DBRS Morningstar Revises Hercules Capital, Inc.’s Trend to Positive; Confirms Ratings at BBB

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Hercules Capital, Inc. (Hercules or the Company), including the Company’s Long-Term Issuer Rating of BBB. At the same time, DBRS Morningstar has revised the trend on the ratings to Positive from 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 confirmation of ratings and revising the trend from Stable to Positive reflect Hercules’ continued strong performance supported by its defensible position in the venture capital (VC) ecosystem. The Company’s significant direct venture lending franchise has maintained robust earnings generation capacity while sustaining sound credit quality. The ratings also consider Hercules’ broad and diversified funding profile, as well as its conservative leverage.

Due to the volatility in equity markets and pullback from SPAC exits for the VC market over 1Q22, Hercules expects to experience a slowing in loan prepayment activity, which allows the Company to methodically grow its high yielding investment portfolios supporting earnings. Slower prepayments also will likely lead to the Company seeking new debt and equity capital to fund originations, instead of recycling cash flows from principal repayments. However, additional earnings from accelerated original issue discount (OID) and warrant and equity uplift may become more challenged in the current environment. Hercules has strong underwriting capabilities, well-established sponsor relationships and expertise in technology and life sciences industries, which should position the Company well for these market dynamics.

The Positive trend reflects the strength of the Hercules franchise that has sustained strong operating performance through business cycles and should be well-placed to manage a rising interest rate environment. The trend also considers DBRS Morningstar’s view that the geopolitical instability, while increasing risk to the continued U.S. economic recovery, will not overly burden VC-backed companies. Hercules’ technology and life sciences portfolio companies have largely been able to push through rising costs to their customers, which helps mitigate the profit margin pressures in their products and services as a result of inflation, supply-chain disruptions and increased energy costs. Further, as an internally-managed business development company (BDC), Hercules has raised several hundred million in third party private funds managed by its whole-owned adviser subsidiary, including dedicated financing facilities over 2021. We view this as a credit positive as management fees paid by the private funds will grow and Hercules will have additional pockets of capital for investment allocations of larger transactions, which will ultimately decrease concentration risk in the investment portfolio, once the separate funds are fully ramped.

RATING DRIVERS
The ratings would be upgraded with sustained strong earnings and credit fundamentals. The ratings would also be upgraded with continued growth of third party investment vehicles, whose co-investments may lead to diversification of the Company’s portfolio and reduce balance sheet risk.

Conversely, a reversal of earnings performance that erodes net asset value would lead to a revision of the trend to Stable. A material increase in non-accrual investments or a sizable loss that significantly reduces the Company’s capital buffer to regulatory requirements would also result in a ratings downgrade.

RATING RATIONALE
Hercules’ significant franchise provides deep access to a wide variety of VC lending opportunities across technology and life sciences portfolio companies, providing the Company ample access to attractive risk-return investment opportunities. At year-end 2021, the Company’s investment portfolio was $2.4 billion at fair value (FV), consisting of 90.8% debt investments, 7.6% equity investments and 1.6% warrant positions, across 92 debt-related portfolio companies and 155 warrant and equity-related portfolio companies.

The Company’s investment advisor subsidiary, Hercules Adviser LLC, has raised several hundred million from a number of institutional investors and dedicated fund financings, which has diversified Hercules’ revenue base while providing another outlet to syndicate larger loan transactions and non-qualifying BDC assets. The Company’s earnings have remained strong, with consistent profitability each year since 2005. Hercules reported a net increase in net assets from operations (net income) of $174.1 million in 2021, down from $227.3 million in 2020, primarily due to lower net realized and unrealized gains as portfolio valuations decreased. Total investment income (primarily comprised of interest income from debt investments) was $281 million in 2021 a slight decrease of 2% from 2020, and net investment income (NII) of $150 million a 5% decrease from 2020.

Hercules’ risk profile is solid, underpinned by a strong risk-management framework, and demonstrated underwriting and portfolio monitoring performance. The underlying credit risk of VC-backed loans is elevated as repayments are heavily reliant upon future rounds of fundraising or exits and not internal deleveraging. Hercules mitigates some of this risk by collateralizing its investments through first priority security interest in a portfolio company’s assets, which may include intellectual property. The Company also sets internal investment portfolio limits to ensure portfolio diversity and is proactive in portfolio management while focused on specific industry verticals within technology and life sciences. Life sciences portfolio companies, typically have longer time horizons and are less focused on near-term economic conditions, providing stability in a volatile market environment. The Company has had very low loss levels, experiencing just $58.8 million of cumulative total net realized losses since inception, or an annualized loss rate of just 2.6 basis points. Since 4Q17, non-accruals at cost have consistently remained low, peaking at 2.4% of cost at 2Q20, at the height of the coronavirus pandemic, and were only 1.0% ($24 million) at year-end 2021.

Hercules successfully refinanced its near-term debt maturities in early 2022 and has a broad, diversified funding profile, having accessed multiple different types of products and investor markets over its history. The Company’s funding is more diversified than other BDCs that primarily rely on secured revolving credit facilities with modest unsecured debt issuance. At year-end 2021, Hercules had $1.2 billion debt outstanding, comprised of institutional and retail unsecured debt, convertible notes, and Small Business Administration (SBA) debentures. Hercules refinanced $380 million of its convertible notes and institutional notes in early 2022, after raising $675 million in debt financing through two transactions in January 2022 and September 2021, that further unencumbered the balance sheet. Refinancing risk is well-managed with well-laddered maturities. Liquidity is appropriately managed with sufficient liquidity to meet all unfunded commitments ($287 million as of December 2021), non-binding term sheets ($382 million as of February 18, 2022), and fund new investments over the near-term with unrestricted cash of $133 million and revolver capacity of $470 million as of December 2021.

The Company has strong capitalization, operating below its target leverage ratio range of 0.95x to 1.25x debt-to-equity, at 0.84x on a regulatory leverage basis, which excludes SBA debt. The cushion to the asset coverage ratio (ACR) was approximately $778 million, implying that Hercules would need to take a loss on 32% of its investment portfolio at fair value to breach the 2.0x debt-to-equity regulatory limit. As the Company continues to trade publicly at a significant premium to book value (approximately 1.6x P/BV at April 11, 2022), it has capacity to raise equity either through its at-the-market (ATM) program or through overnight follow-on offerings.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 2, 2021): https://www.dbrsmorningstar.com/research/383936/global-methodology-for-rating-non-bank-financial-institutions. Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021): https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

The primary sources of information used for this rating include Morningstar Inc. and Company Documents. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

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