Hercules Capital, Inc. Quarterly report pursuant to Section 13 or 15(d)

Quarterly report pursuant to Section 13 or 15(d)

Fair Value of Financial Instruments

Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2022

3. Fair Value of Financial Instruments

Fair value estimates are made at discrete points in time based on relevant information. These estimates may be subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Investments measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations as of September 30, 2022 and December 31, 2021.


(in thousands)	Balance as of September 30,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2022		(Level 1)		(Level 2)		(Level 3)
Cash equivalents
Money Market Fund	$	25,000	$	25,000	$	—	$	—

Other assets
Escrow Receivables	$	1,282	$	—	$	—	$	1,282

Investments
Senior Secured Debt	$	2,607,006	$	—	$	—	$	2,607,006
Unsecured Debt		54,393		—		—		54,393
Preferred Stock		41,038		—		—		41,038
Common Stock		93,096		58,319		7,175		27,602
Warrants		27,159		—		9,520		17,639
	$	2,822,692	$	58,319	$	16,695	$	2,747,678
Investment Funds & Vehicles measured at Net Asset Value (1)		3,046
Total Investments excluding cash equivalents	$	2,825,738

Total Investments including cash equivalents	$	2,850,738
(in thousands)	Balance as of December 31,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2021		(Level 1)		(Level 2)		(Level 3)
Other assets
Escrow Receivables	$	561	$	—	$	—	$	561

Investments
Senior Secured Debt	$	2,156,709	$	—	$	—	$	2,156,709
Unsecured Debt		52,890		—		—		52,890
Preferred Stock		69,439		—		—		69,439
Common Stock		115,271		84,460		8,843		21,968
Warrants		38,399		—		10,922		27,477
	$	2,432,708	$	84,460	$	19,765	$	2,328,483
Investment Funds & Vehicles measured at Net Asset Value (1)		1,814
Total Investments excluding cash equivalents	$	2,434,522

Total Investments including cash equivalents	$	2,434,522

(1)

In accordance with U.S. GAAP, certain investments are measured at fair value using the net asset value per share (or its equivalent) as a practical expedient and are not categorized within the fair value hierarchy as per ASC 820. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the accompanying Consolidated Statement of Assets and Liabilities.

The table below presents a reconciliation of changes for all financial assets and liabilities measured at fair value on a recurring basis, excluding accrued interest components, using significant unobservable inputs (Level 3) for the nine months ended September 30, 2022 and 2021.


(in thousands)	Balance as of January 1, 2022		Net Realized Gains (Losses) (1)			Net Change in Unrealized Appreciation (Depreciation) (2)			Purchases (5)		Sales			Repayments (6)			Gross Transfers into Level 3 (3)		Gross Transfers out of Level 3 (3)			Balance as of September 30, 2022
Investments
Senior Secured Debt	$	2,156,709	$	(1,883	)	$	(11,377	)	$	854,978	$	(73,500	)	$	(314,417	)	$	—	$	(3,504	)	$	2,607,006
Unsecured Debt		52,890		—			(1,880	)		3,383		—			—			—		—			54,393
Preferred Stock		69,439		7,966			(22,458	)		3,614		(11,101	)		—			—		(6,422	)		41,038
Common Stock		21,968		(74	)		9,462			—		(19	)		—			207		(3,942	)		27,602
Warrants		27,477		992			(13,795	)		6,127		(3,162	)		—			—		—			17,639
Other Assets
Escrow Receivable		561		401			(328	)		1,148		(500	)		—			—		—			1,282
Total	$	2,329,044	$	7,402		$	(40,376	)	$	869,250	$	(88,282	)	$	(314,417	)	$	207	$	(13,868	)	$	2,748,960

(in thousands)	Balance as of January 1, 2021		Net Realized Gains (Losses) (1)			Net Change in Unrealized Appreciation (Depreciation) (2)			Purchases (5)		Sales			Repayments (6)			Gross Transfers into Level 3 (4)		Gross Transfers out of Level 3 (4)			Balance as of September 30, 2021
Investments
Senior Secured Debt	$	2,079,465	$	(3,744	)	$	7,066		$	884,833	$	—		$	(754,373	)	$	—	$	—		$	2,213,247
Unsecured Debt		14,970		—			(1,194	)		36,519		—			—			—		—			50,295
Preferred Stock		58,981		—			54,508			13,954		(61,732	)		—			—		(1,267	)		64,444
Common Stock		27,398		(60,904	)		15,592			4,371		60,900			—			—		(16,025	)		31,332
Warrants		21,483		2,584			9,043			1,854		(4,630	)		—			—		(1,769	)		28,565
Other Assets
Escrow Receivable		65		584			(1,515	)		2,473		(1,036	)		—			—		—			571
Total	$	2,202,362	$	(61,480	)	$	83,500		$	944,004	$	(6,498	)	$	(754,373	)	$	—	$	(19,061	)	$	2,388,454

(1)

Included in net realized gains (losses) in the accompanying Consolidated Statements of Operations.

(2)

Included in net change in unrealized appreciation (depreciation) in the accompanying Consolidated Statements of Operations.

(3)

Transfers out of Level 3 during the nine months ended September 30, 2022 related to the initial public offerings of Gelesis, Inc., Pineapple Energy, LLC, and the conversion of Level 3 debt investments into common stock investments. Transfers into Level 3 during the nine months ended September 30, 2022 related to the decline of liquidity of Kaleido Biosciences, Inc. shares.

(4)

Transfers out of Level 3 during the nine months ended September 30, 2021, related to the initial public offerings of Proterra, Inc., 23andMe, Inc., Sprinklr, Inc., Century Therapeutics, Couchbase, Inc., and Xometry, Inc. There was no activity related to transfers into Level 3 during the nine months ended September 30, 2021.

(5)

Amounts listed above are inclusive of loan origination fees received at the inception of the loan which are deferred and amortized into fee income as well as the accretion of existing loan discounts and fees during the period. Escrow receivable purchases may include additions due to proceeds held in escrow from the liquidation of level 3 investments. Amounts are net of purchases assigned to the Adviser Funds.

(6)

Amounts listed above include the acceleration and payment of loan discounts and loan fees due to early payoffs or restructures along with regularly scheduled amortization.

For the nine months ended September 30, 2022, approximately $23.2 million in net unrealized depreciation and $9.5 million in net unrealized appreciation relating to assets still held at the reporting date were recorded for preferred stock and common stock Level 3 investments, respectively. For the same period, approximately $12.2 million and $13.4 million in net unrealized depreciation was recorded for debt and warrant Level 3 investments, respectively, relating to assets still held at the reporting date.

For the nine months ended September 30, 2021, approximately $6.5 million in net unrealized depreciation and $15.6 million in net unrealized appreciation were recorded for preferred stock and common stock Level 3 investments, respectively, relating to assets
still held at the reporting date. For the nine months ended September 30, 2021, approximately $0.4 million and $8.0 million in net unrealized appreciation was recorded for debt and warrant Level 3 investments, respectively, relating to assets still held at the reporting date.

The following tables provide quantitative information about the Company’s Level 3 fair value measurements as of September 30, 2022 and December 31, 2021. In addition to the techniques and inputs noted in the tables below, according to the Company’s valuation policy, the Company may also use other valuation techniques and methodologies when determining the Company’s fair value measurements. The tables below are not intended to be all-inclusive, but rather provide information on the significant Level 3 inputs as they relate to the Company’s fair value measurements. See the accompanying Consolidated Schedule of Investments for the fair value of the Company’s investments. The methodology for the determination of the fair value of the Company’s investments is discussed in “Note 2 – Summary of Significant Accounting Policies”. The significant unobservable input used in the fair value measurement of the Company’s escrow receivables is the amount recoverable at the contractual maturity date of the escrow receivable.


Investment Type - Level 3 Debt Investments	Fair Value as of September 30, 2022 (in thousands)		Valuation Techniques/Methodologies	Unobservable Input (1)	Range	Weighted Average (2)

Pharmaceuticals	$	37,851	Originated Within 4-6 Months	Origination Yield	9.28% - 10.26%	10.16%
		982,922	Market Comparable Companies	Hypothetical Market Yield	10.48% - 18.10%	13.17%
				Premium/(Discount)	(0.75)% - 1.50%	0.02%

Technology		43,732	Originated Within 4-6 Months	Origination Yield	9.90% - 12.53%	10.41%
		910,488	Market Comparable Companies	Hypothetical Market Yield	11.72% - 17.52%	14.22%
				Premium/(Discount)	(0.75)% - 1.50%	0.16%
		20,354	Convertible Note Analysis	Probability weighting of alternative outcomes	1.00% - 50.00%	35.83%
		4,270	Liquidation (3)	Probability weighting of alternative outcomes	15.00% - 55.00%	46.57%

Sustainable and Renewable Technology		2,961	Market Comparable Companies	Hypothetical Market Yield	13.67%-13.67%	13.67%
				Premium/(Discount)	0.75%-0.75%	0.75%

Medical Devices		14,835	Originated Within 4-6 Months	Origination Yield	14.84% - 14.84%	14.84%
				Premium/(Discount)	0.50% - 0.50%	0.50%

Lower Middle Market		25,595	Originated Within 4-6 Months	Origination Yield	9.67% - 9.67%	9.67%
		308,155	Market Comparable Companies	Hypothetical Market Yield	12.71% - 17.82%	13.94%
				Premium/(Discount)	(2.00)% - 1.50%	(0.38)%
		8,318	Liquidation (3)	Probability weighting of alternative outcomes	20.00% - 80.00%	80.00%

Debt Investments for which Cost Approximates Fair Value
		130,945	Debt Investments originated within 3 months
		77,801	Imminent Payoffs (4)
		93,172	Debt Investments Maturing in Less than One Year
	$	2,661,399	Total Level 3 Debt Investments

(1)

The significant unobservable inputs used in the fair value measurement of the Company’s debt securities are hypothetical market yields and premiums/(discounts). The hypothetical market yield is defined as the exit price of an investment in a hypothetical market to hypothetical market participants where buyers and sellers are willing participants. The premiums/(discounts) relate to company specific characteristics such as underlying investment performance, security liens, and other characteristics of the investment. Significant increases (decreases) in the inputs in isolation may result in a significantly lower (higher) fair value measurement, depending on the materiality of the investment.

Debt investments in the industries noted in the Company’s Consolidated Schedule of Investments are included in the industries noted above as follows:

•

Pharmaceuticals, above, is comprised of debt investments in the “Drug Discovery & Development” and “Healthcare Services, Other” industries.

•

Technology, above, is comprised of debt investments in the “Communications & Networking”, “Information Services”, “Internet Consumer & Business Services”, “Media/Content/Info” and “Software” industries.

•

Lower Middle Market, above, is comprised of debt investments in the “Healthcare Services, Other”, “Internet Consumer & Business Services”, “Diversified Financial Services”, “Sustainable and Renewable Technology”, and “Software” industries.

(2)

The weighted averages are calculated based on the fair market value of each investment.

(3)

The significant unobservable input used in the fair value measurement of impaired debt securities is the probability weighting of alternative outcomes.

(4)

Expected realizable value represent debt investments that the Company expects to be fully repaid within the next three months, prior to their scheduled maturity date.


Investment Type - Level 3 Debt Investments	Fair Value as of December 31, 2021 (in thousands)		Valuation Techniques/Methodologies	Unobservable Input (1)	Range	Weighted Average (2)
Pharmaceuticals	$	206,461	Originated Within 4-6 Months	Origination Yield	11.23% - 12.84%	11.40%
		451,587	Market Comparable Companies	Hypothetical Market Yield	9.69% - 13.89%	11.34%
				Premium/(Discount)	(0.50)% - 0.75%	0.06%

Technology		109,904	Originated Within 4-6 Months	Origination Yield	11.12% - 11.68%	11.39%
		654,320	Market Comparable Companies	Hypothetical Market Yield	8.98% - 14.54%	11.64%
				Premium/(Discount)	(0.50)% - 0.75%	0.12%
		2,608	Liquidation (3)	Probability weighting of alternative outcomes	20.00% - 50.00%	40.48%
		20,425	Convertible Note Analysis	Probability weighting of alternative outcomes	1.00% - 35.00%	32.95%

Sustainable and Renewable Technology		247	Convertible Note Analysis	Probability weighting of alternative outcomes	40.00% - 60.00%	51.84%
		7,500	Expected Realizable Value (4)	Probability weighting of alternative outcomes	100% - 100%	100.00%

Lower Middle Market		3,100	Originated Within 4-6 Months	Origination Yield	5.17% - 5.17%	5.17%
		81,566	Market Comparable Companies	Hypothetical Market Yield	12.23% - 16.01%	13.22%
				Premium/(Discount)	0.00% - 1.50%	0.43%
		90,504	Expected Realizable Value (4)	Probability weighting of alternative outcomes	30.00% - 70.00%	57.74%
				Hypothetical Market Yield	10.64% - 10.64%	10.64%
				Premium/(Discount)	(1.00)% - (1.00)%	(1.00)%
		8,269	Liquidation (3)	Probability weighting of alternative outcomes	20.00% - 80.00%	80.00%

Debt Investments for which Cost Approximates Fair Value
		441,524	Debt Investments originated within 3 months
		131,584	Debt Investments Maturing in Less than One Year
	$	2,209,599	Total Level 3 Debt Investments

(1)

Debt investments in the industries noted in the Company’s Consolidated Schedule of Investments are included in the industries noted above as follows:

•

Pharmaceuticals, above, is comprised of debt investments in the “Drug Discovery & Development” and “Healthcare Services, Other” industries.

•

(2)

The weighted averages are calculated based on the fair market value of each investment.

(3)

The significant unobservable input used in the fair value measurement of impaired debt securities is the probability weighting of alternative outcomes.

(4)

Expected realizable value represent debt investments that the Company expects to be fully repaid within the next three months, prior to their scheduled maturity date.

Investment Type - Level 3 Equity and Warrant Investments

Fair Value as of
September 30, 2022
(in thousands)

Valuation Techniques/
Methodologies

Unobservable Input (1)

Range

Weighted Average (5)

Equity Investments

29,721

Market Comparable Companies

EBITDA Multiple (2)

11.5x - 11.5x

11.5x

Revenue Multiple (2)

0.6x - 15.4x

6.6x

Tangible Book Value Multiple (2)

1.7x - 1.7x

1.7x

Discount for Lack of Marketability (3)

7.19% - 32.68%

20.53%

13,397

Market Adjusted OPM Backsolve

Market Equity Adjustment (4)

(97.29)% - 7.80%

(16.68)%

21,945

Discounted Cash Flow

Discount Rate (7)

17.08% - 28.80%

23.32%

—

Liquidation

Revenue Multiple (2)

2.1x - 2.1x

2.1x

Discount for Lack of Marketability (3)

84.00% - 84.00%

84.00%

3,577

Other (6)

Warrant Investments

10,968

Market Comparable Companies

EBITDA Multiple (2)

11.5x - 11.5x

11.5x

Revenue Multiple (2)

0.6x - 9.3x

3.6x

Discount for Lack of Marketability (3)

0.00% - 32.7%

21.35%

6,671

Market Adjusted OPM Backsolve

Market Equity Adjustment (4)

(97.29)% - 10.57%

(18.68)%

—

Liquidation

Revenue Multiple (2)

7.1x - 7.1x

7.1x

Discount for Lack of Marketability (3)

90.00% - 90.00%

90.00%

—

Other (6)

Total Level 3
Warrant and Equity Investments

86,279

(1)

The significant unobservable inputs used in the fair value measurement of the Company’s warrant and equity securities are revenue and/or earnings multiples (e.g. EBITDA, EBT, ARR), market equity adjustment factors, and discounts for lack of marketability. Significant increases/(decreases) in the inputs in isolation would result in a significantly higher/(lower) fair value measurement, depending on the materiality of the investment. For some investments, additional consideration may be given to data from the last round of financing or merger/acquisition events near the measurement date. The significant unobservable input used in the fair value measurement of impaired equity securities is the probability weighting of alternative outcomes.

(2)

Represents amounts used when the Company has determined that market participants would use such multiples when pricing the investments.

(3)

Represents amounts used when the Company has determined market participants would take into account these discounts when pricing the investments.

(4)

Represents the range of changes in industry valuations since the portfolio company's last external valuation event.

(5)

Weighted averages are calculated based on the fair market value of each investment.

(6)

The fair market value of these investments is derived based on recent private market and merger and acquisition transaction prices.

(7)

The discount rate used is based on current portfolio yield adjusted for uncertainty of actual performance and timing in capital deployments.

Investment Type - Level 3 Equity and Warrant Investments

Fair Value as of
December 31, 2021
(in thousands)

Valuation Techniques/
Methodologies

Unobservable Input (1)

Range

Weighted Average (5)

Equity Investments

26,587

Market Comparable Companies

EBITDA Multiple (2)

20.6x - 20.6x

20.6x

Revenue Multiple (2)

1.0x - 18.4x

11.8x

Tangible Book Value Multiple (2)

2.5x - 2.5x

2.5x

Discount for Lack of Marketability (3)

18.81% - 34.69%

25.53%

24,910

Market Adjusted OPM Backsolve

Market Equity Adjustment (4)

(88.67)% - 47.22%

0.81%

11,990

Discounted Cash Flow

Discount Rate (7)

15.93% - 25.30%

20.46%

—

Liquidation

Revenue Multiple (2)

2.1x - 2.1x

2.1x

Discount for Lack of Marketability (3)

84.00% - 84.00%

84.00%

27,920

Other (6)

Warrant Investments

14,517

Market Comparable Companies

EBITDA Multiple (2)

20.6x - 26.0x

20.7x

Revenue Multiple (2)

0.6x - 9.5x

4.5x

Discount for Lack of Marketability (3)

18.81% - 37.35%

26.93%

11,914

Market Adjusted OPM Backsolve

Market Equity Adjustment (4)

(88.67)% - 47.22%

(7.76)%

1,046

Other (6)

Total Level 3 Warrant and Equity Investments

118,884

(1)

(2)

Represents amounts used when the Company has determined that market participants would use such multiples when pricing the investments.

(3)

Represents amounts used when the Company has determined market participants would take into account these discounts when pricing the investments.

(4)

Represents the range of changes in industry valuations since the portfolio company's last external valuation event.

(5)

Weighted averages are calculated based on the fair market value of each investment.

(6)

The fair market value of these investments is derived based on recent market transactions.

(7)

The discount rate used is based on current portfolio yield adjusted for uncertainty of actual performance and timing in capital deployments.

The Company believes that the carrying amounts of its financial instruments, other than investments and debt, which consist of cash and cash equivalents, receivables including escrow receivables, accounts payable and accrued liabilities, approximate the fair values of such items due to the short maturity of such instruments. The debt obligations of the Company are recorded at amortized cost and not at fair value on the Consolidated Statements of Assets and Liabilities. The fair value of the Company’s outstanding debt obligations are based on observable market trading prices or quotations and unobservable market rates as applicable for each instrument.

As of September 30, 2022, the 2033 Notes were trading on the New York Stock Exchange (“NYSE”) at $23.48 per unit at par value. The par value at underwriting for the 2033 Notes was $25.00 per unit. Based on market quotations on or around September 30, 2022, the 2031 Asset-Backed Notes were quoted for 0.970. The fair values of the SBA debentures, July 2024 Notes, February 2025 Notes, June 2025 Notes, June 2025 3-Year Notes, March 2026 A Notes, March 2026 B Notes, September 2026, and January 2027 Notes are calculated based on the net present value of payments over the term of the notes using estimated market rates for similar notes and remaining terms. The fair values of the outstanding debt under the MUFG Bank Facility and the SMBC Facility are equal to their outstanding principal balances as of September 30, 2022.

The following tables provide additional information about the approximate fair value and level in the fair value hierarchy of the Company’s outstanding borrowings as of September 30, 2022 and December 31, 2021:


(in thousands)	September 30, 2022
	Carrying		Approximate		Identical Assets		Observable Inputs		Unobservable Inputs
Description	Value		Fair Value		(Level 1)		(Level 2)		(Level 3)
SBA Debentures	$	169,591	$	153,614	$	—	$	—	$	153,614
July 2024 Notes		104,459		99,364		—		—		99,364
February 2025 Notes		49,723		45,739		—		—		45,739
June 2025 Notes		69,555		63,834		—		—		63,834
June 2025 3-Year Notes		49,577		47,626		—		—		47,626
March 2026 A Notes		49,676		44,107		—		—		44,107
March 2026 B Notes		49,647		44,181		—		—		44,181
September 2026 Notes		321,112		261,406		—		—		261,406
January 2027 Notes		344,271		286,885		—		—		286,885
2031 Asset-Backed Notes		147,810		145,500		—		145,500		—
2033 Notes		38,799		37,568		—		37,568		—
MUFG Bank Facility(1)		102,000		102,000		—		—		102,000
SMBC Facility		25,000		25,000		—		—		25,000
Total	$	1,521,220	$	1,356,824	$	—	$	183,068	$	1,173,756


(in thousands)	December 31, 2021
	Carrying		Approximate		Identical Assets		Observable Inputs		Unobservable Inputs
Description	Value		Fair Value		(Level 1)		(Level 2)		(Level 3)
SBA Debentures	$	145,498	$	151,471	$	—	$	—	$	151,471
2022 Notes		149,563		152,906		—		152,906		—
July 2024 Notes		104,238		110,496		—		—		110,496
February 2025 Notes		49,637		51,983		—		—		51,983
June 2025 Notes		69,433		72,031		—		—		72,031
March 2026 A Notes		49,605		52,646		—		—		52,646
March 2026 B Notes		49,570		52,751		—		—		52,751
September 2026 Notes		320,376		315,495		—		—		315,495
2033 Notes		38,718		42,672		—		42,672		—
2022 Convertible Notes		229,740		236,049		—		236,049		—
Union Bank Facility(1)		—		—		—		—		—
SMBC Facility		29,925		29,925		—		—		29,925
Total	$	1,236,303	$	1,268,425	$	—	$	431,627	$	836,798

(1)

The June 2022 amendment of the MUFG Bank Facility replaced the Union Bank Facility via an amendment which changed the lead lender.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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