservative leverage basis and given our asset class and amortization, we’re not running up against a ceiling as other folks are.
Operator
Our next question comes from [Brandon Wohl] - Lehman Brothers.
[Brandon Wohl] - Lehman Brothers
I just wanted to ask real quick about two things. One, can you guys walk me through the spill-over from last year, the realized gains this year and what you can keep in-house versus what’s required to be paid out, because I think there’s some weird rule there that I don’t remember exactly?
And two, Manuel you spoke in your talk about you took down life sciences exposure by about 5% because of an adjustment you saw going on. I’m just interested in what adjustment you guys seeing going and how you feel about that going forward?
Manuel A. Henriquez
Let me answer the last part of the question while David gets the documentation to walk you through on the spill-over. It’s not that we don’t like and we’re de-emphasizing life sciences.
That’s not the impression I want to give. We’re still very bullish and extremely committed to the life sciences sector; however as we’ve seen in our own public life sciences holdings it’s a very volatile and choppy market right now.
And what we’re seeing is frankly really good opportunities in public life sciences companies that frankly should go private that may have gone out too early. And you’re seeing a dislocation and valuation differential between the private sector and the public sector in the life sciences areas where ironically you’re seeing higher valuations occurring in the private sector compared to the public side.
So we think that’s not generally a good trend and we think that trend needs to flip flop and get fixed, and I think we’re going to wait it out a little bit for one or two quarters to see how that takes place. But we’re certainly seeing good opportunity to go the private route on some of these publicly traded life sciences companies.
[Brandon Wohl] - Lehman Brothers
In terms of clearly this quarter this sector consolidation in life sciences started in a big way. Do you expect to see an acceleration in your M&A portfolio going forward there?
Manuel A. Henriquez
We’ve certainly seen obviously with Genzyme now being in play that a lot of pharma companies are much more inclined given their declining product lines coming off patent that they have no choice but to go out and buy biologics or biotechnology type drugs in order to put it in their distribution. So we think certainly that many of our portfolio companies will be exiting through pharma partner M&A events over the next couple of quarters.
And we’re pretty optimistic about that outlook.
David M. Lund
With regards to the first part of your question, the spill-over from prior year was approximately $0.13 that needs to be paid out in the course of this year. We do have the ability to either distribute a long-term capital gain, pay an excise tax and carry those over the following year and pay those out to shareholders in the subsequent year.
We also have the ability to pay the normal corporate tax rate on those and actually use them as permanent capital. We’ve not done that so far.
We believe that the amount that we’ve had in capital gains at this point warrants distribution as opposed to retention. But I’d be more than happy to discuss this further if you’d care to give me a call and go over the details.
Manuel A. Henriquez
Let’s get more specific. We’re sort of looking at right now, and again I have a caveat to all this because it can change in terms of performance.
Right now we’re looking at probably $0.11 or so in short-term gains in the portfolio realized so far. We have another $0.05 on long-term gains in the portfolio and approximately $0.13 in 2007 to 2008 spill-over that have taken place in the portfolio in and by itself.
And you see from our press release today we’ve already realized another $0.01 approximately which is not included in these numbers of long-term gains or so on one of our investments, Epicept which we just realized some securities on. So again we’re well positioned from our trailing taxable earnings and these spill-overs and these long-term gains and short-term gains to well position and more than cover the dividend.
[Brandon Wohl] - Lehman Brothers
You said short term 08 gains was $0.11 and long term was what?
Manuel A. Henriquez
Short term is approximately $0.11, long term is approximately $0.05, and spill-over is approximately $0.13.
David M. Lund
That’s on a year-to-date basis.
Operator
Our next question comes from Quinton Maynard - Morehead Capital.
Quinton Maynard - Morehead Capital
Most of my questions have been answered. I just want to know a little bit of color on the $3.4 million or I think maybe $3.5 million of depreciation particularly in light of the general loan quality improving in the quarter?
Manuel A. Henriquez
It’s made up of some unrealized losses that we had on some loans where we’ve actually written them down to estimated realized value based on the company’s performance so far. The net of that was about $718,000.
We’ve also had unrealized appreciation of a small amount in our equity portfolio that was very nominal. The biggest part was just net unrealized depreciation in the warrant portfolio of about $2.8 million.
And we do the calculation on a black [sholes] basis and a lot of the depreciation has to do with volatility in the market and the way that the metrics are put into the black [sholes] calculation and also just some flat rounds or even down rounds of some of the private companies we’ve had recently. But again the biggest part of this is really related to the warrant portfolio which fluctuates quarter-to-quarter.
David M. Lund
Let me just add further. It is broadly distributed with no one cell concentration making up that number.
So it’s not two or three companies. It’s a basket of probably 15 to 20 different companies that make that up.
Quinton Maynard - Morehead Capital
As you look at the $4 million that you’re preparing for sale, how much of the loan are you expecting to get back in that sale? Do you have any estimate internally on that?
Manuel A. Henriquez
We do actually. The number right now ranges from 98% to 99%.
Quinton Maynard - Morehead Capital
With your stock being where it is right now, I don’t know with the [inaudible] whether this is even something you can do, but have you all given any consideration to buying back any stock? It looks like the stock is yielding about the same as the effective yield on the whole portfolio if not a little bit stronger.
Manuel A. Henriquez
It’s a question every BDC right now is asking themselves and you saw I think one of our other BDC brothers out there; BlackRock announced a share buy-back. We continue to look at that share buy-back program and clearly obviously your point’s well taken that looking at the yield on it, but conversely we believe that we can originate very similar yields anyways on the underlying investments that we’re making.
So it’s a little bit of push to either buy when you can actually originate the same yields. So I don’t want to signal to the market that we can’t find good quality assets to underwrite.
But clearly as the stock has sustained itself at these levels, it’s certainly something that we’ll probably consider even looking at deeper than we have. But in the short term I think we’re just going through a tough patch right now and we’re not seeing any abatement of good investment opportunities out there to take that precious capital and buy-back our stock.
Operator
At this time we have no further questions in the queue so I’ll turn the call back over to management for any additional or closing remarks.
Manuel A. Henriquez
Thank you everybody for joining us today. I want to re-emphasize what I’ve said all along in each one of our calls.
If any investor would like to meet with management as we prepare to be on a non-deal road show here over the next couple of weeks, please feel free to contact us.