Morningstar DBRS Confirms Stellus Capital Investment Corporation's Long-Term Credit Ratings at BBB (low) With a Stable Trend

DBRS, Inc. (Morningstar DBRS) confirmed the Long-Term Issuer Rating and Long-Term Senior Debt rating of Stellus Capital Investment Corporation (Stellus or the Company) at BBB (low), with a Stable trend. The Company's Intrinsic Assessment (IA) is BBB (low), while its Support Assessment is SA3, resulting in the Company's final credit rating being equalized with its IA.

KEY CREDIT RATING CONSIDERATIONS
The confirmation of the credit ratings reflects Stellus' balanced operating performance supported by its solid franchise anchored by its external-advisor, Stellus Capital Management (the Advisor), a private credit manager focused on the lower middle market. The Advisor grew its assets under management (AUM) by 21% year-over-year to $3.4 billion at Q4 2024. Earnings have remained solid despite lower debt portfolio yields with improving profitability as fair value marks were minimal through 2024. However, the Company's asset level credit performance worsened as non-accruals increased to its highest level in over five years, demonstrating challenges in lower middle market companies. The Company's funding is relatively reliant on its SBA debentures which constitute more than half of its funding structure alongside its revolving credit facility and private placements. As its SBA debentures began to mature in March 2025, the Company is in the process of applying for a third SBIC license though timing for that approval is uncertain. Importantly, capitalization has improved as leverage is well below the Company's target level but is still high on a financial basis compared to BDC peers. The Company has had a track record of its co-investment equity gains offsetting most of its historical realized losses, and its ability to manage its leverage through the at-the-market (ATM) equity issuance program when it trades at a premium to net asset value are also supportive of the credit ratings level. However, Stellus currently trades at 0.93x P/BV as of April 9, 2025, limiting access to the equity ATM.

The Stable trend is based on our view that despite volatility in macroeconomic conditions from changing U.S. government policies, Stellus' improved capitalization, franchise strength, and solid earnings generation ability, balance credit weakness in its investment portfolio. The trend also considers uncertainty surrounding tariff implications for the Company's lower middle market portfolio, which appears relatively protected given its limited exposure to international customers and supply chains.

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 Assessment: Good / Moderate
Stellus' franchise benefits from its relationship with the Advisor, whose AUM outside of the BDC provides additional pockets of capital to invest alongside the BDC due to SEC co-investment exemptive relief, which mitigates concentration risk while speaking for larger underwritten transactions. The Company provides financing to lower middle market, sponsor-backed companies with $5 million to $50 million of EBITDA, with a weighted average EBITDA of approximately $18.5 million. The Company's $953.5 million investment portfolio was comprised of 90% first lien debt, 1% second lien debt, 1% unsecured debt and 8% equity positions across 105 portfolio companies at Q4 2024.

Earnings Building Block Assessment: Moderate
The Company's earnings power has improved even though the weighted average yield on debt investments decreased by approximately 160 basis points from the prior year to 10.3% as of December 31, 2024, as mark-to-market realized and unrealized gains and losses largely offset each other. The Company reported a net increase in net assets (net income) of $45.8 million for full year 2024 up from $17.5 million for 2023, which had been constrained by net realized losses. Net investment income (NII) was $41.9 million for 2024, relatively flat to $42.2 million for 2023, as the investment portfolio grew by 9% year-over-year, and there was $1.8 million of income incentive fees that were waived. PIK income remains low at 3% of total investment income, down from 4% in 2023, from restructuring investments to support portfolio company liquidity. Stellus does not provide PIK toggles at the start of a loan for its lower middle market borrowers, unlike in the upper middle market or technology focused growth industries where initial PIK toggles have become more prevalent. We believe some earnings pressure may come from the refinancing of low-cost SBA debentures which after ten years are coming to maturity.

Risk Building Block Assessment: Good / Moderate
Credit performance has weakened as non-accruals increased to 7.8% of the total investment portfolio at cost (8.3% of the debt investments) at Q4 2024, the highest it has been in over six years consisting of seven portfolio companies. Five of the portfolio companies went on non-accrual during 2024, and while remediation plans are underway, we note that restructurings may take an extended period, particularly for lower middle market borrowers that may have less operational flexibility as larger competitors. Of the investment portfolio, 5.3% of the investments at cost was fair value marked at or below 85% of cost at Q4 2024. Earnings benefited from realized and unrealized gains of $14.6 million on Stellus' equity investments outweighing losses in its debt investments for 2024.

Funding and Liquidity Building Block Assessment: Moderate
The Company's funding profile consists of low-cost, long duration SBA debt, a revolving credit facility led by Amegy Bank, and unsecured notes. On April 1, 2025, the Company closed a $75 million 7.25% unsecured notes due April 2030, demonstrating funding resiliency in volatile market conditions. SBA debt was 54% of Stellus' funding at Q4 2024, with $16.3 million subsequently repaid in March 2025 and an additional $48.8 million maturing through 2026. Pro-forma for the issuance, unsecured debt (excluding SBA debt) consisted of approximately 30% of total drawn funding. The Company is applying for its third SBIC license which would allow it to draw a total of $350 million in SBA debt across the platform, but the timing of an approval undefined. At Q4 2024, the Company had liquidity of approximately $160 million consisting of $140 million of available capacity under the revolving credit facility and $20 million of cash, more than sufficient to cover unfunded commitments of $41.3 million.

Capitalization Building Block Assessment: Moderate / Weak
Stellus' regulatory leverage of 0.75x debt-to-equity (1.6x financial leverage, which includes SBA debentures as debt) at Q4 2024 remains below management target of 1.0x for regulatory leverage. On a financial leverage basis, including SBA debentures as debt, financial leverage improved to 1.6x from 1.8x a year ago but is still elevated on a financial basis compared to BDC peers. While we expect management to increase both leverage ratios over the medium-term, current levels are supportive of the credit ratings. The Company raised $46.5 million of equity through its ATM program in 2024, which allows it to manage leverage levels when trading above NAV. The cushion to the asset coverage ratio (ACR) cap was approximately $231.9 million per our estimates, implying that Stellus would need to take a full loss on 24% of its investment portfolio to breach the 2.0x regulatory limit.

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 (August 13, 2024) https://dbrs.morningstar.com/research/437781

Notes:
All figures are in U.S. 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 (August 13, 2024) https://dbrs.morningstar.com/research/437781 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 these credit ratings 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 our Credit Ratings Global Policy, which can be found in the Morningstar DBRS Understanding Ratings section of our website.

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.

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

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