DBRS Morningstar Revises Hercules Capital, Inc.’s Trend to Stable; 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. DBRS Morningstar also has revised the trend on the ratings to Stable from Negative. 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 Stable, DBRS Morningstar recognizes Hercules’ strong performance through the challenging economic environment due to the Coronavirus Diseases (COVID-19) pandemic. The Company’s established, scaled franchise within venture lending has supported solid earnings despite broader macroeconomic concerns, with its sizable investment portfolio generating consistent interest income and enhanced returns through equity and warrant investments. The confirmation also considers Hercules’ diverse funding mix of unsecured debt, SBA-guaranteed debt, convertible notes and asset-backed securities, as well as its well-laddered debt maturity profile and appropriate leverage.

Hercules’ niche focus on expansion and established stage venture capital (VC)-backed companies was a cause for concern at the onset of the coronavirus pandemic, given expectations for significant challenges in the VC markets. DBRS Morningstar sees, though, that Hercules’ strong underwriting capabilities, deep sponsor relationships, and focus on specific sub-sector industries – software, drug discovery & development, and internet consumer & business services - helped it largely avoid the worst of the economic crisis. Furthermore, the VC ecosystem has been broadly resilient, with record investment in high-growth startups, record capital raised by VC funds and the second-highest year for VC-backed exits in 2020. The IPO window rapidly re-opened through the second half of 2020 after the initial market correction at the onset of the pandemic, leading to significant VC exits. This dynamic has underpinned higher valuations among VC-backed companies leading to growth in net asset value from Hercules’ net realized and unrealized gains.

The Stable trend reflects DBRS Morningstar’s view that some key sources of uncertainty related to the pandemic are behind us, contributing to the broader market certainty and investor conviction. Most businesses have adapted to social distancing practices and periodic government restrictions on activities that address recent waves in new virus cases. The vaccination roll-out to communities across the U.S. continues to increase. Consistent with our moderate economic scenario published March 17th, 2021, expectations are for a strong economic recovery in 2021, buffered by government stimulus and central bank actions that should produce robust origination pipelines for BDCs.

RATING DRIVERS
Expansion of third party investment vehicles, whose co-investments may lead to a diversification of the BDC portfolio and reduce balance sheet risk, combined with strong earnings and credit fundamentals, would lead to a ratings upgrade.

Conversely, a significant deterioration in the capital buffer to the regulatory requirements would result in a ratings downgrade.

RATING RATIONALE
Hercules has a strong, well-established franchise which brings competitive advantages within the VC market. The Company’s scale and recognition across VC firms and the start-up ecosystem as a leading provider of financing to VC-backed companies drives good access to quality, attractive investment opportunities. At year-end 2020, Hercules’ investment portfolio totaled $2.4 billion at fair value (FV) consisting of 89% debt investments, 9.5% equity investments and 1.5% warrant positions, across 97 debt-related portfolio companies and 138 warrant and equity-related portfolio companies.

The Company established a wholly-owned investment adviser subsidiary, Hercules Adviser LLC, which will provide investment management services to other investment vehicles. Benefitting the Company’s risk profile, this subsidiary will allow Hercules to broaden its asset base through off-balance sheet investments in other vehicles. Also this will help to grow advisory fee earnings, diversifying Hercules’ revenue base.

The Company has demonstrated sound earnings generation capabilities, with solid profitability each year since 2005, which provides for strong dividend coverage. Despite 1Q20 volatility in its portfolio valuations, which was driven by the widening credit spreads and market volatility at the onset of the pandemic, Hercules for the most part reversed its $76 million unrealized loss over 2Q20 and 3Q20 as the market rebounded quickly and its investments in the technology and life sciences space performed well. In 2020, Hercules reported a net increase in net assets from operations (net income) of $227.3 million, up from $173.6 million in 2019. Total investment income (primarily comprised of interest income from debt investments) was a record $287.3 million in 2020, up 7% from 2019, and net investment income of $157.1 million, up 10% from 2019, which was driven by the health of the VC ecosystem and strength of the origination platform.

Hercules’ credit risk profile is solid, supported by a well-designed risk management framework, good underwriting and sound portfolio monitoring. The Company’s credit risk is elevated, as loan repayment is highly reliant upon future rounds of fundraising. Hercules mitigates this risk by collateralizing its investments by obtaining a first priority security interest in a portfolio company’s assets, which may include intellectual property. The Company also sets portfolio limits to ensure good diversity in the investment portfolio, has sound monitoring including prudent internal risk scoring, is proactive in portfolio management and has a disciplined focus on specific industry verticals. This risk discipline is evidenced by generally low loss levels, as the Company has experienced $79.7 million of cumulative total net realized losses since inception, or an annualized loss rate of 4.5 basis points. Non-accruals continue to be manageable comprising just 1.30% ($31 million) of the investment portfolio at cost at year-end 2020, versus 0.40% at year-end 2019.

Hercules has developed a broad, diversified funding profile, with access to multiple different funding channels and investor markets. The Company’s funding profile is generally more diversified than other BDCs. At year-end 2020, Hercules had $1.3 billion of debt outstanding comprised of institutional and retail unsecured debt, convertible notes, asset-backed securities, and Small Business Administration (SBA) debentures. Hercules proactively tapped the institutional debt market three times in 2020 raising $170 million in five year debt, terming out some near term maturities and completely paying down the Company’s two revolving facilities, with the nearest significant debt maturity of $430 million due in 2022. The Company’s debt profile remains diversified with well-laddered maturities. Liquidity is appropriately managed with sufficient liquidity to meet all unfunded commitments ($179.8 million as of December 2020 an increase from $133.7 million in December 2019), non-binding term sheets ($247.5 million to three new companies as of December 2020), and fund new investments over the near-term with unrestricted cash of $198.3 million and revolver capacity of $475 million as of December 2020.

Hercules has a well-established track record of consistent NAV performance and disciplined management of the buffer to the asset coverage ratio supporting its solid capitalization. In December 2018, shareholders approved an increase in the Company’s leverage limit to 2.0x debt/equity. At year-end 2020, Hercules regulatory debt/equity ratio (excluding SBA debt) was 0.93x, below its target leverage ratio of 0.95x to 1.25x with GAAP leverage at 1.00x. The Company’s regulatory cushion was estimated at $693 million, implying that Hercules would need to take a loss on 29% of its investment portfolio at fair value to breach the regulatory limit (2.0x D/E). Additionally, as the Company continues to trade at a significant premium to book value (~1.5x P/BV), it also has the capacity to raise equity through follow-on offerings, or by its active at-the-market (ATM) equity program. During 2020, the Company raised approximately $77 million through the ATM program, which helps support balance sheet growth.

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 29, 2020): https://www.dbrsmorningstar.com/research/367510/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.

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 access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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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