Fitch Affirms Hercules Capital at 'BBB-'; Outlook Stable

Published: 2025-07-01 05:00:23 ET HTGC

Published on 07/01/2025 at 05:00

Fitch Ratings has affirmed Hercules Capital, Inc.'s Long-Term Issuer Default Rating (IDR) and unsecured debt rating at 'BBB-'.

Additionally, Fitch has affirmed the company's secured debt rating at 'BBB'. The Rating Outlook is Stable.

Today's rating actions have been taken as part of a broader review of a group of business development companies (BDCs), which included eight publicly rated firms. For more information on the peer review, please see 'Fitch Ratings Completes Peer Review of 8 US BDCs,' available atwww.fitchratings.com.

Key Rating Drivers

First Lien Focus: Hercules' ratings reflect the first lien focus of its investment portfolio, solid track record in credit, broad industry relationships, and consistent operating performance. The ratings also reflect its strong funding flexibility with demonstrated access to public debt and equity markets, above-average asset coverage cushion, and experienced management team.

Sector Concentrations: Rating constraints include above-average sector concentrations due to Hercules' focus on technology and life sciences-related companies. Fitch believes the company's exposure to recurring-revenue based deals increases its portfolio risk; however, its solid historical credit performance mitigates this risk. Fitch also notes that Hercules' lack of affiliation with a broader investment platform could pose a longer-term challenge if bank financing for the sector becomes more constrained.

Competitive Underwriting Environment: Rating constraints for BDCs include the market impact on leverage, dependence on access to the capital markets to fund growth and limited ability to retain capital. Fitch believes BDCs will face a competitive underwriting environment, weaker earnings and dividend coverage metrics, and deterioration in asset quality metrics throughout 2025.

Strong Credit Performance: Net realized losses as a percentage of the total portfolio, at value, were 0.2% annualized in 1Q25 and averaged a 0.1% gain between 2021 and 2024-well-above the peer average. At 1Q25, Hercules had two portfolio investments on non-accrual status, representing 0.5% of the debt portfolio at fair value and 1.9% at cost. Although Hercules' industry exposure is concentrated compared to peers, the portfolio is senior-focused, with 86.6% first lien loans. Top exposures are to less-cyclical industries that have historically performed well.

Higher-than-Peer Earnings: Core earnings have been consistently above the peer average, which Fitch attributes to Hercules' higher-yielding venture lending investment strategy and internally managed business model, offering better cost efficiency. The net investment income (NII) yield was 8% annualized in 1Q25 and averaged 8.1% from 2021-2024. While Hercules' investment advisor subsidiary's growing earnings will contribute positively to profitability, falling rates and spreads are expected to be headwinds to earnings in 2025.

Appropriate Asset Coverage Cushion: Leverage, measured by par debt to tangible equity, was 1.0x at 1Q25, which compares to target leverage of 1.25x or below. Excluding Small Business Administration (SBA) borrowings, statutory leverage was 0.85x, up from 0.76x at YE 2024. The company's asset coverage cushion was 31.0% at 1Q25, which is at the high end of Fitch's 'bbb' category benchmark range of 11%-33%. Fitch expects the firm will operate with a higher asset coverage cushion relative to peers, given the elevated risk profile of the portfolio. A sustained decline in the cushion below 25% could result in negative rating action, given the higher-risk nature of the portfolio.

Strong Funding Flexibility: At 1Q25, unsecured debt represented 61% of total debt, which is well above the peer average and within Fitch's 'bbb' category benchmark range of 35%-100% for BDCs. Hercules' funding profile is well diversified, consisting of multiple unsecured notes, a convertible note, a debt securitization, SBA borrowings and secured credit facilities. Fitch views Hercules's funding profile favorably and expects it to remain predominantly unsecured.

Solid Liquidity and Dividend Coverage: At 1Q25, Hercules had solid liquidity, consisting of $51.2 million of cash and $509.6million of aggregate undrawn capacity on its credit facilities. This compares with unfunded commitments of $455.7 million and $100 million of senior unsecured notes due in March 2026. Fitch believes Hercules has sufficient capacity under its credit facility to refinance the near-term debt maturity, although Fitch believes the firm will remain opportunistic regarding additional unsecured issuances.

NII coverage of base dividends was 111.8% in 1Q25, down from the 2021-2024 average of 116.1%. Hercules had $0.92 per share of spill-over income at 1Q25, representing over two quarters of base dividends, which Fitch believes provides dividend stability. Adjusting for net payment-in-kind (PIK) income and other non-cash items, coverage falls to 97.5% in 1Q25 from 117.1% in 2024.

Net PIK income represented 10.8% of interest and dividend income in 1Q25, above the peer average and up from 7.0% in 2024. Fitch believes most of Hercules' PIK is structured into deals at the time of underwriting, but notes that credit issues could drive the figure higher. Fitch would view an inability to reduce PIK and/or demonstrate strong collections of accrued PIK in cash negatively.

Stable Outlook: The Stable Outlook reflects Fitch's expectation that Hercules will continue to focus on first-lien debt investments and maintain consistent operating performance and strong asset quality. Fitch also expects that Hercules will maintain an unsecured funding mix above 35% and an asset coverage cushion above 25%.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

A sustained reduction in the asset coverage cushion below 25% would be negative for ratings. 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.

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, combined 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.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The senior secured debt rating of 'BBB' is one-notch above Hercules' Long-Term IDR and reflects Fitch's view of good recovery prospects in a stress scenario given its funding mix and available asset coverage.

The alignment of the unsecured debt rating with the Long-Term IDR reflects average recovery prospects under a stress scenario since Hercules is subject to a 150% regulatory asset coverage requirement.

DEBT AND OTHER INSTRUMENT RATINGS: RATING SENSITIVITIES

The secured and unsecured debt ratings are primarily linked to the Long-Term IDR and are expected to move in tandem. However, the notching could change if there is a shift in the funding mix or reduction in available asset coverage, which Fitch believes impacts the recovery prospects of the instruments in a stress scenario.

ADJUSTMENTS

The Standalone Credit Profile (SCP) has been assigned in line with the implied SCP.

The Funding, Liquidity & Coverage score has been assigned below the implied score due to the following adjustment reason: Funding flexibility (negative).

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

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' 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. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visithttps://www.fitchratings.com/topics/esg/products#esg-relevance-scores.