FIDUS INVESTMENT Corp Q1 FY2024 Earnings Call

Good day, and welcome to the Fidus First Quarter 2024 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Ms. Jody Burfening. Please go ahead, ma'am.

Thank you, Chuck, and good morning, everyone, and thank you for joining us for Fidus Investment Corporation's First Quarter 2024 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, May 3, 2024, 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 first quarter 2024 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 share with you our outlook for the remainder of 2024. 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. As expected, the first quarter shaped up to be very active from a new investment perspective while repayments were on the lighter side. We put a fair amount of capital to work, redeploying proceeds from the fourth quarter. With net originations totaling $85.7 million, the total portfolio on a fair value basis grew to over $1 billion. To put our investment activity for the quarter in perspective, originations of $145.9 million nearly equal the total amount invested in the first half of 2023. Consistent with our established practice, we grew the portfolio with a focus on capital preservation and the generation of attractive risk-adjusted returns. We continue to invest in industries in the lower middle market that we know well, leveraging our relationships with deal sponsors, and carefully selecting businesses with defensive characteristics, sustainable business models, and positive long-term outlooks that generate cash to both service debt and support growth. Our debt portfolio generated adjusted net investment income of $18.1 million, an increase of 21.8% compared to $14.9 million last year, primarily reflecting higher interest income and fee income for the quarter. Taking into account the higher average share count resulting from the equity raises over the past 12 months, adjusted net investment income on a per share basis was $0.59 per share compared to $0.60 per share for the same period last year. In Q1, we paid a base dividend of $0.43 per share plus a $0.22 per share supplemental dividend for a total distribution to shareholders of $0.65 per share. For the second quarter of 2024, the Board of Directors declared dividends totaling $0.59 per share, consisting of a base dividend of $0.43 per share and a supplemental dividend of $0.16 per share, equal to 100% of the surplus in adjusted NII over the base dividend from the prior quarter, which will be payable on June 26, 2024, to stockholders of record as of June 19, 2024. Net asset value grew 3.2% to $608.3 million compared to $589.5 million. On a per share basis, net asset value was $19.36 at quarter end compared to $19.37 as of December 31, 2023. As I mentioned earlier, originations totaled $145.9 million for the first quarter. We stay focused on investing in first lien investments, on structuring investments with a high percentage of equity cushion and on co-investing in the equity of portfolio companies. Debt investments totaled $137.5 million, of which first lien amounted to $96.1 million or 70%. Equity investments totaled $8.4 million. Of the $145.9 million total in originations, $94.6 million was invested in 7 new portfolio companies, which were added to the portfolio primarily through M&A transactions. Proceeds from repayments and realizations totaled $60.2 million for the first quarter, consisting of debt repayments of $57 million and proceeds from the sale of equity investments of $3.2 million, resulting in net realized gains of $1.7 million primarily from the exit of Applied Data Corporation. Our portfolio of debt investments on a fair value basis was $916.4 million or 87% of the total portfolio at quarter end. First lien investments are still the largest portion of the debt portfolio at 69%, including the fair value of our equity portfolio of $131.7 million. The fair value of the total portfolio at quarter end stood at $1.05 billion, equal to 102.2% of cost, and we ended the first quarter with 87 active portfolio companies. Our portfolio remains well structured, positioned to produce high levels of recurring income and the potential for enhanced returns from the sale of equity securities. Overall, our portfolio from a credit perspective remains solid with no change in the companies we have on nonaccrual from the fourth quarter. While the performance of the 2 operating companies on nonaccrual continued to improve, each of them remains high-risk situations. As a percentage of the total portfolio on a fair value basis, nonaccruals represented under 1% for the first quarter. The health of our portfolio is attributable to our strict underwriting discipline focused on carefully investing in businesses with strong and sustainable cash flow-generating business models and positive long-term growth prospects. With capital preservation in mind, we remain very deliberate in our investment selection process. As we look ahead to the remainder of 2024, we are positioned to continue to grow the portfolio. Deal flow and M&A activity are at reasonable levels, and slowly improving relative to 2023. That said, quality is spotty at the present time. As a result, originations for the second quarter are expected to be meaningfully lighter than the first quarter. Nevertheless, our portfolio is healthy and positioned to continue to generate adjusted NII well in excess of our base dividend to generate attractive risk-adjusted returns and grow net asset value over the long term. 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 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 2023. Total investment income was $34.7 million for the 3 months ended March 31, a $1.7 million decrease from Q4, primarily due to a $1.3 million decrease in interest income, including PIK, a $1.2 million decrease in fee income given higher prepayment fees in Q4. The decrease in interest and fee income was offset by a $0.1 million increase in dividend income and a $0.7 million increase in interest income on excess cash, which was due to the new investments in Q1 being back-end loaded as approximately 72% of invested capital in Q1 closed in March. Total expenses, including income tax provision, were $17 million for the first quarter, $2.3 million lower than Q4, driven primarily by a $1.4 million decrease in the capital gains fee accrual and a $1 million decrease in income taxes related to the annual excise tax accrual in Q4. We ended the quarter with $463.1 million of debt outstanding, comprised of $175 million of SBA debentures, $250 million of unsecured notes, $22.5 million outstanding on the line of credit, and $15.6 million of secured borrowings. Our debt-to-equity ratio as of March 31 was 0.8x or 0.5x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.6% as of March 31, 2024. Net investment income, or NII, for the 3 months ended March 31 was $0.57 per share versus $0.58 per share in Q4. Adjusted NII, which excludes any capital gains, incentive fee accruals, or reversals attributable to realized and unrealized gains and losses on investment was $0.59 per share in Q1 versus $0.65 in Q4, which includes an increase in the weighted average shares outstanding and a decrease in the capital gains fee accrual in Q1. For the 3 months ended March 31, we recognized approximately $1.7 million of net realized gains, primarily related to the sale of our equity investments in Applied Data Corporation. Turning now to portfolio statistics. As of March 31, our total investment portfolio had a fair value of over $1 billion. Our average portfolio company on a cost basis was $11.8 million, which excludes investments in 4 portfolio companies that have sold their operations or are in the process of winding down. We have equity investments in approximately 81.3% of our portfolio companies with average fully diluted equity ownership of 3.5%. Weighted average effective yield on debt investments was 14% as of March versus 14.2% at year-end 2023. 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. In Q1, we repaid the remaining $35 million of outstanding SBA debentures in our second SBIC Fund, completing the wind down of this fund. As of March 31, our liquidity and capital resources included cash of $27.1 million and $77.5 million of availability on our line of credit resulting in total liquidity of approximately $104.6 million. Now I will 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 Chuck for Q&A. Chuck?

And the first question will come from Robert Dodd with Raymond James.

Congratulations on the quarter. I have several questions. Regarding the deployment outlook, you mentioned that Q2 will see a decrease compared to Q1, which is substantial. What are your expectations for the year? Admittedly, it's challenging to predict further out, but could 2024 potentially be the first time you reach $400 million in originations for the year considering the start you've had this year? Or is that unrealistic? Are we still anticipating figures in the 300s for this year, just roughly?

Sure. Great question. And as you know, originations and timing of deals are very hard to predict. I mean, yes. And what I would say, when you talk about Q1, we had a reasonable level of deal flow. We also had some holdover transaction opportunities from Q4, which helped the activity levels. So we were fortunate, right, to have a very strong quarter, which was great. Q2 deal flow has been solid; I would say, quality has been a bit spotty. We do have an expectation that deal flow will pick up here a little bit. M&A, there's just a lot of discussion around it. We think actually there is transaction activity that's starting to increase. For us, this quarter is probably going to be lighter than Q1 by a good bit. And that's okay. What I would say is our portfolio continues to be acquisitive, so that's part of our investments. And then new transaction activity, we're working on a couple of deals very seriously right now. I don't know if they'll close or not, but that's our hope. So we definitely are very busy, but it's not like Q1. And so when I look out to the rest of the year, I expect an increase in activity levels over Q2. Do we get to $400 million like you asked? There’s a possibility of that. Over the last 12 months, I think we've been near that number, but that's a pretty aggressive number at the same time. So I would get something shy of that, but it's also a distinct possibility.

Understood. Yes, yes. No, it's not what we had to say. On the repayments side, I mean, you have deployed a lot of capital over the last 12 months, and a lot of the portfolio is relatively young as a result. I mean you said Q1 repayments were light, and they were. But at the same time, should we expect that to continue for a while given how much the portfolio is relatively fresh? Or do you think there's a different dynamic that's going to play out in the payment level?

Sure. Another great question. I wish I had a crystal ball. But what I would say is, we do have several companies, probably more than several, that are evaluating strategic alternatives at the moment. It's unclear if any of those are Q2 or they kind of push into Q3 and which ones actually transact. The other piece of the puzzle is some of those portfolio companies are equity-only investments and not the really large ones, for instance. And so I'm not, at the moment, expecting a real high level of repayments here in Q2. The current expectation, based on what we know today, is it's less than Q1. Having said that, we do have an expectation that repayments will pick up in Q3 and Q4. As you know, the market is more aggressive. And also, we do see transactions from a realization perspective, company sale M&A type stuff taking place in Q3 and Q4 for us. Hopefully, that clarifies things.

Understood. That is very helpful, although one comment, if I can. Shelby, your color on 72% of capital being deployed in March was very helpful for figuring out direction spreads, et cetera, et cetera; would be really helpful if color like that was in the press release. So thank you. And that's it for me.

The next question will come from Mickey Schleien with Ladenburg.

Ed, LSEG is reporting that middle market spreads have declined about 50 basis points over the last year, but they're still above pre-COVID levels. So when we think about how resilient the economy has remained and the fact that there's plenty of debt capital available out there, what's your outlook on spreads in your bread and butter business?

That's a great question. Comparing to a year ago, the situation has changed significantly. The banks were facing challenges during a banking crisis, but now they're active along with direct lenders, SBIC funds, and BDCs. This increased activity is a notable contrast to the previous year, leading to a decline in spreads. Additionally, the economy is displaying resilience, and there's a growing comfort with the current conditions. Consequently, spreads have decreased. Given the current levels of uncertainty, we've prioritized quality in our investments, which has meant focusing on first lien investments, resulting in slightly lower yields. Overall, I’d anticipate yields today to be 50 to 100 basis points lower than a year ago, with larger markets, particularly in the middle market and above, showing spreads that could be even narrower, around 150 basis points lower. We're witnessing this trend in our investment originations as well. Last quarter, our originations focused on first lien investments yielded 12.9%, while repayments averaged around 13.7%, illustrating the reason for our yield decline. Looking ahead, I expect our yields to remain stable or slightly decrease, considering the current market dynamics.

That's really, really helpful, Ed. And if I could follow that up. You mentioned the, I don't remember what you want to call it, frothiness in the upper middle market, but let's just say a very active upper middle market. I mean part of your playbook is to invest in companies that will grow and succeed. I imagine some of your portfolio companies have done that pretty well and could look to potentially refinance into the upper middle market. How concerned are you about that refinancing risk in your portfolio?

Not terribly. I mean those are investments. I think you're exactly right. We have some companies, and we continue to support those companies that are performing extremely well. And could they get refinanced at lower rates at some point in time in the future, say in the next 12 months? The answer to that is yes. At the same time, we add a lot of value to the portfolio of companies. We've got strong relationships, but they're built on trust and adding value. But your point is a good one. That is a part of the market today. And so it is our expectation that there will be some of that activity, whether it's in Q3, Q4, or into next year. That's a piece of the puzzle for sure. It's not alarming to us; it's just part of the equation.

I understand. And my last question regarding balance sheet leverage. You're still below your target, which I believe is debt to equity of 0.8 to 1.1. I understand that takes into account a lot of different moving parts. But with the discussion you just had about pressure on portfolio yields, are you hoping to increase leverage on the balance sheet to continue to deliver financial performance at the BDC?

Great question, Mickey. The answer is yes. We're focused on actions that benefit our shareholders in the long term. Recently, there has been some instability in the debt markets, particularly affecting the unsecured and treasury sectors. However, we have alternative ways to secure capital. Our revolver maintains a strong liquidity position, and we also have the option to expand its size. In comparison to other BDCs, our revolver is relatively modest. Additionally, we submitted our SBIC application in December, and we anticipated a lengthy process. We are still in line for that, and it will play a role in our strategy. So yes, we are looking to increase leverage, but we're committed to doing it thoughtfully and in the best interest of our shareholders in the long run.

The next question will come from Bryce Rowe with B. Riley.

I wanted to maybe follow up just on those comments you made, Ed, about the SBA license and maybe expanding the credit facility, any color around where you'd like to see the credit facility go in terms of commitment? And then I think last quarter, you talked about the SBA license, the newer one, maybe being in place by the middle of this year. Is that still your expectation from a timing perspective?

I believe the SBA license process is quite challenging. The SBA informed us that it would take some time, making it difficult to estimate a timeline. As of today, without any new information, I would consider June to be somewhat optimistic. Progress is being made, but timing remains hard to predict, and June might indeed be too soon. I anticipate it will be more likely in Q3 or Q4. Regarding the credit facility, we don't have a specific target in mind, but we are contemplating increasing the size of the facility, as that seems prudent. From a capital structure standpoint, I think having a diverse strategy is important. Secured and unsecured components are vital, including SBIC debentures. All of these elements are significant for us, and we have the potential to increase leverage across all three areas; it's simply a matter of timing.

Okay. Okay. I wanted to maybe follow up on that adjective you used 'spotty' in terms of kind of quality that you're seeing in the market today; what does that mean in particular?

We are looking for high-quality businesses that generate strong free cash flow and typically command high EBITDA multiples, indicating they are valuable assets. However, this quarter, there are fewer of these attractive opportunities compared to the previous quarter. Sometimes circumstances align perfectly, and other times they don’t. We're being very cautious and focusing on the best assets available, but there are fewer quality companies in the market right now. If the right conditions aren't met, such as winning the right sponsor or securing appropriate financing, the deal may not go through. Quality remains a critical factor for us, and we are committed to focusing on those high-value businesses.

Can you provide any insights on the credit quality, specifically regarding the weighted average leverage in the portfolio and the current weighted average loan-to-value?

Sure. For our core lower middle market portfolio, excluding a few investments in the larger sector, our leverage is approximately 4.37 times debt to EBITDA, and our interest coverage is at 3.1 times. What was the last question?

I think you talked about kind of loan-to-value within the portfolio in the past?

Yes. Loan-to-value is pretty stable. It's just under 40% in the quarter.

The next question will come from Paul Johnson with KBW.

Kind within the marks on the equity portfolio, you mentioned the one gain this quarter. That was nice. But is there any other significant notable movements or marks within the equity portfolio?

I just want to confirm that I understood you correctly. Were you asking if there were any notable changes in the marks?

Yes.

Overall, the equity portfolio performed well. We did experience a write-down in Pfanstiehl, our largest position, which is managing the challenges of pharma destocking. However, we believe we are nearing the end of this trend, and we anticipate improvements in performance. Pfanstiehl remains a high-quality business with a strong outlook, currently navigating the inventory destocking in the pharma sector, but is close to concluding that phase. The rest of the portfolio has been stable and has performed admirably. Despite the situation with Pfanstiehl, the equity portfolio appreciated during the quarter, along with the debt portfolio. Overall, it was a solid quarter with stable and commendable performance.

Thanks for that. And then just in terms of the deal flow you're seeing in the markets, wondering, trying to get your thoughts on kind of what you think of the relative value of the first lien sort of structure opportunities that you see versus any kind of subordinated opportunities that are out there today and if that's something that you're even seeing and that makes sense?

It's a great question and a tough one, too. The market has shifted significantly towards first lien solutions. However, mezzanine investments remain a core part of the market, even though their market share has decreased. Despite this, mezzanine opportunities are still present for us. Last quarter, we made two mezzanine investments in high-quality companies, and we will continue to seek out similar opportunities where we see value in both the debt and equity of potential portfolio companies. I expect that first lien solutions will continue to dominate our investments moving forward, but we are actively looking for appealing mezzanine opportunities.

Your next question will come from Erik Zwick with Hovde Group.

I wanted to follow up on your earlier comments. You mentioned that the market is quite active right now and that competition is rather intense, which is affecting spreads. I'm curious if you're noticing any decline in the market regarding structures, particularly if you're losing any deals because you're adhering to your credit quality standards and underwriting while others may be starting to compromise.

Sure. Great question. We haven't really seen structural changes. One of the things we like about the lower middle market is we have real maintenance covenants. Many times, we have 2 covenants, both the leverage and a fixed charge. That's a large majority of our situations in our investments. And that's different than the upper market, if you will, the larger market, very different. And I would say the spreads to those maintenance covenants are also narrower. So we like the ability to have a seat at the table, and we have not seen any real changes from that perspective. Clearly, pricing and spreads narrowing is a part of the market in the business today, but structures have not started to change yet, which is a good thing. And to be honest, in the lower middle market, you don't really see a deviation away from pretty strong structures at the end of the day. So again, it's one of the things we really like about the lower middle market and our ability to risk-manage our investments, if you will.

Thanks, I agree with you. That's good to hear. For my last question, I recall you mentioned that the two existing non-accruals are showing improvement but still carry high risk. Could you elaborate a bit more on what you mean by 'improving'? Are you referring to the underlying financial metrics and trends at those companies, or is it more about moving towards some sort of resolution? What do you specifically mean by that comment?

Sure. Great question. What I'm referring to there is really the EBITDA level. So EBITDA levels in both cases are growing and improving on current basis and on a last 12-month basis in a meaningful way. But at the same time, these businesses had some idiosyncratic issues that were meaningful as well. And so the EBITDA performance is improving. We do not expect any quick resolutions or anything like that in either case. And so we're just managing through kind of the situation, trying to work through an improved outlook in both cases. And I would also say we've got supportive equity sponsors in both those cases as well, which is great. There is a lot of work being done to try to improve the overall position of both assets, but we've got a ways to go.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Ed Ross for any closing remarks. Please go ahead.

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

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