This is a series of articles to assess risk for the 26 BDCs that I cover and a follow up to my other "BDC Risk Profile" articles. There are many reasons why assessing risk for BDCs is important, including expected returns, valuations, and the potential loss of capital during an economic downturn or general business cycle. I use 'relative risk rankings' in many of my articles for valuation purposes, because I believe BDCs should be measured on projected risk vs. return. This series will take into account new metrics, and I will be adjusting my rankings accordingly, as well as updating my suggested 'risk averse' BDC portfolio.
The following are some of the indicators of risk and portfolio quality that I will be discussing in this series:
- General portfolio mix and yield
- Portfolio debt-to-EBITDA
- Average investment size and portfolio concentration risk
- BDC leverage vs. portfolio mix
- NAV growth vs. declines
- Fair value of investments as a percentage of cost
- Dividend coverage and the need to reach for yield
The previous articles in this series are:
- BDC Risk Profiles Introduction
- Apollo Investment (NASDAQ:AINV)
- PennantPark Floating Rate Capital (NASDAQ:PFLT)
- THL Credit (NASDAQ:TCRD)
I consider Fidus Investment (NASDAQ:FDUS) to have an average risk profile due to its lower than average portfolio leverage ratios but higher than average portfolio yield as well as only having around 22% of its portfolio in senior secured debt type investments as discussed in my "FDUS Articles". FDUS has been slowly improving the investment mix of its portfolio and mentioned the following on the recent earnings call: "We continue to remain patient and disciplined, focused on capital preservation, and performing well over the long term. One result of this approach is that our senior secured or unit tranche debt portfolio has increased from approximately 11% of our portfolio a year ago, to just over 21% on a cost basis as of June 30."
Historically, FDUS has had one of the lowest debt-to-EBITDA ratios in the industry as discussed last year in my "FDUS: Higher Total Returns?" article, that also addressed some of my concerns related to its "lower-than-average investment class mix and higher-than-average portfolio yields." FDUS has continued to focus on portfolio credit quality and on the most recent earnings call mentioned: "The credit performance of the portfolio remained solid as well, with our portfolio company's combined ratio of total net debt to Fidus' debt investments to total EBITDA of 3.7 times. We believe this is a prudent level of risk for our portfolio. We track the combined ratio of our portfolio company's total EBITDA to total cash interest expense, which was 3.3 times in the second quarter. We believe that this level is an indicator that our portfolio companies as a whole currently have significant cushion to meet their debt service obligations to us. Overall, these metrics reflect our longstanding cautious and deliberate investment approach."
Debt-to-EBITDA measures the weighted average portfolio debt as a multiple of EBITDA. Ratios greater than five times usually indicate that a company is likely to face difficulties in handling its debt burden, and is less likely to be able to raise additional loans required to grow and expand the business and it can result in a lowered credit rating. At 3.7 times, FDUS's portfolio has a better than average ratio. As a comparison, I recently reviewed the risk profile for PennantPark Floating Rate Capital (NASDAQ:PFLT), THL Credit (NASDAQ:TCRD) and Apollo Investment (NASDAQ:AINV) with ratios of 3.7, 4.2 and 5.4 times, respectively.
The CEO, Ed Ross, also mentioned: "From a debt structuring perspective, we look to maintain significant cushions to our borrower's enterprise value, in support of our capital preservation and income goals. As we said many times, we seek to selectively invest in high quality, lower middle market companies that our market leaders and their respective niches, that operate in industries we know well, that generate excess free cash flow for debt service and investment, and have positive long term outlooks. And due to the sheer size and fragmentation of the lower middle market, our target market continues to be active and attractive, and generally is less competitive than the broader markets."
The impact from FDUS's continued focus on higher quality investments has resulted in a lower portfolio yield as discussed in "FDUS: BDC Dividend Coverage Part 12" and shown in the chart below:
Currently, the top ten portfolio investments for FDUS account for 44.2% implying a much higher concentration risk than the previously reviewed BDCs, especially PFLT at 26.1% of a similar size portfolio.
Management recently discussed the investments on non-accrual status:
"During the second quarter, we wrote down our investment in Avrio to zero, and placed the debt investment on non-accrual, due to a meaningful increase in the risk in this investment. We also put the PIK interest of Paramount Building Solutions on non-accrual status, as we work to better position the company for future growth."
"Avrio have been underperforming for some time, and several events that transpired over the last couple of months, meaningfully increased the risks of our investments in the company, and so the current level of risk is reflected in our valuation of the securities we invested in. And Paramount falls in a different category for sure, but it had a couple events that occurred recently, that increased our risk, and so we are currently working with management to position the company for the future."
"We have equity investments in approximately 91.9% of our portfolio companies, with an average fully diluted equity ownership of 7.6%. Our equity investments should not only offset our investment losses, but also should provide incremental gains, and to that point, our investment portfolio has generated over $30 million in net realized gains since our IPO."
I will be updating the following table to include the other BDCs, as well as new risk-related metrics throughout this series. The goal of using a side-by-side comparison is to show an 'apples to apples' view of each BDC in an attempt to clarify my revised relative risk rankings. I have included the results for PFLT, TCRD and AINV, showing FDUS closer to the riskier end of the spectrum. Keep in mind that these companies are currently ranked by my 'previous risk rankings' that I will be adjusting at the end of this series. At this point I would consider FDUS riskier than the others, including AINV, due to its portfolio concentration risk and higher portfolio yield, most likely due to having 62% of investments in subordinated loans. Other reasons for considering FDUS to have a higher risk profile is its declining net asset value ("NAV") per share related to the non-accruals discussed earlier.
For more information about this series, please read "BDC Risk Profiles: An Introduction", and I will be adding my 'vintage analysis', as well as including information about BDCs with 'recession-resistant investments'. For updates to this series and links to previous risk-related articles on Seeking Alpha, please check my "BDC Risk Profile" page, as well as the "BDC Research Page" that I will continue to update as well as my "Index to BDC Articles" for more information on specific BDCs.
Disclosure: The author is long PFLT.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.