Morningstar DBRS Assigns Lafayette Square USA, Inc. Long-Term Credit Ratings of BBB (low) With a Stable Trend
Non-Bank Financial InstitutionsDBRS, Inc. (Morningstar DBRS) assigned a Long-Term Issuer Rating and a Long-Term Senior Debt credit rating to Lafayette Square USA, Inc. (LS or the Company) of BBB (low) with a Stable trend. The Company's Intrinsic Assessment (IA) is BBB (low), while its Support Assessment is SA3 which assumes no timely systemic support, resulting in the Company's final credit rating being equalized with its IA.
KEY CREDIT RATING CONSIDERATIONS
The credit ratings reflect LS' growing franchise with a $668.7 million investment portfolio lending to middle market businesses through a mission-based investment strategy that focuses on supporting working class people in working class communities. The Company's earnings power is acceptable with a weighted average yield on the total investment portfolio of 11.1% at fair value at Q1 2025 while limited mark-to-market volatility and a growing investment portfolio has supported steady improvement in profitability. To date, LS' credit performance has been strong but the Company's limited track record, and top position concentrations constrains its risk profile. The Company has access to low-cost, long-term SBA debt in addition to a revolving credit facility with a sustainability linked pricing structure. LS' capitalization is supportive of the credit ratings level with a financial leverage target range of 1.00x - 1.25x gross debt-to-equity, well below the 2.0x regulatory limit.
The Stable trend is based on our view that despite potential macroeconomic headwinds, LS' affiliated Worker Solutions® product helps engrain enhanced managerial assistance to improve credit outcomes for its non-sponsored and sponsored investment portfolio. The trend also considers uncertainty surrounding tariff and federal spending implications for the Company's portfolio companies, which appears relatively protected given its limited exposure to international customers and supply chains and federal contracts.
CREDIT RATING DRIVERS
Over the long-term, strong financial operating performance combined with enhanced scale of the investment portfolio, reduced portfolio concentrations, diversified funding while maintaining conservative leverage would result in a credit ratings upgrade. Conversely, a meaningful increase in non-accrual investments or a sizeable loss that materially reduces the Company's cushion to regulatory leverage requirements would lead to a credit ratings downgrade. If the Company operates with financial leverage well above its target range for a sustained period, the credit ratings would be downgraded.
CREDIT RATING RATIONALE
Franchise Building Block Assessment: Good / Moderate
LS started investment operations in 2022 with institutional investor equity capital ($360 million in net assets with a $668.7 million investment portfolio at Q1 2025) to lend to middle market companies that are in areas less trafficked by traditional direct lenders. LS is a business development company (BDC), whose franchise strength benefits from its relationship with its external advisor, LS BDC Adviser, LLC (the Advisor) a subsidiary of Lafayette Square Holding Company, LLC (Lafayette Square). Lafayette Square is a private credit platform with approximately $1.0 billion of assets under management including LS, a fund-of-one and separately managed account. LS lends to both sponsored and non-sponsored companies (split approximately in half) focused at the top of the capital structure with 94.2% first lien loans, 5.0% equity investments and 0.8% other investments with 42 portfolio companies with a weighted average EBITDA of $20.4 million at Q1 2025. LS utilizes Lafayette Square's proprietary technology platform, Potomac X Lafayette Square¿ for local socioeconomic data to deliver insights in both origination and underwriting. The Company also offers its portfolio companies a Worker Solutions® affiliated product which allows LS to provide enhanced managerial assistance to optimize employee turnover through benefit enhancements.
Earnings Building Block Assessment: Moderate
As the investment portfolio ramps, LS' earning power continues to improve with a reported net investment income (NII) of $29.6 million for full year 2024 up from $8.7 million for full year 2023 and $8.6 million for Q1 2025. Limited mark-to-market volatility and solid credit performance has strengthened the Company's net increase in net assets (net income) of $27.8 million for full year 2024 compared to $11.0 million in 2023 and $11.1 million for Q1 2025. Since inception, the Company has had no PIK income and LS benefits from low-cost SBA debt. Going forward, we expect earnings may moderate in the medium-term as LS diversifies into more expensive unsecured funding and if asset yields further compress.
Risk Building Block Assessment: Good / Moderate
The Company's risk profile is acceptable with solid credit performance despite vintage and individual portfolio company concentration which has been considered in the credit rating. While there were no investments on non-accrual since inception, LS has a limited track record, and the top five portfolio companies constituted 28.4% of the investment portfolio which is elevated compared to other BDCs. We expect as the investment portfolio scales, that the highest portfolio company exposures of over 5% of the investment portfolio will migrate towards a more manageable level of 2-4% to maintain portfolio diversity. The largest industry concentrations were professional services (9.4%) and commercial services and supplies (8.6%). While half the Company's investment portfolio consists of non-sponsored companies, the portfolio's weighted average interest coverage was 3.0x, net leverage was 3.6x with a loan-to-value of 48%, demonstrating conservative underwriting. With 92.9% of the investment portfolio based on floating rates, a decrease of 100 basis points would decrease annual NII by an estimated $3.5 million at Q1 2025.
Funding and Liquidity Building Block Assessment: Moderate
LS has a funding profile that consists of a revolving credit facility and two SBIC licenses which provides it access to issue low-cost long-term SBA debt (the weighted average stated interest rate was 5.05% at Q1 2025 of the SBA debt). We expect the Company will issue unsecured debt in the near-term and management targets a 35% unsecured debt funding structure. At Q1 2025, the Company had $452.5 million of debt consisting of 45% SBA debt and the remainder from its secured revolving credit facility. Debt maturities begin in 2029 and beyond, giving the Company ample time to diversify and address refinancing and extending the facility. The Company has liquidity of $147.1 million, primarily consisting of unrestricted cash on the balance sheet, which is tight to meet unfunded commitment of $147.9 million (only $74 million of undrawn revolver capacity) at Q1 2025.
Capitalization Building Block Assessment: Moderate
The Company's capitalization is acceptable and supportive of its credit rating level as LS targets a gross GAAP (financial) leverage of 1.00x - 1.25x debt-to-equity ratio, below regulatory limits of 2.0x. The Company operates at 0.69x regulatory debt-to-equity (1.26x on a financial basis) at Q1 2025 but still has undrawn equity commitments of approximately $65.8 million. As a private BDC, the Company's reinvestment period as currently structured lasts until 2032, but LS plans to execute an IPO or exchange listing prior to then once the investment portfolio is fully scaled. Importantly, Morningstar DBRS believes the Company's current leverage and target range have sufficient cushion to the asset coverage ratio (ACR) regulatory limit to absorb potential valuation volatility from the investment portfolio. At Q1 2025, the cushion was approximately $234.8 million, implying that the Company would need to take a full loss on 35% of the $668.7 million investment portfolio at fair value to breach the ACR limit. Dividend coverage from NII for the full year 2024 was 102%, and improved to 103% for Q1 2025. Morningstar DBRS considers dividend coverage from recurring sources of income important for BDCs, given the reliance on access to the equity markets for capital to fund originations and balance sheet growth.
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 Factors in Credit Ratings at (May 16, 2025) https://dbrs.morningstar.com/research/454196.
Notes:
All figures are in US dollars unless otherwise noted.
The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (November 19, 2024) https://dbrs.morningstar.com/research/443208. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (May 16, 2025) https://dbrs.morningstar.com/research/454196 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.
For more information on Morningstar DBRS' policy regarding the solicitation status of credit ratings, please refer to the Credit Ratings Global Policy, which can be found in the Morningstar DBRS Understanding Ratings section of the website: https://dbrs.morningstar.com/understanding-ratings.
The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' trends and credit ratings are under regular surveillance.
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