Hercules Capital, Inc. Q4 FY2021 Earnings Call

Thank you for standing by, and welcome to Hercules Capital Fourth Quarter 2021 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your host, Michael Hara. Please go ahead, sir.

Thank you, Carmen. Good afternoon, everyone, and welcome to Hercules' conference call for the fourth quarter and full year 2021. With us on the call today from Hercules are Scott Bluestein, CEO and Chief Investment Officer; and Seth Meyer, CFO. Hercules fourth quarter and full year 2021 financial results were released just after today's market close and can be accessed from Hercules Investor Relations section at htgc.com. We have arranged for a replay of the call at Hercules web page or by using the telephone number and a passcode provided in today's earnings release. During this call, we may make forward-looking statements based on current expectations. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein due to timing delays between the date of this release and in the confirmation and final audit results. In addition, the statements contained in this release are not purely historical; they are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements, including, without limitation, the risks and uncertainties, including the uncertainty surrounding the current market turbulence caused by the COVID-19 pandemic and other factors we identified from time to time in our filings with the SEC. Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also can be incorrect. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained in this release are made as of the date hereof, and Hercules assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of related SEC filings, please visit our website. And with that, I'll turn the call over to Scott.

Thank you, Michael, and thank you all for joining us today. 2021 was a transformative year for Hercules Capital, and I am incredibly proud of what our team accomplished. Our record-setting performance in 2021 culminated with the strongest originations quarter in the company's history and the recent declaration of a new increased supplemental distribution program for our shareholders. Hercules Capital was able to deliver yet another strong year of outstanding originations performance, solid financial results and strong credit performance. In addition, 2021 marked the establishment and launch of our new private credit business under our wholly-owned registered investment adviser subsidiary, which has significantly expanded our platform capabilities and should help drive enhanced total shareholder return over time. We took additional steps in 2021 to further strengthen our balance sheet, enhance our funding flexibility, and drive down our cost of capital, which will allow us to continue to demonstrate to our existing and new borrowers the importance of having a partner with a strong and stable balance sheet and our ability to grow with these companies as they scale. In 2021, the health and vibrancy of the VC ecosystem, continued strength and expansion of our origination platform and capabilities, robust liquidity position and strong balance sheet put us in position to deliver achievements on multiple fronts, including record total gross debt and equity commitments of $2.64 billion, up 122% year-over-year and our fourth consecutive year with over $1 billion of new commitments; record total gross fundings of $1.57 billion, up 106% year-over-year; increased our base distribution to $0.33 per share; record cash distributions of $1.66 declared for 2021, a 23% year-over-year increase; record undistributed earnings spillover of $192.1 million or $1.65 per share based on ending shares outstanding; closing our first index-eligible public offering of $325 million, 2.625% notes; a record 40 portfolio company IPO and M&A events; and finally, over $225 million of investments assigned to and/or funded directly out of the new adviser funds that we manage through our wholly-owned RIA. As much as it was a year that showed the true strength of our brand, reputation and world-class originations team, it was also an important year of investments in the company that we believe will lead to further growth in our platform and ultimately to enhance total shareholder returns. Let me recap some of the key highlights of our performance for Q4. We originated a record of over $948 million of gross new debt and equity commitments, an increase of over 32% from our previous quarterly record and delivered record gross fundings of over $503 million, an increase of 17% from our previous quarterly funding record. Our technology and life sciences teams both turned in exceptional performance in Q4. Our funding activity was balanced between our 2 core verticals with a slight weighting towards life sciences investments during the fourth quarter. For the full year, our funding activity was split nearly evenly between our technology and our life sciences verticals. This unique portfolio balance and diversification strategy afford Hercules the ability to navigate the market irrespective of the macro environment. In addition to strong funding activity for new portfolio companies, we were also able to expand our funding relationship with numerous portfolio companies that continue to show strength and achieve performance milestones during the quarter. Given the magnitude of our new commitment activity during 2021, we expect this trend of increased follow-on fundings to existing portfolio companies to continue in 2022. The momentum that we saw throughout 2021 has carried into 2022, and we are pleased by our performance on originations quarter-to-date. Since the close of Q4 and as of February 18, 2022, Hercules has already closed $238.5 million of new commitments, and we have pending commitments of an additional $382.3 million in signed nonbinding term sheets. Our new deal pipeline currently exceeds $1 billion of potential investments, and we expect this number to increase and strengthen in terms of quality if the equity capital markets remain volatile. While the recent equity market volatility for certain growth stage companies may negatively impact net asset value short term, we expect it to be a long-term net benefit to our business in terms of increased investment opportunities. Consistent with our historical approach to underwriting credit and our internally managed structure that allows us to focus on total shareholder return versus growth at all costs, we will remain patient and disciplined on new originations irrespective of market conditions. During Q4, we continued to see strength in terms of portfolio company exits and liquidity events. For 2021, we had 16 M&A events, 16 companies that completed their public offerings through either traditional IPOs or SPAC mergers and 8 additional companies that are in registration or have agreed to SPAC transactions for a total of 40 exit and liquidity events, breaking our previous annual record of ‘22. This, combined with continued very strong performance across our broader portfolio, again, drove high levels of early payoffs. Early loan repayments were nearly $426 million, above the top end of our guidance of $300 million and a significant increase from $319 million in Q3. For the year, we had a record $1.1 billion of early payoffs, surpassing 2020's level of $709 million. This increase is solid evidence of the strength of our portfolio and the ability to pick the top companies to partner with. For Q1 2022, we expect prepayments to slow and be between $150 million and $250 million, although this could change materially as we progress in the quarter. The lower levels of early payoffs that we are projecting will reduce our short-term net investment income because of lower fee income but should position us to deliver greater net portfolio growth and enhance the longer-term earnings power of the business, assuming that originations remain strong. Even with the record levels of early prepayments in 2021, our record originations activity put us in position to deliver net debt investment portfolio growth of over $120 million, while at the same time allowing us to assign to and/or fund directly over $225 million of investments out of the new external private funds that we now manage through our wholly-owned adviser subsidiary. Our private funds business has allowed us to increase the size of our addressable market, scale further with our companies as they grow and continues to position us well to take advantage of market opportunities when they arise. Since launching our first private fund in Q1 2021, we have secured over $500 million of equity and debt commitments to date. This provides us with tremendous optionality and flexibility in terms of new business generation going forward. The majority of our prepayments in 2021 were directly attributable to M&A events and enhanced liquidity for many of our borrowers as a result of the strong capital markets for the best-performing companies. This trend continued in Q4, where over $225 million of our early prepayments came as a direct result of M&A transactions or equity capital markets events. The velocity of capital in our ecosystem makes achieving and sustaining scale difficult, but we have proven the unique ability to do this over the last 17-plus years, which is a clear differentiator of our business and our platform. In Q4, we generated total investment income of $72.5 million and net investment income of $40.4 million or $0.35 per share. Our portfolio generated a GAAP effective yield of 13% in Q4 and a core yield of 11.2%, which was consistent with our guidance for the quarter. With net regulatory leverage at a very conservative 73.9% and continued robust liquidity across our platform, we remain very well positioned. Credit quality on the debt investment portfolio remained solid in Q4 with a weighted average internal credit rating of 2.10 as compared to 1.92 in Q3. Overall, our grade 1 and 2 credits decreased slightly to 73.2% in Q4 versus 79.4% in Q3. Grade 3 credits increased slightly to 26.3% in Q4 versus 20.2% in Q3. Our rated 4 and 5 credits made up 0.5% of the entire debt portfolio's fair value. In Q4, the number of loans on nonaccrual remains the same with 3 debt investments with a cumulative investment cost and fair value of approximately $24 million and $10 million, respectively or 1% and 0.4% as a percentage of the company's total investment portfolio at cost and value, respectively. During Q4, Hercules had net realized gains of $6.3 million, comprised of gross realized gains of $9 million offset by $2.7 million of gross realized losses due to the loss on debt extinguishment. For 2021, Hercules had net realized gains of $20.9 million, comprised of gross realized gains of $25.3 million offset by $4.4 million of gross realized losses due to the loss on debt extinguishment. We ended Q4 with strong liquidity of $628 million, which provides us with substantial coverage of our available unfunded commitments of $287 million and the ability to fund our ongoing anticipated business activity. Seth will discuss our most recent institutional bond raise and the repayment of the convertible bond and redemption of our 2022 notes and how it will further drive down our cost of debt capital. We have made substantial progress in terms of lowering our cost of debt capital and pushing out our debt maturity wall over the course of the last several years, and these efforts are ongoing. The venture capital ecosystem continues its sprint to an all-time record, closing 2021 with fundraising activity at $128 billion and investment activity at $330 billion compared to $87 billion and $167 billion in 2020, respectively, according to data gathered by PitchBook and the National Venture Capital Association. To provide some reference, VC investment activity increased 98% year-over-year, similar to our own debt and equity commitments increasing 122% year-over-year. For the year 2021, inclusive of Q4, we have declared $1.66 of distributions to our shareholders, which is a 23% increase over the same period last year. Given the positive outlook that we have on our business, in combination with our record undistributed earnings spillover of approximately $192.1 million or $1.65 per share, our Board of Directors have approved a new supplemental cash distribution program of $0.60 for the next 4 quarters, payable $0.15 per quarter beginning with Q4 2021, which was previously $0.07 per quarter. The undistributed earnings spillover continues to provide us with added flexibility with respect to our shareholder distributions going forward and the ability to continue to invest in our team and platform. Throughout the course of 2021, we added talent to all levels of our organization and made investments in our infrastructure and platform. In addition, as we previously announced, we made 2 promotions that added a Chief Operating Officer and Chief Credit Officer to the executive management team as well as naming a new General Counsel. These investments and promotions are designed to best position us to source, service and support our growing and diversified investment platform. We accomplished a lot in 2021, and I am grateful to each of our talented employees who contributed to our success this past year. We set records for new fundings and commitments. We expanded our industry-leading platform with the launch of our private credit fund business. We further strengthened our balance sheet and enhanced our product offering capabilities. These achievements contributed to us being able to increase our shareholder distributions by 23% year-over-year and have positioned us incredibly well heading into 2022. We are thankful to the many companies, management teams and investors that continue to make Hercules their partner of choice. With our expanded platform, diversified business model and scale, we look forward to being able to support these companies over the years to come. I will now turn the call over to Seth.

Thank you, Scott, and good afternoon, everyone. With another record quarter for Hercules, we concluded a record-breaking 2021, achieving several of our key strategic objectives. Alongside our record investment activity, we strengthened our team, platform, and infrastructure, enhanced our balance sheet, and lowered our cost of capital. Since 2020, our weighted average cost of debt has decreased from 5.2% to 4.5% in the last quarter. We accomplished this in part by repaying more expensive legacy instruments through the issuance of $325 million in institutional unsecured notes at an attractive fixed coupon of 2.65%. Additionally, we established a new credit facility with SMBC, providing $100 million in extra liquidity at a lower cost and flexibility that aligns with our business needs. We ended the year with strong liquidity and modest leverage, well-positioned to take advantage of market opportunities in 2022. Our ongoing efforts to enhance our balance sheet and reduce our cost of capital continue, and I will provide updates on our progress in the first quarter of 2022 shortly. As usual, I will focus on four primary areas: income statement performance and highlights, NAV unrealized and realized activity, leverage and liquidity, and finally, the outlook. Now, looking at the income statement performance and highlights, our net investment income was $40.4 million, or $0.35 per share in Q4, an increase from the previous quarter, mainly due to growth in the net interest margin. Total investment income was $72.5 million, also up from the prior quarter. As seen in previous periods, the increase in fee income lagged behind the increase in payoffs, mainly due to the nature and size of the one-time and unamortized fees linked to the loans that were paid off. Our effective and core yields in the fourth quarter were 13% and 11.2%, respectively, compared to 12.7% and 11.4% in the third quarter. The slight decline in the core yield was due to a minor decrease in coupon interest. Regarding expenses, our gross operating expenses for the quarter slightly rose to $33.7 million, compared to $33.4 million in the prior quarter. After accounting for costs charged to the RIA, our operating expenses were $32.1 million, consistent with the previous quarter. Interest expenses and fees declined to $14.1 million, down from $14.7 million in the prior quarter. The acceleration of unamortized debt issuance costs from the repayment of securitizations in October is reflected separately as a realized loss this quarter. SG&A expenses increased to $19.6 million from $18.7 million in the prior quarter, exceeding my guidance. The rise compared to guidance and the prior quarter was driven by higher compensation costs, related mainly to record funding activity during the quarter. Net of costs recharged to the RIA, the SG&A expenses were $18 million. Our weighted average cost of debt was 4.5%, a reduction of 40 basis points compared to the prior quarter of 4.9%. This reduction resulted from refinancing $289 million in securitizations with an average interest expense above 4.6% and greater utilization of lower-cost SBA loans. Our ROAE or NII over average equity was 12.3% for the fourth quarter, and our ROAA or NII over average total assets was 6.1%. Moving to NAV and unrealized and realized activity, our NAV decreased by $0.32 per share to $11.22 per share during the quarter, showing a decline of 2.8% quarter-over-quarter. The primary reason for this decline was a $42.9 million change in unrealized depreciation, countered by $6.3 million in realized gains, leading to a $36.6 million decrease in NAV. This decrease largely stemmed from mark-to-market movements in our publicly traded equity positions. The net realized gain of $6.3 million included $9 million from equity and warrant disposals, balanced by a $2.7 million realized loss related to debt extinguishments. For leverage and liquidity, our GAAP and regulatory leverage stood at 95.6% and 84.1%, respectively, decreasing from the prior quarter due to a one-month overlap of the new debt issuance in September and the repayment of two securitizations in October. After accounting for cash on the balance sheet, our net GAAP and regulatory leverage was 85.4% and 73.9%, respectively, placing us in a strong position as we enter the new year. We continued utilizing our third SBA license, drawing down an additional $86 million in debentures at an attractive annual interest cost of around 2%. At year-end, we had access to an additional $24.5 million in SBA debentures for qualifying investments. We concluded the quarter with robust liquidity of $628 million, not including capital raised by our wholly-owned RIA subsidiary. Following the year-end, in January, we issued $350 million in institutional unsecured notes at an attractive fixed coupon of 3.375%. These proceeds were used in February to redeem $230 million of 4.375% convertible notes at maturity and $150 million of 4.625% October '22 notes at a slight premium for early redemption. Together with previous steps taken in late 2021, this represents a refinancing of over 50% of our outstanding leverage, postponing our next major long-term maturity date to 2024 and further reducing our overall cost of debt capital. Finally, regarding outlook points, for the first quarter, our core yield guidance remains at 11% to 11.5%, consistent with our experiences in the second half of 2021. It’s worth noting that 94% of our debt portfolio is floating with a 4% floor, so the anticipated interest rate hikes in 2022 will ultimately benefit our core yield moving forward. Although it's challenging to anticipate, as Scott mentioned, we expect $150 million to $250 million in prepayment activity in the first quarter. In line with 2021, we anticipate first-quarter prepayments will result in a lower acceleration fee recognition rate of 2.5% to 3% due to the average vintage of the prepayments. We expect our first-quarter interest expense to remain stable compared to the previous quarter. While we've made strides in lowering our long-term cost of debt, the refinancing completed in the first quarter will lead to some cost duplication due to the timing of borrowing and repayment of the two instruments. For the first quarter, we project gross SG&A expenses of $19 million to $20 million, with the midpoint aligning with the fourth quarter. It's important to remember that the first quarter typically incurs higher payroll taxes. We expect an RIA allocation similar to what we experienced in the second and third quarters of 2021, around $1.2 million to $1.3 million, since the fourth quarter was elevated due to increased originations and allocated business. Given our cost-saving actions taken thus far, I want to highlight two points relevant to our first-quarter outlook. First, concerning the refinancing of the $150 million October '22 notes, we expect approximately $3.6 million or $0.03 per share loss on debt extinguishment to be recorded as a realized loss, which includes the premium on early redemption and the acceleration of unamortized debt issuance costs. Second, regarding the settlement of the $230 million convertible notes, we opted to settle the principal in cash and the option value in shares. The option settlement led to the issuance of just under 1 million shares, affecting the Q1 net asset value and likely resulting in short-term dilution of net investment income. This, combined with the anticipated lower prepayments in Q1, fewer calendar days in the quarter, and the previously mentioned higher payroll taxes, will probably result in lower net investment income per share in Q1 compared to Q4. We are wrapping up an exceptional year and are looking forward to another strong year ahead. I will now turn the call over to the operator to start the Q&A session.

Your first question comes from Crispin Love with Piper Sandler.

First on the migration of Grade 1 to Grade 2 and 3 credits. Can you give a little bit more detail on what drove that, if there were any specific subsectors where you saw any degradation there? And then other than what drove that, just kind of what your near-term expectations are for credit quality and just the health of the companies in your portfolio?

Thank you, Crispin. The changes in credit ratings were not significant in any category. The main reason for the decline in rated 1 credits was due to payoffs. Several larger rated 1 credits had their loans paid off in Q4 due to M&A transactions. As those Grade 1 credits were eliminated, the percentage of grade 1 credits in our portfolio decreased quarter-over-quarter. There was nothing significant to address aside from three large Grade 1 credits that paid off because of M&A transactions during the quarter. Regarding our credit outlook, we continue to see strength across the portfolio. There was a slight decrease in the weighted average credit rating across the portfolio in Q4, but nothing major. Year-over-year, our weighted average credit rating at the end of Q4 was 2.10, compared to 2.16 at the same time last year. This demonstrates stability throughout the year, and we are not noticing any indicators suggesting that we will not maintain a stable credit environment for our portfolio moving forward.

So that's helpful. And then just on the environment as a whole, how are you viewing the current environment, especially with the volatility that we've been seeing in public market valuations? And then from your seat as well, how have public valuations fared relative to private valuations? And then just how do you expect the volatility to impact equity raising, IPO exits and then just your debt levels?

Sure. So there's a lot there. And what I would tell you is our view of the current environment is that it's actually quite attractive for us, which is why I think you heard a lot of optimism in terms of our prepared remarks and why you're seeing the activity that you're already seeing in terms of our Q1 closed and Q1 pending numbers. Volatility in the equity markets, whether it's public equity or in the private markets from a private capital raise perspective, will negatively impact net asset value short term, right? Our book is mark-to-market on a quarterly basis. If the stock prices for our public equity and warrants go down, you'll see some NAV decline quarter-over-quarter, and that's what you saw in Q4 of this year. From an NII perspective, we view it as a long-term net positive because we expect to see and we are seeing more opportunities for us to make attractive investments. We are seeing better-quality companies come to us looking for debt solutions. And I think this is where having an experienced team that's been doing this for 17-plus years is a key differentiator of our business. There are a lot of companies right now that are looking to the debt markets because they don't view the equity markets as attractive, and then there are a lot of companies that are looking to the debt markets right now because they just simply can't raise equity. And I think having a team that can distinguish and differentiate between those 2 scenarios is critical. I think we have a proven track record of being able to identify in volatile markets those companies that can raise equity just want to defer it because the valuations aren't there versus going after and chasing the companies that just can't raise equity. And so we're very optimistic about the current environment. We're obviously cognizant of the increased volatility, and it's something that we're watching pretty closely. But we are absolutely of the view that, that's a net positive for our ability to originate attractive quality deals on a short- and medium-term basis here.

Our next question comes from Kevin Fultz with JMP Securities.

In your prepared remarks, you noted that prepayment activity in the current quarter is coming down a bit. Can you talk about your expectations for Hercules investment portfolio growth over the next few quarters?

Sure. So we don't provide portfolio growth guidance, and we don't provide NII guidance on a go-forward basis. What I can tell you is that we do expect prepayments to slow. If you look at the last 2 quarters of 2021, in Q4, we had $425 million of prepayments. In Q3, we had $319 million, and then our guidance for Q1 is $150 million to $250 million. So we do expect on a short-term basis prepayments to decline, which given the strength of our originations activity should lead to greater net portfolio growth short term, but we don't have a specific number that we're prepared to speak to in terms of guidance. And then longer-term outlook, it's still difficult to sort of provide any perspective on prepayments longer-term. If you were to ask us today, our expectation would be that we expect prepayments to normalize and revert back to what we traditionally saw going back the first half of '21 into 2020.

Okay. That's helpful. And then just a follow-up question relating to interest rate sensitivity. Could you provide the weighted average LIBOR floor for floating rate investments?

Say it again, Kevin, you said the weighted average floor?

The weighted average LIBOR floor for floating rate investments.

So our floor is 1% on our LIBOR loans. So it's not weighted average, it just is 1%.

Got it. Okay. That's helpful. And that's it for me, and congratulations on a strong quarter.

Our next question comes from Finian O'Shea with Wells Fargo Securities.

Scott, during the COVID era last year or 2 years ago, you would give us certain metrics on the liquidity runway for your portfolio companies. Not expecting you to have that in front of you still. But if you do, can you touch on it or otherwise tell us how that has trended into today's market?

Sure. Thanks, Fin. So we stopped providing that about a year ago, so we do not have that at the top of our tongue here for the call. What I would tell you is from a high-level perspective, we really haven't seen any material changes throughout the course of 2021. Capital raising for our portfolio continued to be incredibly strong and robust in Q4. We had several companies, some that were public, some that were private, raise large rounds of financing in Q4 on a quarter-to-date basis. We have continued to see companies be able to raise equity capital. So from an RML perspective or from a key metrics perspective, we really wouldn't anticipate there being any material change from some of the items that we discussed historically. So we don't have that information updated as of Q4.

Sure. Understood. That's helpful. And just a follow-up for raising for Hercules. I think you said the fund is $500 million or so now. Can you remind us how you think about capital raising between the BDC and the fund you manage? Is there some relative return or opportunity analysis? Or have you been just focused on getting that scaled? And where are you in that journey?

Sure. The focus for us is on both platforms: the public BDC and the private fund business. I would point out, again, the model that we've been able to utilize to set this up is unique in the industry. All of the benefit of our private credit fund business, whether it is additional net investment income or net asset value appreciation as a result of the valuation of that RIA business, accretes to the benefit of our public company shareholders. So when we think about public BDC versus private credit funds, we're largely agnostic. Because the reality is, the better performance that we get out of the private fund business, the better it is for our public company shareholders. The private fund business over the course of the last 12 months has really accomplished exactly what we expected it to accomplish. It's allowed us to pursue larger, more later-stage transactions. It has significantly increased the addressable market that we're able to pursue, and you can see that by virtue of what we accomplished in 2021 with $2.65 billion of commitments, $1.6 billion of fundings. The private fund business has also allowed us to be really more competitive with respect to some larger public transactions and some international transactions, and it's also provided a significant benefit on a short-term basis to our shareholders by virtue of the fact that we're able to spread the costs of our platform across not just the public BDC but now also through the private credit fund business as well.

That's helpful. Congrats on the quarter.

Our next question comes from Christopher Nolan with Ladenburg Thalman.

Seth, when assuming the Fed raises rates, what's the timing difference do you expect to hit for the left and right side of the balance sheet?

So on the left and right sides of the balance sheet, the situation on the left is quite immediate. It will generate additional income for us, assuming the interest rate is not significantly below the floor, which it shouldn’t be. On the right side, our credit facilities consist of floating instruments. As you may have noticed, there was minimal borrowing against the $500 million capacity available in the credit facilities, around $29 million or $30 million from what I recall. The impact will depend on how much those facilities are used, but most of our $1.25 billion in debt is at a fixed rate.

As a follow-up, with the market anticipating several Fed rate hikes, how do you expect your prepayment volumes to change? Will they increase or decrease? What are your thoughts on that?

I believe, as Scott mentioned, the overall market volatility and the Fed's actions to reduce liquidity should be beneficial for us, not just for originations but also in returning to a new normal. The exact position we reach remains to be seen, but it will likely be less than $1.1 billion compared to 2022, similar to what we observed in 2021. Therefore, I expect that these actions will help us retain business and originate even better opportunities.

Our next question comes from Kenneth Lee with RBC Capital Markets.

One on the follow-up on the liability side. You talked about lowering some funding costs over the past year. Wondering if you could talk about any further expectations of further optimizations on your funding costs going forward?

Yes, absolutely, Ken. So as I mentioned, we've refinanced more than 50% of our fixed-rate instruments, and we've really addressed everything that was within reach of a reasonable economic prepayment penalty, where we felt that it was advantageous for us, for our shareholders, to make any prepayment penalty with the given interest rate environment. So I would say that we will continue to strategically evaluate the present value of each of those instruments that we still have outstanding and determine whether there are additional instruments that come available, for instance, in the passage of time when make-whole premiums become more reasonable as they're constructed in the instruments or as interest rates move in the correct direction to beneficially cause us to decide that economically it makes sense to go out and refinance additional portions of that. But at the moment, we have no plans that we could communicate related to that. It's just a statement that absolutely we'll do what economically makes sense for the shareholders.

Great. And just one follow-up if I may, and this is just a follow-up to some of the previous questions around the volatile equity markets. Wondering if you could just talk about what you saw historically in terms of the volatility around equity markets and potential implications for the debt investment valuations. Maybe just talk about what you're seeing around loan spreads currently.

Sure. So from a spread perspective, we're seeing a pretty stable environment. In Seth's prepared remarks, we gave core yield guidance for Q1 of 11% to 11.5%. That is consistent with our core yield guidance throughout the course of 2021. We're really not expecting to see much change there with respect to core yield guidance. And so we really, from a pure sort of correlation perspective, we're expecting a pretty benign environment as it relates to that question.

Our next question comes from Ryan Lynch with KBW.

I wanted to ask about Scott's comments regarding the outlook for credit quality in your portfolio, which you mentioned looks strong moving forward. Considering the volatility in the equity markets and the pressure on private market high-growth valuations, it seems that some of your portfolio companies might find it more challenging to secure additional rounds of capital at their previous valuations, given the overall valuation adjustments in these private markets. This could potentially exert pressure on some of your borrowers. I would like to know your thoughts on this.

Sure. So valuation and valuations in general are really just one part of the analysis that we do when we're thinking about sort of credit, credit performance, credit rating and credit outlook. If you look historically at how we underwrite credits, we're typically underwriting these loans at a loan to value of 10% to 20%. Weighted average loan-to-value across our portfolio at the end of the year was roughly 13%, 14%. So even with a significant or a material downtick in valuations, the loan to value across our portfolio continues to be incredibly attractive. Companies that are not raising equity capital because they can't are obviously going to be negatively impacted from a credit perspective. We would view those situations very differently than we would view a company that is simply deferring an equity round because it's not happy with the valuation. If the company is performing from a metric perspective from some of the other KPIs that we look to when determining credit, it really doesn't have a significant impact. I would also point out, and we made this comment throughout the course of 2021, when you had those few periods where our weighted average credit rating dropped below 2x, that was not a normal credit environment for us. If you look historically, going back 17 years, our weighted average credit rating has typically been in the 2.2 to 2.5x range. And so for us, that is reflective of a very stable credit environment. We're still below that. When you look at our weighted average credit rating at the end of Q4 at 2.10. So while there could be some decline in that weighted average credit rating over the course of the next couple of quarters, we are not seeing any signs that would lead us to believe that it's going to revert outside of our historical credit performance metrics.

Okay. Have you noticed any meaningful change in some of your borrowers' willingness to try to raise additional equity in these markets? Or are they also looking for different sources, as you mentioned the opportunity set for you as they may pursue more debt options versus equity options?

It's a great question. We've really noticed it more from the perspective of potential new borrowers. There were several companies that we were having conversations with consistently throughout the course of the last year that kept sort of deferring that decision to go forward and raise debt capital because they were contemplating either a private equity round or raising equity capital in the public markets. We've seen a significant increase in the number of those companies coming back to us over the course of the last 60 days and now just with a very different tone and sort of context for the discussions. Whereas last year, it was we like what you're able to offer, but we just think the equity markets are more attractive. Now a lot of those companies are coming to us and saying, 'We're going to move forward and we're going to do a round of debt financing here,' and wanting to talk to us, which is why we are incredibly optimistic about our originations activity over the short to medium term. So we've seen it more from a new borrower perspective than we've really seen it from a portfolio perspective. The companies in our portfolio that we're contemplating raising rounds of capital have largely done so over the course of the last 90 days.

Okay, I understand. On a different note, I'm looking for more clarity on the expense reimbursements from the adviser since you indicated that they are expected to decrease in Q1, closer to levels seen in previous quarters Q2 and Q3. I would have expected that as the assets under management with that adviser have grown over the last few quarters, the expense allocation would have actually increased. So I was surprised by the guidance predicting a decrease in Q1. Can you explain how the expense reimbursement is determined? Is it based on the net operating income from those funds, which you mentioned were stronger in Q4 but may decline in Q1 due to lower prepayment fees? Any additional information on this would be appreciated.

Yes. Ryan, your question is pretty logical. It makes sense. So let me explain the construction of it. I gave that guidance because we did have an outsized record quarter in originations, new fundings, not only could the commitments, but the fundings as well. And we're certainly not projecting that we beat that again in the short term. So hopefully, we do. But the construction of it is really 3 categories of expenses. One, the direct expenses related to originating and funding business that gets allocated or originated by the funds themselves, so that includes the originator bonuses that we've talked about in the past that are the variable part of our compensation. The second is a much smaller portion of it related to AUM. So those support functions, finance, operations, legal, anybody that is working related to the continued operations of those funds. And that is largely connected to either time allocated or AUM if there's a pure math associated with that. And then direct expenses, which is an even smaller portion of it, related to accounting services, legal services that the funds themselves need to procure and certainly any investment services. So it's those 3 categories, and the biggest category is that first one, and that is why we're guiding to a lower allocation because we're not guiding to a record quarter of funding.

We have a question from Casey Alexander with Compass Point.

Stacy, I've been called worse than that before. So I have 2 questions. First of all, in the fourth quarter and also in the subsequent events, putting them together, the company looks like it sold about 2.1 million shares of common stock under the equity ATM program. I'm just curious what the thinking is in terms of selling your own stock as opposed to just raising those funds with a publicly-traded equity portfolio that's of much larger size, is equally as liquid. I'm just curious, why go the direction of selling your own stock as opposed to some of the publicly-traded equity that you held, even though maybe you're not top taking it, is still well ahead of much of its cost?

Sure. Thanks, Casey. Great question, and 2 specific things that I would say on that. So number one, if you think about what we did from a liability perspective over the course of the quarter, we paid off $380 million of debt between the prepayment or the payoff of the convertible note in February as well as the October 2022 bond retirement, and we replaced that with a $350 million unsecured institutional public bond. So there was a small delta there between the $350 million that we raised and the $380 million that we paid off. The second part, which is the more important piece, is we are seeing tremendous strength right now from an originations perspective. You pointed out some of the subsequent disclosures. We also disclosed between our closed and pending commitment activity through February 18. We're already at about $621 million of closed and pending transactions. And we're also projecting, per Seth's comments, prepayments to slow pretty considerably down to that $150 million to $250 million guidance. So some of that activity was really essentially in preparation for what we expect to be enhanced portfolio growth over the course of the next quarter or 2, and those are really the 2 key drivers of that. I would also point out that through the course of Q4, we did continue to sell some of our public stock positions. We had close to $10 million of net realized gains from dispositions of our public stock positions, and we would expect those efforts to continue to monetize some of those positions, obviously, subject to market conditions to continue.

Great. My other question is about how shareholders are currently benefiting from the special distributions that are helping to reduce a significant amount of spillover, which I believe Seth mentioned is around $1.60 per share. What needs to happen to lower that spillover to a level where you feel comfortable no longer needing to issue special supplemental distributions? Is it below $1 per share? What are your thoughts on this?

Yes. I think you hit the nail right on the head there, Casey. There is no preset sort of target. But in an ideal situation, we would work that spillover down to about $1 per share. Right now, it's at $1.65 per share. If you assume no activity in the course of 2022, which is obviously not a real expectation, but if you just sort of model it out, if we did nothing from a realized activity up or down in 2022 with the $0.60 supplemental distribution that we declared now, we would get that $1.65 down right roughly to about $1 per share at the end of 2022, assuming no other changes.

Thank you. And I'm not showing any further questions in the queue. I will pass it back to management for any final thoughts.

Thank you operator, and thanks to everyone for joining our call today. As a note, we will be participating in the Piper Sandler Western Financial Services Conference on March 8. If you would like to arrange a meeting with Hercules management, please contact Piper Sandler directly or Michael Hara. We look forward to reporting our progress on our next earnings call. Thank you, and have a good night.

And with that, ladies and gentlemen, we thank you for participating in today's program, and you may now disconnect.