Investment Trust (NASDAQ:FDUS) is a BDC that, like most BDCs, offers customized debt and equity financing solutions, primarily to low-capitalization businesses.
The investment objective is also the same as in the entire BDC space – ie, the main focus on the high-yield stream income streams with a secondary objective of sustainably maintaining and increasing NAV over time.
In terms of investment policy, the criteria outlined mean that FDUS seems to prefer fairly conservative investments, which in my opinion is a good thing. Many other BDCs tend to take relatively large risk positions through inherently risky companies (eg, early stage life science companies, biotech, etc.) thus making exposure to the BDC factor more unpredictable than a base already aggressive (risky).
So, in the case of FDUS characteristics of the target company are as follows:
- Market leaders with protected market positions
- Diverse customer and supplier bases
- Strong free cash flows or asset backing
- Significant enterprise value / capital cushions
- Strong management teams with significant ownership or equity incentives
As we can see, we are not talking about cash-burning companies here, whose financial prospects are highly unpredictable. Instead, FDUS emphasizes highly defensive names, which should result in more stable cash generation and lower discounts.
The breakdown of the portfolio by industry level shows a relatively high degree of diversification across the board, with an expected IT services component. The remaining sectors can be considered largely conventional and stable without a meaningful bias towards speculative risks.
The most important and specific aspect for FDUS in the context of the fundamental characteristics of the portfolio is the quality of the portfolio companies. As reflected in the table above, the average net leverage and interest coverage levels of FDUS companies are very impressive – 5.3x and 3.0x, respectively (as of Q3, 2023).
Typically, a net leverage of ~5x is considered a sweet spot by many businesses to keep their capital structure at optimal levels. Similarly, interest coverage of 3 times can also be considered safe and indicative of a sound financial position.
As a result, fair value non-accruals have been fairly minimal and stable over time (eg only 1.3% in Q3, 2023).
According to Edward Ross, CEO, FDUS still remains committed to its prudent investment underwriting policy (according to the latest call earnings):
As we have added debt and equity investments to our portfolio, we continue to carefully select high quality companies that generate excess levels of cash flow to service debt and structure our investments with a high percentage of equity cushions in an attempt to manage downside risk. which is especially important in today’s higher rate environment.
Now that we have established that FDUS is a relatively conservative BDC, the question arises whether the yield offered is sufficient in the context of the assumed risk.
Historically, FDUS has managed to outperform the broader BDC index by a wide margin. There are two obvious sources of alpha:
First, FDUS has held a large load of external leverage that has boosted returns during the COVID-19 recovery period.
Then, going into 2022, FDUS had timed the deleveraging process quite well by having much less exposure to external leverage as interest rates started to rise. This not only protected FDUS spreads, but also provided attractive terms where Management could take on additional debt (without overstating the balance sheet) to capitalize on the recent headwinds in the industry.
The second source of alpha was the gradual increase in first lien debt exposure, which contributed to an even riskier FDUS profile, allowing markets to reprice the position accordingly.
Having said that, FDUS’ current portfolio is still heavily skewed towards positions other than first lien debt, which is the safest position to be in as a lender or BDC. Approx. 60% of AuM in first lien is a relatively small fraction compared to the BDC peer average, where we typically see 70-85% in first lien.
In this situation, FDUS maintains quite significant allocations to more vulnerable and riskier debt positions – eg. second lien and subordinated debt together account for ~34% of total asset value.
From a dividend yield perspective, FDUS has managed to improve its profile during this high interest rate environment reaching ~14% (based on quarterly TTM and separate dividend payments). This is a very high level compared to other BDC players, who on average maintain a yield of 10.5 – 12%.
However, looking at the recent history of dividend coverage, the model does not look great. Namely, in the following 4 quarters, FDUS has distributed a larger dividend than it has earned through NII. This difference was financed by the proceeds from the sale of assets (FDUS’s equity investments), which were well appreciated in value. So it is not that FDUS has suddenly decided to go down an unsustainable path by paying dividends on its capacity (or value generated), but investors should be aware of the fact that the element of net realized profit is essentially unpredictable and faster. or later it will decrease or even become negative.
While FDUS is a sound BDC with fairly resilient portfolio companies in terms of leverage and industry risks, the current dividend yield of ~14% looks unsustainable as a significant portion of it is covered by profitable equity sales.
Plus, FDUS’s focus on non-prime liability categories makes the Fund less conservative than its peers, who also prefer to avoid investing in speculative companies and follow prudent investment underwriting principles.
In my view, FDUS offers low exposure to the conservative end of the BDC space.