FIDUS INVESTMENT Corp Q1 FY2023 Earnings Call

Good day, and welcome to the Fidus Investment Corporation First Quarter 2023 Earnings Conference Call. I would like to advise all participants that this call is being recorded. Thank you. I'd now like to welcome Shelby Sherard to begin the conference. Shelby, over to you.

Thank you, Gavin, and good morning, everyone. Thank you for joining us for Fidus Investment Corporation's First Quarter 2023 Earnings Conference Call. Fidus issued a press release yesterday afternoon with the details of the company's quarterly financial results. A copy of this press release is available on the Investor Relations page of the company's website at fdus.com. I'd also like to call your attention to the customary safe harbor disclosure regarding forward-looking information included on today's call. The conference call today will contain forward-looking statements, including statements regarding the goals, strategies, beliefs, future potential, operating results, and cash flows of Fidus Investment Corporation. Although management believes these statements are reasonable based on estimates, assumptions, and projections as of today, May 5, 2023, these statements are not guarantees of future performance. Time-sensitive information may no longer be accurate at the time of any telephonic or webcast replay. Actual results may differ materially as a result of risks, uncertainties, and other factors including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission. Fidus undergoes no obligation to update or revise any of these forward-looking statements. With that, I would now like to turn the call over to Ed. Good morning, Ed.

Good morning, Shelby, and good morning, everyone. Welcome to our first quarter 2023 earnings conference call. On today's call, I'll start with a review of our first quarter performance and our portfolio at quarter end, and then give you an update on our views about market conditions in the lower middle market for the rest of 2023. Shelby will cover the first quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions. Our first quarter results demonstrate the enhanced earnings power of our portfolio, which derives from our success in building our portfolio of income-producing assets last year and from higher yields. Our first quarter performance also demonstrates the efficacy of our experience, industry knowledge, and relationships with deal sponsors as we continue to build our portfolio without sacrificing quality, even though credit conditions remain tough and deal activity remained relatively slow in the lower middle market. Our strategy of selectively investing in high-quality companies with defensive characteristics and positive long-term outlooks that operate in industries we know well and generate strong free cash flow continues to produce a healthy and high-performing portfolio. We generated adjusted net investment income well in excess of the base dividend for the quarter. Adjusted net investment income, which we define as net investment income, excluding any capital gain incentive fee attributable to realized and unrealized gains and losses, increased 40.2% to $14.9 million or $0.60 per share compared to $10.6 million or $0.43 per share last year. A 52% increase in interest income drove this performance and reflected the positive combination of higher average debt investments and a debt yield of 14.3%, which is 240 basis points higher than the debt yield for the first quarter last year. For the first quarter, we paid dividends totaling $0.66 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.15 per share, and a special cash dividend of $0.10 per share. As a reminder, we are distributing a special cash dividend of $0.10 per share each quarter this year to satisfy RIC requirements and to bring our spillover income in line with our target level. For the second quarter, on May 1, 2023, the Board of Directors declared dividends totaling $0.70 per share consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.19 per share equal to 100% of the surplus and adjusted NII over the base dividend from the first quarter, and a special cash dividend of $0.10 per share, which will be payable on June 28, 2023, to stockholders of record as of June 21, 2023. Including the special cash dividend of $0.10 per share, we ended the quarter with an NAV of $484.6 million or $19.39 per share. In terms of originations for the quarter, we invested $51.5 million, further expanding our portfolio of debt securities that generate recurring interest income while also continuing to execute our strategy of co-investing in equity securities to add a margin of safety and the opportunity to generate incremental profits. This quarter, $40.2 million or a little more than 3/4 of total originations was invested in 3 new portfolio companies. In each case, the investments were made in connection with an M&A transaction, and we also continue to support the M&A activity of our existing portfolio companies. In terms of repayments and realizations in the first quarter, we received proceeds totaling $15.9 million including $15.7 million in first lien debt repayments. With net originations of $35.6 million for the quarter, the fair value of the portfolio at quarter end grew to $897.3 million equal to 103.7% of cost. We ended the first quarter with 78 active portfolio companies and 2 companies that have sold their underlying operations. Subsequent to quarter end, we invested $2.5 million in debt in a new portfolio company and exited our debt and equity investments in Rhino Assembly Company, recognizing a net realized gain of approximately $2.1 million. In terms of the total portfolio mix on a fair value basis, we ended the first quarter with debt investments of $772.8 million and equity investments of $124.5 million. Debt investments accounted for 86% of the total portfolio, with first lien debt representing the majority of the debt portfolio. Overall, our portfolio remains healthy from a credit perspective. Cost pressures and supply chain challenges are showing signs of easing. By and large, our portfolio companies are performing reasonably well, doing what they need to do to navigate current economic uncertainties, especially those with pricing power. We are, however, dealing with select company performance issues, which led us to place one additional company on nonaccrual during the quarter. As of March 31, nonaccruals represented 2% of the total portfolio on a fair value basis. As a reminder, we have residual debt investments in 2 legacy portfolio companies that were previously sold as part of the nonaccrual list. Importantly, our nonaccruals are all isolated company-specific issues versus related to macroeconomic factors applicable to the entire portfolio. As always, we are managing our overall portfolio in a proactive manner and more specifically, working closely with the financial sponsors and management teams of our portfolio companies. In summary, thus far, 2023 is unfolding as we thought it would, and our proven investment strategy and underwriting standards continue to serve us well. Although the pace of new deal activity in the lower middle market has been slower than it was in 2021 and most of 2022, we are continuing to find attractive opportunities to invest in high-quality, high cash flow generating companies and grow our portfolio. With an expanding portfolio of income-producing assets and the benefits of our balance sheet in a widening spread environment, our portfolio remains very well positioned to generate adjusted NII in excess of base dividends and to grow net asset value over the long term, supporting our long-term goals of preserving capital and generating attractive risk-adjusted returns for our shareholders. Now I'll turn the call over to Shelby to provide some details on our financials and operating results.

Thank you, Ed, and good morning, everyone. I'll review our first quarter results in more detail and close with comments on our liquidity position. Please note, I will be providing comparative commentary versus the prior quarter Q4 2022. Total investment income was $29.1 million for the 3 months ended March 31, a $1.6 million increase from Q4, primarily due to a $1.9 million increase in interest income, including PIK, and a $0.2 million increase in dividend income, partially offset by a $0.6 million decrease in fee income. The increase in interest income was driven by an increase in average debt investment balances outstanding as well as an increase in the yield on our debt investments, given an increase in interest rates on variable rate loans. Total expenses, including tax provision, were $14.3 million for the first quarter, a $0.7 million lower than Q4, driven primarily by a $1.4 million decrease related to the annual excise tax accrual that occurs in Q4, offset by a $0.6 million increase in income incentive fee and a $0.3 million increase in interest expense related to incremental debt outstanding, both SBA debentures and borrowings under our line of credit. We ended the quarter with $446.6 million of debt outstanding comprised of $165 million of SBA debentures, $250 million of unsecured notes, $15 million outstanding on our line of credit, and $16.6 million of secured borrowings. Our debt-to-equity ratio as of March 31 was 0.9x or 0.6x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.2% as of March 31, 2023. Net investment income, or NII, for the 3 months ended March 31 was $0.59 per share versus $0.51 per share in Q4. Adjusted NII, which excludes any capital gains, incentive fee accruals, or reversals attributable to realized and unrealized and losses on investments, was $0.60 per share in Q1 versus $0.51 per share in Q4. Turning now to portfolio statistics. As of March 31, our total investment portfolio had a fair value of $897.3 million. Our average portfolio investment on a cost basis was $11.1 million, which excludes investments in 2 portfolio companies that sold their operations during the process of winding down. We have equity investments in approximately 76.3% of our portfolio companies with an average fully diluted equity ownership of 3.9%. Weighted average effective yield on debt investments was 14.3% as of March 31 versus 13.8% at December 31. The weighted average yield is computed using effective interest rates for debt investments at cost, including the accretion of original issue discount and loan origination fees, but excluding investments on nonaccrual, if any. Now I'd like to briefly discuss our available liquidity. As of March 31, our liquidity and capital resources included cash of $36.4 million, $5 million of available SBA debentures and $85 million of availability on our line of credit, resulting in total liquidity of approximately $126.4 million. Now I'll turn the call back to Ed for concluding comments.

Thanks, Shelby. As always, I'd like to thank our team and the Board of Directors at Fidus for their dedication and hard work and our shareholders for their continued support. I will now turn the call over to Gavin for Q&A.

And your first question comes from the line of Mickey Schleien of Ladenburg.

Can you hear me all right?

Yes, I can. Yes.

Ed, I see that the portfolio's cash interest coverage ratio increased which is a bit of a surprise, considering the increase in interest rates. I do see that most of your net investments were in first liens, and it may have better ratios, and you have almost 1/3 of the portfolio in fixed-rate investments. But could you comment on what's supporting that trend, please?

There are several factors to consider. One is our leverage; it's 4x on average, which is significantly higher than what larger companies typically have. This is certainly a contributing factor. Interest rates only started to increase in the latter part of last year, which also plays a role. Additionally, some of our newer portfolio companies have improved that ratio. Overall, the fact that we are at 4x leverage is a significant piece of the puzzle.

I understand there are a couple more questions. How exposed are your five aerospace portfolio companies to any potential cuts in military spending?

They are certainly exposed. However, based on the platforms they are utilizing and honestly, the outlooks appear quite strong. Therefore, we feel very optimistic about our aerospace portfolio in the long term. There are some challenges, including supply chain issues, at both our company and the customer level that are still being addressed. Nonetheless, when I consider our aerospace portfolio for the long term, it seems very promising and robust.

All right. That's good to hear. Lastly, one sort of technical question. I think in the press release, you mentioned you received a distribution on your Rhino equity. And I'm just curious whether you're going to recognize a dividend from that investment or a realized gain below the line.

Sure, great question.

That will be a realized gain. Effectively, the underlying operations were sold. And so it's effectively a liquidation. So it will be a realized gain on our GAAP financial statements.

Your next question comes from the line of Robert Dodd of Raymond James.

Congratulations on the quarter. Regarding the nonaccrual commentary, you mentioned isolated company-specific issues. Can you provide any further details on that? Additionally, what has been the sponsor's response so far? Is the sponsor being supportive, or is there some anxiety on their part? I understand some of this may be confidential, but any insights would be appreciated.

Sure. Of the three operating companies that are nonaccrual, two of them, including us and another partner, have been supportive of one, which is EbLens. That situation is currently quite challenging. The other two are owned by financial sponsors, one involving two sponsors and the other one sponsor. In both cases, these sponsors have been very active with their portfolio companies and have also provided capital support. We believe in the long-term potential of those businesses, as do the sponsors, but they are experiencing some difficulties right now. We are working diligently to maximize the outcomes for all stakeholders, particularly for ourselves.

Got it. Regarding Su Co, it's a relatively new asset, originated at the end of 2021. You mentioned company-specific issues. Did these issues develop quickly, or was there a significant event like a fire? Any insights on that would be helpful, as it seemed to happen soon after the original underwriting.

The Suited Connector is a digital lead generation platform focusing on the mortgage sector, home services, and insurance verticals. I can tell you that the mortgage sector has been struggling, and the insurance vertical has faced its own challenges. The performance declined noticeably last year. However, we believe we have a solid operating company and a strong management team, even though we are dealing with tough market conditions. It's a strong franchise, but the risk profile of our debt and equity investments is reflected in their valuations.

Got it. In broader terms, your market commentary is always excellent. Things are relatively slow, yet you still deployed $50 million in the first quarter, which is typically a slow quarter. Do I need to reconsider what "slow" means in the context of your business, which has seen growth and a larger portfolio? Does a slow quarter for you now signify $50 million, while five years ago it might have been $20 million? Or has the scale of the business increased so significantly that the interpretation of "slow" has changed compared to a few years ago?

I believe the scale of the business has significantly changed compared to five years ago. Last fall, particularly in October, November, and December, new deal volumes in M&A slowed considerably, resulting in a rather weak performance by the end of the year. The first quarter began in a similar way, but things have since improved. Currently, deal flow has picked up notably, although the quality varies. It's encouraging to see that M&A processes have started, and engagements are beginning to happen. There are several companies out there that are performing well, and many are making decisions based on the current market realities, recognizing the positive performance of their companies. Although the first quarter was indeed slower, we anticipate an increase in transaction volumes as the year advances. While it won't reach the highs of last year or 2021, we do expect gradual growth over time. Overall, it was a slower quarter from our perspective.

Your next question comes from the line of Bryce Rowe of B. Riley.

I wanted to maybe just start or talk about the dividend construct, Ed. I mean you obviously have a pretty powerful dividend at this point with all 3 elements kind of thrown in there. The regular, the supplemental, and the special. Quite a good kind of dividend profile or dividend coverage profile that you have. And even in some down rate-type scenarios, you look like you'll comfortably still cover that dividend. So could you talk a little bit about the discussions at the Board level in terms of maybe adjusting that regular or the base higher, would you consider doing that? Or are you kind of comfortable with the current construct the way it is?

Sure, that's a great question, Bryce. We are actively evaluating the base dividend and have spent considerable time on it. We are pleased to have increased it significantly over the past 18 months. Additionally, since our dividend structure allows shareholders to fully participate in all of the company's earnings, we are paying out 100% of the excess, which provides us with comfort and flexibility. Your question is very valid, and we are optimistic about the business's outlook and performance, which is on our minds. However, given the current quarter's events and the fact that shareholders fully participate in the dividend, we believe we can wait a quarter or two to assess further results. The positive aspect from our perspective is the 100% payout of adjusted net investment income, so there is no urgency to adjust the base dividends at this time.

Yes. Okay. Okay. And then maybe a question around kind of the market environment and pricing and maybe how you're interacting with some banks. I know you've probably partnered with some banks in the past on some deals. So if you could speak to how that's evolving in this current market? And then maybe just any kind of general commentary around pricing spreads, etc.

From a market perspective, it has been slower, but we are currently experiencing a lot of deal flow. The quality of these deals varies. We anticipate this trend to continue and expect activity to increase for the rest of the year, especially in the latter half. In terms of pricing, spreads remain wider, approximately 100 basis points wider than they were before COVID. Leverage levels are lower, and the terms are favorable. In the lower middle market, we have maintained strong maintenance covenants. Therefore, we consider this a very appealing time to invest, provided we can find the right opportunities. We are diligently searching for those and remain selective in our choices. Regarding the banks, regional banks have indeed scaled back their aggressiveness, but they are not out of the market. This presents opportunities for us in the current environment. We still engage with them on new transactions occasionally and take advantage of situations where banks are not involved for various reasons. Overall, we see this as a positive competitive and pricing dynamic.

Your next question comes from the line of Erik Zwick of Hovde Group.

I wanted to start with a question about the pipeline. As you look at the pipeline today, what does the mix look like in terms of industry concentration? Additionally, could you share your current preferences? Ed, you mentioned earlier that you’re seeing more deal flow, but the quality has been inconsistent. I'm curious if this issue is specific to FAR or if there are certain industries you are currently avoiding due to stress or other concerns. Any insights on this would be appreciated.

We have a lot going on, so let me break it down. We're actively focusing on health care services and just completed a deal in the collision repair sector. We're also exploring several business service opportunities, including some in software. Generally, we want to avoid capital-intensive businesses and prefer companies with stable and sustainable revenues. We're steering clear of retail, particularly those targeting lower-income consumers, as well as capital-intensive energy services. While we have one successful portfolio company in energy, we're not looking to increase our involvement in that area. Additionally, consumer-focused businesses aren't a major focus for our portfolio right now, and we are cautious about adding new investments in that space. Does that answer your question, Erik?

Yes, that's great. You hit it all. And just the second one I had today, I was looking at your leverage profile, I'd say you have a more conservative kind of stance than some others in the industry. And just curious how you think about that today. You mentioned that kind of the rest of the year, you would expect more opportunity for originations going forward. And if you do see good risk-adjusted opportunities, are you okay taking leverage higher? Or would you really look to maybe just kind of hold the portfolio level consistent and use prepayments and then pay downs to fund new opportunities?

Sure. That's a good question. We're currently below the 1:1 mark. Our long-term goal is to reach 1:1, but we are comfortable exceeding that for a temporary or extended period. Our main focus is on identifying strong investment opportunities. We won't take on excessive leverage, as that's not in our nature. However, we are okay with going above the 1:1 leverage mark if it makes sense, particularly for the short term. Additionally, our portfolio is now more weighted towards first-lien investments compared to 6, 7, or 8 years ago, making it easier for us to increase leverage. Therefore, we're in a good position to take on more leverage if it aligns with our strategy, but I would maintain the goal of 1:1 from our perspective.

And there are no further questions at this time. So I'd like to hand back to Ed.

Thank you, Gavin, and thank you, everyone, for joining us this morning. We look forward to speaking with you on our second quarter call in early August. Have a great day and a great weekend.

That does conclude our conference for today. Thank you for participating. You may now all disconnect.