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

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Stellus Capital Investment Corporation (SCM or the Company), including the Company’s Long-Term Issuer Rating of BBB. DBRS Morningstar also has revised the trend on the ratings to Stable from Negative. The Company’s Intrinsic Assessment (IA) is BBB, while its Support Assessment is SA3, resulting in SCM’s final ratings positioned in line with its IA.

KEY RATING CONSIDERATIONS
The confirmation of the ratings reflects SCM’s consistent performance through the challenging economic environment due to the Coronavirus Diseases (COVID-19) pandemic, while maintaining appropriate leverage. SCM’s performance is supported by its established middle market lending franchise with a management team that has worked together through several business and economic cycles. The ratings also consider management’s progress shifting its investment portfolio mix to first lien loans from second lien. Further, the confirmation reflects the Company’s diverse funding profile through unsecured debt issuance and SBA-guaranteed debt, and well-laddered debt maturity profile. The Company’s lower percentage of first lien senior secured loans in its investment portfolio versus BDC peers is also considered in the ratings.

The Stable trend reflects DBRS Morningstar’s view that some key sources of uncertainty related to the pandemic are behind us, contributing to the broader market certainty and investor conviction. Most businesses have adapted to social distancing practices and periodic government restrictions on activities that address recent waves in new virus cases. The successful vaccination roll-out to communities across the U.S. continues which should support a more permanent reopening of the economy. Consistent with our moderate economic scenario published May 4th, 2021, expectations are for a strong economic recovery in 2021, buffered by government stimulus and central bank actions that should produce robust origination pipelines for BDCs. We expect some deterioration in credit quality across the BDC sector due to specific portfolio company situations. This concern is somewhat mitigated by support of SCM’s portfolio companies from private equity sponsors, which may selectively invest additional capital in their portfolio companies.

RATING DRIVERS
Over the longer term, sustained strong earnings supported by growth of the investment portfolio while maintaining credit quality and disciplined deployment of leverage would result in a ratings upgrade. Additional unsecured debt that unencumbers the balance sheet in a leverage neutral transaction would be viewed positively. Conversely, weak performance in the investment portfolio which erodes net asset value (NAV) would result in a ratings downgrade. A significant deterioration in the buffer to the regulatory leverage requirements or if dividend distributions are not covered by net investment income for an extended period of time, would result in a ratings downgrade.

RATING RATIONALE
We view SCM’s sound franchise as benefiting from access to Stellus Capital Management’s (the Advisor) senior investment professionals and their relationships. The Advisor was formed in 2012, as a spin-out of the direct capital unit of D.E. Shaw. As of March 31, 2021, the Advisor and its credit-focused funds managed approximately $1.8 billion of assets under management. SCM benefits from the strong sourcing and sponsor relationships of the Advisor developed by management over their more than 20 years of working together and lending to the sponsored middle market space. As of March 31, 2021, SCM’s investment portfolio totaled 70 companies with a fair value of $714.5 million, with 79.0% of the investment portfolio comprised of first lien senior secured, 8.6% second lien, 4.5% unsecured, and 7.9 equity investments.

SCM has an acceptable credit risk profile which has benefited from management’s investment portfolio shift towards sponsor-backed first lien, senior secured loans to middle market companies and away from second lien loans. Indeed, the percentage of first lien loans in the investment portfolio has been materially increased from 38% at year-end 2017, when the Company shifted its investment focus towards senior parts of the capital structure. Nonetheless, at 79% of the investment portfolio, SCM’s first lien loan component still trails the similarly rated peer average. Overall, credit performance has been acceptable since inception with a recent elevation in nonaccrual investments due to portfolio company specific reasons, as well as the coronavirus pandemic. At March 31, 2021, SCM had five investments on non-accrual status representing 5.3% of the investment portfolio at cost, or 1.8% at fair value.

Earnings generation is viewed as sound with SCM exhibiting consistent profitability despite the loss in 1Q20 due to credit spreads widening. For 2020, SCM reported a net change in assets from operations (net income) of $20.2 million, which was a 24% decrease from 2019. However, results improved in 1Q21, with net income totaling $4.9 million, as portfolio valuation marks largely stabilized, compared with a loss of $45.7 million in 1Q20. The Company’s earnings are supported by a good level of recurring investment income from debt investments and appropriate cost management. In 1Q21 and 2020, 97% and 98% of total investment income was comprised of interest income from debt investments. SCM’s profitability has also benefited during the last couple of years from realized gains on equity investments, which management sees as offsetting any realized losses on loans.

SCM continues to diversify its funding profile, most recently with a $100 million institutional unsecured debt issuance in January 2021 that refinanced its existing $49 million notes due in 2022, as well as paid off credit facility borrowings. The Company is reliant on wholesale funding with traditional unsecured funding comprising 21% of the total $476 million of debt outstanding. We note that $210 million, or 44% of total funding, is comprised of SBA debt. We view SBA debt favorably as it is a long-term, low-cost source of funding. Refinancing requirements are very manageable with no meaningful maturity until 2024, when the credit facility revolving period ends. Liquidity is solid with sufficient available liquidity to meet requirements which are primarily unfunded commitments of $22.8 million at March 31, 2021.

Capital is considered solid and prudently managed. Overall, the Company’s GAAP leverage is higher than the DBRS Morningstar BDC peer group, but on a regulatory basis which excludes SBA debt, leverage has been below the peer average since 2017, and consistent with the ratings. SCM’s regulatory leverage has averaged 0.7x over the last five years, and was 1.0x at March 31, 2021. SCM has set a leverage target of 1.0x debt to equity, which would be consistent with the ratings per DBRS Morningstar’s methodology.

Importantly, we see the leverage target as still leaving a solid cushion to the ACR regulatory limit to absorb potential valuation volatility in the investment portfolio. As of March 31, 2021, we estimate the Company’s cushion to the credit facility’s leverage cap (debt to equity of 1.50x) at $99.4 million, implying that SCM would need to incur a loss on 14% of its investment portfolio at fair value to breach the credit facility’s leverage covenant.

While SCM has no intention to issue dilutive new equity, SCM has received annual shareholder approval to issue common stock below net asset value, if necessary, which we view as prudent capital management. Additionally, SCM has an active at-the-market equity program in place that may be utilized to manage overall leverage. The Company may issue under the program, should the stock trade to a level where management feels comfortable issuing accretive equity.

ESG CONSIDERATIONS
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/373262.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 29, 2020): https://www.dbrsmorningstar.com/research/367510/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.

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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