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

DBRS, Inc. (Morningstar DBRS) 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 Positive from Stable. The Company’s Intrinsic Assessment (IA) is BBB, while its Support Assessment is SA3, resulting in Hercules’ final credit ratings positioned in line with its IA.

KEY CREDIT RATING CONSIDERATIONS
The trend revision from Stable to Positive is based on Hercules’ strong operating performance through 2023 despite broad challenges in the venture capital ecosystem. The Company’s franchise strength, access to capital and low leverage profile supported the Company’s performance and originations growth as the banking sector disruption in 1H23 caused competitors to pull-back lending to VC-backed companies. Further, we expect Hercules will be able to continue growing its market share while maintaining a conservative leverage profile and solid earnings even if the VC market remains unsteady.

The credit ratings confirmation reflects Hercules’ continued solid franchise as a marquee lender in the VC financing ecosystem with a scaled on balance sheet investment portfolio of $3.2 billion at 4Q23, with over $4.2 billion of assets under management across the platform. The investment portfolio generates high core yields and accelerated prepayments have supported earnings through accelerated fee recognition. However, with base rates at peak levels, we expect earnings to moderate over the medium-term even as its registered investment advisor (RIA) distributes dividends while providing expense support allocations. Hercules is one of the only BDCs to maintain annual profitability since 2005 through multiple economic cycles. While we consider the elevated credit risk profile of VC-backed companies, Hercules has a long-standing track record of low non-accruals and minimal defaults, with only 1.0% of the investment portfolio at cost on non-accrual at 4Q23, and an annualized loss rate of 1.4 basis points since inception. Additionally, the credit ratings are supported by Hercules’ diversified funding profile and conservative regulatory and financial leverage profile which were 0.77x and 0.87x debt-to-equity, respectively at 4Q23, well below the regulatory limit of 2.0x.

CREDIT RATING DRIVERS
The credit ratings would be upgraded with sustained strong earnings and credit fundamentals while maintaining a conservative leverage profile. Conversely, meaningfully worse operating performance would lead to a revision of the trend to Stable. A material increase in non-accrual investments well above normal ranges or operating with leverage substantially higher than its target range for a prolonged period would result in a credit ratings downgrade.

CREDIT RATING RATIONALE

Franchise Building Block (BB) Assessment: Good
Hercules continues to grow its direct lending platform, including third-party credit funds to invest in growth-stage VC-backed technology and life sciences companies, to $4.2 billion of assets under management at year-end 2023. At 4Q23, Hercules’ $3.2 billion on-balance sheet investment portfolio consisted of 83.6% first lien, 8.4% second lien, 2.2% unsecured debt, 4.8% equity investments and 1.0% warrant positions across 125 debt-related portfolio companies, 74 equity portfolio companies and 103 warrant holdings. The Company’s investment advisor subsidiary, Hercules Advisor LLC, (RIA) has deployed over $1.0 billion of investments in multiple private credit funds, and provides meaningful expense support allocations and has started dividend distributions to the Company.

Earnings Building Block (BB) Assessment: Good / Moderate
Hercules had net increase in net assets from operations (net income) of $337.5 million in 2023 compared to $102.1 million in 2022 which was constrained by unrealized losses from lower portfolio marks as the VC market pulled back valuations. Net investment income (NII) was $304.0 million for 2023, an increase of 61.7% year-over-year, benefitting from higher base rates, accelerated fee income from higher prepayments, and expense allocations with a weighted average core yield of 14.3% at 4Q23. We expect Hercules’ strong earnings to moderate over the medium-term as base rates appear to be at their peak levels and the Company refinances $275 million of debt maturities in 2024 and 2025 with a weighted average interest expense of 4.8% into potentially higher cost debt. This earnings headwind is somewhat mitigated by the increasing expense support allocations and dividend distributions from the RIA (approximately $10.5 million combined for the year 2023).

Risk Building Block (BB) Assessment: Good / Moderate
Hercules’ credit performance has been strong with low non-accruals (1.0% of the investment portfolio at cost at 4Q23) despite its approximately $40 million write-off in Convoy, Inc., a digital freight broker that shutdown during 4Q23 after a failed sale process. Hercules has a diversified investment portfolio balanced in both technology and life sciences portfolio companies working across many different VCs and sponsors. Hercules has experienced $45.4 million of cumulative total net realized losses since inception, an annualized net loss rate of 1.4 basis points. While PIK interest income increased modestly from $20.5 million in 2022 to $24.7 million in 2023, it has decreased as a percentage of total interest and dividend income (6.7% to 5.7%). Payment on PIK is normally received only in the event of a payoff, unlike cash interest income. Overall, the PIK receivable balance was only $38.0 million, or approximately 1% of total debt investments.

Funding and Liquidity Building Block (BB) Assessment: Moderate
Hercules has a broad, diversified funding profile supported by a deep institutional and retail fixed income investor base and strong financial institution counterparty relationships. The Company received a green light letter from the SBA to pursue an additional SBIC license that would allow Hercules to draw another $175 million of SBIC debt that is exempt from the regulatory leverage calculation. Hercules has $275 million of debt maturing in 2024 and 2025, so Morningstar DBRS expects some additional medium-term issuance of unsecured debt for refinancing purposes. Unsecured funding comprised approximately 70% of total drawn funding at 4Q23, providing a good level of unencumbered assets should the need arise for additional pledged assets. Liquidity of $743.9 million at 4Q23 is comprised of available capacity under the revolving credit facilities ($470 million), the letter of credit ($175 million), and unrestricted cash and cash equivalents ($98.9 million) compared to unfunded commitments of $335.3 million and non-binding term sheets of $676.8 million.

Capitalization Building Block (BB) Assessment: Moderate
Hercules’ continues to operate at a conservative capitalization level, benefitting from its stock that continues to trade at a significant premium to book value (1.6x P/BV as of March 19, 2024). This enables the Company to issue equity through both overnight follow-on offerings as well as its at-the-market program. In 2023, the Company raised $338.2 million of equity proceeds, up from $232.1 million in 2022. Hercules’ regulatory debt-to-equity ratio of 0.77x and GAAP debt-to-equity ratio of 0.87x at 4Q23 is well below its long-term target range of 0.95x – 1.25x and supportive of the credit ratings level. The cushion to the asset coverage ratio (ACR) cap was approximately $1.1 billion, implying that Hercules would need to take a full loss on 34% of its investment portfolio to breach the 2.0x regulatory limit. We estimate that if the additional $175 million SBIC debt is fully drawn and the $105 million July 2024 private placement is repaid, that pro-forma GAAP leverage would be 0.90x, and regulatory leverage would be 0.71x, which would still be supportive of the credit ratings. We note that the timeframe to receive the additional SBIC license remains undefined.

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

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at (January 23, 2024) at https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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 1, 2023): https://dbrs.morningstar.com/research/420144/global-methodology-for-rating-non-bank-financial-institutions. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

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

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS’ outlooks and credit ratings are monitored.

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