I Bought Fidus Investment: 12% Yield And 35% Below Book

Introduction

This article is part of a series discussing how to build a retirement portfolio using business development companies (“BDCs”) currently yielding over 12% and their safer notes – baby bonds/preferred shares with yield-to-maturities ranging from 6.5% to 10.0%. The previous article discussed Golub Capital (GBDC) which is a lower yielding BDC that typically implies a “safer” portfolio and/or sustainable dividend coverage.


BDC Buzz Starts a Position in FDUS

I recently started a position in Fidus Investment (FDUS) because I believe that there’s a good chance for a total return potential of 30% or higher over the next 12 months as discussed at the end of the article. My subscribers are well aware that I often wait for stocks to have a relative strength index of (“RSI”) of close to 30 before buying. This is the definition from Investopedia:

The relative strength index (RSI) is a momentum indicator developed by noted technical analyst Welles Wilder that compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security. It’s primarily used to attempt to identify overbought or oversold conditions in the trading of an asset. Traditional interpretation and usage of the RSI is that RSI values of 70 or above indicate that a security is becoming overbought or overvalued, and therefore may be primed for a trend reversal or corrective pullback in price. On the other side of RSI values, an RSI reading of 30 or below is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.”


FDUS Baby Bonds “FDUSG”, “FDUSZ” and “FDUSL”:

I purchased FDUS’s baby bonds during the recent dip in March 2020 as I believe they are a good balance for overall portfolio diversification. I will discuss the pricing and quality of these investments in another article.


FDUS Management Fee Agreement

FDUS has a base management fee of 1.75% of assets excluding cash and does not include a “total return hurdle” or “lookback” feature when calculating income incentive fees. However, the capital gains incentive fees have a lookback feature measuring cumulative aggregate realized capital gains and losses since the “Formation Transactions” and IPO.

FDUS has a generous 8% hurdle rate which is applied to “net assets” to determine “pre-incentive fee net investment income” per share before management earns its income incentive fees. As shown in the following table, the company will likely earn around $0.308 per share each quarter before paying management incentive fees covering around 103% which is “math” driven by an annual hurdle rate of 8% on equity.

The following table is from the recently updated BDC Expense and Return Ratios report showing the dividend coverage for each BDC before management is paid an incentive fee.

  • BDCs such as MAIN, HTGC, and CSWC are internally managed and do not have the same fee structures so they are not included in the table.
  • OCSL recently increased its quarterly dividend from $0.095 to $0.105.
  • PNNT has energy exposure which could result in lower NAV over the coming quarters.

Source: SEC Filings & BDC Buzz


FDUS Dividend Update

My previous reports to subscribers correctly predicted the reduction in FDUS’s quarterly dividend from $0.39 to $0.30 per share which was announced on May 1, 2020:

From previous call: “In light of the uncertain magnitude and duration of economic weakness associated with COVID-19, we are particularly focused on maintaining a strong liquidity position and our ability to fund and support our existing portfolio companies as warranted. In consideration of these near-term priorities and to give us additional liquidity on our balance sheet, the Board is reducing the second quarter dividend to $0.30 per share. We believe the vast majority of our portfolio companies are resilient and possess very positive long-term outlooks, and we look forward to getting to the other side of this crisis. In the meantime, we will continue to operate in the long-term interest of our shareholders with an abundance of caution focused on capital preservation. We have elected to waive 20% of the income incentive fee for the second quarter.”

Source: FDUS Earnings Call

It should be noted that over the last three years FDUS has paid a special dividend in Q4 and there is an excellent chance of another one this year. On July 24, 2020, FDUS exited its debt and equity investments in Microbiology Research Associates and received payment in full of $9 million on its subordinated debt investment as well as selling the common equity portion for a realized gain of $1.4 million in Q3 2020 or $0.06 per share which could be used for upcoming special dividends.

Source: Fidelity

FDUS has estimated spillover income or taxable income in excess of distributions of around $1.12 per share and management was recently asked about potential changes to the base or special dividends:

Q. “I wanted to ask about the about the dividend actually Ed and relative to where NII is so. So obviously $0.37 here in the quarter and I guess there’s some potential for revenue to drop off with some level of prepayment activity. But your sense of credit is certainly better than it was last quarter. So you’ve got a bit of a – I guess of a Class A problem here with NII well above the dividend, and then plenty of spillover income sitting on the balance sheet. So I’m just curious how you think about the dividend level here going forward, do you think about maybe base dividend plus supplemental structure to account for any variability? Just wondering how you’re thinking about it?

A. “Sure. That’s a great question. And quite frankly there is a discussion this week obviously at the board meeting. You know, what I would say is, we continue at this point in time to believe it’s in the long-term interest and best long-term interest of our shareholders to operate with an abundance of caution. And that includes our dividend distribution policy. We’ve always operated the business with a conservative mindset. We’re very focused on maintaining a strong balance sheet. And we’re also equally as focused on maintaining a very strong liquidity position to enable support of our portfolio companies and also obviously, drive shareholder value.”

“And I’ll just mention the portfolio because you brought it up. We believe it’s a high quality portfolio, it’s pretty resilient. And it’s going to serve our shareholders well over the long term. It’s been constructed with an eye towards investing in companies that we believe have very defensive characteristics that possess long-term cash flow abilities and then obviously have strong outlooks over the long term as well. So we feel like we’re very well positioned today. We do recognize from a dividend perspective, we may need to think about some things in the future. We do what we like the idea of waiting a little longer and finding a place have a little bit greater visibility. And then I would also say depending on how things go, we may need to make special distributions in order to meet some RIC spillover distribution requirements over the medium term. But quite frankly, we need to probably play a couple of more innings first to figure out the whole equation. So hopefully that’s helpful. We’re thrilled to be in a position where we can actually start having this conversation. But we want to be patient and wait on it.”

Source: FDUS Earnings Call


FDUS June 30, 2020 Update

For Q2 2020, FDUS reported just below its best-case projections covering 123% of its previously-reduced dividend mostly due to two portfolio companies were added back to accrual status and are now contributing to dividend coverage as well as maintaining its portfolio yield. Also, management waived 20% if the income incentive fee for the quarter that contributed around $400,000.

Edward Ross, Chairman/CEO: “Despite ongoing business disruptions and uncertainties associated with the COVID-19 pandemic, our portfolio generated adjusted net investment income of $0.37 with many investments performing materially better than we had expected last quarter, and we were able to remove two of them from non-accrual status. Total investment income was $20.4 million for the three months ended June 30, 2020 $0.4 million increase from Q1 due to a $1.4 million increase in interest income, with approximately $0.6 million of the increase relating to returning to non-accruals, EbLens and Virginia Tile back to accrual status. About $100,000 was catch-up from Q1. The rest was all related to Q2.”


Management has been working to improve dividend coverage and previously sold/harvested many of its non-income-producing equity investments and is reinvesting into income-producing assets increasing interest income to above $20 million.

As of June 30, 2020, FDUS had $19 million in cash and cash equivalents, $57 million of unused capacity under its senior secured revolving credit facility. In March 2019, FDUS received its third SBIC license to borrow up to $175 million in additional SBA debentures for a maximum of $350 million excluded from debt for purposes of BDC asset coverage requirements. The company had access to an additional $162 million of SBA borrowings.

As of June 30, our liquidity and capital resources included cash of $19.3 million, $57 million of availability on our line of credit, resulting in total liquidity of approximately $76.4 million. Taking into account subsequent events, we have total liquidity of approximately $94.9 million. We also have access to $161.5 million of additional SBA debentures under a third SBIC license, subject to SBA regulatory requirements and approval.”

Source: FDUS Earnings Call

Source: FDUS Earnings Presentation

Management has guided for additional portfolio investments over the coming quarters and is taken into account with the updated projections:

Although, we hit the pause button on deal activity during the second quarter, out of an abundance of caution, we have since reopened channels and are carefully evaluating select opportunities. We intend to take a conservative approach to origination with a view towards protecting our capital and our balance sheets.

Source: FDUS Earnings Call

On July 2, 2020, FDUS exited its debt investment in Hoonuit, LLC and received payment in full of $7.3 million on its first-lien debt, which includes a prepayment penalty. As mentioned earlier, FDUS exited its debt and equity investments in Microbiology Research Associates and received payment in full of $9.0 million on its subordinated debt investment as well as selling the common equity portion for a realized gain of $1.4 million.

Subsequent to quarter-end, we received payment in full of $7.3 million on first lien debt, including a prepayment penalty in connection with the exit of Hoonuit, LLC. And we exited our debt and equity investments in Microbiology Research Associates, Inc [MRA]. We received payment in full of $9 million on our subordinated debt investment. We exited our common equity investment for a realized gain of approximately $1.4 million. The MRA was unique situation, quite frankly we were unaware of the – that the transaction was going on. I think it happened quite quickly, and it was a strategic transaction, meaning a strategic buyer. This company was benefiting from COVID-19 actually, and I think someone saw that and ultimately it ended up being a very nice outcome from a debt and an equity perspective for everyone quite frankly.”

Source: FDUS Earnings Call


FDUS Risk Profile Update

Management is focused on capital preservation and closely tracks relevant credit metrics such as debt-to-EBITDA and cash interest coverage ratios of portfolio companies. This focus is partially responsible for the above-average NAV per share growth.

My primary concerns for FDUS are mostly related to more than 30% of the portfolio invested in equity and subordinated debt positions. This combined with the lack of total return hurdle incentive fee structure to protect shareholders from capital losses that could result in material losses for common shareholders.

During Q2 2020, FDUS’s net asset value (“NAV”) per share was mostly stable for the quarter (from $15.37 to $15.39) due to various general markups offset by $9.6 million or $0.39 per share of additional losses from Accent Food Services as discussed later.

Edward Ross, Chairman/CEO: “Overall, the fair value of the portfolio has stabilized after an approximately 5.7% write-down last quarter and we ended the quarter with NAV per share of $15.39. During this period of challenging economic conditions, we will continue to manage our business conservatively focused on maintaining liquidity and on long-term capital preservation. After writing down the fair value of our portfolio last quarter by approximately 5.7% in response to elevated risk in the economy, our net asset value held steady and we ended with the second quarter with a net asset value of $15.39 per share, compared to $15.37 per share as of March 31 2020.”

Source: FDUS Earnings Call

The credit quality of the portfolio improved as two of the new non-accruals from Q1 2020 (Virginia Tile Company and EbLens) were added back to accrual status during Q2 2020:

In addition, in terms of non-accruals, we ended the second quarter in an improved position relative to last quarter when as you may recall, we had proactively placed two portfolio companies on non-accrual, even though they ultimately made their interest payments. Since then, our initial concerns about those two companies EbLens and Virginia Tile Company have not been realized, and we have removed them from non-accrual status. Debt investments in Accent Food Services remain on non-accrual and Mirage Trailers remains on PIK non-accrual. As a result, we ended the quarter with non-accruals in aggregate of $21.4 million, 2.9% of our portfolio on a fair value basis.”

Source: FDUS Earnings Call

As of June 30, 2020, Accent Food Services has and Mirage Trailers remain on non-accruals and account for around 2.9% of the portfolio fair value and 5.6% at cost:

Source: SEC Filings

Accent Food Services has been discussed in previous reports and remains on non-accrual and was discussed on the recent call:

Our depreciation came primarily from one asset and that is one non-accrual, and that Accent is a franchise business, a very good business. And but having said that we’re, you know, a second lien lender in it, we’re not getting paid. And quite frankly, the company has been impacted by the shelter-in-place orders and also its geographic locations in particular, as big as locations in Texas. And so, that’s a large majority of the – well that represented, I guess over $9 million of depreciation this quarter. If you were to exclude Accent, the total portfolio appreciated $8.1 million, debt portfolio appreciated by a couple million bucks, and our equity portfolio appreciated by almost $6 million. So I would, Accent unfortunately is the reason for that but what I would say absent Accent the portfolio did appreciate very nicely and quite frankly is holding its own in a very, an admirable way if you will and something we’re pleased with.”

Source: FDUS Earnings Call

Only 2.3% of the portfolio fair value has “potential for some loss of investment return, but we expect no loss of principal” but there is still almost 20% of the portfolio “performing below expectations” but management expects “a full return of principal and collection of all interest”:

Source: SEC Filings

  • Investment Rating 3 is used for investments performing below expectations and indicates the investment’s risk has increased somewhat since origination. The portfolio company requires closer monitoring, but we expect a full return of principal and collection of all interest and/or dividends
  • Investment Rating 4 is used for investments performing materially below expectations and the risk has increased materially since origination. The investment has the potential for some loss of investment return, but we expect no loss of principal.
  • Investment Rating 5 is used for investments performing substantially below our expectations and the risks have increased substantially since origination. We expect some loss of principal.

It should be noted that FDUS has been able to maintain a higher portfolio yield by investing in higher-risk subordinated debt and equity investments. However, the company has also maintained NAV per share performance and realized gains relative to most BDCs. The company has equity investments in around 90% of its portfolio companies and primarily responsible for NAV growth and dividend income to support special dividends.

“We have equity investments and approximately 89.6% of our portfolio of companies with a weighted average fully diluted equity ownership of 4.7%.”

Source: FDUS Earnings Call

Source: SEC Filings

Source: FDUS Earnings Presentation


FDUS Risk Profile Discussion from Management (August 7, 2020):

Our portfolio companies had prepared plans to ensure business continuity and to manage through supply and demand challenges. We had structured our portfolio to handle severe economic stresses, and we believe that our investing strategy and our underwriting discipline would help us weather the storm. Nevertheless, we knew the portfolio contained elevated levels of risk, and we proceeded with a great deal of caution, working closely with the senior management teams and sponsors of our portfolio companies. I’m pleased to report our portfolio companies having been thrown a curve ball are for the most part holding their own.”

“From an industry perspective, our portfolio of high quality lower middle market companies remains well diversified with oil and gas related businesses accounting for 4.3% and a little more than 3% in retail, unchanged from last quarter. The portfolio companies that serve retail and leisure in markets are currently performing despite the fact that they were shut down 90 days ago. We do not have any direct exposure to the restaurants or hospitality sectors other than one equity investment with a fair value of less than $300,000. With the exception of one non-accrual, our assessment of portfolio risk across the board, based on the company, operations and valuations has improved materially since last quarter. At that time, our view was that a little more than 80% of the portfolio on a fair value basis was in the low-to-medium risk range. Today, our view is that about 88% of the portfolio is in the low-to-medium risk range, and about 68% is in the low risk category.”

“Since last May, the overall risk levels of the portfolio have improved. From a liquidity perspective, our portfolio companies are doing better than expected and are currently well positioned for the remainder of the year. They were paying their interests without stretching their cash flows and their resilient business models and capital structures are providing them with bulwarks against the storm. Overall, our portfolio companies are finding their way through the crisis, adjusting their business operations, conserving cash, cutting costs, and maintaining spending discipline even as their circumstances may differ due to the patchwork of rules and regulations and to varying degrees of economic activity. After shelter-in-place restrictions were lifted, some of these companies reopened to find a less competitive environment. Others reopened to find softened demand. These latter companies are working hard to find their way back to pre-pandemic levels of business. A few of our portfolio companies have identified pockets of opportunity because of the pandemic while others are using this period of reduced activity to focus on improving business efficiencies and profitability. The PPP program was helpful to some of our portfolio companies. And so that is a positive. Quite frankly looking at it today don’t see really a material need for incremental support as we sit here today, at least in our portfolio. And that’s as a whole, but that’s generally what I think. When I look at things like a stimulus, I think that’s healthy for the overall economy and probably helpful to retailers in particular. And so I think that would be positive if there was a stimulus. But as I look at our portfolio companies today, including the retailers they are holding their own. And I don’t think it’s a requirement for them to continue to perform well, but I think it would enhance their performance at the end of the day.”

Source: FDUS Earnings Call


Summary and Estimates for FDUS Pricing

The following “Executive Summary” table is a quick glance showing many of the items discussed above including the four quarter average expense ratio of 42.6% which is the “Operating Expense as a Percentage of Available Income.” This is higher than most BDCs but the company has better-than-average historical NAV performance (shown below) and previously paid special dividends which are not taken into account with the 12% yield shown below.

There are many ways to price BDCs as I have discussed thoroughly in previous articles. I use a combination of rankings of risk profile and dividend coverage. However, risk and dividend coverage are very interrelated on many levels. BDCs with lower dividend coverage are more likely to “reach for yield” and/or grow the portfolio during frothy lending periods, taking on increased risk.

Riskier portfolios eventually have higher credit issues that drive lower earnings and dividend cuts. Credit issues also drive lower net asset value per share, which is critical for BDCs that use higher amounts of leverage due to the requirements for BDCs to have certain asset coverage ratios limiting their debt-to-equity ratios. After assessing risk rankings and dividend coverage potential, I assign an appropriate yield to each BDC relative to its peers, which calculates/correlates to an appropriate price.

  • Risk (portfolio credit quality and vintage, quality of management, historical credit and NAV performance, effective leverage ratios, portfolio diversification, rate sensitivity, and the need to reach for yield to sustain dividends).
  • Dividend Coverage (historical and projected dividend coverage, yield compression sustainability, repayment exposure, recurring vs. one-time dividend and fee income, PIK vs. cash, EPS growth/decline, operational cost efficiency).

Source: BDC Buzz


Most people use a much simpler approach such as expected dividend yield or price-to-NAV ratios which is my least favorite as there are some BDCs with poor management that overvalue their assets compared to others that undervalue and over-deliver with realized gains each year.

That said, using these simple approaches and roughly categorizing by changes in NAV per share over the last three years would value FDUS’s stock closer to $12.00 to $15.00 compared to the current $10.00.

  • Yield-based using 10.2% = $11.76
  • NAV multiple of 1.00 = $15.39

Assuming that the company continues to pay $0.30 per quarter in dividends and no special dividends in Q4 2020 (very likely) would imply a total return of $3.20 to $6.20 or 30% to 60% over the next 12 months. That is why I started a position in this stock.

Disclosure: I am/we are long FDUS, FDUSG, FDUSL, FDUSZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.