Morningstar DBRS Upgrades Hercules Capital, Inc.'s Long-Term Credit Ratings to BBB (high) From BBB and Revises the Trend to Stable From Positive

DBRS, Inc. (Morningstar DBRS) upgraded the Long-Term Issuer Rating and Long-Term Senior Debt rating of Hercules Capital, Inc. (Hercules or the Company) to BBB (high) from BBB. The trend on all ratings has been revised to Stable from Positive. The Company's Intrinsic Assessment (IA) is BBB (high), while its Support Assessment is SA3, resulting in the Company's final credit rating being equalized with its IA.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings upgrade reflects Hercules' sustained strong operating performance through 2024 even with lingering challenges in the venture capital (VC) ecosystem as exit activity remains limited. Hercules continued to grow its assets under management (AUM) by approximately 14% year-over-year to $4.8 billion, solidifying its position as the largest non-bank dedicated lender to the VC ecosystem with a well-established franchise. Additionally, the Company's asset level credit performance, diversified funding profile, and conservative balance sheet leverage support the credit ratings upgrade. While we consider VC-backed companies to generally have elevated credit risk profiles, Hercules non-accruals have remained low compared to Morningstar DBRS rated BDC peers, and at Q4 2024 totaled 1.7% of the investment portfolio at cost. Meanwhile, only 5.5% of the investment portfolio at cost was fair value marked at 85% or below of cost. The Company received its fourth SBIC license in July 2024, unlocking access to $175 million of low-cost debentures, which do not count toward its regulatory leverage. Hercules' leverage remained low at 0.76x regulatory debt-to-equity, well below its target range, which is also supportive of the credit ratings.

In connection with the credit ratings upgrade, the trend has been revised to Stable from Positive. The Stable trend considers our expectation that Hercules will continue to benefit from its franchise leading scale despite the uncertainty the impact of changing U.S. government policies may have on the VC market. While profitability may be pressured by yield compression, we expect the Company may selectively increase leverage towards its target range, which should help maintain dividend coverage while providing capital to deploy in a healthy origination market.

CREDIT RATING DRIVERS
Over the longer-term, strong operating performance, continued funding diversification and maintaining a conservative leverage profile would result in a credit ratings upgrade. Conversely, a meaningful increase in non-accrual investments or a sizeable loss that materially reduces the Company's cushion to regulatory leverage requirements would lead to a credit ratings downgrade. While not expected, if leverage increases beyond the Company's long-term target range of 0.95x to 1.25x debt-to-equity for a sustained period, the credit ratings would also be downgraded.

CREDIT RATING RATIONALE

Franchise Building Block Assessment: Good
Hercules' venture lending franchise has been amplified by its investment advisory subsidiary, Hercules Advisor LLC (RIA) which has enabled the Company to manage an additional $1.0 billion, bringing its AUM to $4.8 billion at Q4 2024. This capital is deployed across its investment strategies and helps Hercules maintain portfolio company diversity on-balance sheet with its $3.7 billion investment portfolio which consisted of 87.0% first lien, 6.4% second lien, 2.1% unsecured debt, 3.5% equity investments, 0.8% warrant positions and 0.2% investment funds and vehicles. As of December 31, 2024, Hercules' investment portfolio included 118 debt-related portfolio companies, with warrant positions in 98 companies and equity holdings in 72 companies.

Earnings Building Block Assessment: Good / Moderate
The Company's earnings power continues to be solid even though the weighted average effective yield on debt investments decreased by approximately 160 basis points from the prior year to 13.7% at year-end 2024, as the Prime rate decreased by 100 basis points over the period. The Company reported a net increase in net assets (net income) of $263.0 million for full year 2024, constrained by $62.9 million of net realized and unrealized losses, compared to net income of $337.5 million for 2023. Net investment income (NII) was $325.8 million for 2024, up from $304.0 million in 2023, supported by the larger investment portfolio as well as higher expense support allocations and dividend distributions from the RIA. We note that PIK income has increased to $51.3 million or 10.4% of total investment income in 2024 compared to 5.4% in 2023, which may be a harbinger of portfolio company liquidity issues but has so far been mostly due to competitive reasons at deal origination. We expect PIK income will be managed lower through selective new originations. We believe earnings may moderate with further yield compression, though high Prime floors and the increasing benefits from the RIA mitigate some downside risk.

Risk Building Block Assessment: Good / Moderate
While we continue to view the credit risk of VC-backed loans as elevated as repayments are typically reliant upon future capital raises and exits to repay obligations instead of internal cash flow deleveraging, Hercules' credit performance over a long-track record has consistently been strong compared to other venture lenders as well as broad BDC peers. Non-accruals were 1.7% of the investment portfolio at cost at Q4 2024. Only 5.5% of the investment portfolio at fair value was marked at or below 85% of cost at Q4 2024, though there is the potential for further credit deterioration if the VC ecosystem experiences volatility. Hercules' diversified investment portfolio consists of both technology and life sciences companies across many different VCs and sponsors with its ten largest positions representing 31.6%.

Funding and Liquidity Building Block Assessment: Moderate
Hercules's diversified funding consists of public and private debt in the retail and institutional markets, a securitization, and SBA debentures. In July 2024, the Company received its fourth SBIC license, which allows Hercules to issue an incremental $175 million in low-cost SBA debt which is excluded from regulatory leverage metrics. The Company's debt maturities are well-balanced with $170 million maturing in 2025 ($50 million of which was repaid in February 2025) and $425 million in 2026, excluding revolving credit facility borrowings which we expect will be amended and extended. The Company priced a $250 million convertible note offering at 4.75% due September 2028, which is expected to close on March 10, 2025, and further diversifies its funding. Unsecured funding comprised approximately 52% of total drawn funding at Q4 2024 pro-forma for the $50 million February 2025 repayment, providing a high level of unencumbered assets should the need arise for additional pledged assets. Liquidity of $658.8 million is comprised of cash and cash equivalents, revolver and letter of credit capacity, and undrawn SBA debentures compared to unfunded commitments of $448.5 million at Q4 2024.

Capitalization Building Block Assessment: Good / Moderate
Hercules has maintained its conservative capitalization level at 0.76x regulatory debt-to-equity and 0.90x GAAP debt-to-equity at Q4 2024, with a regulatory average of 0.83x throughout 2024, well below its target range of 0.95x - 1.25x. This leverage level is supportive of the credit ratings. The cushion to the asset coverage ratio (ACR) cap was approximately $1.2 billion, implying that Hercules would need to take a full loss on 34% of its investment portfolio to breach the 2.0x regulatory limit. Hercules also benefits from its public equity which trades at a significant premium to book value (1.6x P/BV as of March 5, 2025), which enables it to raise accretive equity through both overnight and at-the-market offerings, and in 2024 raised $218.3 million of net proceeds.

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 Factors in Credit Ratings (August 13, 2024) at https://dbrs.morningstar.com/research/437781/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-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 (November 19, 2024): https://dbrs.morningstar.com/research/443208/global-methodology-for-rating-non-bank-financial-institutions. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-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 credit 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' trends and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit https://dbrs.morningstar.com.

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