Morningstar DBRS Downgrades Stellus Capital Investment Corp.’s Long-Term Credit Ratings to BBB (low) from BBB; Trend Stable

DBRS, Inc. (Morningstar DBRS) downgraded the Long-Term Issuer Rating and Long-Term Senior Debt rating of Stellus Capital Investment Corp. (Stellus or the Company) to BBB (low) from BBB. The trend on the credit ratings has been revised to Stable from Negative. The Company's Intrinsic Assessment (IA) is BBB (low), while its Support Assessment is SA3, resulting in Stellus' final credit ratings positioned in line with its IA.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings downgrade is based on the sustained elevated financial leverage at Stellus. While regulatory relief excludes Small Business Association debentures (SBA debt) from its regulatory asset coverage ratio, ultimately it has to paid off at maturity and is the source of the Company's higher financial leverage compared to our BDC peers. Other BDCs with SBA debt have broader funding or larger investment portfolios which make the difference between regulatory leverage and financial leverage significantly lower. The credit ratings action also considers Stellus' credit performance with a non-accrual level that is in line with BBB (low) rated BDC peers while equity gains have offset most realized losses historically.

Balancing these constraints, 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 and approximately $2.9 billion of AUM at 4Q23. Stellus has diversified funding avenues with debt maturities that are well laddered with no significant near-term debt maturities. The Company also continues to access the equity markets through its at-the-market equity program when its stock trades at or above net asset value (NAV), raising $62.9 million over 2023.

The Stable trend reflects our view that while the Company will continue to operate with elevated financial leverage due to its reliance on SBA funding, this debt benefits from lower interest costs and a longer duration than other funding sources, while providing a significant buffer to the regulatory asset coverage ratio. We expect credit performance to continue to be in line with our BDC peers while Stellus' franchise strength and acceptable earnings profile supports the credit ratings level.

CREDIT RATING DRIVERS
A material reduction in financial leverage with a sustained improvement in operating performance would result in a credit ratings upgrade. Conversely, should operating performance materially worsen, including notable losses that erode net asset value, or significant credit deterioration, the credit ratings would be downgraded. If financial leverage were to be well above 2.0x debt-to-equity for a sustained period, the credit ratings would also be downgraded.

CREDIT RATING RATIONALE

Franchise Building Block (BB) Assessment: Good / Moderate
Stellus' franchise benefits from its relationship with the Advisor, a private credit manager that focuses on the lower middle market. Stellus provides financing solutions to sponsor-backed companies with $5 million to $50 million of EBITDA, with a weighted average EBITDA of $19 million at 4Q23. The Company's $874.5 million investment portfolio consisted of 89% first lien debt, 2% second lien debt, 1% unsecured debt, and 8% equity positions across 93 portfolio companies at 4Q23.

Earnings Building Block (BB) Assessment: Moderate
The Company's acceptable earnings profile has benefitted from high base rates with a weighted average yield on debt investments of 11.9% at 4Q23, up from 11.1% at 4Q22. For 2023, net investment income (NII) was $42.2 million, up 48% year-over-year, while net increase in net assets resulting from operations (net income) of $17.5 million was constrained by $30.2 million of net realized losses. Realized losses were driven a previously written down portfolio company, Protect America as well as the restructuring of a debt position in ArborWorks, backed by New State Capital Partners. We expect profitability to moderate in the medium-term as base rates appear to be at their peak levels and credit deterioration may continue with the seasoned investment portfolio.

Risk Building Block (BB) Assessment: Good / Moderate
While Stellus' risk profile is acceptable, credit performance has slightly worsened over the last year with net realized losses from certain portfolio companies while four loans remained on non-accrual, representing 4.0% of the investment portfolio at cost at 4Q23. Non-accruals peaked at 7.1% of the investment portfolio at cost at 3Q23, prior to the partial write-off and restructuring of ArborWorks during 4Q23. While PIK interest income has increased to $3.8 million in 2023 from $1.4 million in 2022, it still only represents 4% of total investment income, lower than the 5% average of BDCs under our coverage universe. Payment on PIK is normally received only in the event of payoff, unlike cash interest income and is at risk if a portfolio company defaults.

Funding and Liquidity Building Block (BB) Assessment: Moderate
The Company's diversified funding profile consists of a private placement issuance, multiple issuances of low-rate, long duration (10 year maturity at issuance) SBA debt, and a primary revolving credit facility led by Amegy Bank. SBA debt comprised 56% of the Company's funding at 4Q23, with the first maturities of $16.3 million starting in March 2025 with the full $150 million under SBIC I maturing in small tranches through March 2029. The Company expects to start the process with the SBIC for a third license, though that approval timing remains undefined. At 4Q23, Stellus had liquidity of approximately $126 million comprised of available capacity under the revolving credit facility ($100 million) and cash ($26 million) compared to unfunded commitments of $37 million.

Capitalization Building Block (BB) Assessment: Moderate / Weak
Stellus' regulatory leverage of 0.81x debt-to-equity at 4Q23 remains below management targets of 1.1x debt-to-equity; however, financial leverage, which includes SBA debt, has been elevated compared to Morningstar DBRS' BDC coverage universe with an average of 1.94x debt-to-equity over 2023 and was at 1.83x at 4Q23. While there are numerous benefits for SBA debt as part of the Company's funding structure, we consider high financial leverage as a credit ratings constraint. Stellus' cushion to the Company's credit facility covenant (1.5x regulatory debt-to-equity) was approximately $146.5 million, or 17% of the investment portfolio at 4Q23. Improving capitalization, Stellus has been an active issuer of equity through its at-the-market equity program, raising $62.9 million of equity in 2023.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS   
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.
 
A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at (January 23, 2024) at https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (April 15, 2024): https://dbrs.morningstar.com/research/431187/global-methodology-for-rating-non-bank-financial-institutions. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/about/methodologies.

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

The credit rating was initiated at the request of the rated entity.

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

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit 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. Morningstar DBRS' outlooks and credit ratings are monitored.

For more information on this credit or on this industry, visit dbrs.morningstar.com.

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