Fidus Investment Corp

NASDAQ:FDUS

Earnings Call Analysis

Earnings Call Transcript 2023-Q3

[Operator]

Good day and welcome to Fidus Third Quarter 2023 Earnings Call. [Operator Instructions]. Please note that this event is being recorded. I will like to turn the conference over to Ms. Jody Burfening. Please go ahead.

[Jody Burfening, executive]

Thank you, Nick, and good morning, everyone, and thank you for joining us for Fidus Investment Corporation's Third 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 and cash flows of Fidus Investment Corporation. Although management believes these statements are reasonable based on estimates, assumptions and projections as of today, November 3, 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 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 third quarter 2023 earnings conference call. On today's call, I'll start with a review of our third quarter performance and our portfolio at quarter end and then share with you our outlook for the remainder of 2023. 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.

We delivered strong results for the third quarter, with our portfolio continuing to grow adjusted net investment income and with adjusted net investment income remaining well in excess of our base dividend. Much like the first half of 2023, deal flow was decent but not robust by any means as M&A activity remains subdued in the lower middle market. We're patient, and we're disciplined and we're staying focused on our proven strategy of selectively investing in value-added businesses that generate high levels of free cash flow and have positive long-term outlooks.

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 46% to $18.2 million in Q3 compared to $12.5 million last year. Interest income growth drove this increase, reflecting both higher average loans outstanding and a 170 basis point increase in average debt yields to 14.6%.

Taking into account the increase in weighted average shares outstanding resulting from our equity raise during the quarter, adjusted net investment income on a per share basis increased 33.3% to $0.68 from $0.51. We paid dividends totaling $0.72 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.21 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, roughly the equivalent of dividends for 3 quarters.

For the fourth quarter, on October 30, 2023, the Board of Directors declared dividends totaling $0.80 per share, consisting of a base dividend of $0.43 per share, a supplemental dividend of $0.27 per share, equal to 100% of the surplus and 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 December 27, 2023, to stockholders of record as of December 20, 2023.

Net asset value at quarter end was $548.6 million or $19.28 per share compared to $483.3 million or $19.13 per share as of June 30. During the quarter, we continued to invest in 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.

Originations totaled $56.7 million, consisting of $48.5 million in debt and $8.2 million in equity. First lien investments accounted for $43.1 million or nearly all of the additions to the debt portfolio. We invested $33.1 million in 2 new portfolio companies that were added to the portfolio financing M&A transactions. The remaining portion of originations was invested in add-ons in support of our existing portfolio companies.

Proceeds totaling $69.9 million were slightly higher than originations for the third quarter, reflecting 4 debt repayments and 2 equity realizations including the sale of Hallmark, which occurred earlier than we had expected. From an equity perspective, we received proceeds of $11 million, resulting in realized gains of $9.8 million most of which came from the sale of our equity investment in Hallmark.

Our portfolio of debt investments on a fair value basis was $798 million or 86% 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 $128.8 million, the fair value of the total portfolio at quarter end stood at $926.9 million equal to 103.5% of cost. We ended the third quarter with 80 active portfolio companies and 2 companies that have sold their underlying operations.

Subsequent to quarter end, we invested $31.8 million in first lien debt and preferred equity in 2 new portfolio companies, and we had debt repayments in 3 companies generating net proceeds of approximately $29.3 million. As we added debt and equity investments to our portfolio, we continue to carefully select high-quality companies that generate excess levels of cash flow to service debt and to structure our investments with a high percentage of equity cushion in an effort to manage downside risk, which is especially important in today's higher rate environment.

For the most part, our portfolio of companies have adjusted to current economic conditions and those with pricing power, generally found ways to prosper despite inflationary cost pressures and higher interest rates. Select portfolio companies are continuing to navigate today's tougher conditions, and we are monitoring them closely. As of September 30, we had 2 operating companies on nonaccrual, unchanged from the second quarter.

Non-accruals represented 1.3% of the total portfolio on a fair value basis. In summary, the credit quality of our portfolio overall remains very solid. As we close out the year, the pace of deal activity in the lower middle market has been picking up relative to Q3. Our portfolio remains healthy, and with our strong liquidity, we are well positioned to grow the portfolio selectively and deliberately, investing in high-quality companies in the lower middle market that possess resilient business models and positive long-term outlooks and generate high levels of cash flow.

As always, we are committed to managing the business for the long term into our goals of preserving capital, generating attractive risk-adjusted returns and delivering value 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 third 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, Q2 2023. Total investment income was $34.2 million for the 3 months ended September 30, a $3.6 million increase from Q2, primarily due to a $3.7 million increase in interest income, including PIC, offset by a slight 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 $17.5 million for the third quarter, $3.8 million higher than Q2, driven primarily by a $2.7 million increase in the accrued capital gains incentive fee, a $0.4 million increase in interest expenses, in part due to incremental SBA debt outstanding and a $0.7 million increase in the base management and income incentive fees.

We ended the quarter with $454.3 million of debt outstanding comprised of $188 million of SBA debentures, $250 million of unsecured notes and $16.3 million of secured borrowings. Our debt-to-equity ratio as of September 30 was 0.83x or 0.49x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.3% as of September 30, 2023. Net investment income or NII for the 3 months ended September 30 was $0.63 per share versus $0.67 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 $0.68 per share in Q3 versus $0.62 per share in Q2. In Q3, we realized net gains of $9.8 million, primarily related to the exit of our equity investment in Hallmark Healthcare Solutions.

Turning now to portfolio statistics as of September 30. Our total investment portfolio had a fair value of $926.9 million. Our average portfolio company investment on a cost basis was $11.2 million, which excludes investments in 2 portfolio companies that have sold their operations and are in the process of winding down. We have equity investments in approximately 76.8% of our portfolio companies with average fully diluted equity ownership of 3.2%.

Weighted average effective yield on debt investments was 14.6% as of September 30 versus 14.5% at June 30. 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 3.2 million shares at an average share price of $19.54, raising net proceeds of approximately $61.5 million. As of September 30, our liquidity and capital resources included cash of $80.3 million, $22 million of available SBA debentures and $100 million of availability on our line of credit resulting in total liquidity of approximately $202.3 million.

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 Nick for Q&A. Nick?

[Operator]

[Operator Instructions] First question will be from Bryce Rowe, B. Riley.

[Bryce Rowe, analyst]

Ed, I wanted to ask you guys or talk about the ATM usage. Obviously, nice to see the stock trade above NAV and give you the ability to raise some equity in the third quarter, pretty substantial amount. Can you kind of delineate between the opportunistic -- being opportunistic with the stock above NAV and maybe just raising the equity in anticipation of some more activity, whether it be in the fourth quarter or into the first part of '24.

[Edward Ross, executive]

Sure. It's a great question, Bryce. I think from my perspective, first off, I think we're very pleased with our overall performance and where the stock has been trading. But I think more importantly, what we're pleased with is the opportunities that we are seeing in the market. And in particular, these are mostly very high-quality companies that we are pursuing. The leverage levels are very reasonable. Loan to values are 30% to 50%, if you will.

And so we think from a risk-adjusted return basis, this is a great time to invest. And quite frankly, the companies that are coming to market from an M&A perspective are very high-quality companies that we believe can withstand any of the uncertainties that we are all fearful of. But we feel good about the opportunity set. And obviously, we feel also good about the fact that our stock has been trading well.

[Bryce Rowe, analyst]

Great. That's helpful. And then maybe another question here just on the dividend, nice to see the bump higher in the dividend, at least the regular dividend. Just curious how you're thinking about possibly paying out the excess earnings over and above the base dividend amount? Do you expect to continue to pay out the full excess? Or will you moderate that a bit as we move into '24.

[Edward Ross, executive]

Sure. Great question, Bryce. I think, again, we're thrilled with the performance of the business. And as you know, we've had some very meaningful equity realizations over the last, really several years. And so the earnings power of the business is at a higher level. And so we're very pleased to have raised the base dividend. Our current posture is to continue to pay out our excess earnings as we are today. And so that would -- that's our current posture, and that's our expectation as we move into 2024.

Obviously, this quarter, Q4 is the last quarter we intend on paying this extra $0.10 special, which we've been paying for the past 5 quarters, including Q4 of this year. But we do intend on continuing to pay out 100% of our excess earnings in the prior period as we move forward or move into 2024.

[Operator]

Next question will be from Mickey Schleien of Ladenburg.

[Mickey Schleien, analyst]

Ed and Shelby, I want to start with a high-level question perhaps for Ed. In the upper middle market, we're starting to see spreads come in, just as a function of the amount of private capital that's out there and the lack of M&A volume and we have a supply and demand mismatch, are you starting to see that trickle down into the middle market and lower middle market where you operate Ed?

[Edward Ross, executive]

Great question, Mickey. And the short answer to that is a little bit. I would say the spreads have narrowed, maybe 25 basis points, in certain situation 50 over the last 6 months or so. I think there was a period 12 months ago, 9 months ago, where there were certain lenders that were really not in the marketplace at all. Today, there appears to be more competition. It's not crazy at any level. People are being disciplined. But I do think for the high-quality situations, which is what we're focused on, that spreads have narrowed a little bit here over the last 3 to 6 months. So very similar in nature.

[Mickey Schleien, analyst]

Okay. I appreciate that insight. Going back to the equity issuance question, I just want to understand, are you still expecting to operate the BDC somewhere between 0.8x and 1.1x on a debt -- on a total debt to equity basis? And is your current level, which is at the bottom end of that range, also factoring in some expectation about headwinds for the economy?

[Edward Ross, executive]

Sure. Great question. I think your initial comment of 0.8x to 1.1x is a good one. It's -- where we have operated really has been 0.8x to 1.1x historically. We are comfortable going over 1.1x as opportunities arise, but there was an opportunity to raise capital here. We saw that Q4 was going to be active. We also believe 2024 will probably show up a little bit more active than 2023.

There's just pent-up demand out there, and there's a need -- more of a need for actually transactions that take place. So we thought being prepared for that, made a ton of sense. So I wouldn't say we're concerned. We were raising capital to position the business to withstand concerns about the economy. It was more to position the business to handle the opportunities that we think we're going to see here going forward.

[Mickey Schleien, analyst]

Okay. I understand. My last question is more -- a little bit more of a housekeeping question on interest income, which increased 13% quarter-to-quarter, but the debt portfolio at cost actually declined 1% and your average portfolio yields only increased 10 basis points. So the interest income growth seems high unless I'm doing my math incorrectly. Was there anything sort of nonrecurring and interest income accrued this quarter that we should be aware of?

[Edward Ross, executive]

Sure. I'm going to let Shelby take that. I understand your question, but I'll let her take that.

[Shelby Sherard, executive]

No, there were no kind of particularly unique items. With debt repayments, we will have acceleration of OID, but that's kind of routine in course with respect to repayments.

[Edward Ross, executive]

We also had interest income from some of the cash on our balance sheet through a part of it. And as such, average loans outstanding were higher during the quarter than they were at quarter end -- some of the repayments.

[Mickey Schleien, analyst]

Right. Yes. I was going to just say it. It sounds like it has to do with the cadence of the investment -- investments that you made, right?

[Edward Ross, executive]

That's true. Correct.

[Operator]

Next question will be from Robert Dodd of Raymond James.

[Robert Dodd, analyst]

On the color, I had about -- running the ATM because you're seeing more opportunities. Can you tell us about the -- I mean you mentioned here that the quality of deals available now are very high quality. If I look back last quarter, obviously, it varies about whether you're pursuing them or not. But last quarter, some of the available deals in the market you described has hit on this.

So have you seen a change in kind of the mix of deals that are coming to market that are higher quality, which then justifies the -- running the ATM because if you can obviously win those deals, it's great for portfolio quality overall. I mean, is there any mix going on at the moment, mix-shift?

[Edward Ross, executive]

No. Not really. What I would say is, look, deal flow -- actually, deal flow wasn't bad by any stretch of imagination in Q3. Quality has been hit or miss all year, though, is what I would say. So that's a big piece of the puzzle. And then in terms of our investment activity in Q3, we had a couple of deals spill over into Q4. And again, we think Q4 will be a stronger investment period than Q3, partly because of that and also just the pickup in activity.

From a type of business or mix that we're seeing, it's really largely across the board where we're spending time on those companies that have recurring or reoccurring revenues. So pretty strong stability backgrounds, if you will. And so -- and high free cash flows. And so those are the types of businesses that we are focused on, and we are seeing a little bit of an uptick, but some of that's just Q4 versus Q3 where the summer slows things down a little bit. But we are hopeful that next year will be -- and kind of anticipate a little bit of a pickup in M&A activity in 2024.

[Robert Dodd, analyst]

Got it. And then just on where -- and obviously, credit quality across the portfolio looks [ tight ] but [indiscernible] where -- what are the reactions [indiscernible]. In terms of sponsor interactions, I mean, is anything changing on that front given now we've been in a high rate environment for a relatively prolonged period now. Are they starting to change how they're looking at supporting portfolio companies? Or is everything just business as usual?

[Edward Ross, executive]

I'm not seeing really any noticeable change. I mean we've seen some support and tougher situations that we have where to go through an amendment, we're requiring support. We have a portfolio that's very active from an add-on acquisition perspective and folks are doing that. I am -- what I'm seeing and what we're seeing [Technical Difficulty] pretty high level or pretty high interest in trying to define high-quality companies recognizing that rates are higher.

And maybe, quite frankly, in some cases, private equity groups are paying a little more than they would like to. But for A assets, I think that's where there's a flight to quality from an equity perspective and from a debt perspective. And if people can locate and get an opportunity to invest in a very high-quality A type business, then folks are willing to still pay up for them, quite frankly. And you're seeing that in some of the utilizations that we are -- that we have as well.

[Operator]

[Operator Instructions]. Next question will be from Paul Johnson with KBW.

[Paul Johnson, analyst]

On the Hallmark, just going back to the Hallmark healthcare sale. I'm just trying to understand kind of, obviously, that was a successful in for you guys. Just kind of understanding what's going on there with the company. It looks like you have just a little bit of an equity investment left in the portfolio. Just any color you can kind of give on what perpetuated the sale and what you guys have left remaining in the portfolio of that company?

[Edward Ross, executive]

Sure. Great question, Paul. Paul, this -- Hallmark has been a great performer for us. We -- actually, the company was -- and the sponsor was evaluating a couple of things. One was more of a dividend recap or a sale transaction. And quite frankly, we weren't in the know as much as maybe we would have even like. But so the sale transaction transpired. It was documented legally as a full sale of the whole equity tranche.

Having said that, the sponsor is rolling over a significant portion, not up to 50%, less than 50%, but a significant portion of their investment, and we follow that lead. And so we also invested the same percentage in the business on a go-forward basis. So it's a full realization, but we invested a significant amount in the go-forward capitalization of the business. Is that helpful?

[Paul Johnson, analyst]

Yes. That's very helpful. That's great color. And Obviously, you guys recognize the gain on the sale, but was that investment also written up during the quarter? Are you able to quantify that at all? Impact on that?

[Edward Ross, executive]

Jody, do you have that at your fingertips or I'll give a higher level?

[Jody Burfening, executive]

I don't have the exact number, but I can confirm that the realization that we had in Q3 was materially higher than the fair value we had marked out at the end of Q2.

[Paul Johnson, analyst]

Okay. And then so last quarter, you just kind of gave -- I think it was an approximation of, I think you said 55% of your companies were still growing EBITDA last quarter. Are you able to provide any kind of similar approximation of the percent of your portfolio that you still see growing revenues or EBITDA at this point?

[Edward Ross, executive]

Sure, sure. It's a great question. The portfolio continues to perform well. I think of the core lower middle-market businesses that we're invested in EBITDA. I guess -- what's the number -- 35 of 56 companies that fall in that category. And we also have some equity stand-alone businesses or orphaned equity investments that are not included there. And so about 63% of the companies grew cash flows or EBITDA. And then overall, our portfolio grew on an LTM basis this quarter, just less than 5%. So we're seeing still healthy performance and healthy growth in the underlying portfolio, which we're very pleased with.

[Paul Johnson, analyst]

That's very helpful. And then last one at this point. Obviously, $0.68 was very strong results this quarter. I'm just curious, at this point, you kind of see this as sort of the full flow-through, if you will, of higher rates at this point, at least from an NII perspective in the portfolio? Or is there a possibility of continued, I guess, higher OID amortization. I sort of think fees from the payments and such to continue, I guess, generating results around these levels or possibly even higher. Any kind of color there would be -- would also be helpful? And that's all for me.

[Edward Ross, executive]

Sure. It's a great question. One, that -- it's is not that easy to answer. But I think we are -- obviously, we're very pleased with the performance this quarter. This next quarter, I do want to highlight, we will have excise expense, so that will impact NII in Q4 which is relevant. I do think interest income, so on the revenue side, it's at a pretty high level.

At this point, I don't see that rate going higher. Obviously, the Fed stay put. And I actually see a couple of higher-yielding investments in our portfolio that will probably repay. And so I see stability there from a yield perspective. But at the same time, and I do think there'll be continued monetization of certain equity investments. It's not going to be like 2021 where there was just a very robust amount of M&A activity. But M&A is still transpiring, and we expect equity investments to still monetize, if you will.

And so we think the outlook is very good as we move forward. Exactly where we end up? Do we go above 68%? It's clearly possible. It has to do with a lot of things, getting more invested. Are fee -- is fee income at a reasonable level that quarter or not? Are there any dividends? All those things, you got to take into account a little bit. But obviously, $0.68 is a great quarter, and we would -- we're going to strive to do better. But at the same time, we're focused on portfolio quality and consistency as opposed to just driving the highest earnings we can.

So hopefully, that's helpful. But Q4 will be impacted and I think that's relevant. Shelby, do you have anything to add to that?

[Shelby Sherard, executive]

No. You mentioned the excise tax. So that's just kind of an annual accrual that we have, which we'll continue to have this year.

[Operator]

This concludes our question-and-answer session. I'd like to turn the call back over to Mr. Ed Ross for closing remarks.

[Edward Ross, executive]

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

[Operator]

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