As an investor in BDC, I am constantly looking for other players in the sector that I believe have the potential to become excellent long-term investments. Whenever I’m looking to invest in a company, my goal is to look at different indicators to see if they meet the buy and hold criteria that I typically look for when investing. Business development companies are still considered risky, but in my opinion they are stronger than they have ever been. Better management teams and defensively positioned portfolios make them stocks not only for the short term, but also for the future.
One BDC that has recently popped up on my radar is Fidus Investment (NASDAQ:FDUS). Their name came up several times in the comments of my article, so I felt obliged to do an analysis about them. My first thought was that they reminded me a little another one of my favorites and industry holdings (WE), South-West Capital (CSWC). The company seems to have all the makings of a superstar. In this article I explain why I think Fidus Investment could be a standout in the sector and why they can be a great long-term investment for income investors.
Who is the FDUS?
Fidus Investment is a business development company specializing in leveraged buyouts, refinancings, strategic acquisitions, growth capital, business expansion and leveraged investments. Unlike many other BDCs, they do not invest in companies in recovery or financial difficulty.
This is why some prefer not to invest in the sector. Since most loans are made to companies in financial difficulty, this can discourage investors. Another difference is that FDUS invests in warrants and sometimes takes a minority stake in the companies in which it chooses to invest. Warrants are similar to options. and maybe be considered risky but can generate high returns.
Warrants, like options, come in call or put versions. This is a way for some BDCs to reward their shareholders with very high returns. Another thing that sets FDUS apart is that it has a much higher concentration in the information technology sector than its other peers, at almost 34%.
This is compared to peers Ares Capital (ARCC) which has invested 23.2% in the software and services sector, and in the Capital Southwest portfolio where this represents only 3%. Additionally, FDUS is also geographically diversified with most of its investments in the Southeast and Southwest. With a high concentration in the IT sector, FDUS is defensively positioned and is likely to generate consistent and stable cash flows.
When looking at BDCs, I generally like those with a long track record, preferably those that existed before the Great Financial Crisis. Seeing how companies performed during turbulent times can give you good insight into not only their financial struggles during this time, but also the management team.
Many BDCs fell on hard times during the 2008-2009 recession, but again, many other companies fell on hard times. I prefer those who have done it. Think about it. If you have a friend who wants you to invest in their business that just opened 6 months ago, what would your reaction be? And what about someone who has been in business for 20 years?
The person who has been in business for two decades not only during the GFC but also during the 2020 pandemic. And while that doesn’t necessarily mean they are a better business, it does give them experience in economic downturns . And even though they faced financial difficulties, they probably learned from it. Same concept I look for when researching companies.
FDUS went public in 2011, so they have some time under their belt. Not as much as other peers like ARCC or CSWC, but enough to assess their track record and get an idea. Since 2011, BDC has grown its portfolio from 23 companies to 80. Additionally, the majority of its debt investments are first/second lien loans at 67.3%.
Strong growth and dividend yield
What impressed me most about FDUS was its dividend growth. In 2023, the company paid out a lot of additional income in the form of special dividends, rewarding its shareholders. Additionally, they increased the base dividend by almost 5% and the additional dividend by over 42%, from $0.19 to $0.27. In the third quarter, BDC paid a total of $0.72 in dividends. Over the last 3 years, FDUS has had a DGR of 43.33%. This compares to 39.02% of the CSWC.
During the third trimester In November, FDUS continued to grow its financial data quarter over quarter. In the chart below, you can see net investment income and total investment income both increased by double digits. In addition, the BDC continued to defer additional revenue and recorded $32.7 million in the third quarter, or $1.15 in induced revenue.
The company also continued its growth path with two new investments worth $80.3 million during the quarter. One was a leading software provider for automobile dealerships and the other was a leading regional provider of medical equipment to hospice agencies and subacute care facilities.
In the table below, I compare FDUS to one of my favorites in the industry, CSWC. The latter outperformed most of its peers in terms of total return. They have even outperformed Fidus over the past year. You can see the CSWC doubling the FDUS’s 20.35%.
But looking over a 3 year period you can see that the former outperforms CSWC by a considerable margin.
Here they also outperform CSWC by over 40% over a 5 year period.
Below you can see looking further, CSWC more than doubles FDUS’ total return percentage to over 366%, up from almost 169% over a 10-year period. But that’s still impressive considering it’s an annual return of over 16% and higher than the S&P’s typical annual return.
A well-adjusted debt
FDUS also has an impressive balance sheet that comes with a growing portfolio and dividends. BDC has no debt maturing before 2026, when rates are expected to be significantly lower by then. And even then, they have very little due in the coming years after the $251 million due in the next two years. All their debts had a weighted average interest rate of 4.1%. Additionally, they had $100 million in borrowing available under the revolving credit facility and $80.3 million in cash.
BDCs 2024 will continue to reward shareholders
Recently I wrote an article titled “Don’t give up on BDCs in 2024.” With three rate cuts expected in the coming year, some might be worried about the sector. While I expect to see some of their prices drop once this starts, the higher quality ones will continue to pay out additional revenue in the form of promotions and extras.
The reason is that many of them have benefited from income spillovers and will likely continue to benefit from them in the new year. With growing portfolios and higher than corporate dividends, many can and likely will use the surplus to continue rewarding shareholders. So, as rates are expected to fall, BDC revenues will continue to increase.
FDUS management addressed this issue during its most recent third-quarter earnings call. Their CEO said they plan to continue paying out 100% of their excess revenue in the future. And in doing so, I expect their stock prices, like many of their peers, to continue to reflect this and trade above their NAV.
And I also see their management teams taking advantage by issuing shares and raising capital while prices remain high. FDUS recently issued 3.2 million shares at an average price of $19.54, generating net proceeds of $61.5 million. So, 2023 was a great year and 2024 and beyond looks promising.
Risks and valuation
FDUS has done a great job keeping tabs on their non-accruals. While peers like TriplePoint Venture Growth (TPVG) saw theirs increase significantly due to the high interest rate environment. I discussed it in a recent article. The Fidus percentage has been very manageable. At the end of the third quarter, non-accruals represented only 1.3% of their portfolio in fair value. This was 1.2% at the end of 2022, so the company has done a good job of keeping this percentage low. This also reflects the quality and financial strength of their portfolio companies.
But one thing that has increased since 2022 is their PIK interest income. This figure more than doubled from 2022. And while this doesn’t necessarily mean there are portfolio issues, it’s something to watch for going forward.
Additionally, the stock is currently trading at a premium to its NAV of $19.28. Priced at $19.67 at the time of writing, BDC offers little upside to its price target of less than $21. And while I expect the price to trade close to here for the foreseeable future, I would advise investors to wait for a price decline before adding or starting a position.
FDUS has all the assets to become a future superstar in the sector. Additionally, they have performed well in 2023 and I expect this to continue as they reward shareholders with additional income in 2024. They have also been growing their portfolio consistently and have a strong balance sheet with maturities well-scheduled debt. However, with rates expected to fall, I expect prices to fall for the foreseeable future.
Additionally, PIK’s revenues have grown significantly over the past year, but management has done a good job of keeping non-accruals below the KBW BDC average. Despite its performance over the past three and five years, I think BDC still has some proving to do going forward. Due to PIK’s rising earnings and above-NAV valuation, I currently view the stock as a Hold.