FIDUS INVESTMENT Corp Q3 FY2023 Earnings Call

Good day and welcome to Fidus Third Quarter 2023 Earnings Call. Please note that this event is being recorded. I'd like to turn the conference over to Ms. Jody Burfening. Please go ahead.

Thank you, Nick, and good morning, everyone, and thank you for joining us for Fidus Investment Corporation's Third Quarter 2023 Earnings Conference Call. With me this morning are Ed Ross, Fidus Investment Corporation's Chairman and Chief Executive Officer; and Shelby Sherard, Chief Financial Officer. Fidus Investment Corporation issued a press release yesterday afternoon with the details of the company's quarterly financial results. A copy of the 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, November 3, 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 undertakes 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, Jody, and good morning, everyone. Welcome to our third quarter 2023 earnings conference call. On today's call, I'll start with a review of our third quarter performance and our portfolio at quarter end and then share with you our outlook for the remainder of 2023. Shelby will cover the third quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions. We delivered strong results for the third quarter, with our portfolio continuing to grow adjusted net investment income and with adjusted net investment income remaining well in excess of our base dividend. Much like the first half of 2023, deal flow was decent but not robust by any means as M&A activity remains subdued in the lower middle market. We're patient, disciplined, and staying focused on our proven strategy of selectively investing in value-added businesses that generate high levels of free cash flow and have positive long-term outlooks. 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 46% to $18.2 million in Q3 compared to $12.5 million last year. Interest income growth drove this increase, reflecting both higher average loans outstanding and a 170 basis point increase in average debt yields to 14.6%. Taking into account the increase in weighted average shares outstanding resulting from our equity raise during the quarter, adjusted net investment income on a per share basis increased 33.3% to $0.68 from $0.51. We paid dividends totaling $0.72 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.21 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, roughly the equivalent of dividends for 3 quarters. For the fourth quarter, on October 30, 2023, the Board of Directors declared dividends totaling $0.80 per share, consisting of a base dividend of $0.43 per share, a supplemental dividend of $0.27 per share, equal to 100% of the surplus and 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 December 27, 2023, to stockholders of record as of December 20, 2023. Net asset value at quarter end was $548.6 million or $19.28 per share compared to $483.3 million or $19.13 per share as of June 30. During the quarter, we continued to invest in our portfolio of debt securities that generate recurring interest income and co-invested in equity securities as a means of adding a margin of safety and creating the opportunity to enhance returns. Originations totaled $56.7 million, consisting of $48.5 million in debt and $8.2 million in equity. First lien investments accounted for $43.1 million or nearly all of the additions to the debt portfolio. We invested $33.1 million in 2 new portfolio companies that were added to the portfolio financing M&A transactions. The remaining portion of originations was invested in add-ons in support of our existing portfolio companies. Proceeds totaling $69.9 million were slightly higher than originations for the third quarter, reflecting 4 debt repayments and 2 equity realizations including the sale of Hallmark, which occurred earlier than we had expected. From an equity perspective, we received proceeds of $11 million, resulting in realized gains of $9.8 million most of which came from the sale of our equity investment in Hallmark. Our portfolio of debt investments on a fair value basis was $798 or 86% of the total portfolio at quarter end. First lien investments continue to account for the largest piece of the debt portfolio at 65%. And including the fair value of our equity portfolio of $128.8 million, the fair value of the total portfolio at quarter end stood at $926.9 million equal to 103.5% of cost. We ended the third quarter with 80 active portfolio companies and 2 companies that have sold their underlying operations. Subsequent to quarter end, we invested $31.8 million in first lien debt and preferred equity in 2 new portfolio companies, and we had debt repayments in 3 companies generating net proceeds of approximately $29.3 million. As we added debt and equity investments to our portfolio, we continued to carefully select high-quality companies that generate excess levels of cash flow to service debt and to structure our investments with a high percentage of equity cushion in an effort to manage downside risk, which is especially important in today's higher rate environment. For the most part, our portfolio of companies has adjusted to current economic conditions and those with pricing power generally found ways to prosper despite inflationary cost pressures and higher interest rates. Select portfolio companies are continuing to navigate today's tougher conditions, and we are monitoring them closely. As of September 30, we had 2 operating companies on non-accrual, unchanged from the second quarter. Non-accruals represented 1.3% of the total portfolio on a fair value basis. In summary, the credit quality of our portfolio overall remains very solid. As we close out the year, the pace of deal activity in the lower middle market has been picking up relative to Q3. Our portfolio remains healthy, and with our strong liquidity, we are well positioned to grow the portfolio selectively and deliberately, investing in high-quality companies in the lower middle market that possess resilient business models and positive long-term outlooks and generate high levels of cash flow. As always, we are committed to managing the business for the long term into our goals of preserving capital, generating attractive risk-adjusted returns, and delivering value for our shareholders. Now I'll turn the call over to Shelby to provide some details on our financial and operating results. Shelby?

Thank you, Ed, and good morning, everyone. I'll review our third 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, Q2 2023. Total investment income was $34.2 million for the 3 months ended September 30, a $3.6 million increase from Q2, primarily due to a $3.7 million increase in interest income, including PIC, offset by a slight decrease in dividend 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 the increase in interest rates on variable rate loans. Total expenses, including income tax provision, were $17.5 million for the third quarter, $3.8 million higher than Q2, driven primarily by a $2.7 million increase in the accrued capital gains incentive fee, a $0.4 million increase in interest expenses, in part due to incremental SBA debt outstanding, and a $0.7 million increase in the base management and income incentive fees. We ended the quarter with $454.3 million of debt outstanding comprised of $188 million of SBA debentures, $250 million of unsecured notes, and $16.3 million of secured borrowings. Our debt-to-equity ratio as of September 30 was 0.83x or 0.49x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.3% as of September 30, 2023. Net investment income or NII for the 3 months ended September 30 was $0.63 per share versus $0.67 per share in Q2. Adjusted NII, which excludes any capital gains, incentive fee accruals or reversals attributable to realized and unrealized gains and losses on investments, was $0.68 per share in Q3 versus $0.62 per share in Q2. In Q3, we realized net gains of $9.8 million, primarily related to the exit of our equity investment in Hallmark Healthcare Solutions. Turning now to portfolio statistics as of September 30. Our total investment portfolio had a fair value of $926.9 million. Our average portfolio company investment on a cost basis was $11.2 million, which excludes investments in 2 portfolio companies that have sold their operations and are in the process of winding down. We have equity investments in approximately 76.8% of our portfolio companies with average fully diluted equity ownership of 3.2%. The weighted average effective yield on debt investments was 14.6% as of September 30 versus 14.5% at June 30. 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 non-accrual, if any. Now I'd like to briefly discuss our available liquidity. In Q3, we issued 3.2 million shares at an average share price of $19.54, raising net proceeds of approximately $61.5 million. As of September 30, our liquidity and capital resources included cash of $80.3 million, $22 million of available SBA debentures, and $100 million of availability on our line of credit, resulting in total liquidity of approximately $202.3 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 Nick for Q&A. Nick?

First question will be from Bryce Rowe, B. Riley.

Ed, I wanted to ask you guys to talk about the ATM usage. Obviously, nice to see the stock trade above NAV and give you the ability to raise some equity in the third quarter, pretty substantial amount. Can you kind of delineate between being opportunistic with the stock above NAV and maybe just raising the equity in anticipation of some more activity, whether it be in the fourth quarter or into the first part of '24?

Sure. It's a great question, Bryce. I think from my perspective, first off, I think we're very pleased with our overall performance and where the stock has been trading. But I think more importantly, what we're pleased with is the opportunities that we are seeing in the market. And in particular, these are mostly very high-quality companies that we are pursuing. The leverage levels are very reasonable; loan to values are 30% to 50%, if you will. And so we think from a risk-adjusted return basis, this is a great time to invest. And quite frankly, the companies that are coming to market from an M&A perspective are very high-quality companies that we believe can withstand any of the uncertainties that we are all fearful of. But we feel good about the opportunity set. And obviously, we feel also good about the fact that our stock has been trading well.

Great. That's helpful. And then maybe another question here just on the dividend, nice to see the bump higher in the dividend, at least the regular dividend. Just curious how you're thinking about possibly paying out the excess earnings over and above the base dividend amount? Do you expect to continue to pay out the full excess? Or will you moderate that a bit as we move into '24?

Sure. Great question, Bryce. We're excited about the business's performance and have seen significant equity realizations over the past several years. As a result, the business's earnings power is at a higher level, and we are pleased to have increased the base dividend. Our current approach is to continue distributing our excess earnings as we are doing now, and we expect to maintain this as we enter 2024. This quarter, Q4, will be the last time we pay the additional $0.10 special dividend, which we have been providing for the past five quarters, including this quarter. However, we plan to keep distributing 100% of our excess earnings from the previous period as we move forward into 2024.

Next question will be from Mickey Schleien of Ladenburg.

I want to start with a high-level question perhaps for Ed. In the upper middle market, we're starting to see spreads come in, just as a function of the amount of private capital that's out there and the lack of M&A volume and we have a supply and demand mismatch, are you starting to see that trickle down into the middle market and lower middle market where you operate, Ed?

Great question, Mickey. And the short answer to that is a little bit. I would say the spreads have narrowed maybe 25 basis points, in certain situations 50, over the last 6 months or so. I think there was a period 12 months ago, 9 months ago, where there were certain lenders that were really not in the marketplace at all. Today, there appears to be more competition. It's not crazy at any level. People are being disciplined. But I do think for the high-quality situations, which is what we're focused on, that spreads have narrowed a little bit here over the last 3 to 6 months. So very similar in nature.

Okay. I appreciate that insight. Going back to the equity issuance question, I just want to understand, are you still expecting to operate the BDC somewhere between 0.8x and 1.1x on a total debt to equity basis? And is your current level, which is at the bottom end of that range, also factoring in some expectation about headwinds for the economy?

Sure. That's a great question. Your initial comment about operating between 0.8x and 1.1x is accurate. Historically, we've functioned in that range. We are open to exceeding 1.1x when suitable opportunities arise. We recognized a chance to raise capital, anticipating an active Q4, and we expect 2024 to be more active than 2023. There is considerable pent-up demand and a greater need for transactions. So, we believed it made sense to prepare for that. I wouldn't say there's any concern; we raised capital to strengthen the business against economic worries. It was primarily to position the company for the opportunities we anticipate going forward.

Okay. I understand. My last question is a bit of a housekeeping inquiry regarding interest income, which increased 13% quarter-over-quarter, while the cost of the debt portfolio actually declined 1% and your average portfolio yields only rose by 10 basis points. The growth in interest income seems significant unless I've miscalculated. Was there anything unusual in the interest income accrued this quarter that we should be aware of?

Sure. I'm going to let Shelby take that; I understand your question, but I'll let her take that.

No, there were no particularly unique items. With debt repayments, we will have acceleration of OID but that's kind of routine in course with respect to repayments.

We also had interest income from some of the cash on our balance sheet during part of the quarter. Average loans outstanding were higher during the quarter than they were at the end of the quarter due to some repayments.

Next question will be from Robert Dodd of Raymond James.

Regarding the color, I wanted to inquire about running the ATM due to the increasing opportunities. You mentioned that the quality of available deals is very high. Looking back at last quarter, it varied based on whether we pursued these deals. However, some of the deals in the market were described as favorable. Have you noticed a change in the mix of deals coming to market that are of higher quality? This would justify running the ATM, as winning those deals would greatly enhance overall portfolio quality. Is there currently a shift in the mix?

No, not really. What I would say is that deal flow wasn't bad at all in Q3, although the quality has been inconsistent throughout the year. That's an important factor. Regarding our investment activity in Q3, a few deals carried over into Q4, and we believe Q4 will be a stronger investment period than Q3, partly due to that and also an increase in activity. We're seeing a diverse range of businesses, primarily focusing on those with recurring revenues, which provide strong stability, along with high free cash flows. These are the types of businesses we're concentrating on, and we are noticing a slight uptick. Some of this can be attributed to the differences between Q4 and Q3 as summer tends to slow things down. However, we are optimistic about a potential increase in M&A activity in 2024.

Got it. Regarding credit quality across the portfolio, what are the reactions to the sponsor interactions? Is anything changing in how they support portfolio companies now that we've experienced a prolonged high rate environment, or is everything remaining the same?

I'm not noticing any significant changes. We've observed some support in challenging situations where we have to go through an amendment, and we're requiring that support. Our portfolio is very active in terms of add-on acquisitions, and people are engaging in that. What I'm observing is a strong interest in identifying high-quality companies, especially in the context of higher rates. In some instances, private equity groups are perhaps paying a bit more than they prefer. However, there's a clear trend towards high-quality assets, both from an equity and debt standpoint. If investors can find opportunities to invest in top-tier businesses, they're willing to pay a premium for them, and that's reflected in some of our utilization metrics as well.

Next question will be from Paul Johnson with KBW.

On the Hallmark just going back to the Hallmark Health Care sale. I'm just trying to understand kind of, obviously, that was a successful in for you guys just kind of understanding what's going on there with the company. It looks like you have just a little bit of an equity investment left in the portfolio. Just any color you can kind of on what perpetuated as the sale and what you guys have left remaining in the portfolio with that company.

Sure. Great question, Paul. Hallmark has performed very well for us. The company and the sponsor were considering a couple of options, including a dividend recap or a sale transaction. To be frank, we weren’t as involved in the decision-making as we would have preferred. However, the sale transaction took place and was legally documented as a complete sale of the entire equity tranche. That said, the sponsor is reinvesting a substantial portion, which is under 50% but still significant, and we are following their lead. We also invested the same percentage in the business moving forward. While it's a full realization, we made a considerable investment in the future capitalization of the business. Is that helpful?

Yes. That's very helpful. That's great color. And obviously, you guys recognize the gain on the sale, but was that investment also written up during the quarter? Are you able to quantify that at all? Impact on that?

Jody, do you have that at your fingertips or I'll give a higher level.

I don't have the exact number, but I can confirm that the realization that we had in Q3 was materially higher than the fair value we had marked at the end of Q2.

Last quarter, you mentioned that approximately 55% of your companies were still growing EBITDA. Can you provide a similar estimate of the percentage of your portfolio that continues to grow revenues or EBITDA at this time?

Sure, sure. It's a great question. The portfolio continues to perform well. I think of the core lower middle-market businesses that we're invested in EBITDA; I guess, what's the number? 35 of 56 companies that fall in that category. And we also have some equity stand-alone businesses or orphaned equity investments that are not included there. And so about 63% of the companies grew cash flows or EBITDA. And then overall, our portfolio grew on an LTM basis this quarter, just less than 5%. So we're seeing still healthy performance and healthy growth in the underlying portfolio, which we're very pleased with.

That's very helpful. Just one last question. Clearly, $0.68 was a strong result this quarter. I'm wondering if you see this as the full effect of higher rates in terms of net interest income in the portfolio, or is there a chance of continued higher other-than-temporary impairment amortization? I believe fees from payments will keep generating results at these levels or possibly even higher, so any insights on that would be appreciated. That's all from me.

It's a great question and not easy to answer. However, we are very pleased with our performance this quarter. In the next quarter, I want to highlight that we will face an excise expense, which will impact net interest income in Q4. On the revenue side, interest income is currently at a high level, and I don't anticipate an increase in rates. The Fed has maintained its position, and I see a few higher-yielding investments in our portfolio approaching payoff, indicating stability in yields. At the same time, we expect continued monetization of certain equity investments. While M&A activity won't be as robust as in 2021, it is still occurring, and we anticipate further monetization of equity investments. Thus, the outlook for the future is promising. As for whether we will exceed $0.68, it is certainly possible and depends on various factors like how much we get invested and if fee income remains reasonable during that quarter, as well as considering dividends. $0.68 is an excellent result for the quarter, and we aim to improve on that, though our priority is on maintaining portfolio quality and consistency rather than solely maximizing earnings. Hopefully, that provides clarity. Shelby, do you have anything to add?

No. You mentioned the excise tax. So that's just kind of an annual accrual that we have, which we'll continue to have this year.

This concludes our question-and-answer session. I'd like to turn the call back over to Mr. Edward for closing remarks.

Thank you, Nick, and thank you, everyone, for joining us this morning. We look forward to speaking with you on our fourth quarter call in early March 2024. Have a great day and a great weekend.

Conference has now concluded. Thank you for attending today's presentation. You may now disconnect.