DBRS Morningstar Assigns Long-Term Ratings of BBB to Stellus Capital Investment Corp., Trend Neg

DBRS, Inc. (DBRS Morningstar) has assigned a Long-Term Issuer Rating of BBB and a Long-Term Senior Debt Rating of BBB to Stellus Capital Investment Corporation (Stellus). The trend on the ratings is Negative. The Company’s Intrinsic Assessment (IA) is BBB, while its Support Assessment is SA3.

KEY RATING CONSIDERATIONS
The ratings reflect Stellus’ solid franchise in lending to U.S. middle market companies, the well-established management team that has worked together through several business and economic cycles, solid earnings generation, and appropriately managed leverage. Additionally, the ratings consider the investment portfolio’s moderately higher portion of non-first lien investments relative to other business development company (BDC) peers, a degree of key man risk, and the required level of earnings distribution as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code. While the funding profile is reliant on secured forms of wholesale funding, a large portion of the secured funding is comprised of SBA-guaranteed debt, which we view more favorably since it provides long-dated, low cost funding.

The Negative trend reflects DBRS Morningstar’s view that the challenging and uncertain environment due to the Coronavirus Disease (COVID-19) pandemic has the potential to adversely impact the performance of the investment portfolios of BDCs. While we note that the performance of Stellus’ investment portfolio through the pandemic has been sound, we see the headwinds for middle market borrowers in the current environment as still substantial. These concerns are somewhat mitigated by support of Stellus’ portfolio companies from private equity sponsors, which may selectively invest additional capital in their portfolio companies.

RATING DRIVERS
Given the Negative trend, a ratings upgrade is unlikely in the near-term. The trend would return to Stable if Stellus were to sustain appropriate balance sheet fundamentals, while generating acceptable earnings despite the headwinds from the coronavirus pandemic. Should the uncertain environment caused by the coronavirus pandemic result in significantly weakened credit fundamentals, the ratings would be downgraded. A significant and sustained deterioration in the buffer to the regulatory leverage requirements would also result in a ratings downgrade.

RATING RATIONALE
DBRS Morningstar views Stellus’ franchise as solid benefiting from access to Stellus Capital Management’s (Stellus Capital or the Advisor) senior investment professionals and their relationships. Houston, Texas-based Stellus Capital was formed in 2012, as a spin-out of the direct capital unit of D.E. Shaw, the management of which have worked together for more than 20 years. As of September 30, 2020, Stellus Capital and its credit-focused funds managed approximately $1.6 billion of AUM. Stellus benefits from the strong sourcing and sponsor relationships of the Advisor developed by management over their long history of lending to the sponsored middle market space. The Advisor sources investment opportunities from the more than 155 sponsors its management has worked with over their careers. Over the last 12 months, Stellus Capital has screened over 500 deals for potential investment, of which the Company closed approximately 2% of those reviewed. The Stellus platform product offering is diverse with a range of products available to investors including the BDC, as well as private credit funds. As of September 30, 2020, Stellus’ investment portfolio totaled 66 companies with a fair value of $622.4 million with 80% of the investment portfolio comprised of first lien senior secured, 10% second lien, 3% unsecured, and 7% equity investments.

Stellus’ credit risk profile is viewed as solid. The Company’s investment portfolio is primarily comprised of debt investments to sponsor-backed middle market companies. We consider the credit risk profile of all BDCs as high given their focus on small and middle market lending, which are companies that typically have less flexibility during periods of economic stress. Furthermore, these investments held by BDCs tend to be illiquid. The Company’s portfolio is considered slightly more risky than those of other middle market focused BDCs given that 10% of the Company’s investment portfolio is comprised of second lien loans, which is moderately higher than most peers. However, some of these second lien loans are actually unitranche last pay loans. Further, the component of second lien loans has been reduced from 30% at year-end 2018.

We consider the Company’s risk management system, including due diligence process, underwriting, valuation and monitoring functions, to be sound. Generally, Stellus prefers to make investments in portfolio companies that are new to private equity sponsorship and prefers that the funds are early in their investment cycle. Overall, credit performance has been solid since inception with a recent elevation in nonaccrual investments due to portfolio company specific reasons, as well as the coronavirus pandemic. At September 30, 2020, Stellus had five investments on non-accrual status representing 6.8% of the investment portfolio at cost, or 1.6% at fair value.

Earnings generation is viewed as sound with Stellus exhibiting consistent profitability supported by a good level of recurring investment income from debt investments and appropriate cost management. Overall, the Company’s profitability has also benefited during the last couple of years from realized gains on equity investments. Stellus has generated an annual profit each year since 2014 and had been profitable on a quarterly basis for 16 consecutive quarters until 1Q20. The loss in 1Q20 was driven by the general movement in market spreads as the coronavirus pandemic intensified, driving unrealized losses on the investment portfolio. Subsequently, Stellus reported net income (net increase in net assets resulting from operations) of $47.3 million for 2Q20 and 3Q20 combined. The significant improvement in results reflect a slight rise in net investment income and a material write-back in fair value of portfolio investments as credit spreads tightened in 2Q20, reversing most of the MTM losses. Unrealized losses in the 9M20 totaled $11.1 million, and 9M20 net income was $3.4 million versus $24.6 million in 9M19.

Stellus’ funding profile is appropriately diversified. As of September 30, 2020, the Company was reliant on secured forms of wholesale funding with unsecured funding comprising just 12% of the total $390.9 million of debt outstanding. We note that $158.1 million, or 40% of funding, is comprised of SBA debt. While SBA debt is a form of secured debt, we view such debt favorably as it is a long-term, low-cost source of funding. Refinancing requirements are very manageable with no meaningful maturities until $48.9 million of senior notes mature in September 2022. Liquidity is solid with sufficient available liquidity to meet requirements. At September 30, 2020, Stellus had total available liquidity of $113.0 million, which includes cash and investments, available capacity under the revolving credit facilities, subject to borrowing base requirements, as well as SBA-debt issuing capacity. Meanwhile, the Company had $30.7 million in unfunded commitments, or just 27% of available liquidity.

Capital is considered solid and prudently managed. Overall, the Company’s GAAP leverage is higher than that of most BDCs, but on a regulatory basis, excluding SBA debt, leverage has been below the DBRS Morningstar peer average since 2017, and consistent with the ratings. Stellus’ leverage (excluding SBA debt) has averaged 0.68x over the last five years, and was 0.90x at September 30, 2020. With the adoption of the higher regulatory leverage limit in June 2018, Stellus has set a leverage target of 1.00x debt to equity, which would be consistent with the ratings per DBRS Morningstar’s methodology. Importantly, we see the new leverage target as still leaving a solid cushion to the ACR regulatory limit to absorb potential valuation volatility in the investment portfolio. As of September 30, 2020, we estimate the Company’s cushion to the credit facility’s leverage cap (debt to equity of 1.50x) at $103.3 million, implying that Stellus would need to incur a loss on 17% of its investment portfolio at fair value to breach the credit facility’s leverage covenant. We note that the Company has sought and received annual shareholder approval to issue common stock below net asset value, if necessary, which we view as prudent capital management.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financials (September 29, 2020): https://www.dbrsmorningstar.com/research/367510/global-methodology-for-rating-non-bank-financial-institutions.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. 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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