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

DBRS, Inc. (DBRS Morningstar) confirmed the Long-Term Issuer Rating and Long-Term Senior Debt rating of Hercules Capital, Inc. (Hercules or the Company) at BBB. The trend on the ratings has been revised to Stable from Positive. 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 revision of the trend to Stable from Positive incorporates the counterbalanced challenges and opportunities driven by the upheaval in the venture capital (VC) ecosystem following the failure of Silicon Valley Bank (SVB). In the immediate-term, as the Fed has backstopped uninsured deposits for SVB customers, cash is available for portfolio companies’ ongoing operations, importantly including debt service. As the largest VC lender, SVB provided revolving credit facilities and term loans to VC-backed companies, who likely will seek out alternative financing sources over the medium-term, creating a strong origination tailwind for well-capitalized direct lenders with ample available capacity within leverage targets, especially Hercules. While origination opportunities have strengthened, SVB was the key player in the VC and early stage company ecosystem, which will be hard to replace. Moreover, decreased portfolio company valuations from the market dislocation will likely drive mark-to-market losses in the near-term, challenging earnings strength. Hercules has a number of portfolio companies with exposure to SVB through cash management or financing relationships and is in continuous contact with VCs and management teams to navigate the near term disruption. Hercules’ technology and life sciences portfolio has a relatively short duration, giving flexibility to the Company to originate loans in sectors that have more attractive risk-adjusted returns over time. Importantly, the Company has sufficient capital to actively compete for new originations from existing SVB borrowers.

The ratings confirmation reflects Hercules’ consistently strong operating performance despite volatility in the VC-backed industries and stress in the VC financing ecosystem. The Company has sustained a scaled investment portfolio at $3.0 billion at 4Q22, generating high effective yields while maintaining sound investment portfolio performance. The ratings also consider Hercules’ diversified funding profile, access to multiple pockets of investor capital and expansion of its private credit funds, as well as its overall conversative leverage profile.

RATING DRIVERS
The ratings would be upgraded with sustained strong earnings and credit fundamentals while maintaining a conservative leverage profile.

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

RATING RATIONALE
Hercules’ established direct lending franchise provides access to an array of lending opportunities across VC-backed technology and life sciences portfolio companies without concentrations to any single VC firm. During 2022, the Company’s investment portfolio grew by approximately $530 million to $3.0 billion at fair value at 4Q22. At 4Q22, the portfolio consisted of 75.3% first lien, secured loans, 17.4% second lien, 1.8% unsecured investments, 4.5% equity investments and 1.1% warrant positions, across 120 debt-related portfolio companies and 110 warrant portfolio companies and 81 equity holding companies. As an internally-managed BDC, Hercules has been profitable every year since its IPO in 2005, despite down markets, increased volatility and competition in the direct lending space targeting VC-sponsored growth companies.

Since 2021, the Company’s investment advisor subsidiary, Hercules Adviser LLC, has deployed over $600 million of capital in investments in private credit funds, which allows the platform to speak for larger transactions without concentration issues while providing an outlet for expense support allocations. Hercules reported a net increase in net assets from operations (net income) of $102.1 million in 2022, compared with $174.2 million in 2021, as lower marks on the portfolio resulted in $86 million of unrealized depreciation for 2022. Net investment income (NII) was $188.1 million, a 25.4% increase year-over-year as higher base rates and a larger investment portfolio helped support stronger NII.

While we continue to believe 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’ historical credit performance has been consistently strong. Hercules has experienced $53.9 million of cumulative total net realized losses since inception, or an annualized loss rate of just 1.9 basis points. Non-accruals remained minimal at year-end 2022, with 0.6% of the investment portfolio at cost ($18 million) on non-accrual after peaking at 2.4% of cost at 2Q20 at the height of the COVID-19 pandemic. While we expect non-accruals will increase across the BDC coverage universe particularly with heightened risk in the market from SVB’s failure, we believe potential losses at Hercules will be manageable given their track record of portfolio monitoring and underwriting. Additionally, the investment portfolio is 95.3% floating-rate based, positioning Hercules to continue to benefit from a rising rate environment.

Hercules has a broad, diversified funding profile, with a robust institutional and retail fixed income investor base in both the unsecured and securitization markets, as well as supportive bank relationships for its credit facilities. The Company also has access to SBA debentures which have long duration and a low cost of financing. At 4Q22, Hercules had $1.6 billion of debt outstanding comprised of institutional and retail unsecured debt, securitization, and SBA debentures. The Company’s next term debt maturity is in July 2024 totalling $105 million, and the remaining debt maturities are well-laddered.

The Company has strong capitalization, operating within its stated target leverage ratio range of 0.95x to 1.25x debt-to-equity, at 1.01x on a regulatory leverage basis, which excludes SBA debt. At 4Q22, the cushion to the asset coverage ratio (ACR) cap was approximately $614 million, implying that Hercules would need to take a full loss on 21% of its investment portfolio at fair value to breach the 2.0x debt-to-equity regulatory limit. Over 2022, the Company was a more active issuer of equity through its at-the-market (ATM) program, raising $232.1 million of gross proceeds, compared with $10.8 million in 2021. Despite recent market volatility, Hercules’ equity still trades at a premium to book value, so any additional equity issuances are accretive to NAV which will keep leverage levels within its target range as the investment portfolio grows.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/ Social/ Governance factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (May 17, 2022)

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions: https://www.dbrsmorningstar.com/research/402314/global-methodology-for-rating-non-bank-financial-institutions. (September 2, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings: https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

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.

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

The conditions that lead to the assignment of a Negative or Positive trend are generally 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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