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

6 Months Ended

Jun. 30, 2023

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 June 30, 2023 and December 31, 2022.


(in thousands)	Balance as of June 30,			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2023			(Level 1)		(Level 2)		(Level 3)
Other assets
Escrow Receivables	$	803		$	—	$	—	$	803

Investments
Senior Secured Debt	$	2,878,923		$	—	$	—	$	2,878,923
Unsecured Debt		59,019			—		—		59,019
Preferred Stock		41,249			—		—		41,249
Common Stock (1)		94,931			61,144		—		33,787
Warrants		34,314			—		13,134		21,180
	$	3,108,436		$	61,144	$	13,134	$	3,034,158
Investment Funds & Vehicles measured at Net Asset Value (2)		4,353
Total Investments, at fair value	$	3,112,789
Derivative Instruments (3)	$	(554	)
Total Investments, at fair value including derivative instruments	$	3,112,235
(in thousands)	Balance as of December 31,			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2022			(Level 1)		(Level 2)		(Level 3)
Other assets
Escrow Receivables	$	875		$	—	$	—	$	875

Investments
Senior Secured Debt	$	2,741,388		$	—	$	—	$	2,741,388
Unsecured Debt		54,056			—		—		54,056
Preferred Stock		41,488			—		—		41,488
Common Stock		92,484			66,027		1,398		25,059
Warrants		30,646			—		11,227		19,419
	$	2,960,062		$	66,027	$	12,625	$	2,881,410
Investment Funds & Vehicles measured at Net Asset Value (2)		3,893
Total Investments, at fair value	$	2,963,955

(1)

Common Stock includes non-voting security in the form of a promissory note with a lien on shares of issuer's Common Stock.

(2)

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.

(3)

Derivative Instruments are carried at fair value and a level 2 security within the Company's fair value hierarchy.

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 six months ended June 30, 2023 and 2022.


(in thousands)	Balance as of January 1, 2023		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 June 30, 2023
Investments
Senior Secured Debt	$	2,741,388	$	(5,845	)	$	19,330		$	648,729	$	—		$	(524,679	)	$	—	$	—		$	2,878,923
Unsecured Debt		54,056		—			4,276			687		—			—			—		—			59,019
Preferred Stock		41,488		(1,941	)		1,702			—		—			—			—		—			41,249
Common Stock		25,059		—			8,322			1,000		(594	)		—			—		—			33,787
Warrants		19,419		(1,763	)		722			2,809		(7	)		—			—		—			21,180
Other Assets
Escrow Receivable		875		80			—			—		(152	)		—			—		—			803
Total	$	2,882,285	$	(9,469	)	$	34,352		$	653,225	$	(753	)	$	(524,679	)	$	—	$	—		$	3,034,961

(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 (4)		Gross Transfers out of Level 3 (4)			Balance as of June 30, 2022
Investments
Senior Secured Debt	$	2,156,709	$	(1,883	)	$	(16,525	)	$	599,596	$	(73,500	)	$	(164,254	)	$	—	$	(3,504	)	$	2,496,639
Unsecured Debt		52,890		—			(2,025	)		3,362		—			—			—		—			54,227
Preferred Stock		69,439		2,867			(14,157	)		2,903		(4,772	)		—			—		(6,422	)		49,858
Common Stock		21,968		(93	)		10,240			—		—			—			207		(3,942	)		28,380
Warrants		27,477		409			(8,120	)		4,391		(2,167	)		—			—		—			21,990
Other Assets
Escrow Receivable		561		312			—			167		(398	)		—			—		—			642
Total	$	2,329,044	$	1,612		$	(30,587	)	$	610,419	$	(80,837	)	$	(164,254	)	$	207	$	(13,868	)	$	2,651,736

(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)

There were no transfers into or out of Level 3 during the six months ended June 30, 2023.

(4)

Transfers out of Level 3 during the six months ended June 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 six months ended June 30, 2022 related to the decline of liquidity of Kaleido Biosciences, Inc. shares.

(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 six months ended June 30, 2023, approximately $1.7 million in net unrealized depreciation and $8.3 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 $23.0 million in net unrealized appreciation and $0.8 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 six months ended June 30, 2022, approximately $14.9 million in net unrealized depreciation and $10.2 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 $17.7 million and $8.6 million in net unrealized depreciation 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 June 30, 2023 and December 31, 2022. 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 June 30, 2023 (in thousands)		Valuation Techniques/Methodologies	Unobservable Input (1)	Range	Weighted Average(2)
Pharmaceuticals	$	1,046,205	Market Comparable Companies	Hypothetical Market Yield	11.72% - 18.25%	14.52%
				Premium/(Discount)	(1.00)% - 3.50%	0.10%

Technology		1,047,563	Market Comparable Companies	Hypothetical Market Yield	12.87% - 20.20%	15.57%
				Premium/(Discount)	(0.75)% - 3.00%	0.39%
		22,407	Convertible Note Analysis	Probability weighting of alternative outcomes	1.00% - 50.00%	35.22%

Sustainable and Renewable Technology		1,856	Market Comparable Companies	Hypothetical Market Yield	11.10%	11.10%
				Premium/(Discount)	0.75%	0.75%

Lower Middle Market		252,658	Market Comparable Companies	Hypothetical Market Yield	14.07% - 17.36%	13.96%
				Premium/(Discount)	(0.75)% - 1.75%	0.23%
		7,073	Liquidation(3)	Probability weighting of alternative outcomes	20.00% - 80.00%	80.00%
Debt Investments for which Cost Approximates Fair Value
		255,144	Debt Investments originated within 6 months
		142,446	Imminent Payoffs(4)
		162,590	Debt Investments Maturing in Less than One Year
	$	2,937,942	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”, “Consumer & Business
Services”, “Media/Content/Info” and “Software” industries.

•

Sustainable and Renewable Technology, above, is comprised of debt investments in the “Sustainable and Renewable Technology” industry.

•

Lower Middle Market, above, is comprised of debt investments in the “Healthcare Services – Other”, “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)

Imminent payoffs 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, 2022 (in thousands)		Valuation Techniques/Methodologies	Unobservable Input (1)	Range	Weighted Average(2)
Pharmaceuticals	$	903,427	Market Comparable Companies	Hypothetical Market Yield	11.74% - 19.04%	15.17%
				Premium/(Discount)	(0.75)% - 1.75%	0.01%

Technology		967,108	Market Comparable Companies	Hypothetical Market Yield	12.05% - 18.53%	15.21%
				Premium/(Discount)	(1.00)% - 1.50%	0.20%
		20,356	Convertible Note Analysis	Probability weighting of alternative outcomes	1.00% - 50.00%	35.79%
		1,671	Liquidation(3)	Probability weighting of alternative outcomes	5.00% - 80.00%	48.29%

Sustainable and Renewable Technology		3,006	Market Comparable Companies	Hypothetical Market Yield	14.71% - 14.71%	14.71%
				Premium/(Discount)	0.75% - 0.75%	0.75%

Lower Middle Market		328,393	Market Comparable Companies	Hypothetical Market Yield	13.68% - 18.49%	14.82%
				Premium/(Discount)	(2.00)% - 0.75%	(0.43)%
		8,042	Liquidation(3)	Probability weighting of alternative outcomes	20.00% - 80.00%	80.00%
Debt Investments for which Cost Approximates Fair Value
		392,168	Debt Investments originated within 6 months
		77,676	Imminent Payoffs(4)
		93,597	Debt Investments Maturing in Less than One Year
	$	2,795,444	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.

•

Sustainable and Renewable Technology, above, is comprised of debt investments in the “Sustainable and Renewable Technology” industry.

•

(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)

Imminent payoffs 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
June 30, 2023
(in thousands)

Valuation Techniques/
Methodologies

Unobservable Input(1)

Range

Weighted Average(5)

Equity Investments

35,966

Market Comparable Companies

EBITDA Multiple(2)

13.3x - 13.3x

13.3x

Revenue Multiple(2)

0.6x - 18.0x

7.9x

Tangible Book Value Multiple(2)

1.7x - 1.7x

1.7x

Discount for Lack of Marketability(3)

5.47% - 32.11%

23.35%

8,882

Market Adjusted OPM Backsolve

Market Equity Adjustment (4)

(83.47)% - 13.33%

(13.31)%

27,161

Discounted Cash Flow

Discount Rate(7)

19.95% - 31.68%

26.14%

—

Liquidation

Revenue Multiple(2)

1.7x - 1.7x

1.7x

Discount for Lack of Marketability(3)

83.00% - 83.00%

83.00%

3,027

Other (6)

Warrant Investments

15,936

Market Comparable Companies

EBITDA Multiple(2)

13.3x - 13.3x

13.3x

Revenue Multiple(2)

0.7x - 9.9x

3.9x

Discount for Lack of Marketability(3)

5.47% - 32.50%

22.91%

5,244

Market Adjusted OPM Backsolve

Market Equity Adjustment(4)

(63.49)% - 23.93%

6.56%

Total Level 3 Equity and Warrant Investments

96,216

(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, 2022
(in thousands)

Valuation Techniques/
Methodologies

Unobservable Input (1)

Range

Weighted Average(5)

Equity Investments

30,086

Market Comparable Companies

EBITDA Multiple(2)

12.4x - 12.4x

12.4x

Revenue Multiple(2)

0.7x - 16.1x

7.4x

Tangible Book Value Multiple(2)

1.6x - 1.6x

1.6x

Discount for Lack of Marketability(3)

8.11% - 28.90%

19.79%

13,795

Market Adjusted OPM Backsolve

Market Equity Adjustment(4)

(97.82)% - 16.34%

(16.69)%

19,153

Discounted Cash Flow

Discount Rate(7)

17.72% - 30.13%

24.46%

—

Liquidation

Revenue Multiple(2)

2.1x - 2.1x

2.1x

Discount for Lack of Marketability(3)

85.00% - 85.00%

85.00%

3,513

Other(6)

Warrant Investments

12,479

Market Comparable Companies

EBITDA Multiple(2)

12.4x - 12.4x

12.4x

Revenue Multiple(2)

0.6x - 8.8x

3.4x

Discount for Lack of Marketability(3)

8.11% - 32.70%

18.97%

6,934

Market Adjusted OPM Backsolve

Market Equity Adjustment(4)

(97.82)% - 66.43%

(8.86)%

—

Liquidation

Revenue Multiple(2)

6.2x - 6.2x

6.2x

Discount for Lack of Marketability(3)

90.00% - 90.00%

90.00%

6

Other(6)

Total Level 3 Equity and Warrant Investments

85,966

(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 June 30, 2023 and December 31, 2022, the 2033 Notes were trading on the New York Stock Exchange (“NYSE”) at $24.70 and $24.59 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 June 30, 2023 and December 31, 2022, the 2031 Asset-Backed Notes were quoted for 0.932 and 0.951. 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 June 30, 2023 and December 31, 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 June 30, 2023 and December 31, 2022:


(in thousands)	June 30, 2023
	Carrying		Approximate		Identical Assets		Observable Inputs		Unobservable Inputs
Description	Value		Fair Value		(Level 1)		(Level 2)		(Level 3)
SBA Debentures	$	170,028	$	146,395	$	—	$	—	$	146,395
July 2024 Notes		104,680		103,447		—		—		103,447
February 2025 Notes		49,809		47,754		—		—		47,754
June 2025 Notes		69,676		65,121		—		—		65,121
June 2025 3-Year Notes		49,694		47,831		—		—		47,831
March 2026 A Notes		49,747		46,038		—		—		46,038
March 2026 B Notes		49,725		46,105		—		—		46,105
September 2026 Notes		321,849		274,835		—		—		274,835
January 2027 Notes		345,269		301,265		—		—		301,265
2031 Asset-Backed Notes		148,251		139,740		—		139,740		—
2033 Notes		38,880		39,520		—		39,520		—
MUFG Bank Facility(1)		61,000		61,000		—		—		61,000
SMBC Facility		130,000		130,000		—		—		130,000
Total	$	1,588,608	$	1,449,051	$	—	$	179,260	$	1,269,791


(in thousands)	December 31, 2022
	Carrying		Approximate		Identical Assets		Observable Inputs		Unobservable Inputs
Description	Value		Fair Value		(Level 1)		(Level 2)		(Level 3)
SBA Debentures	$	169,738	$	155,257	$	—	$	—	$	155,257
July 2024 Notes		104,533		102,019		—		—		102,019
February 2025 Notes		49,751		47,044		—		—		47,044
June 2025 Notes		69,595		64,198		—		—		64,198
June 2025 3-Year Notes		49,616		47,528		—		—		47,528
March 2026 A Notes		49,700		45,512		—		—		45,512
March 2026 B Notes		49,673		45,588		—		—		45,588
September 2026 Notes		321,358		269,509		—		—		269,509
January 2027 Notes		344,604		296,826		—		—		296,826
2031 Asset-Backed Notes		147,957		142,620		—		142,620		—
2033 Notes		38,826		39,344		—		39,344		—
MUFG Bank Facility(1)		107,000		107,000		—		—		107,000
SMBC Facility		72,000		72,000		—		—		72,000
Total	$	1,574,351	$	1,434,445	$	—	$	181,964	$	1,252,481

(1)

In June 2022 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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