DBRS Initiates Coverage of Hercules Capital, Inc. at BBB, Stable Trend

DBRS, Inc. (DBRS) assigned a Long-Term Issuer Rating of BBB to Hercules Capital, Inc. (Hercules or the Company). At the same time, DBRS assigned a Long-Term Senior Debt Rating of BBB. The trend on the ratings is Stable. The Company’s Intrinsic Assessment (IA) is BBB, while its Support Assessment is SA3, resulting in Hercules’ final ratings positioned in line with its IA.

KEY RATING CONSIDERATIONS
The ratings and Stable trend consider the Company’s strong franchise with the necessary scale to maintain a leading position in providing debt financing to high-growth venture capital (VC)-backed companies in technology, life sciences, and renewable and sustainable energy-related industries. This also contributes to sound earnings generation capabilities, which provides for strong dividend coverage. Furthermore, Hercules has demonstrated a solid risk management framework with good underwriting standards and processes, as well as sound portfolio monitoring.

The ratings also consider Hercules’ exposure to VC-backed companies at various stages of development, which introduces elevated credit risk and could adversely impact the Company if there an industry-specific slowdown. The ratings also factor in any increase in leverage under the Small Business Credit Availability Act (the SBCA Act), which allows for a reduction in the Company’s regulatory asset coverage ratio (ACR) to 150% from 200%. Hercules’ Board has approved a reduction in the Company’s ACR to 150%, and shareholder approval is expected in December. As a business development company (BDC), the Company’s inability to retain its organic capital to support balance sheet growth and reliance on wholesale funding is a rating constraint.

RATING DRIVERS
A sustained improvement in earnings with net investment income yield exceeding 7%, while maintaining disciplined balance sheet leverage under the newly adopted regulatory limits, could lead to positive rating action. Consistent low levels of nonaccruals that are in line with the next highest rating level could positively pressure ratings.

A sustained deterioration in earnings resulting in net investment yield consistently below 5% would likely lead to negative rating pressure. An increase in realized losses on investments that consistently exceeds net investment income resulting in decreases in assets from operations or a sustained weakening of the buffer to the asset coverage ratio could pressure negatively ratings.

RATING RATIONALE
Hercules has a strong franchise underpinned by certain competitive advantages, including scale and well-established presence in the market. Hercules provides bespoke and flexible debt financing, equity capital and complementary services throughout the lifespan of its clients, which include VC-backed companies in the technology, life sciences, and renewable and sustainable energy related-industries. Since inception, Hercules has made over $8 billion in debt commitments to over 430 companies. At June 30, 2018, Hercules’ investment portfolio totaled $1.7 billion at fair value (FV) across 100 companies. As a BDC, Hercules has various regulatory constraints including eligible investment assets, income composition, and leverage requirements. The Company has met these requirements to-date, and DBRS sees Hercules as well-positioned to maintain its regulatory compliance.

Hercules is led by its founder, Chairman and CEO, Manuel Henriquez, who has more than 30 years of experience in the venture capital and financing community. While Mr. Henriquez’s vast experience, deep industry knowledge, and long-established relationships with the VC firms have been key contributors to Hercules’ success, it does introduce a level of key man risk that is considered in the ratings.

Hercules has been a disciplined manager of balance sheet leverage, and has demonstrated consistent access to the equity markets to support balance sheet growth. Regulatory leverage is viewed as moderate at 0.64x as of 2Q18. In March 2018, the SBCA Act was enacted into law, allowing BDCs to increase their balance sheet leverage due to a reduction in the regulatory ACR, subject to board of director or shareholder approval. The ratings consider the approval of the increase in leverage. In DBRS’s view, Hercules’ well-established track record of sound dividend coverage, strong NAV performance, disciplined past management of the buffer to the ACR and sound portfolio performance are supportive of the ratings despite the expected increase to leverage. DBRS notes that the Company’s new leverage ratio target of 0.95x to 1.25x remains within DBRS’s tolerance for the current rating and is amongst the lowest leverage targets set by a BDC following the adoption of the SBCA.

The Company has sound earnings generation capabilities supported by healthy and consistent core yield from its investment portfolio. For 1H18, Hercules generated net assets resulting from operations of $58 million, which compares strongly to full-year net assets resulting from operations of $79 million in 2017. Total investment income is sound comprised predominately of interest income from debt investments, which is recurring and considered higher quality by DBRS. The Company demonstrates good operating efficiency reflecting the scale of its franchise and good cost control. Hercules is an internally managed BDC, resulting in employee compensation and other administrative costs being consolidated on its income statement, which are not included in externally managed BDC financials.

Hercules’ risk profile is solid supported by a well-designed risk management framework, good underwriting, and sound portfolio monitoring. Nevertheless, given the relatively youthful age of the VC-backed companies that Hercules lends to, credit risk is elevated. Performance of the debt portfolio has been strong with only $43 million of net realized losses across the $8 billion of debt commitments since inception. Non-accruals also continue to be very manageable comprising just 0.16% of the investment portfolio at cost as of June 30, 2018. As of 2Q18, 86% of the investment portfolio was first lien senior secured loans. DBRS sees the Company as having some industry concentration, with approximately 81% of its investment portfolio at FV invested in just five industries. On the other hand, DBRS views positively that Hercules focuses on industry verticals where it has a strong and deep knowledge base. To manage concentrations in the investment portfolio, Hercules has set risk limits by single name, VC firm, and geography. Further, DBRS considers Hercules’ internally managed business model as a credit positive as there is less motivation to grow the investment portfolio to generate management fees.

The Company has developed a broad funding profile that benefits from access to several funding channels. Maturities are well-balanced with no meaningful maturity wall over the medium-term. Liquidity is appropriately managed with sufficient liquidity to meet all unfunded commitments, as well as fund new investments over the near-term. At June 30, 2018, Hercules had $818 million of debt outstanding, sourced from several wholesale funding channels. The Company had available liquidity of $195 million as of 2Q18, which is sufficient to meet potential near-term calls on liquidity. Additionally, Hercules generates liquidity through principal repayments on investments and prepayments, which totaled approximately $626 million in 2017.

Notes:
All figures are in U.S. Dollars unless otherwise noted.

The applicable methodology is the Global Methodology for Rating Finance Companies (November 2017), which can be found on our website under Methodologies.

The primary sources of information used for this rating include company documents. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Lisa Kwasnowski, Senior Vice President –Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG – Global FIG
Initial Rating Date: September 6, 2018
Last Rating Date: Not applicable as no last rating date.

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.

For more information on this credit or on this industry, visit www.dbrs.com.