FIDUS INVESTMENT Corp Q2 FY2023 Earnings Call

Good morning, and welcome to the Fidus Second Quarter 2023 Earnings Conference Call. I will now turn the call over to Jody Burfening.

Thank you, Savi, and good morning, everyone. Thank you for joining us for Fidus Investment Corporation's Second Quarter 2023 Earnings Conference Call. With me this morning are Ed Ross, Chairman and Chief Executive Officer of Fidus Investment Corporation, and Shelby Sherard, Chief Financial Officer. Fidus Investment Corporation issued a press release yesterday afternoon detailing the company's quarterly financial results. You can find a copy of the press release on the Investor Relations page of our website at fdus.com. I also want to highlight the usual safe harbor disclosure regarding forward-looking information discussed during today's call. This conference call will include forward-looking statements about Fidus Investment Corporation's goals, strategies, beliefs, future potential, operating results, and cash flows. While management believes these statements are reasonable as of today, August 4, 2023, they are not guarantees of future performance. Time-sensitive information may not remain accurate during any telephonic or webcast replay. Actual results may differ significantly due to risks, uncertainties, and other factors outlined in the company's filings with the Securities and Exchange Commission. Fidus has no obligation to update any of these forward-looking statements. Now, I would like to turn the call over to Ed. Good morning, Ed.

Good morning, Jody, and good morning, everyone. Welcome to our second quarter 2023 earnings conference call. On today's call, I'll start with a review of our second quarter performance in our portfolio at quarter end and then share with you our outlook for the second half of 2023. Shelby will cover the second quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions. For the second quarter, we continued to enhance the earnings power of our healthy and high-performing portfolio by further building our portfolio of income-producing assets and benefiting from a widened spread. We grew our total portfolio to $928.7 million on a fair value basis at quarter end, putting a fair amount of capital to work in a reasonably active second quarter. Although deal activity is still spotty, our relationships with deal sponsors, experience, and industry knowledge continue to enable us to invest selectively in companies with predictable revenues, strong cash flow generation, and positive long-term outlooks that meet our strict underwriting standards. In addition, we continue to generate 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 50.1% to $15.6 million or $0.62 per share compared to $10.4 million or $0.43 per share last year. Interest income increased due to growth in our debt portfolio and a debt yield that expanded 260 basis points to 14.5% compared to the second quarter last year. We paid dividends totaling $0.70 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.19 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 third quarter, on July 31, 2023, the Board of Directors declared dividends totaling $0.72 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.21 per share, equal to 100% of the surplus in adjusted NII over the base dividend from the prior quarter, and a special cash dividend of $0.10 per share, which will be payable on September 27, 2023, to stockholders of record as of September 20, 2023. Net asset value was $483.3 million or $19.13 per share as of June 30. Originations for the quarter totaled $95.8 million, about two-thirds of which or $64.6 million was invested in five new portfolio companies that were added to the portfolio through M&A financing. Drilling down further, we invested a total of $47.2 million in first lien investments in four of the five new portfolio companies. The remaining portion of originations was invested in add-ons in support of our existing portfolio companies. We continue to build our portfolio of debt securities that generate recurring interest income and co-invest in equity securities as a means of adding a margin of safety and creating the opportunity to enhance returns. We received proceeds totaling $60.6 million, primarily from the exit of four companies including $7.6 million in proceeds from equity sales, resulting in net originations of $35.2 million for the quarter. Our portfolio of debt investments on a fair value basis grew to $808.3 million or 87% of the total portfolio at quarter end. First lien investments continue to account for the largest piece of the debt portfolio at 65%, including the fair value of our equity portfolio of $120.4 million. The fair value of the total portfolio at quarter end stood at $928.7 million, equal to 103.7% of costs, and representing a 3.5% increase compared to the end of the first quarter. We ended the second quarter with 79 active portfolio companies and two companies that have sold their underlying operations. Subsequent to quarter end, we invested $19 million in first lien debt, subordinated debt, and equity in a new portfolio company. Overall, our portfolio remains healthy from a credit perspective. And for the most part, our portfolio companies continue to perform well. As always, there are some puts and takes that you would expect for a portfolio of our size. A few portfolio companies have been struggling while others have seen improved performance and outlook. To that end, we removed Already from nonaccrual during the quarter and placed Vertex on nonaccrual. Already is performing materially better and has a positive outlook. While Vertex has had a few hiccups, we expect performance to improve in both the near and medium term. In addition, we wrote off our investment in Netherlands and recognized an $11.5 million loss. As of June 30, nonaccruals represented 1.5% of the total portfolio on a fair value basis. Looking ahead to the second half of 2023, we continue to see ample opportunities in the lower middle market to invest in high-quality companies that possess defensive characteristics, strong cash flow-generating business models, and positive long-term outlooks, further building our debt portfolio and co-investing in equity investments. With a healthy and growing portfolio of debt investments generating strong recurring income, we remain positioned to generate adjusted NII growth well in excess of base dividends. As always, we intend to adhere to our prudent investment strategy and remain focused on our long-term goals of growing our net asset value over time, 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 financial and operating results.

Thank you, Ed, and good morning, everyone. I'll review our second quarter results in more detail and end with comments on our liquidity position. I will provide comparative commentary against the prior quarter, Q1 2023. Total investment income was $30.6 million for the three months ended June 30, which is a $1.5 million increase from Q1. This increase was primarily due to an $8 million increase in interest income, which includes PIK, and a $0.8 million increase in fee income related to higher originations, along with a $0.4 million prepayment fee. These were slightly offset by a $0.1 million decrease in dividend income. The growth in interest income was driven by a rise in average debt investment balances and an increase in the yield on our debt investments as interest rates on variable rate loans increased. Total expenses, including the income tax provision, were $13.8 million for the second quarter, which is $0.6 million lower than Q1. This reduction was primarily due to a $1.3 million decrease in the accrued capital gains incentive fee, offset by a $0.4 million increase in interest expenses linked to additional debt outstanding, including both SBA debentures and borrowings under our line of credit, along with a $0.4 million increase in base management and income incentive fees. We ended the quarter with $478.6 million of debt outstanding, which includes $182 million of SBA debentures, $250 million of unsecured notes, $30 million outstanding on our line of credit, and $16.6 million of secured borrowings. Our debt-to-equity ratio as of June 30 was 0.99 times or 0.6 times statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.5% as of June 30, 2023. Net investment income for the three months ended June 30 was $0.67 per share compared to $0.59 per share in Q1. Adjusted net investment income, which excludes capital gains, incentive fee accruals, or reversals linked to realized and unrealized gains and losses on investments, was $0.62 per share in Q2 versus $0.60 per share in Q1. Turning to portfolio statistics as of June 30, our total investment portfolio had a fair value of $928.7 million. Our average portfolio company investment on a cost basis was $11.3 million, excluding investments in two portfolio companies that sold their operations or are winding down. We hold equity investments in approximately 75.3% of our portfolio companies with an average fully diluted equity ownership of 3.2%. The weighted average effective yield on debt investments was 14.5% as of June 30, compared to 14.3% on March 31. This was computed using effective interest rates for debt investments at cost, including the accretion of original issue discounts and loan origination fees, but excluding any nonaccrual investments. Now, I would like to briefly discuss our available liquidity. As of June 30, our liquidity and capital resources included $38 million in cash, $8 million in available SBA debentures, and $70 million of availability on our line of credit, which gives us total liquidity of approximately $116 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 Savi for Q&A.

It is now time for the Q&A session. The floor is open. Our first question comes from Robert Dodd with Raymond James.

Congratulations on another good quarter. Ed, regarding the market environment, are you observing significant activity in the smaller end of your core market? It appears that there is more activity there compared to larger companies. Are you noticing any changes among competitors, perhaps as more people are entering this space because deals are still occurring with smaller companies?

Yes, great question, Robert. Regarding the market, we noted in our last quarter's call that deal flow increased a bit in late spring. It was a decent quarter with good deal activity, though the quality varied. This trend seems to be ongoing, with fluctuations in activity. Summer tends to be slower, but we expect things to pick up a bit after Labor Day seasonally. Overall, the deal flow in our market is decent, and there are many individuals looking to sell or transact. However, some are hesitant, citing lower valuations, inflation, and interest rates affecting peak valuations, so they prefer to wait. There's a mix of both situations occurring. In our market, there's still a good flow, and we are actively seeking the highest quality transactions. From a competitive standpoint, I've noticed some large debt capital providers slightly reducing their activity, but it hasn't affected us. We haven't lost any surprising deals. I'm also aware that some private equity groups are seeking smaller companies than they typically would. It's an interesting market, and I believe the lower middle market is more active compared to the larger market. Hopefully, that's helpful.

Got it. Yes, that is very helpful. Regarding the new nonaccrual, I didn't write down the name, but you mentioned expecting near and medium-term improvement. How are the interactions with sponsors going on that right now? Are they willing to step up promptly and make changes or put in more capital, or are they holding their ground a bit more?

Certainly. When I examine our nonaccruals, we have two operating companies that are currently nonaccrual. One of them is Suited Connector, which was also mentioned last quarter. This company operates as a digital lead generation platform that focuses on the mortgage, home services, and insurance sectors. Consumers looking to compare options provide their information through company-owned websites operated by a sponsor. The sponsor is actively involved from a capital standpoint. The mortgage market has been challenging, catching many by surprise, and all parties, including financial sponsors, aim to navigate through it successfully. In this case, we have a supportive sponsor, though they may be reluctant to provide additional capital unless there's a compelling long-term reason to engage further. Generally, most sponsors are inclined to invest for the long term. The second case, Vertex, is a new nonaccrual situation as well. It’s a manufacturing company that focuses on applications within the defense sector and various government platforms, dealing with electronics manufacturing. It operates in a solid end market, is of significant size, and has a supportive sponsor, despite having faced some challenges. However, we are optimistic about the near- and medium-term outlook for both companies.

Our next question comes from Mickey Schleien with Ladenburg.

Ed, are you seeing any incremental opportunities for Fidus from the pull back of regional banks? And how is that impacting the sort of structures of deals that are your sweet spot currently and the terms that you can get on those deals?

Sure. Great question, Mickey. We are seeing additional opportunities to provide capital in areas where banks have previously been active. While this isn't a flood of deals, it is a part of the current market. Regarding our first lien product, which involves collaboration with banks, the market remains active; however, bank aggressiveness has significantly decreased. This shift isn’t hindering our business. Although banks are less active in terms of leverage, pricing remains similar. They tend to focus on strong companies, particularly those with deposits. We are finding ways to pursue these structures and plan to continue doing so moving forward. There has been a notable change in their aggressiveness, not a dramatic one, but definitely a shift.

Okay. I understand. That's helpful, Ed. Ed, to follow up on Robert's question, spreads have generally been stable despite the rise in LIBOR and SOFR. I'm curious if you're seeing some irrational private capital entering the market. We've seen that happen before, and is that causing any dislocation?

When you say the irrational private, I just want to make sure I'm following the question, you mean people in our capital structures of our investments or?

No. Competitors that might be offering deal terms that you don't think are appropriate risk-adjusted returns for the borrowers?

I got you. Generally speaking, the answer to that is no. I think what we are seeing primarily is pretty good discipline across the board. I think banks, obviously, are looking for more yield. The Fincos, the CLO finance businesses are being quite disciplined relative to previous periods. I think they have less capital. They're being less aggressive as well by a long shot, some of them being almost out of the market. I think BDCs are being very rational from our perspective. Then SBIC is down in the very low end of the market. We don't compete a lot against them, but a little bit. Sometimes you find them doing things that they'll accept yields that are lower than you might think they would for an equity investment, if you will. So it's a little bit, but it's not the norm, and it's not really greatly impacting our business by any stretch of imagination.

My last question, Ed, you mentioned CLOs and the more broadly syndicated market. We're sort of seeing bifurcation in those markets where you have half of the portfolios doing well in terms of revenues and EBITDA and margins being sustainable and the other half not so well. Are you seeing sort of the same bifurcation in the middle market and lower middle market? And how concerned are you with those trends in relation to your own portfolio?

Sure. Great question. From our perspective, what we're seeing is kind of slow growth or even still seeing pretty good growth in the portfolio. If I were to look at EBITDA this quarter as a portfolio, and this is absent the ARR loans and the large company that skews the analysis, our EBITDA grew about 2% this quarter. So on an annualized basis, that would be 8%. So we're still seeing overall pretty good performance. Slow growth is generally the theme. So we are obviously paying very close attention to the portfolio, interest expense is higher, right? And you got to pay attention and make sure cash flows are where they need to be. Not every company is doing great. Don't get me wrong. I think 55% of our companies grew EBITDA this quarter, but most were very stable. I mean our leverage, if you look at that metric, went down from 4x to 3.9x. EBITDA for the portfolio grew. I really feel like there's pretty good stability out there where the issues are, and it's always the case. There are one or two companies that have had some events happened, that you got to manage through. Thankfully, that's a very small number in our portfolio and something that we believe is manageable as well.

Our next question comes from Bryce Rowe with B. Riley.

Let's see, I wanted to maybe start on capital structure. And Shelby, you might be able to cover these. But just curious how you're thinking about capital structure at this point? You all typically don't use the credit facility all that regularly. And obviously, you have some outstanding now. So that's kind of question number one is just how you're thinking about kind of max usage of the credit facility? And then in relation to that, you drew another $8 million of SBA debentures subsequent to quarter end, what is the ultimate capacity from an SBA perspective at this point beyond the $8 million?

Shelby, you want to take that?

Sure. That's a great question. Regarding the SBIC capacity, we have an additional $25 million available. As you know, there are intermittent capital applications required to access that money. We have now received SBA approval for that $25 million. Along with the $8 million we had drawn by the end of the quarter, we now have this extra funding. Our goal is to identify SBIC-eligible deals, and we have several in the pipeline to utilize the $25 million. Any additional funds will go towards the RIC or FIC and we will utilize our line of credit. Unlike a year or two ago, when we had a lot of repayments and excess cash, we've put much more money to work now. We are starting to use our line of credit more actively, but we still have plenty of capacity remaining to do so.

Got it. Okay. That's helpful. Another quarter here of activity on the ATM, I assume that there's still appetite there to draw equity off of the ATM, especially considering kind of that, I guess, capital structure backdrop we just talked about?

Yes, I'll jump in there. I think, Bryce, we're pleased with where the stock price is kind of holding its own now. So we're also very pleased with the overall performance of the business. As you just commented, we turned on the ATM program in Q4 of last year. We've raised $5 million of capital in each of the last two quarters, so in Q1 and Q2 of this year. We would expect to keep that open this quarter. If the markets are attractive, then that makes good sense for us from our perspective. It's an accretive way to raise capital and that's what we're looking to do in the long term, whether it's debt or equity, we're looking to enhance the shareholders' position. Hopefully that's helpful.

Yes. That is. Maybe one last one for me just on kind of portfolio stats. I think in the past, Ed, you've talked about loan to values being relatively low for your debt securities, if you could update us on kind of what that's looking like today, whether it be weighted average, average medium, whatever is the most appropriate metric?

Sure. The loan-to-value for the portfolio is 40% at the moment. I think that's in line with last quarter. So 60% equity cushions overall. Typically, when we're structuring new deals, a 40% equity cushion is somewhat of a minimum. Over the last three to five years, it's been 50% to 60%, even 70% and 80% in some cases, some of the ARR type situations. So we feel very good about the enterprise value cushions for the portfolio.

Our next question comes from Paul Johnson with KBW.

Congrats on the good quarter. Only one or two for me. Just kind of broadly on just getting your thoughts on inflation for companies in your portfolio and just companies in general, sort of the lower middle market. Obviously, those businesses are smaller, just a little bit less ability to kind of combat inflation given the smaller size of the company, is that still an issue these days? Or at this point, is that pretty much since Fidus is really no longer a part of conversations with response?

Sure. Great question, Paul. No, I wouldn't say it's totally subsided. But what I would say, not every company, but almost all companies have found ways to really deal or adjust to the new normal, if you will. In most cases, that's raising prices to offset cost increases, whether it's labor, whether it's input costs, what have you. Investing in companies that have pricing power is an important element of being able to deal with this risk. One of the things we like to do is invest in value-added businesses, high free cash flow businesses that typically have that kind of pricing power when they need to. I do think it's slowed down quite a bit. There's a lot of costs that have declined. Think about freight, for instance, a lot of input costs are there. They're there somewhat to stay. But again, I think most companies have adjusted to this new normal, and it's a discussion, but it's not a terrible thing at this point. Maybe that's the right way to think about it.

Got it. I appreciate that. And then just kind of lastly, I mean this has not been as central to your investment strategy, obviously, in recent years here, but I'm just curious if subordinated or any sort of mezzanine capital opportunities have been cropping up thing that you found interesting or are spreads just too good in that part of the capital structure that is just not really on you guys' radar?

Sure. Great question. No, we are continuing to see opportunities there and probably an increase in opportunities. What I would say is a large, large majority of our originations, just like this quarter, four of the five were first lien investments. We're going to focus on more of the first lien category, but there are plenty of situations from our perspective where a junior debt security makes a lot of sense and is highly attractive. We expect the junior debt portfolio to continue to be a minority portion of the portfolio and probably expect senior debt to increase from here, but it will be a piece of the puzzle for us as we move forward. For us, we're looking for great companies with great outlooks and high free cash flow type situations where we have a strong view. In those cases, I think we can get attractive returns, especially in this market, but in all markets with that type of security. So it's not the primary focus, but it clearly is a piece of the puzzle from our perspective.

Our last question is from Eric Zwick with Hovde Group.

Wanted to first just start with the pipeline. Curious if you could quantify either in dollar terms or maybe just directionally where it stands today relative to 30 days ago? And secondly, are there any particular industries or market segments that are more prominent there in the pipeline at present?

Sure, great question. Eric, the pipeline for us tends to fluctuate. There was a slight dip, but it has picked up recently. Not everything has been awarded yet, and we're working hard to secure those awards, which sometimes requires documentation. However, I can say that activity has increased over the past few weeks. We expect the market to remain decent as we approach the fourth quarter, although it won't be very strong. From an industry standpoint, there's a variety of activity happening. We see some software and technology-driven opportunities, along with participation from distributors, industrial businesses, and healthcare sectors. I hope that answers your question; it's a fairly broad landscape.

Yes, that's great color. And then the only other one for me is, could you provide a quick update just on the two companies that remain in the portfolio that have sold their underlying operations? Just kind of the status of those and what the outlook is? Are they going to stay around for a while or I just can't recall?

Sure. Those companies have been sold, and in one case, we are trying to reach a resolution, which is somewhat like an escrow situation. There is value there, but we want to resolve it quickly rather than waiting five years for the final outcome. So, we are working on that. The other situation is the Green Fiber loan, which we are currently keeping in place. It is in a loss scenario, and I have mentioned this before. It is unlikely to recover. We expect it to remain in that status, but it is uncertain whether it will change in the next year. The expectation is that it represents a loss and is currently valued at zero. There is some cash in an account, but beyond that, it is essentially nothing. I hope that provides clarity.

All right. It appears that there are no other questions. So the Q&A is now closed. I will direct the call back to Ed Ross.

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

This concludes the meeting. You may now disconnect.