2023-06-14 21:24:45 ET
Summary
- Fidus Investment is a BDC sporting an attractive 8.2% dividend yield that will be shown to be appropriate for income portfolios.
- Pros include a history of consistent underwriting gains and a high percentage allocation of assets to senior secured debt.
- Cons include a higher than typical management fee and higher than typical cost of leverage.
- Overall, FDUS is valued fairly by the market, trading at roughly NAV.
Introduction
With the Federal Reserve raising interest rates to a significant range of 5.00-5.25%, banks and financial institutions are engaging in intense competition to provide more attractive interest rates on savings accounts and CDs. Currently, the top online accounts in the market offer around 3-5% interest, which is respectable but may not be sufficient for substantial wealth accumulation or maintaining spending power. In such a scenario, it is worth considering whether we are willing to venture into the risk-return spectrum, taking on some level of risk in exchange for potentially higher returns.
BDCs stand out as income-producing investments that produce a significant yield significantly higher than 3-5%. One such example is Fidus Investment ( FDUS ), which provides customized debt and equity financing solutions to lower middle-market companies, defined as U.S. based companies having revenues between $10.0 million and $150.0 million. FDUS' investment objective is to provide attractive risk-adjusted returns by generating both current income from their debt investments and capital appreciation from their equity related investments.
Before we go digging into FDUS' track record, we need to make some motivating information about BDCs and the aspects and limitations of their form.
By law, BDCs must distribute at least 90% of their net investment income as dividends. As a result, BDCs have limited capacity to retain earnings. Consequently, assessing their credit quality and underwriting practices becomes crucial for investors. BDCs with poor underwriting generally experience a decline in net asset value ((NAV)) over time, causing their share prices to decrease.
Overseeing all these aspects are either internal or external managements who receive compensation based on their fee schedules. It is essential to evaluate whether these fee structures incentivize the management to act in the best interests of the shareholders.
BDCs primarily focus on investing in loans provided to middle market businesses. These businesses are too large to qualify for traditional bank loans but too small to access the bond markets. Typically, these loans have an interest rate of prime plus 2-4% and are often floating rate loans.
To enhance their returns, BDCs employ leverage and generate income to cover management fees. Leverage liabilities include bonds, notes, and baby bonds, with interest rates varying based on the issuer's rating and asset portfolio. BDCs are legally bound to maintain a debt-to-equity ratio of 2 or below, although most BDC managements prefer to stay well below this threshold.
All of this means that a thorough investigation of FDUS will need to answer the following six questions:
- Are management & incentive fees in alignment with shareholders?
- Are balance sheet leverage levels reasonably close to a debt to equity ratio equaling 1?
- Do assets tend to be on the conservative side: emphasis on senior secured debt instruments, preferably with floating rates?
- How has FDUS' credit quality been in recent years?
- Is FDUS competitive with other BDCs in terms of its debt vis-à-vis leverage with low interest rates?
- Is there wide diversification by industry, with tilt away from cyclical sectors of the economy?
I will also compare FDUS with the BDCs that I have already analyzed in my most recent articles:
- Ares Capital: Why Its 10% Dividend Belongs In Any Income Portfolio
- FS KKR Capital: 20% Discount To Book Value, 12.9% Dividend Yield Compensate For Weaknesses
- Golub Capital: Why This 10% Yield Is Suitable For Income Investing
- Goldman Sachs BDC: 13% Dividend Yield Does Not Compensate For Poor Underwriting
- Owl Rock Capital: Great 10% Income Yield Where Management Is Aligned With Shareholders
Management Fees Not Entirely Aligned With Shareholders
I will quote the relevant excerpts directly from the most recent 10-K filing, and explain their significance, and make comparisons. BDCs typically charge two meaningful fees: the base management fee and the income incentive fee.
Base Management Fee
The base management fee is calculated at an annual rate of 1.75% of the average value of our total assets (other than cash or cash equivalents but including assets purchased with borrowed amounts).
This one is simple: FDUS charges an amount equal to 1.75% of gross assets per year as its base management fee. Note that it does not have a provision for tapering the base management fee as a function of the amount of leverage FDUS has in its balance sheet - several BDCs do this so that the rewards of leverage are passed on to shareholders. FDUS also stands out as charging the highest base management fee of all the BDCs I have analyzed so far:
Assets below debt to equity ratio of 1 | Assets above debt to equity ratio of 1 | |
FDUS | 1.75% of gross assets/year | 1.75% of gross assets/year |
ARCC | 1.50% of gross assets/year | 1.00% of gross assets/year |
FSK | 1.50% of gross assets/year | 1.00% of gross assets/year |
GBDC | 1.375% of gross assets/year | 1.375% of gross assets/year |
GSBD | 1.00% of gross assets/year | 1.00% of gross assets/year |
ORCC | 1.00% of gross assets/year | 1.50% of gross assets/year |
FDUS' base management fee is the least aligned with shareholders, of the BDCs that I have analyzed so far.
Income Incentive Fee
- no incentive fee in any calendar quarter in which the pre-incentive fee net investment income does not exceed the hurdle rate of 2.0%;
- 100.0% of our pre-incentive fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle rate but is less than 2.5% in any calendar quarter...
- 20.0% of the amount of our pre-incentive fee net investment income, if any, that exceeds 2.5% in any calendar quarter.
Let's translate this back into annual return figures for context. After the base management fee has been paid, any profits beyond a hurdle rate of 8.0% but below 10.0% of NAV / year are charged as the income incentive fee, as well as 20% of returns above 10.0% of NAV / year.
This means that management is encouraged by the incentive fee structure to take on more than the minimum amount of risk needed to earn a 10% return on NAV. This means that management is incentivized to make sure that its asset portfolio yields at least roughly 10% to be able to earn the second part of its incentive fee.
So far, FDUS' fees mirror those of a hedge fund's classic "two and twenty" - two percent of assets, and 20% of profits.
Overall, FDUS charges the highest management fees of all BDCs that I have analyzed so far.
Balance Sheet Leverage Is Relatively Low
The use of balance sheet leverage amplifies the impact of underwriting losses on NAV. When leverage is higher, underwriting losses have a greater impact on NAV per share. Therefore, it is crucial for BDCs to have control over the amount of leverage they employ and not pursue excessive leverage solely for the purpose of generating immediate management fees.
Below are some figures that compute the debt to equity ratio for FDUS:
(millions) | Total Liabilities | Total Equity | Debt To Equity Ratio |
Q1 2023 | 464.4 | 484.6 | 0.96 |
2022 | 455.6 | 480.3 | 0.95 |
2021 | 409.4 | 487.8 | 0.84 |
2020 | 465.0 | 410.8 | 1.13 |
2019 | 337.1 | 412.3 | 0.82 |
2018 | 290.9 | 403.0 | 0.72 |
2017 | 253.0 | 393.3 | 0.64 |
2016 | 233.0 | 353.8 | 0.66 |
2015 | 233.3 | 247.4 | 0.94 |
In 2019, legislation was passed to increase the allowable debt to equity ratio in BDCs from 1 to 2. However, as we can see, FDUS management chose not to increase the balance sheet leverage, even though it could generate more fees for management. Currently, the typical debt to equity ratio in BDCs is about 1.3, however FDUS has kept it at about 1.
This is a testament to FDUS' management's restraint in using leverage.
Majority Of Assets First Lien Senior Secured Debt & Variable Rate
BDCs have the flexibility to invest in a wide range of debt and equity instruments, each carrying different levels of risk. Among these, first lien senior secured debt stands out as the most conservative option. Therefore, income investors would find it desirable to observe a significant proportion of first lien senior secured debt on FDUS' balance sheet. Below is an exhibit from the Q1 2023 10-Q Filing that displays the composition of FDUS' assets:
The majority of FDUS' assets are first lien senior secured debt, followed by a large allocation of second lien senior secured debt. These serve to anchor FDUS' portfolio in stability. Comparing FDUS with other BDCs that I have analyzed so far:
% Allocation to Senior Secured Debt | |
FDUS | 74.7% |
ARCC | 42.1% |
FSK | 60.3% |
GBDC | 94.6% |
GSBD | 86.9% |
ORCC | 71.3% |
Additionally, the vast majority of FDUS' assets are also variable rate, an added plus, since variable rate assets have less volatility in value relative to interest rate fluctuations:
As of March 31, 2023, the fair value of our investment portfolio totaled $897.3 million and consisted of 78 active portfolio companies and two portfolio companies that have sold their underlying operations. As of March 31, 2023, 43 portfolio companies’ debt investments bore interest at a variable rate, which represented $549.9 million, or 71.2% , of our debt investment portfolio on a fair value basis, and the remainder of our debt investment portfolio was comprised of fixed-rate investments.
Excellent Underwriting History
The rate of NAV growth or decline in a BDC is predominantly influenced by the quality of its underwriting. For long-term income investors, a stable NAV is desirable, with the average annual change rate in NAV ideally approaching zero over the long run, or even more preferably, a positive rate that indicates appreciation of investments.
The following figures are extracted from the past 10-K filings of FDUS, providing insights into its underwriting performance.
(millions) | Total Net Realized Gain On Investments | Total Net Change In Unrealized appreciation (depreciation) | Total realized & unrealized gain (loss) | Total NAV | NAV Change Rate |
2022 | 65.6 | -65.7 | -0.1 | 480.3 | -0.01% |
2021 | 55.8 | 41.5 | 97.3 | 487.8 | 24.92% |
2020 | -1.0 | -6.6 | -7.5 | 410.8 | -1.80% |
2019 | -1.2 | 18.2 | 17.0 | 412.3 | 4.31% |
2018 | -10.3 | 25.7 | 15.4 | 403 | 3.99% |
2017 | 17.9 | -5.4 | 12.5 | 393.3 | 3.28% |
2016 | -13.8 | 29.0 | 15.2 | 353.8 | 4.48% |
2015 | 9.5 | -10.1 | -0.6 | 247.4 | -0.22% |
2014 | -17.0 | 13.3 | -3.8 | 243.3 | -1.53% |
2013 | 30.6 | -22.2 | 8.4 | 211.1 | 4.14% |
Average | 4.15% |
The average NAV change rate of 4.15%/year, averaged over a full market cycle, stands out as by far the best of all BDCs that I have analyzed so far:
Average Annual NAV Change Rate | |
FDUS | +4.15% |
ARCC | +0.30% |
FSK | -0.84% |
GBDC | +0.23% |
GSBD | -3.96% |
ORCC | -0.37% |
FDUS' underwriting has been simply excellent: over the last market cycle, the underlying earnings power of each share has grown by 4.15%/year!
Somewhat Higher Cost Of Liabilities
I analyze FDUS' total cost of liabilities by comparing it to the yield of AAA corporate bonds, as well as the same cost for ARCC (largest BDC on the market) and GBDC (lowest cost of liabilities I've found so far). To conduct this assessment, I will use data extracted from FRED. The calculation for FDUS' cost of liabilities will involve dividing its interest expense by its total liabilities. This simplified approach will help us evaluate the relative costs effectively.
(millions) | Net Interest Expense | Total Liabilities | FDUS Cost of Liabilities | AAA bond yield | ARCC Cost of Liabilities | GBDC Cost of Liabilities |
2022 | 18.7 | 455.6 | 4.10% | 4.07% | 3.54% | 2.85% |
2021 | 19.2 | 409.4 | 4.69% | 2.70% | 3.11% | 2.55% |
2020 | 19.7 | 465.0 | 4.24% | 2.48% | 3.51% | 3.66% |
2019 | 17.1 | 337.1 | 5.07% | 3.39% | 3.91% | 2.00% |
2018 | 12.7 | 290.9 | 4.37% | 3.93% | 4.29% | 3.83% |
2017 | 9.8 | 253.0 | 3.87% | 3.74% | 4.29% | 3.96% |
2016 | 10.6 | 233.0 | 4.55% | 3.67% | 4.56% | 3.16% |
2015 | 9.4 | 233.3 | 4.03% | 3.89% | 5.24% | 2.98% |
FDUS' cost of liabilities is higher than the AAA bond yield, and also generally higher than for both ARCC and GBDC.
Wide Diversification By Industry & Little Cyclical Exposure
FDUS' asset portfolio exhibits a substantial level of diversification across various industries, with a notable emphasis on minimizing exposure to cyclical sectors. This aspect holds significant importance for long-term investors who seek to ensure that there are no vulnerable pockets of sensitivity on the balance sheet.
Quite notable is the very small percentage - 1.4% - that is devoted to oil & gas services, which is a sector that generally caused BDC's quite a lot of trouble back in 2014-2015. It is true that IT Service and Business Services are over-represented, however they should not be a cause of concern as they are not cyclical industries.
Conclusions
Overall Fidus Investment is a well-run BDC, with both pluses and minuses in this analysis. The pluses are:
- Consistent underwriting gains across the business cycle
- High allocation towards senior secured debt in the assets
The two minuses are:
- Higher than typical base management fee, and
- Higher than typical cost of leverage.
Like other BDCs I've analyzed so far, FDUS is well diversified and has little cyclical industry exposure. Let's take a peek at FDUS' market valuation, in terms of price to book ratio, alongside ARCC, GBDC, and market darling MAIN:
FDUS is valued by the market at around book value, which I would consider fair value. I would consider FDUS to be an appropriate position for most income portfolios.
For further details see:
Fidus Investment: 8.2% Dividend Yield Available At Fair Value