DBRS Morningstar Confirms Hercules Capital, Inc. at BBB, Trend Changed to Negative

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. The trend for the ratings has been revised to Negative 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
In confirming the ratings and revising the trend to Negative, DBRS Morningstar recognizes the considerable headwinds facing all non-bank financial institutions, particularly those focused on direct lending where many borrowers are likely facing significant near-term challenges. Hercules is a business development company (BDC) that has a strong franchise and substantial scale in a niche lending market that is focused on providing debt financing to high-growth venture capital (VC)-backed and private equity (PE)-backed companies.

Given the abruptness and severity of the economic contraction caused by the Coronavirus Disease (COVID-19), combined with the uncertainty of the magnitude or duration of the downturn, we have concerns regarding the impact on the Company’s concentrated business model. We see the near-term challenges in the VC markets as significant, with potential issues including reduced venture capital transaction volume, downward shifts in valuations, more limited exit opportunities, and faster than anticipated cash burn at portfolio companies, all of which could have an adverse impact on Hercules’ financials. Additionally, while DBRS Morningstar sees Hercules as having strong underwriting capabilities, the risk/reward assumptions associated with its loans and investments may have significantly changed in recent weeks.

Supporting the ratings is Hercules’ positioning in its niche market, where its scale and reputation has certain advantages, including a greater capacity to source and finance deals through a borrower’s life cycle than smaller peers. Its long-standing relationships with banks, investors and VC/PE sponsors should contribute to Hercules’ ability to manage through this highly stressed period. Furthermore, we see Hercules’ focus sectors - technology, life sciences, and renewable and sustainable energy-related industries – as having long-term growth opportunities despite these near-term challenges.

RATING DRIVERS
We see a reversion to a Stable trend as unlikely for the duration of the coronavirus-related downturn. Over the longer-term, the trend could revert back to Stable if Hercules continues to maintain appropriate balance sheet fundamentals, while its portfolio investments maintain support from sponsors.

Conversely, a significant deterioration in the buffer to debt facility covenants or regulatory requirements could result in a ratings downgrade. A severe economic downturn that is prolonged resulting in significantly weakened credit fundamentals would likely result in a ratings downgrade. Additionally, any indication of notable pullback of sponsor funding for Hercules’ portfolio companies 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. At the end of 2019, Hercules’ debt investment portfolio totaled $2.1 billion at fair value (FV) across 97 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 Morningstar sees Hercules as well-positioned to maintain its regulatory compliance.

The Company has demonstrated sound earnings generation capabilities, with solid profitability each year since inception in 2003, which provides for strong dividend coverage. While the Company has maintained a healthy and consistent core yield from its investment portfolio, we expect this to be challenged over the near-term. Total investment income is comprised predominately of interest income from debt investments, which could be impacted if portfolio companies are unable to make interest payments for a period, or if loans are restructured. Hercules’ equity and warrant investment portfolios will likely experience mark-to-market volatility in the current environment resulting in potential unrealized losses.

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. DBRS Morningstar sees these attributes as benefitting Hercules versus smaller peers or new market entrants, as Hercules has a good and proven ability to workout problem loans. This risk discipline is evidenced by generally low loss levels, with Hercules realizing net losses since inception of just $24 million on gross investments at cost of $7.6 billion. Hercules entered this period of severe stress with credit strength, with just three investments on non-accrual status at the end of 2019, or just below 0.40% of the investment portfolio at cost.

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. At the end of 2019, Hercules had $1.3 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. Financial flexibility was enhanced in February 2020 with an upsize of the Company’s credit facility to $400 million, up from $200 million, and a private placement of $120 million (due 2025, with $50 million funded at issuance and another $70 million to be funded in June). The new facility is backed by a larger syndicate of lenders, with lower borrowing costs and higher advance rates. The Company’s debt profile remains diversified with well-laddered maturities. Liquidity is appropriately managed with sufficient liquidity to meet all unfunded commitments, as well as fund new investments over the near-term.

Leverage was 1.15x (GAAP) and 1.02x (regulatory, which excludes SBA debt). While increasing, leverage remains below Hercules’ targeted maximum of 1.25x.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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 2019), which can be found on our website under Methodologies & Criteria: https://www.dbrsmorningstar.com/research/350802/global-methodology-for-rating-non-bank-financial-institutions.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. 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 have 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.dbrsmorningstar.com.

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.

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