Fidus Investment Corp

NASDAQ:FDUS

Earnings Call Analysis

Earnings Call Transcript 2024-Q2

[Operator]

Good day, and welcome to the Fidus Second Quarter 2024 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Jody Burfening. Please go ahead.

[Jody Burfening, executive]

Thank you, Cindy, and good morning, everyone, and thank you for joining us today for Fidus Investment Corporation's Second 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 statements 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, August 2, 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.

[Edward Ross, executive]

Good morning, Jody, and good morning, everyone. Welcome to our second quarter 2024 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 2024. 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.

Our second quarter results demonstrate the strength of our portfolio and the power of our investment strategy. Our debt portfolio generated high levels of adjusted net investment income, amply covering our base dividend. Our equity portfolio produced net realized gains of $9.2 million. In the face of a less than robust M&A environment, we stayed focused on deals in the lower middle market that met our underwriting standards, investing in companies with strong competitive advantages and resilient business models.

Adjusted net investment income for the quarter grew 17.7% to $18.4 million compared to $15.6 million last year, primarily reflecting higher interest income for the quarter. Taking into account the higher average share count from ATM issuances, adjusted net investment income was $0.57 per share compared to $0.62 per share for the same period last year and well in excess of our base dividend.

In Q2, in addition to the base dividend of $0.43 per share, we paid a $0.16 per share supplemental dividend for a total distribution to shareholders of $0.59 per share. For the third quarter of 2024, the Board of Directors declared dividends totaling $0.57 per share consisting of a base dividend of $0.43 per share and a supplemental dividend of $0.14 per share, equal to 100% of the surplus in adjusted NII over the base dividend from the prior quarter, which will be payable on September 26, 2024, to stockholders of record as of September 19, 2024.

At quarter end, net asset value stood at $646.8 million, 9.7% higher than net asset value of $589.5 million as of December 31, 2023. On a per share basis, net asset value was $19.50 at quarter end and compared to $19.37 per share as of December 31, 2023. Originations totaled $62.4 million for the second quarter, including $17.8 million in one new portfolio company. Our portfolio as a whole continued to be very acquisitive in the second quarter, resulting in $44.6 million in follow-on investment activity.

Net investments totaled $58.1 million, all of which were in first lien securities. Equity investments totaled $4.3 million as we continue to co-invest in the equity of portfolio company. Proceeds from repayments and realizations totaled $43.1 million for the second quarter, including $12.6 million in proceeds from the monetization of equity investments, primarily in 2 portfolio companies, Pool & Electrical Products and Virginia Tile, resulting in net realized gains of $9.2 million.

Subsequent to quarter close, we exited one first lien debt investment and received payment in full of $23.1 million, including prepayment fees. Our portfolio grew to $1.1 billion on a fair value basis as of June 30, 2024, equal to 101.9% of costs and consisting of a debt portfolio totaling $945.7 million and an equity portfolio of $132.7 million at quarter end. With debt originations consisting entirely of first lien investments for the second quarter, first lien securities grew to 71% of the debt portfolio at quarter end, we ended the quarter with 86 active portfolio companies.

In terms of credit quality, our portfolio remains healthy and in good shape overall. We continue to manage through the issues of 2 operating companies on nonaccrual as a percentage of the total portfolio on a fair value basis, nonaccrual stayed under 1% for the second quarter.

Turning to our outlook. We still expect deal flow and M&A activity for the remainder of the year to be at reasonable levels. While we expect to see higher investment activity levels, we do also expect to see a pickup in repayment as numerous portfolio companies are evaluating strategic alternatives. We remain focused on opportunities that meet our strict underwriting standards, leveraging our relationships with deal sponsors and our industry expertise within the lower middle market. We continue to invest in businesses with strong and sustainable cash flow generating business models and positive long-term outlook.

At the same time, we continue to structure our debt investments with a high degree of equity cushion maintaining a portfolio that produces both high levels of current and recurring income and the potential for enhanced returns from the monetization of equity and securities. With a healthy and growing portfolio, we remain focused on our long-term goals of growing 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, executive]

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 2024.

Total investment income was $35.7 million for the 3 months ended June 30, a $1 million increase from Q1 primarily due to $3.2 million increase in interest income, including PIK, partially offset by a $0.8 million decrease in fee income related to investment activity and a $1.3 million decrease in interest income on excess cash, which was due to the new investments in Q1 being back-end loaded.

Total expenses, including income tax provision, were $18.7 million for the second quarter, a $1.7 million higher than Q1, driven primarily by a $0.9 million increase in the capital gains fee accrual, a $0.4 million increase in base management and income incentive fees and a $0.2 million increase in the income tax provision related to state tax payments.

Net investment income or NII for the 3 months ended June 30 was $0.53 per share versus $0.57 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 $0.57 per share in Q2 versus $0.59 in Q1, which includes an increase in the weighted average shares outstanding in Q2. For the 3 months ended June 30, we recognized approximately $9.2 million of net realized gains, primarily related to the sale of our equity investments in Pool & Electrical Products and Virginia Tile.

We ended the quarter with $472.8 million of debt outstanding, comprised of $175 million of SBA debentures, $250 million of unsecured notes, $32.5 million outstanding on the line of credit and $15.3 million of secured borrowings. Our debt-to-equity ratio as of June 30 was 0.7x or 0.5x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.6% as of June 30.

Turning now to portfolio statistics. As of June 30, our total investment portfolio had a fair value of $1.1 billion. Our average portfolio company on a cost basis was $11.9 million, which excludes investments in 5 portfolio companies that sold their operations are in the process of winding down. We have equity investments in approximately 81.3% of our portfolio companies with an average fully diluted equity ownership of 3.6%. Weighted average effective yield on debt investments was 14% as of June, in line with Q1. 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 Q2, we issued approximately 1.7 million shares at an average price of $19.80 per share, generating $33 million in net proceeds. As of June 30, our liquidity and capital resources included cash of $48.3 million and $67 million of availability on our line of credit, resulting in total liquidity of approximately $115.8 million. Subsequent to quarter end, we increased our line of credit from $100 million to $140 million, giving us $40 million of incremental liquidity. Now I'll turn the call back to Ed for concluding comments.

[Edward Ross, executive]

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 Cindy for Q&A. Cindy?

[Operator]

[Operator Instructions] Our first question comes from Bryce Rowe of B. Riley.

[Bryce Rowe, analyst]

Ed and Shelby, maybe I'll just start on the capital structure and liquidity profile. Last quarter, we talked about the potential for a fresh SBIC license, I would like to get an update there, if there is one? And then also nice to see the revolving credit facility get expanded and then getting the investment-grade rating subsequent to quarter end too was a good thing to see. So wanted to get your feel in terms of how you think about kind of managing the capital structure at this point, especially in light of what seems to be maybe the lowest debt-to-equity coverage or debt-to-equity ratio in the industry?

[Edward Ross, executive]

Great question, Bryce, and I'll let Shelby jump in here as well. I think, obviously, the increase in the revolver is a good thing, the investment-grade rating is a great point. I appreciate you bringing that up. I think that'd be very helpful when we ultimately do issue unsecured notes in the market, which we will at some point in time.

And then the SBIC is -- we are continuing to go through that process. We still have a fair degree of confidence that we'll get through that by year end. So we are making progress, but when it's completed, it's still a little bit of an unknown, but we feel good about it.

So from an equity capitalization perspective, we did raise some equity through our ATM program last quarter. Part of the -- we're going to keep that open. But generally speaking, we were very focused on liquidity here in Q2, and I wanted to make sure we had a good liquidity position as we were making decisions to make new investments or not. And -- so we feel good about our capitalization right now and our liquidity position, and we also feel good about the fact that we've got some additional places we can go, meaning equity, meaning the SBIC license, hopefully soon as well as using the revolver. So Shelby, do you have any additional thoughts there?

[Shelby Sherard, executive]

No, I would just echo that. We are currently underlevered. But in terms of increasing leverage on the balance sheet, its first line of credit and then SBIC debt once that becomes available to us, and we're obviously well positioned in the unsecured market, but that's probably more opportunistic as opposed to a near-term need.

[Bryce Rowe, analyst]

Okay. Okay. That's great context. Maybe one more for me. Ed, we talked last quarter also about second quarter being a little bit slower in terms of newer originations and certainly, that came to be. I think your other commentary last quarter was around the second half of the year picking up in the press release you noted that. Can you talk a little bit about what the second half might look like and help size it up for us?

[Edward Ross, executive]

Sure. Sure. No. It's -- second quarter, as you mentioned and as we mentioned, it was slower than normal from a new investment perspective. We had a feeling that it would go that way. And some of that is just timing, some of that, we did lose a deal or 2 from a pricing perspective, but we're sticking to our knitting and how we go about things and our risk-adjusted returns are focused. And so -- as we look forward, we do feel like, look, M&A activity is below normal levels, so not robust, but it's -- the good thing about the lower middle market is that there is always activity going on, including add-on activity in our existing portfolio.

So we are working on several opportunities that would be new platform investments and have high hopes that some of those will take place here in Q3. We also expect just overall M&A activity levels to pick up a little bit here from the summer, and so to be decent. And so our hope and expectation is to participate with some of those as we move forward. So it's not a terrible market. It's just not a robust market. And our portfolio will continue to be acquisitive, would be our guess. And so that will also drive some new originations for us. Hopefully, that gives you good feel.

I guess one other point I would make is with that comes repayments, right? And we do have numerous companies that are evaluating strategic alternatives, several are equity-only deals, more smallish in nature. But there is a fair number of companies that are evaluating strategic alternatives. So we do expect repayments to pick up a little bit here in Q3 and Q4, but in line -- that's in line with our expectation for a bit of a pickup on the front end, meaning new investment side of things as well.

[Operator]

The next question comes from Robert Dodd of Raymond James.

[Robert Dodd, analyst]

Congratulations on the quarter. Just to kind of follow up on that theme on repayment that you're talking about strategic alternatives, et cetera. I mean can you give us any color on how -- how does it look within the portfolio for like repricing requests or refinancing activity versus, to your point, strategic alternatives, it sounds like moving into a different area of the market or getting acquired or whatever, right? So -- because obviously, repayments can be triggered by different things. So what are you seeing on the different dynamics between a portfolio company having grown and now looking at a different segment of the market versus looking to refinance versus -- I mean, can you give us any color on the different breakdown within your expectation for repayments to increase?

[Edward Ross, executive]

Great question, Robert, and it's a little nuanced, but I will -- what I would suggest is the strategic alternatives comment that I'm making. And again, some of those are now equity only pretty mature investments that we have, but we have numerous and when I mean numerous, over 5 that are evaluating strategic alternatives at the moment. And that's to be sold. And so that's that piece of the puzzle, if you will.

Repricing. Early in the year, we did have 1 or 2, I actually think it was only 1, but 1 or 2 -- I think it was 1 repricing of a loan. It was an asset that we obviously wanted to keep and it made good sense. The company had delevered and so we executed that transaction. So that's not overly common. And then refinancing, refinancings of companies that have performed well, gotten bigger, maybe another lender will do things cheaper than us. That has happened. We had 1 company in Q2 that actually went to the broadly syndicated loan market. Now we don't have many companies in our portfolio that are big enough for that to happen often, but they did do that and achieved a better level of pricing. And then we had the event in July, that's a subsequent event that we announced. That was a full repayment of a first lien loan that we were leading that we did, then another lender came in and took it at a lower price.

So that is part of the market, as we've talked about. I don't expect it to be a huge trend, but it will be part of the market as we move forward. This is kind of how we think about it.

[Robert Dodd, analyst]

Got it. I appreciate that. And then on credit quality, I mean it's -- obviously, it's a -- you [indiscernible] first lien new nonaccrual since like 2019 and haven't had anything in a year at this point. So -- can you -- I mean, the portfolio is really holding in really well. Rates are up -- the economy does seem to be slowing. I mean the liquidity for portfolio companies is going to be getting more squeezed. I mean what's [indiscernible] -- do you have any significant concerns? Or how are they holding up so well in this situation with the economy and rates, which has been going on a while, and you just haven't had any issues. So can you -- tell us why?

[Edward Ross, executive]

Sure. I'll try. I mean -- I will -- we're very pleased with the overall performance of our portfolio. It comes with a lot of work. We focus on very high caliber, quite frankly, high free cash flow, defensive growth companies. Those are general characteristics that we're looking for. And I think that strategy has worked well for us. We do have 2 nonaccruals as you have noted, well know, and we're working through those. And what I would say is the rest of the portfolio is generally performing quite well. This quarter, 65% of the companies grew their cash flow or EBITDA. So we feel good about the portfolio.

Having said that, you always have some companies that are greatly exceeding expectations and you have some companies that are not meeting expectations, in some cases, in a more meaningful fashion than you would like. And we're not immune to either one of those. That's the good news on the positive. We've got more than a few that are doing great. And we've got a few that also are underperforming relative to expectations. But -- that's all part of it. I think our leverage levels are 4.3x in the core lower middle market, so much more modest than the broader and the bigger market or larger EBITDA market. And I think that's one of the things that helps us and helps us from a cash interest coverage perspective.

And then when -- our portfolio is gravitated towards more of a first lien portfolio, as you well know. And when things aren't going exactly how the sponsor wants it to or the ownership group or we do, that's a discussion. And in those cases where there is tighter liquidity, for instance, because of underperformance, we typically ask the owners to put money in, doesn't mean there's not a discussion in a 2-way street because there typically is. But we very much asked for support to make sure that we're protected on our side of things and the company has room to operate. So that's the general strategy, but I think the strategy of moving to a first lien strategy has helped us when things don't go as well as expected. And also, I think the overall strategy of where we focus in the types of deals and types of companies we're looking for, I think, has helped us as well.

[Robert Dodd, analyst]

Got it. One last one, if I can kind of follow on up on Bryce's first question. Activity is expected to pick up in repayments. I mean in the first half of the year, you grew the portfolio net just a little over $100 million. Most of that was in Q1, which was really, really active, obviously. I mean, so if we look at like $100 million is a 6-month growth number, I mean, do you think in the second half, what's the [ outrun ] on that?

[Edward Ross, executive]

As I sit here today, I would guess that it's going to be less than that because of repayments, because repayments will become a bigger part of the equation. I think it's probably that simple. I think my belief system is originations will most likely outpace repayments. But they're -- so hopefully, that gives you the context. It's very hard to look in Q4 at this point and know what's going to happen, but we expect decent activity levels on both into the coin, if you will, meeting originations and repayments.

[Operator]

Our next question comes from Mickey Schleien of Ladenburg.

[Mickey Schleien, analyst]

Ed, spreads in the sponsored [indiscernible] market are under enormous pressure with so much capital available. So I'm curious whether that's driving you towards looking at more nonsponsored deals. And if you are, how do you look at the underwriting and structuring of nonsponsored deals versus sponsored deals?

[Edward Ross, executive]

Great question, Mickey. And I think we've always looked at nonsponsored deals. There was a time actually when it was 30% to 40% of our portfolio, that is not the case today. I'd say our portfolio is over 90%, 90% of our companies are controlled by private equity groups. Having said that, when companies that are domiciled and industries that we know well, and we really like the characteristics of the business and the outlook, we do look to participate in those situations. The bar is very high, as you might imagine. And they need to be companies that aren't dependent on people as much and the relationships with the customers is really -- so there's an underwriting there that you got to be very, very careful about. But we do always have looked at that as a source of deal flow and of good opportunities. And so we do continue to look, but the bar remains very, very high.

[Mickey Schleien, analyst]

So if I could follow up on that. In terms of your actionable pipeline, are nonsponsored deals a meaningful portion of that at this time?

[Edward Ross, executive]

Actually, no, the deals that are most likely, and that's more than a couple, are all sponsored deals and part of a fund complex, if you will, in committed funds. Having said that, we had some discussions this week about a couple of nonsponsored deals. And we also have one in the longer-term pipeline. It's more of a search fund deal, which is quasi sponsored, definitely. So you're right, it's part of the equation for us, but we're -- sponsor-driven deals is still going to be the majority of our flow and our activity. But we do -- with the right opportunities, we are interested in those types of situations.

[Mickey Schleien, analyst]

Okay. I understand. I want to follow up on the balance sheet question. And I do recall that in the last earnings call, you guided for lower originations in the second quarter, which is indeed what happened. But you also kept issuing a lot of equity. So now you're holding a lot of cash and you're underlevered, which is causing your adjusted NII yield to run below last year. So what's the rationale for that process? And why not pay off at least the balance on the credit facility?

[Edward Ross, executive]

Shelby, do you want to take that on the [indiscernible]?

[Shelby Sherard, executive]

Yes. I'll jump in there. Some of that, Mickey [indiscernible] and seeing that excess cash is timing. Subsequent to quarter end, we did, in fact, pay off the line of credit. I would expect us to start borrowing on the line of credit again before the end of the second quarter, but there's just some timing nuances about where the pipeline is and what might be coming down the road and where cash sits.

[Mickey Schleien, analyst]

And Shelby, just from a working capital perspective, what sort of the minimum amount of cash you typically want to hold on your balance sheet?

[Shelby Sherard, executive]

I mean, if -- really less than $10 million. I mean, our line of credit is fairly facile, so it's easy to go up and down, and we don't have any concerns from a covenant or borrowing base perspective. So there's really no need to sit on excess cash out of -- unclarified from the RIC. As you know, we do have some SBIC funds. And so from time to time, there can be reasons why we might need to sit on some excess cash at an SBIC fund. But generally speaking, there's not a need. But I'm not going to pay down the line and then turn around and borrow shortly thereafter. And timing of closings is very fluid. So it's kind of hard to predict.

[Mickey Schleien, analyst]

Right. So just in terms of a trajectory, if Ed's plan or hope for net portfolio growth pans out in the second half, your first source of funds is cash and then the credit facility and then down the road perhaps more SBIC debt, is that correct?

[Shelby Sherard, executive]

Correct.

[Operator]

The next question comes from Paul Johnson of KBW.

[Paul Johnson, analyst]

Congrats on the quarter and more successful exits. Kind of on that and kind of following on some of the questions for M&A. Obviously, it's been slower across the markets, but your portfolio, obviously continues to have these realizations along the way. I'm just curious, I mean, just -- is there any effect where that's just due to -- these are inherently smaller companies and there's maybe just more potential buyers out there for these businesses and the private equity community is obviously under pressure to return more capital. So maybe these are potentially outperforming companies in easier places to potentially prune within their portfolios. But just wondering if there's just anything out there, I guess, that would be kind of, I guess, supporting on these realizations that you continue to have in your portfolio despite the lower M&A market?

[Edward Ross, executive]

Sure. I mean, I think what it speaks to is the lower middle market is, as you know, large, right? It's 90% of the transactions that take place are M&A. They're just not talked about as much in the newspapers. And then one of our strategies is to invest in the lower end of the lower middle market. And if you grow those businesses, there's typically a pretty good opportunity to do 1 or 2 things. Sell it to another private equity group or sell to a strategic. And so it's one of the strategies.

And what I would say is the names that I'm mentioning are all pretty mature investments for us, meaning they're not. They weren't made 2 or 3 years ago. And so we have as you may know, probably 17 to 20, I don't know the exact number of equity investments that are -- we no longer have debt investments associated with those equity investments. And so some of those names, the ones I'm talking about. So it's just -- at some point, they do need to realize they're mostly private equity-driven deals, and they've just taken a little bit longer.

So I think it really just speaks to the portfolio size of 86 companies and the fact that the lower middle market is always somewhat active, and that's where in terms of numbers, that's the majority of the deals they can place. M&A is not dead, it's just not robust right now, and this is one of the things we like about the lower middle market.

[Paul Johnson, analyst]

That's helpful. And then just kind of when you mentioned new platform deals that you've done, I'm just curious, when you're evaluating a new platform deal, does that mean that's a deal that's in a specific industry or vertical that's potentially new for that buyer, and that's an industry that you've already identified as attractive and don't have experience and investment expertise built up around that? Or is that a new platform and potentially industry for you as well?

[Edward Ross, executive]

No, typically not a new industry for us. We really try to focus on where we have experience and expertise, and I think about the 1 new platform company last quarter to tech-enabled services business, which is a 30% to 40% of our portfolio today. Within that segment, we have a lot of different end markets and whatnot, but it's tech-enabled type services, software or what have you. So we really try to stick to what we understand.

So when I say new platform, it's a change -- those are change of control transactions, typically private equity driven, so a new ownership group is the private equity group, and we're financing that buyout and then also co-investing in the equity of the securities alongside the private equity group.

[Operator]

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

[Edward Ross, executive]

Thank you, Cindy, 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]

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