Earnings Call Transcript - FDUS Q3 2024

Operator, Operator

Good day and welcome to the Fidus Third Quarter 2024 Earnings Conference Call. All participants will be in listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Ms. Jody Burfening. Please go ahead. Thank you, Chuck, and good morning, everyone. And thank you for joining us for Fidus Investment Corporation's Third 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. The 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. 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 1st, 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.

Ed Ross, CEO

Good morning, Jody, and good morning, everyone. Welcome to our third quarter 2024 earnings conference call. On today's call I'll start with a review of our third quarter performance in our portfolio at quarter end and then share with you our outlook for the remainder of 2024. 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. Despite lighter investment activity levels overall during the third quarter, we continued to build our portfolio through a combination of our strong relationships with deal sponsors, industry knowledge, and investment expertise in the lower middle market. Our debt portfolio, which has grown 20% over the past 12 months, generated record interest income of $33.7 million and continued to amply cover our base dividend. Through our strategy of selectively investing in high-caliber companies that generate high levels of free cash flow, have defensive characteristics, and positive long-term outlooks, we continue to build a healthy and high-performing portfolio. At quarter end, net asset value stood at $658.8 million, 11.8% higher than the net asset value of $589.5 million as of December 31, 2023. On a per share basis, net asset value was $19.42 per share at quarter end compared to $19.37 per share as of December 31, 2023. Before I start my review of our performance for the quarter, I am pleased to report that the SBA has approved our new SBIC license effective on the last day of the quarter, September 30, 2024. Adjusted net investment income for the quarter grew 12.3% to $20.4 million compared to $18.2 million last year, primarily reflecting higher interest and fee income for the quarter along with a one-time dividend income lift. On a per share basis, adjusted net investment income was $0.61 per share compared to $0.68 per share for the same period last year, which also reflects the higher average share count from ATM issuances. Adjusted NII per share amply covered the base dividend of $0.43 per share for the quarter. In addition, we paid a $0.14 per share supplemental dividend for a total dividend to shareholders of $0.57 per share. For the fourth quarter of 2024, the Board of Directors declared dividends totaling $0.61 per share, consisting of a base dividend of $0.43 per share and a supplemental dividend of $0.18 per share equal to 100% of the surplus and adjusted NII over the base dividend from the prior quarter which will be payable on December 27th, 2024 to stockholders of record as of December 17th, 2024. Originations totaled $65.9 million for the third quarter, including $38.1 million in three new portfolio companies. The remaining $27.8 million in follow-on investment activity reflects a combination of portfolio company acquisitions and refinancings. Debt investments totaled $62.7 million, the vast majority of which were in first lien securities. Equity investments totaled $3.2 million, of which $2.3 million was invested in three new portfolio companies. We continue to structure our debt investments with a high degree of equity cushion which gives us a margin of safety, while our equity investments give us the potential for enhanced returns. As expected, repayments were a larger portion of deal activity during the third quarter, compared to the first half of the year. Proceeds from repayments and realizations totaled $50.8 million for the third quarter, including $8.6 million in proceeds from the monetization of equity investments. We've mentioned on previous calls this year that a number of our portfolio companies were evaluating strategic alternatives, which accounted for three of the exits this quarter. Subsequent to quarter end, we invested $21.1 million in first lien debt and common equity in two new portfolio companies and received $18.5 million in proceeds from the exit of debt investments in two portfolio companies. Our portfolio stood at $1.1 billion on a fair value basis as of September 30th, 2024, equal to 101.5% of cost and consisting of a debt portfolio totaling $959.4 million and an equity portfolio of $131.3 million at quarter end. With first lien investments accounting for nearly all of the debt originations for the third quarter, this security accounted for 73% of debt investments on a fair value basis at quarter end. We ended the quarter with 85 active portfolio companies. Overall, our portfolio remains healthy with sound credit quality and a well-positioned equity portfolio. Furthermore, the portfolio is structured to absorb losses through net realized gains on equity investments over the long term. As an example, in the third quarter, we realized a loss on a debt investment that was nearly offset by a realized gain on an equity investment for a net realized loss of $0.4 million. For the first nine months of this year, we've realized net gains of $10.6 million, well in excess of any realized losses extending our track record of generating enhanced returns. Non-accruals, on a fair value basis, were unchanged from the first and second quarters of the year, and remained under 1% for the third quarter. For the remainder of the year, we expect a modest year-end uptick in M&A activity levels, in other words, another quarter of reasonable investment activity. Having said that, as some portfolio companies are still evaluating strategic alternatives, we do still expect to see a higher level of repayments in the last quarter of the year. New originations may outpace repayments as they did in the third quarter. As we evaluate investment opportunities, we continue to apply our strict underwriting standards to investment selection, focusing on strong cash flow generating businesses with resilient business models and positive long-term outlooks. Our goal is to maintain a healthy portfolio that produces both high levels of current and recurring income and the potential for incremental returns from monetizing equity investments. Adhering to both our investment strategy and underwriting disciplines will enable us to stay focused on our long-term goals of generating attractive risk-adjusted returns for our shareholders and growing net asset value over time. Now I'll turn the call over to Shelby to provide some details on our financial 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, I’ll be providing comparative commentary versus the prior quarter Q2 2024. Total investment income was $38.4 million for the three months ended September 30th, a $2.7 million increase from Q2, primarily driven by a $1.2 million increase in fee income, of which approximately $0.8 million was an increase in prepayment fees. In addition, we had a $1 million increase in dividend income related to the distribution from one of our equity investments. Total expenses, including the income tax provision, were $17 million for the third quarter, $1.7 million lower than Q2, driven primarily by a $2.4 million decrease in the capital gains fee accrual, offset by a $0.1 million increase in base management fees and a $0.5 million increase in income incentive fees. Net investment income, or NII, for the three months ended September 30 was $0.64 per share versus $0.53 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 $0.61 per share in Q3 versus $0.57 in Q2, which includes the increase in weighted average shares outstanding in Q3. For the three months ended September 30th, we recognized approximately $0.4 million of net realized losses, primarily related to a $5.4 million realized loss on the exit of our debt investments in Trellix, offset by a $5 million realized gain on the sale of our equity investment in Gurobi Optimization. We ended the quarter with $479 million of debt outstanding, comprised of $175 million of SBA debentures, $250 million of unsecured notes, $40 million outstanding on the line of credit, and $14 million of secured borrowings. Our debt-to-equity ratio as of September 30th was 0.7 times or 0.5 times statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.6% as of September 30th. Now turning to portfolio statistics as of September 30. Our total investment portfolio had a fair value of $1.1 billion. Our average portfolio company investment on a cost basis was $12.6 million, which excludes investments in five portfolio companies that sold their operations or are in the process of winding down. We have equity investments in approximately 83.3% of our portfolio companies with average fully diluted equity ownership of 3.6%. The weighted average effective yield on debt investments was 13.8% as of September versus 14% at the end of Q2. 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 Q3, we issued approximately 0.7 million shares at an average price of $20.01 per share, generating $14.1 million in net proceeds. As of September 30th, our liquidity and capital resources included cash of $54.4 million and $100 million of availability on our line of credit, resulting in total liquidity of approximately $154.4 million. Further, as Ed mentioned, the SBA has approved our request for a new SBIC license, giving us access to $175 million in additional SBA debentures, subject to regulatory requirements and conditions. Now I will turn the call back to Ed for concluding comments.

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 Chuck for Q&A. Chuck?

Operator, Operator

Thank you. We will now begin the question-and-answer session. And the first question will come from Robert Dodd with Raymond James. Please go ahead.

Robert Dodd, Analyst

HI. Good morning. On looking at the outlook less about Q4, right? I mean you said, you still gave some pretty good color on that. But are you seeing any increase in early stage? I mean, if you see a new deal approach today, it's not closing this year obviously. So well, probably not. How is the early-stage indicators looking for 2025? Because I mean, we've heard from several BDCs now that they're pushing their expectations from a strong end of the year to a strong 2025. Is that consistent with what you're seeing in early-stage opportunities? Or is that just too early to tell?

Ed Ross, CEO

Great question, Robert. I wish I had a clear answer. What we're observing in the market currently is that quality continues to vary. The deal flow in Q3 has been decent, but from our viewpoint, M&A activity remains somewhat subdued. However, we are experiencing the usual increase typical of Q4 this time around. Competition is quite strong, as you're aware. Therefore, we expect Q4 to be a significantly more active investment quarter compared to Q3. We are currently seeing an uptick and are optimistic that 2025 will offer a much stronger M&A environment. That is our expectation, although we haven't seen clear signs of it yet. I believe it's still too early to determine from our standpoint.

Robert Dodd, Analyst

Thank you. Yes, that is helpful. On the competitive side, spreads have been compressing, which has been a noticeable trend. For one of the new capital deals you mentioned, the spreads on the first lien are in line with the overall average spread in the first lien portfolio for everything previously onboarded. Is spread compression still occurring? Has it stabilized? Can you provide any insights on that? Is there increasing momentum in spread compression in market areas that you typically avoid? Any details would be appreciated.

Ed Ross, CEO

It's a good question. Over the past 12 to 18 months, the credit quality has significantly affected spreads, ranging from 50 to 150 basis points. From our viewpoint, there isn't an acceleration; the spreads are quite tight. In the third quarter, our overall yields were 13.8%, which is a decrease of 20 basis points, primarily due to slightly lower net originations. Our new originations were at 13.2%, consisting of variable rate loans, which may decrease a bit further. Our repayments averaged 13.4%, reflecting the current market situation. There is substantial competition, and I don't anticipate a significant decline from our current position. I would prefer and expect stability in the market, even though it remains competitive.

Robert Dodd, Analyst

Thank you. Lastly, there was an increase in amendment fees this quarter of about $400,000. It's not a large amount, but should we be concerned about that? Are these typical amendments, considering your credit quality remains strong? Nonaccruals haven't changed, and there haven't been any new nonaccruals since the start of last year. Does this increase in amendments suggest that there might be some signals to watch for?

Ed Ross, CEO

Well, it's interesting. It was a pretty healthy fee quarter, some from prepayments, right? That was a big number, I think $800,000 if I'm not mistaken and Shelby can correct me if so.

Shelby Sherard, CFO

That's correct.

Ed Ross, CEO

We have made amendments due to our active portfolio, which includes 85 portfolio companies and a high number of debt investments. There are various factors driving these amendments and acquisitions, but overall, we feel positive about our credit quality. While some companies are performing well, others are not meeting expectations. We are navigating a high-interest rate environment and facing some geopolitical risks. Although the economy appears stable, there are areas of weakness, particularly in consumer discretionary spending and certain manufacturing and industrial sectors. These are not signs of recession but indicate some softness that we need to address. Overall, we remain optimistic, though there are challenges to manage.

Robert Dodd, Analyst

Got it. Thank you.

Ed Ross, CEO

Thank you. Good talking to you, Robert.

Operator, Operator

Our next question will come from Paul Johnson with KBW. Please go ahead.

Paul Johnson, Analyst

Yes. Good morning. Thanks for taking my questions. Congrats on the SBIC approval. Regarding the timing for issuing that license, how are you thinking about it? Would you be able to start ramping up on that license and issuing some debentures, possibly buying a little time next year to explore the unsecured market?

Ed Ross, CEO

Sure. Great question. Shelby, do you want to take that one?

Shelby Sherard, CFO

Sure. I think the punchline is you're right. It does give us access to additional debt capital. So it buys us time. We don't have a need to tap the secured debt markets. I mean, opportunistically, it's something we could consider with some heftier repayments coming down the pike. But back to the SBA program for Q4, we're obviously looking for eligible investments. We'll need to fund the first several with equity capital contributed from the parent. So, I wouldn't expect to see a lot of borrowing on the SBA debentures here in Q4, but it does set us up in the first half of next year to start expanding our debt capital stack with additional SBA debentures.

Paul Johnson, Analyst

Thanks, Shelby. That's very helpful. Could you describe the stability of credit this quarter? It's positive, but how would you characterize the quarter-over-quarter trends or the overall performance of the portfolio this year?

Ed Ross, CEO

Sure, it's a great question, Paul. Company performance has generally been healthy this year. This quarter, looking at growth in EBITDA, it's up, but fairly flat. About 45% of our portfolio companies in the core lower middle market grew EBITDA this quarter, which is a bit less robust than others. This reflects a slower economic environment. When considering credit, some companies that have been in the portfolio for a while are facing underperformance. Interest rates are still high, and these situations require attention. We feel good about our portfolio and its positioning but we are not exempt from challenges that we need to address. There has been some migration towards issues to navigate compared to nine months ago. Overall, I still believe our credit portfolio is sound and solid, and our equity portfolio is quite healthy. We are confident, but there are always challenges to work through.

Paul Johnson, Analyst

Got it. I appreciate the answer there. Very helpful. And I'm also just curious on maybe kind of one trend in the market at least in the larger end of the market. You're seeing more examples of secondaries transactions and such. I mean has that been anything that you've seen I guess in the lower middle market with private equity secondary fund interest in portfolio companies? Is that any sort of potential option there for perhaps more exit activity in the portfolio?

Ed Ross, CEO

I want to make sure I understand your question. You're talking about just refinancing generally speaking of our existing portfolio companies? Or

Paul Johnson, Analyst

Or more for the equity co-investments. In the past you've done at least one transaction where you've sold a sleeve of companies to another other investors. So I'm just curious if there's anything similar to that or with secondary fund interest as well in the market that's anything that you've seen?

Ed Ross, CEO

From our perspective, we are not planning any transactions like that in the near future and are not working on one at all. That said, we feel very positive about our equity portfolio, which is, in some cases, mature and ready for activity over the next three, six, or twelve months. This portfolio has been built over time, and some companies are further along than others. It's a significant part of our strategy, with approximately 90% debt and 10% equity. Currently, we have about 8% equity on a cost basis, and it's well prepared for episodic events and realizations. I don't think we're looking to sell a lot of them proactively; rather, we are more inclined to engage in transactions as they arise. I hope that answers your question.

Paul Johnson, Analyst

Yes. That’s all from me. Thank you very much.

Ed Ross, CEO

Okay. Nice talking to you Paul. Thank you.

Operator, Operator

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

Bryce Rowe, Analyst

Thanks a lot. Good morning.

Ed Ross, CEO

Good morning, Bryce.

Bryce Rowe, Analyst

Ed maybe first just want to hit on the concept of some of the portfolio companies exploring strategic processes. You noted that three of the exits in the third quarter were kind of the result of that. Have you seen more portfolio companies kind of, I guess, step up to the plate to explore those processes? And maybe give us an update in terms of the three, are there more out there kind of continuing to go through that process? Just trying to get a feel for what kind of churn we might get within the portfolio?

Ed Ross, CEO

It's a great question. Looking back to last quarter, we had about seven or eight companies exploring opportunities at that time, with three having completed transactions. While I can't confirm many new additions, some processes were in early stages and are still ongoing. It's uncertain what will happen this quarter compared to the next, and which processes might not lead to transactions. However, it indicates that there is ongoing activity in the lower middle market for mergers and acquisitions, although at less vigorous levels. We anticipate some turnover in the portfolio, as well as a few refinancings of our debt investments. Regarding portfolio growth, we foresee an active quarter for new investments and activity within our existing portfolio, along with realizations and repayments. It's challenging to predict whether the portfolio will grow, given the level of activity on both sides.

Bryce Rowe, Analyst

Okay. Yes, that's helpful. There was some discussion around the yield compression quarter-over-quarter, not a big surprise to see that. I was kind of curious, of the 20 basis points of yield compression, how much was that tied to spread compression and how much of it was tied to the drop in SOFR that we saw in the third quarter?

Ed Ross, CEO

Yes. I'll provide a brief answer, and Shelby can add if needed. The brief answer is that very little was related to SOFR. Most of those resets happened early in the fourth quarter in October, so there was minimal impact. The key factor was that we had new originations at lower rates, which were comparable to the repayments.

Bryce Rowe, Analyst

Okay. Maybe last one for me and we've kind of talked about credit within the portfolio stable nonaccruals. As Robert mentioned, nothing added for quite some time. I did notice I guess a change in the internal risk ratings with more 3-rated credits this quarter versus last. Anything to add there relative to that and especially relative to what you've already said here on the call? I mean you might have already exhausted it and explained it, but just curious if there's anything else to read into that.

Ed Ross, CEO

I don't think there's much to interpret beyond the fact that we have a mature portfolio, which experiences fluctuations as is common with any portfolio company. We did experience a few additions to the Grade 3 portfolio, indicating underperformance compared to expectations and a likely increase in risk. Overall, we are confident in the risk level of our portfolio. Loan-to-values are still low, around 42%, which we feel good about. However, there are always unique challenges within a portfolio, and that's what we're observing. These issues aren't primarily driven by economic factors; rather, they are specific situations within certain companies that we need to manage. Consequently, risk levels are slightly elevated as a result.

Bryce Rowe, Analyst

Okay. Good deal. Appreciate the time.

Ed Ross, CEO

Thank you, Bryce. It's good talking to you.

Operator, Operator

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

Ed Ross, CEO

Thank you, Chuck, and thank you everyone for joining us this morning. We look forward to speaking with you on our fourth quarter call in early March 2025. Have a great day and a great weekend.

Operator, Operator

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