DBRS Morningstar confirmed the long-term ratings of Stellus Capital Investment Corp. to BBB with a stable trend

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Stellus Capital Investment Company (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 rating (IA) is BBB, while its support rating is SA3, making Stellus’ final ratings in line with its IA.

KEY SCORING CONSIDERATIONS

The confirmation of the ratings reflects the continued growth of Stellus’ portfolio while generating acceptable earnings, maintaining credit quality performance and regulatory leverage at its target level. The company is backed by its lower-middle-market lending franchise with a management team that has worked together for decades through multiple economic and business 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 reflect the company’s high overall financial leverage (including SBA debt) mitigated by its focus on sponsor-backed portfolio companies and increased senior secured portfolio composition.

The stable trend reflects our view that geopolitical instability in Europe as well as the rising interest rate environment and heightened inflationary pressures, while increasing the risk to continued WE economic recovery, will not weigh too much WE middle market private companies. To date, Stellus portfolio companies have generally been able to pass on rising costs to end customers, easing pressures on their product and service profit margins due to inflation, disruptions supply chain and rising input costs, including energy prices.

DRIVER RATING

Longer term, strong and sustained earnings supported by growth in the investment portfolio while maintaining strong credit quality and disciplined deployment of leverage would lead to improved ratings. Conversely, a sustained increase in overall financial leverage (despite regulatory SBA debt relief) would cause ratings to downgrade. Poor performance of the investment portfolio which erodes the net asset value (NAV), or if dividend distributions are not covered by net investment income for an extended period, would also result in downgrading of ratings.

RATING RATIONALE

The Company’s franchise benefits from access to Stellus Capital Management (the Advisor) seasoned investment professionals and their expertise in the lower middle market sector. At the end of 2021, Stellus’ $773 million the investment portfolio at fair value consisted of 84% first lien, 7% second lien, 1% unsecured investments 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 private perpetual BDC effective March 2022. Stellus is able to co-invest in private credit assets through these different investment vehicles, which helps diversify the company’s balance sheet while strengthening its market competitiveness by improving its ability to speak for sizes of more significant transactions and to win mandates as lead arranger.

Earnings have remained relatively strong, supported by a growing investment portfolio that generates consistent interest income. Stellus announced a net increase in net operating assets (net income) of $33.6 million in 2021, against $21.2 million in 2020 due to portfolio growth, which increased interest income, and higher net realized gains on the investment portfolio. Total investment income (composed primarily of interest income on debt investments) was $63.7 million in 2021 an increase of 12% compared to 2020, and a net investment income (NII) of $19.8 milliona decrease of 10% compared to 2020 due to the increase in interest expenses and incentive bonuses.

The Company’s risk profile is acceptable and has benefited from management’s strategic shift towards sponsor-backed senior lending to lower middle market companies from riskier junior capital. Senior loans represented 84% of the investment portfolio at the end of 2021, a dramatic increase from 38% at the end of 2017. Credit performance was reasonable with three investments not recognized, representing 4.0% of the total investment portfolio. at cost at end-2021, down from the peak of 6.4% of the total investment portfolio at cost in 3Q20. With the investment portfolio being 96% floating rate (LIBOR), interest rate risk from continued Fed rate hikes is limited, and earnings should benefit once benchmark rates in force will have exceeded the interest rate floors by approximately 1% of the investment portfolio.

Stellus’ funding profile has been expanded with a $100 million issuance of institutional debt in January 2021, which refinanced all short-term debt maturities. Therefore, the Company’s earliest deadline is not before 2025 ($26 million of SBA debt). At the end of 2021, nearly half (47%) of the Company’s financing consisted of SBA debt. Positively, this debt is long-term, a low-cost source of funding and exempt from regulatory asset coverage ratio (ACR) calculation to encourage small business lending. The Company has sufficient liquidity in the form of unused capacity on its credit facility of $72.7 million (subject to borrowing base limits) and cash $44.2 millionagainst unfunded commitments of $30.7 million at the end of 2021.

Capitalization has weakened slightly in recent quarters, despite lower regulatory leverage, which excludes SBA debt, as the company’s overall financial leverage remained at a high level compared to DBRS Morningstar BDC. While Stellus’ regulatory leverage at the end of 2021 was 0.97x the debt-to-equity ratio, financial leverage was high at 1.85x, averaging 1.87x over 2021. Management has a regulatory leverage target of approximately 1.1x. The Company’s cushion against its covenant on the credit facility (1.5x the leverage ratio) has been $100.2 million at the end of 2021, which implies that it would have to incur a loss of 13% of its investment portfolio at fair value to break the covenant, which would give it a solid cushion at this stage; especially considering the average size of the holds $11 million within the investment portfolio.

ESG CONSIDERATIONS

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

Remarks:

The main methodology is the Global Rating Methodology for Non-Banking 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.

Primary sources of information used for this rating include Morningstar Inc. and company documents. DBRS Morningstar considers that the information available to it for the purpose of providing this rating was of satisfactory quality.

The rated entity or its related entities participated in the rating process for this rating metric. 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, conditions that lead to a negative or positive trend assignment are resolved within 12 months. DBRS Morningstar’s outlook and ratings are monitored regularly.

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

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Ratings

Date Issued	Debt Rated	Action	Rating	Trend	Attributesi

US = Lead Analyst based in the USA

CA = Lead Analyst based in Canada

EU = Lead Analyst based in EU

UK = Lead Analyst based in UK

E= EU approved

U= UK approved

Unsolicited participation with access

Unsolicited participation without access

Unsolicited Non Participating

05-May-22	Long-Term Issuer Rating	Confirmed	BBB	Stb	US
05-May-22	Long-Term Senior Debt	Confirmed	BBB	Stb	US

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