DBRS Morningstar Confirmed Stellus Capital Investment Corp.’s Long-Term Ratings at BBB with a Stable Trend

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Stellus Capital Investment Corporation (Stellus or the Company), including the Company’s Long-Term Issuer Rating of BBB. The trend on all ratings is Stable. The Company’s Intrinsic Assessment (IA) is BBB, while its Support Assessment is SA3, resulting in Stellus’ final ratings positioned in line with its IA.

KEY RATING CONSIDERATIONS
The confirmation of the ratings reflects Stellus’ continued portfolio growth while generating acceptable earnings, maintaining credit quality performance and regulatory leverage at its target level. The Company is supported by its lower middle market lending franchise with a management team that has been together for decades through several business and economic cycles. The Company has a diversified funding profile with well-laddered maturities, including low-cost SBA debt, which are excluded from regulatory leverage limits. The ratings consider the Company’s elevated overall financial leverage (including SBA debt) mitigated by its focus on sponsor-backed portfolio companies, and increasing first lien senior secured portfolio composition.

The Stable trend reflects our view that the geopolitical instability in Europe as well as the rising interest rate environment and heightened inflationary pressures, while increasing risk to the continued U.S. economic recovery, will not overly burden U.S. private middle market companies. To date, Stellus’ portfolio companies have generally been able to push through rising costs to end customers, which mitigates profit margin pressures in their products and services as a result of inflation, supply-chain disruptions and increased input costs, including energy prices.

RATING DRIVERS
Over the longer term, sustained strong earnings supported by growth of the investment portfolio while maintaining solid credit quality and disciplined deployment of leverage would result in a ratings upgrade. Conversely, a sustained increase in overall financial leverage (despite regulatory relief on SBA debt) would result in a ratings downgrade. Weak performance in the investment portfolio which erodes net asset value (NAV), or if dividend distributions are not covered by net investment income for an extended period of time, would also result in a ratings downgrade.

RATING RATIONALE
The Company’s franchise benefits from access to Stellus Capital Management’s (the Advisor) senior investment professionals and their expertise in the lower middle market sector. At year-end 2021, Stellus’ $773 million investment portfolio at fair value consisted of 84% first lien, 7% second lien, 1% unsecured and 8% equity investments. The Advisor manages approximately $2.6 billion of assets under management through private funds, separately managed accounts, and a newly created perpetual private BDC as of March 2022. Stellus is able to co-invest in private credit assets across these various investment vehicles, which helps diversify the Company’s balance sheet while strengthening its competitiveness in the market by enhancing its ability to speak for more meaningful sizes of transactions and win lead arranger mandates.

Earnings have remained relatively solid, underpinned by a growing investment portfolio that generates consistent interest income. Stellus reported a net increase in net assets from operations (net income) of $33.6 million in 2021, up from $21.2 million in 2020, attributable to the growth of the portfolio, which has increased interest income, and higher net realized gains on the investment portfolio. Total investment income (comprised primarily of interest income from debt investments) was $63.7 million in 2021 an increase of 12% from 2020, and net investment income (NII) of $19.8 million, a 10% decrease from 2020 as interest expense and incentive fees increased.

The Company’s risk profile is acceptable and has benefited from management’s strategic shift towards sponsor-backed first lien loans to lower middle market companies from riskier junior capital. First lien loans consisted of 84% of the investment portfolio at year-end 2021, a dramatic increase from 38% at year-end 2017. Credit performance has been reasonable with three investments on non-accrual, representing 4.0% of the total investment portfolio at cost at year-end 2021, down from a peak of 6.4% of the total investment portfolio at cost at 3Q20. As the investment portfolio is 96% floating rate (LIBOR), interest rate risk from continued Fed rate rises is limited, and earnings should benefit once prevailing reference rates increase above the investment portfolio’s approximately 1% interest rate floors.

Stellus’ funding profile was broadened with a $100 million institutional debt issuance in January 2021, which refinanced all near-term debt maturities. As a result, the Company’s nearest maturity is not until 2025 ($26 million of SBA debt). At year-end 2021, almost half (47%) of the Company’s financing is comprised of SBA debt. Positively, this debt is long-term, a low-cost source of funding and exempt from the regulatory asset coverage ratio (ACR) calculation to encourage lending to small businesses. The Company has sufficient liquidity in the form of undrawn capacity at its credit facility of $72.7 million (subject to borrowing base limitations) and cash of $44.2 million, compared with unfunded commitments of $30.7 million at year-end 2021.

Capitalization has slightly weakened over the past few quarters, despite lower regulatory leverage, which exclude SBA debt, as the Company’s overall financial leverage has remained at a high level compared to DBRS Morningstar BDC peers. While Stellus’ regulatory leverage at year-end 2021 was at 0.97x debt-to-equity, financial leverage was high at 1.85x, with an average of 1.87x over 2021. Management has a regulatory leverage target of approximately 1.1x. The Company’s cushion to its credit facility covenant (1.5x debt-to-equity) was $100.2 million at year-end 2021, implying that it would need to incur a loss of 13% of its investment portfolio at fair value to breach the covenant, giving it a solid cushion at this point; especially given the average hold size of $11 million within the investment portfolio.

DBRS Morningstar notes that this Press Release was amended on July 20, 2022 to incorporate the disclosure for monetary figures referenced in the Press Release.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 2, 2021): https://www.dbrsmorningstar.com/research/383936/global-methodology-for-rating-non-bank-financial-institutions. Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021): https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

The primary sources of information used for this rating include Morningstar Inc. and Company Documents. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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