Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of 'BBB-' to
The Rating Outlook is Stable. Concurrently, Fitch has assigned a secured and unsecured debt rating of 'BBB-' to the firm's outstanding debt.
Key Rating Drivers
The ratings reflect the senior focus of Hercules' investment portfolio, solid track record in credit, broad industry relationships, above-average asset coverage cushion, consistent operating performance, experienced management team, and strong funding flexibility with demonstrated access to the public debt and equity markets.
Rating constraints specific to Hercules include above-average portfolio concentrations, given the focus on technology and life sciences-related companies and the exposure to recurring-revenue based deals, in particular, which Fitch believes elevate portfolio risk. This is somewhat mitigated by Hercules' solid credit performance historically, evidencing a strong underwriting track record. Fitch also believes Hercules' lack of affiliation with a broader investment platform could be a headwind longer term should bank financing become more constrained for the sector.
Rating constraints for business development companies (BDCs) more broadly include the market impact on leverage, given the need to fair-value the portfolio each quarter, dependence on access to the capital markets to fund portfolio growth, a limited ability to retain capital given distribution requirements and deterioration in terms in the middle market resulting from the competitive underwriting environment.
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Hercules' portfolio diversification with respect to industry exposure is more concentrated than peers', with its top three industries, drug discovery & development (38.2%), software (25.2%), and internet consumer and business services (17.6%), representing 81% of the investment portfolio. While Hercules' industry concentrations are relatively elevated, the company's top exposures are to less cyclical industries that have proven resilience, particularly throughout the pandemic. Additionally, companies in the software and business services space tend to have multiple end markets, further diversifying Hercules' exposure.
Hercules' asset quality has been strong. Net realized losses as a percentage of the total portfolio, at value, averaged 0.3% annually from 2018 through 2021, which compares favorably with peers. At
Core earnings have been generally stable and consistently above the peer average. Fitch attributes this to Hercules' investment strategy and asset class of investments, which offer a higher yield, and Hercules' internally-managed model, which offers more cost efficiency. The portfolio's net investment income (NII) yield was 6.4% in 2021, down from 6.7% in 2020, but above the rated peer average of 4.6% for 2021. The yield declined to 5.7% in 1Q22, annualized, driven largely by a reduction in fee income. Fitch expects earnings to grow the remainder of the year, with slower repayment activity and rising rates.
Leverage, as measured by par debt-to-equity, was 1.01x at
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The Stable Rating Outlook reflects Fitch's expectations for a continued focus on first lien debt investments, consistent core earnings generation, solid asset quality, and the maintenance of the asset coverage cushion at-or-above 25% and the unsecured funding mix at-or-above 35%.
The equalization of the secured and unsecured debt ratings with the long-term IDR reflects solid collateral coverage for all classes of debt given Hercules' funding mix and the fact that the company is subject to a 150% asset coverage limitation.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to positive rating action/upgrade:
While not anticipated over the near term, given the higher-risk nature of the firm's investment strategy, an increase in the asset coverage cushion to at least 33% on a sustained basis, assuming no change in the origination strategy, or absent that, a meaningful reduction in portfolio concentrations and/or perceived portfolio risk could yield positive rating momentum. Demonstrated competitive positioning over time, given the relatively recent change in management in combination with maintenance of a strong funding profile, ample liquidity, solid dividend coverage and consistent core operating performance would also be necessary to drive positive rating actions.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
A sustained reduction in the asset coverage cushion below 25%. A significant increase in second lien and/or equity investments, a material increase in non-accrual levels, meaningful realized or unrealized losses, a sustained decline in unsecured funding below 35% of total debt, deterioration in cash earnings coverage of the dividend, or an impairment of the firm's liquidity profile could yield negative rating action.
The secured and unsecured debt ratings are sensitive to changes in the long-term IDR and the firm's funding mix. A material increase in secured funding could result in the unsecured debt being notched down from the IDR.
Best/Worst Case Rating Scenario
International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from '
Date of Relevant Committee
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.
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