Since BDCs distribute almost all of its earnings in dividends and employ high amounts of external leverage to fund investments that provide a decent spread from the cost of debt, this specific asset class is quite attractive for high-yield seeking investors. An additional layer, which renders BDCs interesting is that in contrast to pure fixed income securities or preferred shares, where decent yields could be found as well, by investing in BDCs investors can access a slight capital gains component, which stems from reinvestment of undistributed earnings. Granted, the reinvestments are not so high as the dividend distributions, they still allows the Management to capture that “snowball” effect in terms of growing the underlying NAV base.
However, currently we see several headwinds in this space:
- Interest rates are set to go down, which will lower the floating rate return source (although the picture is not that straight forward as elaborated in one of my previous articles – Debunking 2 Common Myths About BDC Dividend Investing).
- Corporate distress levels have increased materially and the rising non-accruals in the BDC sector (for many players) is a proof of that.
- The M&A and capital markets remain relatively inactive, which makes it difficult to grow the portfolio.
- As a result of the subdued demand from the issuers’ side, BDC face a meaningful spread compression, especially considering that since the banking struggles in 2023, the number of private credit participants has clearly gone up.
Now, in the context of the aforementioned dynamics, investors, who allocate in BDCs with an attempt to capture enticing yields, while keeping the financial risk balanced (including decreasing the probabilities of a dividend cut as much as possible), have to pay extra attention to the underlying fundamentals. In other words, the preference should be now skewed towards inherently more defensive BDC names.
One of the most important metrics, which allows to not only avoid unfavorable volatility in the cash generation, but also to keep the growth potential alive is a conservative leverage. In BDC business the logic is simple – the higher the leverage is, the easier it is to generate high yields and thus distribute juicy dividends (and vice versa). Yet, what high leverage also does is it magnifies the negative effects from any non-accrual position and / or the spread tightening process.
In my opinion, if a BDC is still able to cover the dividend, while having a truly conservative leverage profile on top of a durable business model (e.g., focus on well-established companies), then it definitely is worth considering by defensive dividend investors.
Here are two specific BDC examples that tick these necessary boxes.
Pick #1 – Fidus Investment
Fidus Investment (NASDAQ:FDUS) is a relatively small BDC with a market cap of just over $650 million and an investment strategy that is directed towards the niche-like lower middle market company segment. As of now, it has the fourth lowest leverage profile in the entire BDC space with the debt to equity sitting at 72%.
Currently, FDUS exhibits tailwinds for growing the portfolio size as it has been easier to find deals in the lower middle market company segment compared to the upper middle market area in which many large BDC have been trying to deploy their capital. Investing in companies that have, say, an annual EBITDA generation of $15 million does not make sense for these large players purely from the cost and impact perspective.
Instead, FDUS has been able to capitalize on this inefficiency and grown its portfolio quarter by quarter. For example, in Q2, 2024 FDUS increased its adjusted net investment income generation by ~ 18% compared to Q2, 2023. 3 On a quarter-to-quarter basis, the drop in the adjusted NII per share figure was $0.02 per share, once again primarily due to the higher share count. This is a massive move in 2024, when many other BDCs are in fact struggling to even maintain their existing asset levels.
Having said that, FDUS has not been able to fully avoid the sector-wide spread compression, which we can see in the Q2, 2024 adjusted NII figure that has declined by $0.02 per share from the results that was achieved in the prior quarter.
However, even with this decline, the base dividend coverage remains at 132%, which translates to an annualized yield of 8.9%. Including the supplemental dividends that are more speculative in relation to them being actually paid on a go forward basis, the annualized yield increases to ~ 12% (using Q2 supplemental dividend as a basis).
Plus, FDUS has been one of the best BDCs when it comes to keeping the non-accruals healthy. The recent quarter was not an exception despite, as stated above, many BDCs have suffered from unpleasant non-accruals. Namely, FDUS ended Q2, 2024 with non-accruals representing only 1% of the portfolio fair value.
All of this in combination with FDUS’s depressed leverage levels (in a positive sense) helps de-risk the profile here and equips the Management with a sufficient capacity to seize opportunities, when the time comes. Until then, the dividend remain safely covered, enjoying a notable margin of safety.
Pick #2 – Gladstone Capital
Gladstone Capital (NASDAQ:GLAD) is a rather similar BDC to FDUS as it also carries a small market capitalization level (~ $492 million) and has a fifth the most deleveraged balance sheet in this industry. In terms of the business focus, GLAD is also biased towards smaller cap and cash flowing companies, which allows it to better compete and source the necessary deals volume.
If we look in the data of recent financial performance, we will notice that GLAD has continued to deliver stable results across the board. For example, while the average earnings assets declined in Q2, 2024, the top-line or the total interest income increased by 3% mostly due to the effects stemming from a higher asset based that was achieved via net positive funding activity in the prior quarter.
Another reason why GLAD managed to register a growth was related to the portfolio yield going up, which will be extremely difficult to find for any other BDC out there (including FDUS).
Speaking of the outlook, we should not be worried about GLAD transitioning in a structural portfolio decline phase. In my opinion, the commentary in the recent earnings call by Bob Marcotte – President – provides a very nice color on this as well as confirming the notion of extracting higher value from niche-like focus in the lower middle market company segment:
Regarding our near-term outlook, I’d like to leave you with a couple of comments. The majority of our investments are proprietary originations of lower middle market buyouts, often associated with a business founder transition or first institutional capital raise, and are not driven by refinancing activities. While several more mature and larger investment positions in the portfolio did take advantage of credit market conditions and lower spreads, we continue to see a healthy level of attractive lower middle market financing opportunities, typically with under $10 million of EBITDA. We entered the current quarter with a significant pipeline of awarded and high probability transactions, which we expect will support the resumption of our asset growth in the near-term.
Here, the function of one of the lowest debt levels, growing adjusted NII generation and favorable business strategy warrants GLAD a truly sustainable dividend play, where the current yield of 8.8% is backed by solid 115% dividend coverage level.
The bottom line
BDC investing involves relatively high risks, which is also confirmed by typically double digit yields that are offered by these players. The prevailing market dynamics do not indicate a rosy future, especially for more aggressive BDCs that have followed less strict investment underwriting standards and have huge debt loads.
However, as in any sector, there are exceptions, which embody conservative financial characteristics, and, in this case, are also able to offer enticing dividend yield levels.
Fidus Investment and Gladstone Capital are, in my opinion, the right BDC picks for investors, who seek high yield, while keeping the risk as low as possible.
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