DBRS Morningstar Revises Stellus Capital Investment Corp.’s Trend to Negative and Confirms Ratings at BBB

DBRS, Inc. (DBRS Morningstar) confirmed the Long-Term Issuer Rating and Long-Term Senior Debt Rating of Stellus Capital Investment Corp. (Stellus or the Company) as BBB. Concurrently, the trend on the ratings has been revised to Negative from 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 revision of the trend to Negative from Stable reflects sustained high financial leverage at Stellus in a challenging macroeconomic environment. While the failures of Silicon Valley Bank (SVB) and Signature Bank (Signature) have no direct impact on Stellus or its portfolio companies, regional bank stress and financial market volatility may pressure lower middle market and middle market companies. As credit spreads widen, we expect near-term mark-to-market losses, challenging earnings strength.

The confirmation of the ratings is driven by the Company’s well-established lower middle market lending franchise with a management team with decades of experience together, investing through several business and economic cycles. Earnings have been stable, with top line revenue benefitting from an increase in overall base rates. The confirmation also considers the continued migration of the investment portfolio to one that is predominantly comprised of sponsor-backed, first lien senior secured investments.

RATING DRIVERS
Lower overall financial leverage levels coupled with improved credit performance would result in the trend being revised to Stable. Over the long-term, demonstrated ability to generate sound financial results while maintaining solid credit fundamentals and a conservative leverage profile would result in a ratings upgrade.

Conversely, continued elevated financial leverage (despite regulatory relief on SBA debt) would result in a ratings downgrade. Should operating performance worsen, including a notable loss that erodes net asset value, or if there is significant credit deterioration above our expectations, the ratings would also be downgraded.

RATING RATIONALE
The Company’s franchise benefits from its relationship with Stellus Capital Management (the Advisor), a private credit manager focused on the lower middle market with a multi-decade track record. Stellus provides financing solutions to sponsor-backed companies with $5 million to $50 million of EBITDA. At 1Q23, Stellus’ investment portfolio grew to $877.5 million, consisting of 87% first lien debt, 5% second lien debt, 1% unsecured debt, and 7% equity positions. Stellus has 88 portfolio companies at 1Q23 as it continues to increase portfolio diversification, up from 73 at 4Q21.

Top line revenue strengthened benefitting from a larger investment portfolio and higher base rates. The weighted average annual yield of the whole investment portfolio was 10.8% at 1Q23 compared with 7.5% for full year 2021. Net investment income (NII) was solid at $28.6 million for 2022, a 45% increase year-over-year. However, net increase in net assets resulting from operations (net income) was weaker at $14.5 million in 2022, down from $33.6 million in 2021, as unrealized losses of $17.5 million constrained profitability. NII for 1Q23 was $9.1 million up from $5.5 million for 1Q22 as Stellus benefitted from higher interest rates.

Credit performance has been acceptable and Stellus’ risk profile benefits from management’s strategy shift towards sponsor-backed first lien loans from riskier junior capital tranches. At 1Q23, first liens consisted of 87% of the investment portfolio compared to 38% at 4Q17 at the start of the migration. Four investments are on non-accrual at 1Q23, representing 5.5% of the total investment portfolio at cost, up from 4.0% at the end of 2021, but still below the peak of 6.4% at 3Q20. As Stellus’ investment portfolio is 97% floating-rate, NII should continue to benefit from a rising rate environment.

Stellus has an acceptable funding profile, which is supported by a private placement issuance and multiple issuances of low-cost, long duration SBIC debentures. At 1Q23, over half (51%) of the Company’s financing was from SBIC debentures, which is exempt from the regulatory asset coverage ratio (ACR) calculation to encourage lending to small businesses. While this debt does not count towards regulatory requirements and is secured by specific Stellus SBIC-subsidiaries, it does increase overall financial leverage. The Company’s revolving credit facility was amended in May 2022 and its revolving period ends in September 2024 with a scheduled maturity of September 2025. At 1Q23, Stellus had sufficient liquidity coverage with approximately $83 million of liquidity comprised of $18 million of cash and $65 million of credit facility capacity compared to $25.8 million of unfunded commitments.

Capitalization has continued to weaken as financial leverage has been elevated compared to DBRS Morningstar BDC peers for a sustained period. Stellus’ regulatory leverage at 1Q23 was 1.06x debt-to-equity, slightly below management’s target regulatory leverage of 1.1x. However, financial leverage was high at 2.18x at 1Q23, with an average of 2.13x over the full year 2022. With macroeconomic conditions under stress increasing the likelihood of credit deterioration, we believe overall high financial leverage to be a negative ratings factor. At the end of 1Q23, the cushion to the Company’s credit facility covenant (1.5x regulatory debt-to-equity) was approximately $82 million, implying that Stellus would need to take a full loss on 9% of its investment portfolio at fair value to breach the covenant, which is tighter than many other BDCs. The Company has an active at-the-market equity program and trades at 1.06x price to book value as of May 12th, 2023, giving it ready-access to issue equity.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/ Social/ Governance factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (May 17, 2022)

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions: https://www.dbrsmorningstar.com/research/402314/global-methodology-for-rating-non-bank-financial-institutions. (September 2, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings: https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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 rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action.

DBRS Morningstar had access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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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