Earnings Call Transcript - FDUS Q3 2021

Operator, Operator

Welcome to the Fidus Third Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to one of your speakers today, Ms. Jody Burfening. Please go ahead.

Jody Burfening, Speaker

Thank you, Vic, and good morning, everyone. And thank you for joining us for Fidus Investment Corporation's third quarter 2021 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 05, 2021, 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.

Ed Ross, CEO

Good morning, Jody, and good morning everyone. Welcome to our third quarter 2021 earnings conference call. I hope all of you, your families, friends, and coworkers are staying healthy and well. I am going to open today's call with a review of our third quarter performance and our portfolio at quarter end and then offer you an update on our views on deal activity in the lower middle markets. Shelby will cover the third quarter financial results and our liquidity position. Once we have completed our prepared remarks, we'll be happy to take your questions. As expected, activity levels in the lower middle market from both an M&A activity and refinancings perspective were healthy and robust during the third quarter, continuing a period of heightened activity that began nearly a year ago. Against this backdrop, our portfolio performed well and we continue to see a strong flow of opportunities for investments in high-quality businesses that possess resilient business models that generate strong levels of cash flow to service debt and that have positive long-term outlooks. Repayments remained at high levels and outpaced originations due in part to the timing of deal closings. 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, was $9.8 million or $0.40 per share compared to $9.7 million or $0.40 per share last year. NAV grew to $447.5 million or $18.31 per share, reflecting both a solid operating performance and underlying portfolio value appreciation. In addition, we reported net realized gains of $8.4 million or $0.35 per share as we harvested several mature equity investments in conjunction with sales in excess of portfolio companies. Fidus had a base quarterly dividend of $0.32 per share, a supplemental cash dividend of $0.06 per share, and a special dividend of $0.04 per share for the third quarter. As a reminder, the board has devised a formula to calculate the supplemental dividend each quarter under which 50% of the surplus in adjusted NII over the base dividend from the prior quarter is distributed to shareholders. On November 1, 2021, the Board of Directors declared a base quarterly dividend of $0.32 per share, a supplemental quarterly cash dividend of $0.04 per share, and a special dividend of $0.05 per share for a total dividend of $0.41 per share for the fourth quarter. The dividends will be payable on December 17, 2021, to stockholders of record as of December 3, 2021. In terms of originations, we invested $78.2 million in debt and equity securities, of which $39.6 million or roughly half of the total was invested in first lien debt and roughly 40% was invested in second lien debt. Investments in new portfolio companies consisted of $14.3 million in first lien debt and common and preferred equity in Cardback Intermediate, LLC, a leading provider of chargeback prevention and recovery services for ecommerce in Card Not Present businesses. We invested $10.5 million in second lien debt and common equity in PowerGrid Services Acquisition, LLC, a leading utility services business providing repair and maintenance services for distribution, transmission, and substation infrastructure. As you can see, we continue to focus on companies with stable and diversified demand characteristics, relative insulation from the supply chain constraints and inflationary pressures currently weighing on many companies, and strong positive long-term outlooks. The remaining $53.4 million is a new $20 million second lien loan commitment in Worldwide Express and a number of follow-on investments in support of M&A transactions on the part of some of our portfolio companies. Shortly after the end of the quarter, we invested a total of $27 million in two new portfolio companies. These were $8.5 million in first lien subordinated debt and common equity of Auto CRM LLC, doing business as Dealer Holdings, a leading SaaS-based provider of customer communication software to the auto repair market. $18.5 million in first lien debt, common equity, and warrants of Acendre Midco, Inc., a leading provider of cloud-based talent management software solutions. In addition, we committed $16 million in second lien debt to a leading technology platform for digital customer acquisition across all consumer vehicles, including financial services, home services, and insurance, which we expect to fully fund in Q4. In terms of repayments and realizations in the third quarter, we received proceeds totaling $127.5 million with the majority from second lien and subordinated debt investments and $23.4 million in proceeds from monetizing equity investments. In terms of exits, we received payment in full of $21 million on our first lien debt and converted debt to equity in Hilco Technologies while realizing a net loss of approximately $1 million on our original equity investments in the company. We received payment in full of $11.4 million on our second lien debt in CRS Solutions Holdings, LLC, received payment in full of $20 million on our second lien debt in Worldwide Express LLC, and realized a gain of $3 million on our equity investment. In conjunction with the sale of Worldwide Express, we invested $1.5 million in common equity, of which $0.8 million was rolled over from the original common equity investment and funded a $20 million second lien loan commitment. We received payment in full of $11 million on our subordinated debt investment in LNG Indy, LLC and realized a gain of $4.5 million on our equity investments. We received payment in full of $21.5 million on our subordinated debt in Allied 100 and realized a gain of $1.8 million on our equity investments. We received payment in full of $11.6 million, including a prepayment penalty on our subordinated debt in ECM Industries, LLC. In addition, we received a cash distribution of $0.8 million on our equity investment. We received payment in full of $17.3 million, including a prepayment penalty on our debt investment in Routeware, Inc. Subsequent to the quarter, we received payment in full of $7.1 million including a prepayment penalty on our subordinated debt in Tranzonic Companies. The fair value of the portfolio at quarter end was $719.1 million, equal to 113.9% of cost and reflecting net repayments for the quarter, partially offset by appreciation in the fair value of the portfolio. We ended the third quarter with 70 active portfolio companies and six companies that have sold their underlying operations. Our portfolio remains well-structured, positioned to produce both high levels of recurring income and to provide us with a reasonable margin of safety, along with the opportunity to enhance returns. Given current market conditions, we remain focused on rotating mature equity investments into income-producing assets. With first lien debt investments exceeding repayments and second lien and subordinated debt repayments exceeding originations, during the third quarter, the mix continued to shift in favor of first lien debt on both an absolute basis and as a percent of the total portfolio. At quarter end, first lien debt accounted for 41.2% of the total portfolio on a fair value basis compared to 25.2% as of December 31, 2020, while second lien debt decreased to 28% of the portfolio on a fair value basis from 44.7% as of December 31. Subordinated debt accounted for 9.7% and equity investments grew to 21.1% of the portfolio on a fair value basis. Moving to portfolio performance. Overall, our portfolio continues to perform well and risk remains at comfortable levels. As of September 30, we did not have any companies on non-accrual. Some of our portfolio companies continue to work their playbooks in terms of pricing and productivity measures in response to supply chain challenges created by the pandemic, including component shortages, material and freight cost inflation, and labor availability. In light of these unprecedented business conditions, having a well-diversified portfolio continues to serve us well. To help us assess the overall health, stability, and performance of our investment portfolio, we track several quality measures on a quarterly basis. First, we track the portfolio's weighted average investment rating based on our internal system. Under our methodology, a rating of 1 is outperform and a rating of 5 is an expected loss. At September 30, the weighted average investment ratio for the portfolio was 2 on a fair value basis. Another metric we track is the credit performance of our portfolio, which is measured by our portfolio company’s combined ratio of total net debt to Fidus' debt investments to total EBITDA. For the third quarter, this ratio is 5 times excluding equity only and ARR deals. The third measure we track is the combined ratio of our portfolio company’s total EBITDA to total cash interest expense, which is indicative of the cushion our portfolio companies have in aggregate to meet their debt service obligations to us. For the third quarter, this metric was 3.1 times, excluding equity only and ARR deals. As a result of the elevated velocity of M&A activity that began in the fourth quarter last year, we have seen high levels of originations and repayments in each of the past four quarters. Because repayments outpace originations for the third quarter, we were underinvested as we started the fourth quarter. Nevertheless, we currently expect to grow the portfolio in the fourth quarter. I mentioned earlier that we closed three deals in early October for a total of $43 million in originations, including the $16 million commitment. And strong deal flow offers us the opportunity to add further to originations before the end of the year. While we are encouraged by these near-term opportunities, we will continue to manage the business for the long term and not rush to grow the portfolio in a way that would have us forfeit our underwriting standards. As always, our proven underwriting discipline places greater value on quality than on quantity. In summary, I remain confident that our relationships with deal sponsors, our experience, and our strategy of selectively investing in high-quality companies with defensive characteristics and positive long-term outlooks positions us well for the growth over time with a long-term goal of generating attractive risk-adjusted returns from our debt and equity investments and on preserving capital. Now I'll turn the call over to Shelby to provide some details on our financials and operating results. Shelby?

Shelby Sherard, CFO

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 our view of providing comparative commentary versus the prior quarter, Q2 2021. Total investment income was $21.2 million for the three months ended September 30, a $0.6 million decrease from Q2, primarily due to a $0.5 million decrease in fees and a $0.4 million decrease in fee income, offset by a $0.3 million decrease in interest income. Total expenses, including investment tax provision, were $16.1 million for the third quarter, approximately $0.8 million higher than the prior quarter, primarily due to an $0.8 million increase in the capital gains incentive fee accrual. In Q3, we accrued $4.7 million of capital gains incentive fees given meaningful appreciation in the fair value of the portfolio. Note, the capital gains incentive fee is accrued for GAAP purposes but not currently payable. Excluding the accrued capital gains and incentive fees, total expenses in Q3 were $11.4 million, in line with Q2. As a reminder, expenses will be higher in the fourth quarter as we will incur an annual excise tax expense, which I would estimate to be approximately $0.02 to $0.03 per share similar to prior years. As of September 30, the weighted average interest rate on our outstanding debt was 4.2% excluding secured borrowings. In Q3, we prepaid $44.3 million of SBA debentures. We ended the quarter with $360 million of debt outstanding, comprised of $95 million of SBA debentures, $207.3 million of unsecured notes, $40 million outstanding on our line of credit, and $17.7 million of secured borrowings. Our debt to equity ratio as of September 30 was 0.8 times or 0.6 times statutory leverage, which excludes SBA debentures. Net investment income or NII for the three months ended September 30 was $0.21 per share versus $0.26 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 $0.40 per share in Q3 versus $0.42 per share in Q2. For the three months ended September 30, we recognized approximately $8.4 million of net realized gains, primarily from the sale of our equity investments in Kinetrex Energy, Worldwide Express, and Allied 100. Turning now to portfolio statistics. As of September 30, our total investment portfolio had $119.1 million. Our average portfolio investment on a cost basis was $9 million at the end of the third quarter, which excludes investments in six portfolio companies that sold their operations and are in the process of winding down. We have equity investments in approximately 88.2% of our portfolio companies with an average fully diluted equity ownership of 5.6%. The weighted average effective yield on debt investments was 12.3% as of September 30. The weighted average yield is computed using the 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. As of September 30, our liquidity and capital resources included cash of $98.8 million, $13.5 million of available SBA debentures, and $60 million of availability on our line of credit, resulting in total liquidity of approximately $172.3 million. In October, we successfully issued $125 million of unsecured notes at 3.5% interest rates. The net proceeds and available cash were used to pay down the outstanding balance on the line of credit of $40 million at closing, and to fully redeem $82.3 million of public notes due in 2024 with interest rates ranging from 5.375% to 6%. Given the notice requirements, the bond redemptions occurred on November 2, so we will have one month of incremental interest expense on the public notes in Q4 of approximately $0.4 million. In conjunction with the bond redemptions, in Q4, we realized a onetime loss on extinguishment of debt of approximately $1.6 million relating to the unamortized deferred financing costs on the bonds. Taking into account subsequent events, including the debt refinancing, we currently have approximately $185.2 million of liquidity. Now I will turn the call back to Ed for concluding comments. Ed?

Ed Ross, CEO

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 Vic for Q&A. Vic? Hello? Shelby, are you there?

Shelby Sherard, CFO

I am. I'm not hearing anything on my line either. I'm not sure if we lost.

Ed Ross, CEO

Any recommendation?

Shelby Sherard, CFO

It seems the operator is experiencing technical issues. We can stay on the call for a little longer, but if things don't improve, we may need to conclude the call. They are working to resolve the issue, so hopefully, it will be sorted out soon. However, Ed, we might need to end the call if we cannot get the operator back for the Q&A session.

Ed Ross, CEO

Thanks for your patience, everyone, sorry about this…

Mickey Schleien, Analyst

I guess patience is a virtue. Ed, there is obviously intense competition higher up in the middle market with so much private debt and equity capital available. How would you describe the effects of that competition, if any, on the lower middle market where you operate?

Ed Ross, CEO

From my perspective, the competition over the last year has remained fairly consistent. There hasn’t been a significant influx of new capital, and the same players are still in the game without many new entrants. We've noticed some lenders accepting lower yields, and there have been some unusual actions taken to secure business. Our strategy is to concentrate on the core aspects of our business and remain committed to the long-term industries we understand well and the situations we prefer. In terms of pricing, I would say that market pricing is generally in line with pre-COVID levels, sometimes slightly lower. Leverage appears to be similar to pre-COVID levels as well. When I consider risk-adjusted returns, I look at equity capitalization, which tends to be much higher in the current valuation environment. I believe the risk-adjusted returns are quite favorable. Additionally, in the lower middle market, the terms remain unchanged. When I think about security and covenants, including real maintenance covenants, all those factors are still intact and represent a positive aspect of the market we primarily operate in.

Mickey Schleien, Analyst

That's good news given that there's always a chance that those folks will start to look at the lower middle market down the road. Just one follow-up question. You had another strong quarter of unrealized appreciation. And if I'm not mistaken, the portfolio’s valuation is now at a record level in terms of cost over fair value over costs. What are the main drivers of those valuation gains? And do you see more upside when you look at your portfolio of company's performance and market trends?

Ed Ross, CEO

This quarter, our portfolio saw an appreciation of $23 million, primarily from equity. The main factors driving this growth were the strong performance of the underlying companies, which was the largest contributor, along with increased visibility into certain M&A activities. People are currently willing to pay a premium for strong franchises, a trend you may have heard about recently. Lastly, while market calibration is something we consider each quarter, it only played a minor role in this quarter’s appreciation.

Robert Dodd, Analyst

On the repayment levels in the quarter. Now, I think, year-to-date your repayments have now exceeded the combined number in 2019 and 2020. I mean, when does the pace slow down? Frankly, I mean, just activity level on that side seems to be really, really high. I mean, your originations this quarter were below by historic standards, but they obviously got swamped by new payments.

Ed Ross, CEO

I think from our perspective, and I'm hesitant to say this, because last quarter, there were some surprises, literally a couple surprise repayments in September, we heard about in September and they happened in September. So it's hard to predict as we talked about in the past. What I would tell you is Q4 is, we at least today, feel like is going to be a limited quarter from a repayment perspective relative to last quarter. And so I don't think we'll get anywhere near last quarter. And I think what I would say is the velocity and the overall market activity has been extremely high for four quarters in a row. And obviously, we've had a fair number of M&A transactions where we've also realized equity investments but also just debt refinancings or recapitalizations where we were taken out, which tells you we had a pretty strong portfolio. So our approach has always been and we want to invest in high-quality businesses that can weather the various storms that we anticipate or don't anticipate, but can weather the storms. And so we feel good about getting repaid. Obviously, it creates a challenge for us in terms of reinvesting and from that perspective, we're going to stick to our discipline. We are sticking to how we are going about our business and self-originating a large majority of the investments we’re making and sticking to the industries that we know well. So I do think this quarter it'll slow down and I do think originations will outpace repayments this quarter and the question is to what degree. And we'll be able to tell you that in February. So that's what I'm seeing and I am seeing a slowdown in terms of…

Robert Dodd, Analyst

I appreciate that. With many payments and a lot of recycling, I think roughly half of the capital in the portfolio originated since COVID, including follow-ons and other sources, does not seem to have significantly impacted your portfolio yield. The only notable change during this period might be a slight increase in leverage. Is this more indicative of the types of businesses involved? It appears that you are focusing more on first-time investments rather than second. Would you say your loan-to-value ratios or other characteristics have remained stable or even improved as the portfolio has been renewed? Additionally, with what seems to be a relatively new portfolio, should we anticipate that prepayment fees will be lower over the next year to 18 months, considering how much of that capital is newly issued?

Ed Ross, CEO

There are a lot of questions in there, Robert. Let me address leverage first, which is a bit of an anomaly. In our prepared remarks, I mentioned a net leverage of 5 times, excluding ARR loans on our balance sheet, and that’s an average figure. To be honest, this number is distorted by one particularly large deal in our portfolio that has been around for quite some time and has grown into a very large company. If we exclude this company, the average leverage would be closer to 4.4 times, which better reflects the overall portfolio. Regarding leverage, I don't think there's been a significant change. The loan-to-value ratios have actually improved in this environment, from our perspective. You mentioned prepayments. They will always be a part of the puzzle. Could they decrease a bit next year? Yes, but I don't anticipate a significant drop. Many of the repayments we have come from fairly mature debt investments, and the prepayment fees associated with them are not large. Prepayments will continue to be part of the business; they may be slightly lower, but I can't guarantee a substantial decrease. As for fees, we do generate healthy fee income as an originator, and these depend somewhat on activity levels. We expect fees to move in line with activity. Looking ahead to next year, I anticipate it will be an active year, though perhaps not as active as this year. I still expect to see a number of companies in our portfolio that we believe will be sold, which is a positive outlook from our perspective.

Ryan Lynch, Analyst

Thanks for taking my questions, and really nice quarter. And my first question has to do with, as far as your equity portfolio goes. You guys have a nice exit of $23 million of equity investments this quarter. But given the strength in that portfolio, it actually grew inside despite those exits. And my question was, I would presume that given how active the market is today that you would expect equity investments or equity monetizations to continue at a fairly consistent basis, maybe not as high as you saw in the third quarter. But I was assuming you would consider those to continue to happen, but please let me know if that's not the case. And so my question would be, is the thought process you just continue to monetize equity investments in the normal course like we saw in the third quarter, which again, because of the other strength in your equity portfolios, didn't actually reduce that, which is a good problem to have? Or is there any consideration being given to selling off kind of a basket or portfolio of these minority equity positions similar to what you guys had done in early 2020?

Ed Ross, CEO

I think to start with your question about expectations for further realizations in the equity portfolio, we have portfolio companies that are currently considering strategic alternatives as we approach Q4. Additionally, there are others planning to evaluate strategic options in the first half of next year. We believe the M&A market will remain active, and we anticipate our equity portfolio will be involved to some extent, ideally to a significant degree, in this activity. Your assumption about this is accurate. Regarding the possibility of selling part of the portfolio like we did earlier, that remains an option on the table, although it’s not something we are currently pursuing actively. We do discuss it and will consider it when the time is right, but at the moment, we are not engaging in that process. We appreciate having this option available, but we value the quality of our equity portfolio and prefer not to rush any decisions. We aim to find a balance when it comes to monetizing equity investments, and while we may not achieve that perfectly, we are working to strike the right balance right now.

Ryan Lynch, Analyst

The other question I had was you discussed the elevated level of prepayments with Robert, hopefully, those start to moderate a little bit. But while we're in this process of increasing activity, have you all considered or maybe you guys have actually done this, sort of trying to widen the investment funnel by moving to maybe slightly different areas, for instance, like maybe moving up to slightly larger companies, not necessarily loosening the underwriting procedures, or we’ve been in kind of the underwriting metrics that you guys use, but maybe just moving to like larger companies that then maybe have a little bit of a lower yield but will allow you to put capital to work a little bit quicker to kind of offset some of these repayment. Have you guys done any of that, have you guys considered any of that, why or why not?

Ed Ross, CEO

So what I would tell you is we do play in the larger lower middle market space and we have a couple of companies that I would argue are more just middle market or definitely several companies that are just more middle market investments. So we do that on an opportunistic basis, typically, where we've got good relationships and we've got, again, industry knowledge and a view that is differentiated. So we do participate there. I would also say, one of the things we've done is widen the funnel for instances, over the last three, four years, is focus on more software and tech-enabled space and develop the real expertise there from an industry perspective and a financing perspective. And so we are doing those things. I would tell you our deal flow is extremely strong. So we feel good about the opportunity set. We feel very good about the opportunity set here in Q4 as I discussed in our prepared remarks. But at the same time, we're sticking to our knitting. We're sticking to the business that we have executed well over time. And we do see, again, growth here in the fourth quarter. The question is by how much and that's going to be dependent on both deal closings, as well as what level of repayments. But we do see that the trend of repayment slowing, and to be honest, expect that to slow as we move forward from here. So we are doing a lot of the things you just talked about but I would say in, obviously, a very disciplined and gradual manner as opposed to just switching gears, if you will.

Sarkis Sherbetchyan, Analyst

You guys have plenty of availability to deploy into earning assets. And in light of your comments just now that you've said that you expect the trend of repayments to slow down moving forward. I guess, as we step back, how long do you think it'll take to kind of get back to some target leverage levels? And then if you can remind us how you're thinking about target leverage in the current environments?

Ed Ross, CEO

Over the next three to nine months, we anticipate getting closer to a 1:1 leverage ratio. While we won't achieve this in the current quarter, we expect to make some progress, which we are optimistic and excited about. Our target leverage has always been around 1:1, especially as our portfolio shifts more towards first lien assets, and we foresee this trend continuing. Operating slightly above 1:1 can feel more comfortable, but it's not our goal, and we are fine with that. Currently, some of our SBIC funds operate at a 2:1 leverage, and we successfully managed through the last recession at that level. We're not overly concerned about leverage, but we recognize the need for balance, including cosmetic factors. To achieve good returns, we don't need to over-leverage. A solid target for us remains at 1:1, and we have communicated this consistently without any changes. We expect to make progress towards this target over the next three to nine months.

Sarkis Sherbetchyan, Analyst

And just to be clear, that's 1:1 on a statutory basis, correct?

Ed Ross, CEO

More GAAP basis actually.

Sarkis Sherbetchyan, Analyst

And as we think about kind of the cadence into the next year. Clearly, closing out the year strong, but as we look at the cadence of activity expected next year. Do you think it's going to be a little bit more elevated than historic norms, just kind of given the availability of liquidity and just kind of a generally robust environment in the space you play in?

Ed Ross, CEO

It's a great question and a tough one to answer. If I were to respond, I would say that it will likely be elevated compared to historical levels, but not at the level we've seen in the last four quarters. What we are observing is that many companies are performing very well today. The economy, despite the challenges we've discussed, is growing nicely, albeit at a slower pace, and recent projections have been adjusted downward. However, there are many companies out there achieving strong performance and expecting to continue that trend. This environment sets the stage for significant deal activity. Therefore, I believe it will be above historical norms, but it won't reach the levels we've experienced in the past four quarters.

Operator, Operator

Thank you. And I am showing no further questions from the phone line and I’d like to turn the conference back over to Ed Ross for any closing remarks.

Ed Ross, CEO

Thank you, Vic, and thank you, everyone for joining us this morning. We look forward to speaking with you on our fourth quarter call in early March 2022. Have a great day and a great weekend.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.