DBRS Confirms Hercules Capital, Inc. at BBB, Stable Trend

DBRS, Inc. (DBRS) confirmed the ratings of Hercules Capital, Inc. (Hercules or the Company), including the Company’s Long-Term Issuer Rating of BBB. The trend for all 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 and substantial scale in its niche lending market focusing on providing debt financing to high-growth venture capital (VC)-backed companies in technology, life sciences, and renewable and sustainable energy-related industries. Hercules is a relatively large business development company (BDC) where scale has certain advantages, including a greater capacity to source and finance deals through a borrower’s life cycle. The Company has demonstrated sound earnings generation capabilities, with solid profitability each year since inception in 2004, 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’ recent management changes with the highly publicized departure of its CEO, Manuel Henriquez, in March 2019 due to issues that were personal in nature. Initially, DBRS viewed the loss of Mr. Henriquez as a modest credit negative given his deep industry knowledge and strong track record. Since that time, DBRS has grown very comfortable with the capabilities of Hercules’ management team, its cohesiveness, and its ability to continue fostering franchise momentum while maintaining the current risk profile. Lastly, the ratings also incorporate Hercules’ exposure to VC-backed companies at various stages of development which introduces elevated credit risk. This niche exposure could adversely impact the Company if borrowers are unable to repay their loans due to an economic downturn or a pullback of VC funding.

RATING DRIVERS
Continued strong earnings generation, low levels of nonaccruals and disciplined balance sheet leverage could lead to positive ratings actions.

Significant earnings volatility due to the fair valuing of assets over multiple quarters, or sustained deterioration in earnings resulting in net investment yield consistently below 5%, would likely lead to negative ratings pressure. A deterioration in the buffer to the asset coverage ratio (ACR) beyond current targeted levels could result in a ratings downgrade.

RATING RATIONALE
Hercules has a strong franchise underpinned by certain competitive advantages, including scale and a well-established presence in the market. The Company is widely recognized as a leading global financing provider focusing on VC-backed companies. As its balance sheet has grown, Hercules’ capacity to underwrite larger deals has increased resulting in the Company broadening its lending to include expansion and established-stage companies. This position affords Hercules with good access to quality, attractive investment opportunities with strong risk-adjusted returns. As of 1Q19, Hercules’ investment portfolio totaled $2.1 billion at fair value (FV) across 93 portfolio companies. As a BDC, Hercules has various regulatory constraints including eligible investment assets, income composition, and leverage requirements. It has met these requirements to-date, and DBRS sees Hercules as well-positioned to maintain its regulatory compliance.

The Company has sound earnings generation capabilities supported by a healthy and consistent core yield from its investment portfolio. Total investment income is comprised predominately of interest income from debt investments, which is recurring and higher quality. Hercules’ equity and warrant investment portfolios generate minimal dividend income, but do offer the opportunity for earning enhancing gains. 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. Importantly, the Company has been solidly profitable every year since inception. In 2018, Hercules reported return on average assets (ROAA) of 6.8% and return on average equity (ROAE) of 13.6%.

Hercules’ risk profile is solid, supported by a well-designed risk management framework, good underwriting, and sound portfolio monitoring. Hercules has a long history and track record that allows for selectivity in originations given the high level of inbound deal flow. Nevertheless, credit risk is elevated given the relatively youthful age of the VC-backed companies that Hercules lends to, most of which are not profitable and are highly reliant upon future rounds of fundraising to complete a successful exit strategy. Hercules mitigates this risk by setting portfolio limits to ensure good diversity in the investment portfolio, regular portfolio company monitoring including prudent internal risk scoring, proactive portfolio management and a disciplined focus on the industry verticals in which the Company has expertise. This risk discipline is evidenced by generally low loss levels, with Hercules realizing net losses since inception of just $36 million on gross investments at cost of $6.7 billion. Furthermore, non-accruals continue to be very manageable comprising just 0.11% of the investment portfolio at cost as of March 31, 2019.

The Company has developed a broad funding profile that benefits from access to several funding channels. Its funding profile is generally more diversified than other BDCs. As of March 31, 2019, Hercules had $1.1 billion of debt outstanding, sourced from several wholesale funding channels, including Small Business Administration (SBA) debentures, convertible notes, asset-backed notes, and unsecured senior notes. Maturities are well-balanced with no meaningful maturity wall over the medium-term. Hercules has no debt maturing during the remainder of 2019, just $10 million maturing in 2020 and $54 million maturing in 2021. Liquidity is appropriately managed with sufficient liquidity to meet all unfunded commitments, as well as fund new investments over the near-term.

Hercules has a well-established track record of sound dividend coverage, strong net asset value performance, and disciplined management of the buffer to the ACR supporting its solid capitalization. In December, shareholders approved an increase in the Company’s regulatory leverage limit to 2.0x debt/equity. Hercules expects that its leverage will gradually move up to the high end of its target range of 0.95x to 1.25x over the medium-term. As of 1Q19, Hercules debt/equity ratio, excluding SBA debt, was 0.99x. The Company has been a disciplined manager of balance sheet leverage, and has demonstrated consistent access to the equity markets to support balance sheet growth, including a $72.7 million offering that closed on June 17, 2019. Hercules has received exemptive relief from the SEC to not include the SBA debt in regulatory leverage limits. As a BDC, the Company’s inability to retain its organic capital to support balance sheet growth is a ratings constraint.

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

The applicable methodology is Global Methodology for Rating Non-Bank Financial Institutions (November 2018), which can be found on our website under Methodologies.

The primary sources of information used for this rating include company documents and S&P Global Market Intelligence. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

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

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