Fidus Investment Corporation (NASDAQ:FDUS) Q2 2023 Earnings Call Transcript August 4, 2023

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

Jody Burfening: Thank you, Savi, and good morning, everyone, and thank you for joining us for Fidus Investment Corporation’s Second 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. Conference call today will contain forward-looking statements, including statements regarding the goals, strategies, beliefs, future potential, operating results, cash flows of Fidus Investment Corporation.

Although management believes these statements are reasonable based on — as of today, August 4, 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 any of these forward-looking statements. With that, I would now like to turn the call over to Ed. Good morning, Ed.

Edward Ross: Good morning, Jody, and good morning, everyone. Welcome to our second quarter 2023 earnings conference call. On today’s call, I’ll start with a review of our second quarter performance in our portfolio at quarter end and then share with you our outlook for the second half of 2023. Shelby will cover the second quarter financial results and our liquidity position. After we have completed our prepared remarks, we’ll be happy to take your questions. For the second quarter, we continued to enhance the earnings power of our healthy and high-performing portfolio by further building our portfolio of income-producing assets and benefiting from a widened spread. We grew our total portfolio to $928.7 million on a fair value basis at quarter end putting a fair amount of capital to work in a reasonably active second quarter.

Although deal activity is still spotty, our relationships with deal sponsors, experience and industry knowledge continue to enable us to invest selectively in companies with predictable revenues, strong cash flow generation and positive long-term outlooks that meet our strict underwriting standards. In addition, we continue to generate adjusted net investment income well in excess of the base dividend for the quarter. Adjusted net investment income, which we define as net investment income, excluding any capital gain incentive fee attributable to realized and unrealized gains and losses increased 50.1% to $15.6 million or $0.62 per share compared to $10.4 million or $0.43 per share last year. Interest income increased due to growth in our debt portfolio and a debt yield that expanded 260 basis points to 14.5% compared to the second quarter last year.

We paid dividends totaling $0.70 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.19 per share and a special cash dividend of $0.10 per share. As a reminder, we are distributing a special cash dividend of $0.10 per share each quarter this year to satisfy RIC requirements and to bring our spillover income in line with our target level. For the third quarter, on July 31, 2023, the Board of Directors declared dividends totaling $0.72 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.21 per share, equal to 100% of the surplus in adjusted NII over the base dividend from the prior quarter and a special cash dividend of $0.10 per share, which will be payable on September 27, 2023, to stockholders of record as of September 20, 2023.

Net asset value was $483.3 million or $19.13 per share as of June 30. Originations for the quarter totaled $95.8 million about 2/3 of which or $64.6 million was invested in 5 new portfolio companies that were added to the portfolio through M&A financing. Drilling down further, we invested a total of $47.2 million in first lien investments in 4 of the 5 new portfolio companies. The remaining portion of originations was invested in add-ons in support of our existing portfolio companies. We continue to build our portfolio of debt securities that generate recurring interest income and co-invested in equity securities as a means of adding a margin of safety and creating the opportunity to enhance returns. We received proceeds totaling $60.6 million, primarily from the exit of 4 companies including $7.6 million in proceeds from equity sales, resulting in net originations of $35.2 million for the quarter.

Our portfolio of debt investments on a fair value basis grew to $808.3 million or 87% of the total portfolio at quarter end. First lien investments continue to account for the largest piece of the debt portfolio at 65%, including the fair value of our equity portfolio of $120.4 million. The fair value of the total portfolio at quarter end stood at $928.7 million equal to 103.7% of costs and representing a 3.5% increase compared to the end of the first quarter. We ended the second quarter with 79 active portfolio companies and 2 companies that have sold their underlying operations. Subsequent to quarter end, we invested $19 million in first lien debt, subordinated debt and equity in a new portfolio company. Overall, our portfolio remains healthy from a credit perspective.

And for the most part, our portfolio companies continue to perform well. As always, there are some puts and takes that you would expect for a portfolio of our size, a few portfolio companies have been struggling while others have seen improved performance and outlook. To that end, we removed already from nonaccrual during the quarter and placed Vertex on nonaccrual, already is performing materially better and has a positive outlook. While Vertex has had a few hiccups, but we expect performance to improve in both the near and medium term. In addition, we wrote off our investment in Netherlands and recognized an $11.5 million loss. As of June 30, nonaccruals represented 1.5% of the total portfolio on a fair value basis. Looking ahead to the second half of 2023, we continue to see ample opportunities in the lower middle market to invest in high-quality companies that possess defensive characteristics, strong cash flow-generating business models and positive long-term outlook, further building our debt portfolio and co-investing and equity investment.

With a healthy and growing portfolio of debt investments generating strong recurring income, we remain positioned to generate adjusted NII growth well in excess of base dividends. As always, we intend to adhere to our prudent investment strategy and remain focused on our long-term goals of growing our net asset value over time, preserving capital and generating attractive risk-adjusted returns for our shareholders. Now I’ll turn the call over to Shelby to provide some details on our financial and operating results. Shelby?

Shelby Sherard: Thank you, Ed, and good morning, everyone. I’ll review our second 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 Q1 2023. Total investment income was $30.6 million for the 3 months ended June 30, a $1.5 million increase from Q1 primarily due to an $8 million — a $0.8 million increase in interest income, including PIK and a $0.8 million increase in fee income given higher originations and a $0.4 million prepayment fee, slightly offset by a $0.1 million 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 increase in interest rates on variable rate loans.

Total expenses, including income tax provision, were $13.8 million for the second quarter, $0.6 million lower than Q1, driven primarily by a $1.3 million decrease in the accrued capital gains incentive fee, offset by a $0.4 million increase in interest expenses related to incremental debt outstanding, both SBA debentures and borrowings under our line of credit and a $0.4 million increase in the base management and income incentive fees. We ended the quarter with $478.6 million of debt outstanding, comprised of $182 million of SBA debentures, $250 million of unsecured notes, $30 million outstanding on our line of credit and $16.6 million of secured borrowings. Our debt-to-equity ratio as of June 30 was 0.99x or 0.6x statutory leverage, excluding exempt SBA debentures.

The weighted average interest rate on our outstanding debt was 4.5% as of June 30, 2023. Net investment income or NII for the 3 months ended June 30 was $0.67 per share versus $0.59 per share in Q1. Adjusted NII, which excludes any capital gains, incentive fee accruals or reversals attributable to realized and unrealized gains and losses on investments, was $0.62 per share in Q2 versus $0.60 per share in Q1. Turning now to portfolio statistics as of June 30. Our total investment portfolio had a fair value of $928.7 million. Our average portfolio company investment on a cost basis was $11.3 million, which excludes investments in 2 portfolio companies that sold their operations are in the process of winding down. We have equity investments in approximately 75.3% of our portfolio companies with average fully diluted equity ownership of 3.2%.

Weighted average effective yield on debt investments was 14.5% as of June 30 versus 14.3% at March 31. The weighted average yield is computed using effective interest rates for debt investments at cost, including the accretion of original issue discounts and loan origination fees, but excluding investments on nonaccrual, if any. Now I’d like to briefly discuss our available liquidity. As of June 30, our liquidity and capital resources included cash of $38 million, $8 million of available SBA debentures and $70 million of availability on our line of credit, resulting in total liquidity of approximately $116 million. Now I’ll turn the call back to Ed for concluding comments.

Edward Ross: Thanks, Shelby. As always, I’d like to thank our team and the Board of Directors at Fidus for their dedication and hard work and our shareholders for their continued support. I will now turn the call over to Savi for Q&A. Savi?

Q&A Session

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

Robert Dodd: Congratulations on another good quarter. Ed, on kind of the market environment, are you seeing big — it is smaller end of the market, your core market. It does seem there’s more activity still than there is in the larger company and are you seeing any shift in competitors, maybe looking at “hey, deals are still happening at smaller companies” and any more people coming into it?

Edward Ross: Yes. Great question, Robert. Just to talk about the market for a second. We commented on this on our call last quarter, but deal flows did pick up, call it, late spring, if you will. And it was a, what I would say, a decent quarter or pretty good deal flow, but the quality was hit or miss. And that trend somewhat continues. There are ebbs and flows. The summer is a little slower. Our current expectation is for post Labor Day to pick up a little bit from a seasonal perspective. And so I’d say, overall in our market, deal flow is decent. There are plenty of folks that do want to consider selling or transacting. And then there’s also a fair number as well that are saying, okay, valuations are a little lower, inflation has gotten in the way, interest — total interest expense or interest rates have gotten in the way of peak valuations, and I’m going to wait.

And so — there’s a little bit of both going on. But in our market, there continues to be, what I would say, ample or decent flow, and there are transactions to pursue. And so we are trying to find the best ones and the highest quality ones to do that with. So that’s how I think about that. From a competitive perspective, I do think there’s a little inching down by some of the larger providers of debt capital. But we’re not — it’s not really impacting us. We haven’t lost a deal to someone that’s a surprise for instance, but I am aware of some inching down both on the private equity groups as well. There’s some private equity groups that are inching down into smaller companies than they usually would. So it’s an interesting market, but I do think the lower middle market is more active than the big market for sure.

Hopefully that’s helpful.

Robert Dodd: Got it. Yes, that is very helpful. And then just on the — you had the new nonaccrual, I didn’t write down the name but you said expect near and medium-term improvement. How — and maybe not specifically that, where there’s some incremental — relative underperformance by the company. How are the interactions with sponsors going on that right now? I mean are they willing to step up promptly and make changes or put in more capital or whatever are they holding their ground a little bit more.

Edward Ross: Sure. Another great question. What I would say, when I look at our nonaccruals, just to hit it because you asked about it. We have 2 operating companies on nonaccrual. One is Suited Connector, which was on last quarter as well. And just to hit it, it’s a digital lead generation platform focused on the mortgage, the home services and the insurance verticals. And so consumers looking to comparison shop provide information via company-owned websites. Companies owned by a sponsor. The sponsor is very active and has been active from a capital perspective as well. And so look, that’s a tough, tough market. If you think about the mortgage market right now and probably caught all of us a little by surprise, and so the goal of all the capital structure constituents, including the financial sponsors to get to the other side.

And so that is what they’re doing and it’s what we’re doing as well. So in that case, yes, we’ve got a supportive sponsor. Do they love providing incremental capital? No. But it’s somewhat — if there’s a reason to play for the long term. What we find is almost all situation sponsors play for the long term. And then Vertex is a bit of a one-off situation as well. That’s the new nonaccrual and it’s a manufacturing company that’s focused on applications in the defense space and different government platforms. So it’s electronics manufacturing. So good end market is a company of size and owned by a sponsor and the sponsor is supportive there as well. Did have some hiccups, but we believe in the near and the medium-term outlook, we think those are positive, what I would say.

Operator: Our next question comes from Mickey Schleien with Ladenburg.

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

Edward Ross: Sure. Great question, Mickey. We are seeing incremental opportunity just to provide capital where banks may have done so previously. So that has been an opportunity that’s not — we’re not seeing a flood of them, but it’s definitely a part of the market at this point. And then what I’d say with regard to our first [indiscernible] product, where we do work with banks, it’s still an active market, but the aggressiveness of the banks has greatly reduced as what I would say. It’s not getting in the way of our business. But what I would say is they are less active from a leverage perspective, pricing similar, but they — as you might imagine, they’re interested in good companies and they’re interested in companies that have deposits.

And so there’s interesting pieces of the puzzle. But we are finding ways to continue to pursue those structures, and we’ll plan to continue to do so as we move forward. But it is a bit of a sea change, not a huge change, but somewhat of a change from their aggressiveness.

Mickey Schleien: Okay. I understand. That’s helpful, Ed. Ed, given the — to follow-up on Robert’s question, spreads have been generally hanging in there despite the rise in LIBOR and SOFR. And I’m just curious whether you’re seeing that attract some sort of irrational private capital at the margin. We’ve seen that before and whether those folks are starting to show up and cause some dislocation?

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

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

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

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

Edward Ross: Sure. Great question. From our perspective, what we’re seeing is kind of slow growth or even still seeing pretty good growth in the portfolio. If I were to look at EBITDA this quarter as a portfolio, and this is absent the ARR loans and the large company that skew the analysis, our EBITDA grew about 2% this quarter. So on an annualized basis, that would be 8%. So we’re still seeing overall pretty good performance. And I’d say slow growth is generally the theme. So we are obviously paying very close attention to the portfolio, interest expense is higher, right? And you got to pay attention and make sure cash flows are where they need to be. And not every company is doing great. Don’t get me wrong. I think 55% of our companies grew EBITDA this quarter, but most were very stable.

I mean our leverage, if you look at that metric, went down from 4x to 3.9x. EBITDA for the portfolio grew. And I really feel like the — there’s pretty good stability out there where the issues are, and it’s always the case. There’s 1 or 2 companies that have had some events happen, that you got to manage through. And those are the tougher situations, which we spend a lot of time on, obviously. But thankfully, that’s a very small number in our portfolio. and something that we believe is manageable as well.

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

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

Edward Ross: Shelby, you want to take that?

Shelby Sherard: Sure. Let me — great question. So on the SBIC capacity, we have an incremental $25 million. And as you know, they’re kind of intermittent capital applications that you have to apply for to have access to that money. We have now received SBA approval to be able to access that $25 million. So between the $8 million we had at quarter end that we’ve drawn now we have an incremental $25 million. The goal would be to kind of find SBIC-eligible deals, which we do have plenty in the pipeline and utilize the $25 million. and then kind of have anything else go to the RIC or FIC and utilizing the line of credit. I mean, unlike kind of, call it, a year or 2 ago when we had a lot of repayments and excess cash on the books, we’ve got a lot more money put to work. And so we are starting to more actively use our line, but we do have plenty of capacity remaining to be able to do so.

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

Edward Ross: Yes, I’ll jump in there. I think, Bryce, we’re pleased with where the stock price is kind of holding its own now. So we’re also very pleased with the overall performance of the business. And as you just commented, we turned on the ATM program in Q4 of last year. And then we’ve raised $5 million of capital in each of the last 2 quarters, so in Q1 and Q2 of this year. And so we would expect to keep that open this quarter. If the markets are attractive, then that makes good sense for us from our perspective, it’s an accretive way to raise capital and that’s what we’re looking to do in the long term, whether it’s debt or equity, we’re looking to enhance the shareholders’ position. Hopefully that’s helpful.

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

Edward Ross: Sure. It’s — the loan-to-value for the portfolio is 40% at the moment. I think that’s in line with last quarter. So 60% equity cushions overall. And typically, when we’re structuring new deals, 40% equity cushion is somewhat of a minimum. And what I would say over the last 3 to 5 years, it’s been 50% to 60%, even 70% and 80% in some cases, some of the ARR type situations. So we feel very good about the enterprise value cushions, if you will, for the portfolio.

Operator: Our next question comes from Paul Johnson with KBW.

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

Edward Ross: Sure. Great question, Paul. No, I wouldn’t say it’s totally subsided. But what I would say, not every company, but almost all companies have found ways to really deal or adjust to the new normal, if you will. And in most cases, that’s raising prices to offset cost increases, whether it’s labor, whether it’s input costs, what have you. And so investing in companies that have pricing power is an important element of being able to deal with this risk. And one of the things we like to do is invest in value-added businesses, high free cash flow businesses that typically have that kind of pricing power when they need to. So less commodity oriented, if you will. And so now, I do think it’s slowed down quite a bit. I mean there’s a lot of costs that have declined and think about freight, for instance, a lot of input costs are there.

They’re there somewhat to stay. But again, I think most companies have adjusted to this new normal. And it’s a discussion, but it’s not a terrible thing at this point. Maybe that’s the right way to think about it.

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

Edward Ross: Sure. Great question. No, we are continuing to see opportunities there and probably an increase in opportunities. And what I would say is a large, large majority of our originations just like this quarter, 4 of the 5 were first lien investments. We’re going to focus on more of the first lien category, but there are plenty of situations from our perspective where a junior debt security makes a lot of sense and is highly attractive. And so we expect the junior debt portfolio to continue to be a minority portion of the portfolio and probably expect senior debt to increase from here, but it will be a piece of the puzzle for us as we move forward. For us, we’re looking for great companies with great outlooks and high free cash flow type situations where we have we have a strong view.

We have a good understanding and a strong view. In those cases, I think we can get attractive returns, especially in this market, but in all markets with that type of security. So it’s not the primary focus, but it clearly is a piece of the puzzle from our perspective.

Operator: Our last question is from Eric Zwick with Hovde Group.

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

Edward Ross: Sure. Great question. Eric, I think the pipeline for us, it’s funny, kind of ebbs and flows. There was a little bit of a low, but it’s picked up here recently. But for us, it’s — they’re not all awarded. We’re working hard on things trying to get those awards and obviously had to documentation in some cases. And so — but what I would say is activity has picked up here over the last several weeks. And the — we think it will continue to be a pretty decent market, not robust by any stretch as we move towards the fourth quarter. So from an industry perspective, it’s a little bit across the board. We have some software, more tech-enabled type situations for sure. But then at the same time, distributors, industrial businesses, and healthcare are all pieces of the pipeline that we’re seeing right now. Hopefully, that answers your question, but that’s the — it’s pretty broad-based, if you will.

Erik Zwick: Yes, that’s great color. And then the only other one for me is, could you provide a quick update just on the 2 companies that remain in the portfolio that have sold their underlying operations. Just kind of the status of those and what the outlook is? Are they going to stay around for a while or I just can’t recall.

Edward Ross: Sure. They’re kind of — I mean those companies have been sold and in one case, we’re trying to get to a resolution. It’s kind of an escrow type situation. There is value there. But it’s — I think we probably want to get to a resolution. So we’ll see how it ends up, we’re more interested in a resolution than waiting 5 years for the ultimate outcome. So there’s some work being done on that. The other one is more of a — we’re keeping it in place now. That’s the Green Fiber loan. That — it’s in a loss situation and I’ve articulated that before. So it’s not like that’s going to come back. We expect that to stay in that play — in that realm, if you will, so I don’t know if that will come off in the next year or not, that’s unclear, but it’s — I think the expectation is that’s a loss, and it’s at I think a 0 right now. So there is some cash in an account. But beyond that, it’s 0. Hopefully, that’s helpful.

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

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

Operator: This concludes the meeting. You may now disconnect.