Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of 'BBB-' to Hercules Capital, Inc. (Hercules).

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.

At March 31, 2022, the investment portfolio, at fair value, was comprised of 67.2% first lien debt, 22.9% second lien debt, 7.6% preferred and equity and 2.2% other investments. Fitch views Hercules' above-average exposure to second lien and equity investments with caution, as this may indicate an appetite for higher risk-taking.

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 March 31, 2022, Hercules had one portfolio company investment on non-accrual status, representing 0.0% of the debt portfolio at fair value, and 0.55% at cost.

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 March 31, 2022. Excluding Small Business Administration (SBA) borrowings, Hercules' statutory leverage was 0.88x, up from 0.84x at YE21 and down from 0.93x at YE20, and below the peer average of 1.12x (at YE21). Hercules expects to manage GAAP leverage between 1.00x and 1.25x, which is in line with peers. The company's asset coverage cushion was 29.9% at March 31, 2022, which is at the high-end of Fitch's 'bbb' category benchmark range of 11%-33%. A sustained decline in the cushion below 25% could result in negative rating action given the higher-risk nature of the portfolio.

At March 31, 2022, unsecured debt represented 77.4% of total debt, which is above the peer average and above the upper-end of Fitch's 'bbb' category benchmark range of 35%-50% for BDCs. Hercules' funding profile is well-diversified, consisting of multiple unsecured notes, SBA borrowings and secured credit facilities. Fitch views Hercules's funding profile favorably and expects it to remain predominantly unsecured.

At March 31, 2022, Hercules had solid liquidity, consisting of $59.3 million of cash and $370.9 million of aggregate undrawn capacity on revolving facilities and SBA debentures. This compares with unfunded commitments, of $371.3 million at 1Q22. Hercules has no term debt maturities until July 2024, when $105 million of unsecured debt comes due. NII coverage of base dividends averaged 103.5% from 2018 to 2021, which is solid. Hercules had $1.39 per share of spillover income at 1Q22, which Fitch believes provides dividend stability.

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 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

Date of Relevant Committee

02 May 2022

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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