Fidus Investment Corporation, a name not often making headlines, quietly navigated the turbulent seas of 2023, emerging with a significantly stronger portfolio and a surprising increase in adjusted net investment income. While most Business Development Companies (BDCs) struggled with the subdued M&A activity, Fidus expanded its portfolio by nearly $100 million, a testament to their deep expertise and strong sponsor relationships in the lower middle market. But something even more intriguing lies beneath the surface, a whisper of a contrarian strategy that might be flying under the radar of most analysts.

The clue? Fidus' persistent aversion to high leverage, even in the face of tightening spreads and increasingly aggressive competition.

The BDC landscape in 2023 was a stark contrast to the heady days of 2021. The banking crisis, rising interest rates, and persistent economic uncertainty forced many lenders to retreat, creating a more favorable environment for those who remained. Spreads widened, offering enticing returns for those willing to embrace risk. Yet, Fidus, with its healthy portfolio and strong cash flow generation, chose to maintain a conservative stance on leverage, deliberately operating below market levels.

In the Q4 2023 earnings call, CEO Ed Ross reiterated their commitment to a one-to-one debt-to-equity target, a stance they maintained even as their portfolio shifted towards first lien investments, typically associated with higher leverage capacity. While acknowledging the potential for increased leverage in 2024, particularly through the application for a fourth SBIC license, Ross emphasized their preference for operating with "a little bit less than market leverage."

This seemingly conservative approach raises a fascinating question: Is Fidus anticipating a market downturn and deliberately positioning itself for a less favorable economic climate?

Why This Contrarian Hypothesis Warrants Consideration:

Spread Compression Anticipation: The tightening of spreads in the lower middle market, albeit at a slower pace than the broader market, suggests that the current favorable lending environment might be reaching its peak. By maintaining low leverage, Fidus could be creating headroom to increase lending activity when others are forced to pull back due to higher funding costs and risk aversion.

Opportunistic Deployment: Fidus ended 2023 with a substantial cash position of $119.1 million, further bolstered by the repayment of $35 million in SBA debentures in their second SBIC fund in early 2024. This robust liquidity, coupled with their low leverage, positions them for a significant deployment surge, potentially acquiring assets at more attractive valuations should the market soften.

Interest Rate Sensitivity Mitigation: While Fidus' portfolio is somewhat sensitive to interest rate fluctuations, their lower leverage provides a buffer against rising funding costs, ensuring their earnings power remains robust even if rates climb higher than currently anticipated.

Let's Look at the Numbers

Assuming a hypothetical scenario where spreads tighten by 100 basis points and interest rates rise by 50 basis points, a highly leveraged BDC could see its net investment income erode by 5-7%. Fidus, with its conservative one-to-one leverage and substantial fixed-rate investments, would likely experience a significantly smaller impact, potentially less than 3%.

This resilience, coupled with their substantial dry powder, paints a picture of a BDC poised to capitalize on potential market dislocations.

Originations vs. Repayments

The chart below shows the origination and repayment activity of Fidus in the past two quarters. While Q1 2024 saw significant originations, Q2 is expected to be lighter. However, the company anticipates a pickup in repayments in Q3 and Q4, potentially due to increased M&A activity.

While it's impossible to predict the future with certainty, Fidus' current strategy, characterized by prudent leverage and significant liquidity, suggests a contrarian approach, a calculated bet against a market potentially nearing its cyclical peak. Whether this proves to be a stroke of genius or a sign of excessive caution remains to be seen, but one thing is certain: Fidus Investment Corporation is a BDC worth watching closely in 2024.

"Fun Fact: Did you know that Fidus Investment Corporation derives its name from the Latin word "fides," meaning "trust"? This underscores their commitment to building long-term relationships with sponsors and portfolio companies, a cornerstone of their success in navigating volatile markets."