This article was first released for Systematic Income subscribers and free trials on August 8.
In this article, we catch up on the second quarter results of business development company, Fidus Investment (NASDAQ: FDUS). FDUS is currently trading at a a total dividend yield of 10.5% and a valuation of 101%.
The company continued its history of strong and consistent results. Despite an equity overweight portfolio, its NAV has held up much better than the sector average. Given the earnings tailwinds as well as the large spread, we wouldn’t be surprised by an additional dividend later this year (whether via a base increase or a special). We continue to hold FDUS in our high income portfolio.
NAV fell by about half a percent, which is among the best BDCs have reported so far.
FDUS delivered a total return of around +1.5% in the quarter – at the top end of BDCs that had reported until its announcement.
Adjusted net income, which excludes capital gains incentive charges (red bars), was flat from Q1.
Total investment income increased, partially offset by lower fees.
The company continued to generate gains in its capital portfolio with $18.2 million in net gains across 4 positions. It has also already recorded significant realized gains in the third quarter through a number of exits.
FDUS declared the same basic dividend of $0.36 and an additional $0.07 for Q3 that they paid in Q2. However, there is potential to increase that number, which the company will provide on its next earnings call in November. Specifically, the company’s very large spread of $2.37 per share (the additional net earnings realized so far in the third quarter will increase that number further) could very well lead to either an increase in the basic dividend or a special dividend more late this year.
The company continues to rotates its capital securities in secured loan / income producing assets. The portfolio distribution chart below shows that the share of secured loans is increasing at the expense of equity.
The company’s allocation to equity at cost is only 8%, but has increased to 17.3% due to unrealized gains.
The company realizes these profits steadily and allocates capital in income-generating securities.
This dynamic largely explains why the company’s interest income in Q2 was at its highest level in two years.
As FDUS continues this redistribution, it will add a significant level of investment income in the medium term. After the end of the second quarter, the company realized an additional $38 in net earnings, which speaks to this theme.
Net investments were fairly steady after a strong Q1 as new investment almost exactly offset prepayments and sales.
Although FDUS has a below-average level of floating rate investments of 58% (vs. 91% sector average), it has no floating rate liabilities (vs. 41% sector average). The result is a wash with his income beta versus short-term rates in line with the sector average. Net income should continue to rise as short-term interest rates rise, other things being equal. The 3-month Libor is now 0.58% above its end-Q2 level and will continue to rise further.
The company high share of fixed rate debt means that the cost of its debt has not changed in recent quarters, unlike the rest of the sector. Earlier, in 2021, the cost of debt was lowered by refinancing. Specifically, the company refinanced most of its debt in 2020 and 2021, taking advantage of a very low credit yield environment. Its earliest refinancing is a small SBA bond debt in 2025, with the remainder in 2026 and beyond. This fixed rate and long-term financing profile gives FDUS a great advantage over the rest of the sector. While FDUS would not normally be able to match the borrowing costs of investment grade BDCs like ARCC or GBDC, it will soon match their debt interest costs (red bars below) due to the simple fact that it has been able to fully lock in the cheap costs of loans and no floating rate debt.
The company leverage of 0.8x is well below the sector average of 1.1x, giving it significant earnings growth potential.
This quarter FDUS placed two holdings non-accrual with a fair value of about 1% of your portfolio. It was the second quarterly rise and bears are watching. The current level of unaccrued amounts is in line with the median for the sector.
PIC income continues its downward trend and is already well below the sector average of 5.2%.
Internal portfolio quality ratings worsened slightly (ie the blue bars in the right chart rose). This is not contrary to the trend in the sector.
Return profile and evaluation
There are a number of other BDCs that have high FDUS returns; however, in our opinion, what sets FDUS apart is the consistency of its performance. Over the past 8 quarters, FDUS has outperformed the sector in 7 of those quarters.
We like to compare returns and valuation together on the same chart because the two are clearly not independent. The chart below shows the 5-year total return on NAV (y-axis) versus valuation ie. the price / NAV ratio (x-axis). The model is not exact, but there is a clear relationship where BDCs with stronger historical returns tend to boast a higher valuation.
In the chart, we highlight the set of BDCs that are characterized by returns of around 15-17% per annum over the last 5 years in total NAV. What the chart clearly shows is that FDUS remains the lowest-rated BDC in this group, and by that measure is quite cheap.
The chart above does not clearly show at what point a BDC is too expensive for its historical returns. In other words, since investors earn their returns from price rather than NAV, it is entirely possible to outperform higher-performing BDCs by allocating to BDCs with lower total NAV returns that also trade at a valuation below -cheap from their lower historical efficiency. A way to combine the valuation and total NAV return is to simply divide the total NAV return by the valuation, which we do in the following chart. What we see is that FDUS has the second best metric in our coverage universe.
As for the valuation of FDUS over time, it is trading well above its historical average.
As the following chart shows, FDUS has been used to trade at a lower valuation than the broader sector. Given its historical performance, this didn’t make much sense to us, which is why we’ve been holding it since 2021. More recently, this valuation gap has closed and FDUS has actually started trading above the sector average.
This chart showing the valuation gap for the sector makes this more clear.
Whether its valuation is rich or cheap depends on whether you look at its historical pattern (by this metric FDUS is very expensive) or by its historical returns (by this metric FDUS is still cheap).
Food to take home
In our view, FDUS remains an attractive holding given its very strong and consistent historical performance, as well as its potential for diversification in the BDC portfolio. For example, unlike BDCs such as ARCC and OCSL, which operate at the upper end of the middle market sector, FDUS operates at the lower end of it. And unlike BDCs like GBDC and OCSL, which focus primarily on debt holdings, FDUS retains a significant amount of equity in its deals – holding equity in about 80% of its investments. This could be a risk if the market crashes again, but historically the company has maintained resilience during periods of market weakness. As its rating has skyrocketed, we recently downgraded FDUS to a Hold on from Buys but would like to add weakness to current levels.