Q1 2024 Fidus Investment Corp Earnings Call

Participants

Edward H. Ross; Chairman of the Board & CEO; Fidus Investment Corporation

Jody Burfening; IR Contact; Fidus Investment Corporation

Shelby Elizabeth Sherard; CFO, Chief Compliance Officer & Corporate Secretary; Fidus Investment Corporation

Bryce Wells Rowe; Senior Research Analyst; B. Riley Securities, Inc., Research Division

Erik Edward Zwick; Director; Hovde Group, LLC, Research Division

Mickey Max Schleien; MD of Equity Research & Supervisory Analyst; Ladenburg Thalmann & Co. Inc., Research Division

Paul Conrad Johnson; VP; Keefe, Bruyette, & Woods, Inc., Research Division

Robert James Dodd; Director & Research Analyst; Raymond James & Associates, Inc., Research Division

Presentation

Operator

Good day, and welcome to the Fidus First Quarter 2024 Earnings Conference Call. (Operator Instructions). Please note this event is being recorded.
I would now like to turn the conference over to Ms. Jody Burfening. Please go ahead, ma'am.

Jody Burfening

Thank you, Chuck, and good morning, everyone, and thank you for joining us for Fidus Investment Corporation's First 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 information included on today's call. The conference call today will contain forward-looking statements, including statements regarding the goals, strategies, beliefs, future potential, operating results and cash flows of Fidus Investment Corporation. Although management believes these statements are reasonable based on estimates, assumptions and projections as of today, May 3, 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 H. Ross

Good morning, Jody, and good morning, everyone. Welcome to our first quarter 2024 earnings conference call. On today's call, I'll start with the review of our first quarter performance and our portfolio at quarter end and then share with you our outlook for the remainder of 2024. Shelby will cover the first quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions.
As expected, the first quarter shaped up to be very active from a new investment perspective while repayments were on the lighter side. We put a fair amount of capital to work, redeploying proceeds from the fourth quarter. With net originations totaling $85.7 million, the total portfolio on a fair value basis grew to over $1 billion. To put our investment activity for the quarter in perspective, originations of $145.9 million nearly equal the total amount invested in the first half of 2023.
Consistent with our established practice, we grew the portfolio with a focus on capital preservation and the generation of attractive risk-adjusted returns. We continue to invest in industries in the lower middle market, we know well, leveraging our relationships with deal sponsors, and carefully selecting businesses with defensive characteristics and sustainable business models and positive long-term outlooks that generate cash to both service debt and support growth.
Our debt portfolio generated adjusted net investment income of $18.1 million, an increase of 21.8% compared to $14.9 million last year, primarily reflecting higher interest income and fee income for the quarter. Taking into account the higher average share count resulting from the equity raises over the past 12 months, adjusted net investment income on a per share basis was $0.59 per share compared to $0.60 per share for the same period last year.
In Q1, we paid a base dividend of $0.43 per share plus a $0.22 per share supplemental dividend for a total distribution to shareholders of $0.65 per share. For the second quarter of 2024, the Board of Directors declared dividends totaling $0.59 per share, consisting of a base dividend of $0.43 per share and a supplemental dividend of $0.16 per share, equal to 100% of the surplus in adjusted NII over the base dividend from the prior quarter, which will be payable on June 26, 2024, to stockholders of record as of June 19, 2024.
Net asset value grew 3.2% to $608.3 million compared to $589.5 million. On a per share basis, net asset value was $19.36 at quarter end compared to $19.37 as of December 31, 2023.
As I mentioned earlier, originations totaled $145.9 million for the first quarter. We stay focused on investing in first lien investments, on structuring investments with a high percentage of equity cushion and on co-investing in the equity of portfolio companies. Debt investments totaled $137.5 million, of which first lien amounted to $96.1 million or 70%.
Equity investments totaled $8.4 million. Of the $145.9 million total in originations, $94.6 million was invested in 7 new portfolio companies, which were added to the portfolio primarily through M&A transactions.
Proceeds from repayments and realizations totaled $60.2 million for the first quarter, consisting of debt repayments of $57 million and proceeds from the sale of equity investments of $3.2 million, resulting in net realized gains of $1.7 million primarily from the exit of Applied Data Corporation.
Our portfolio of debt investments on a fair value basis was $916.4 million or 87% of the total portfolio at quarter end. First lien investments are still the largest portion of the debt portfolio at 69%, including the fair value of our equity portfolio of $131.7 million. The fair value of the total portfolio at quarter end stood at $1.05 billion, equal to 102.2% of cost and we ended the first quarter with 87 active portfolio companies.
Our portfolio remains well structured, positioned to produce high levels of recurring income and the potential for enhanced returns from the sale of equity securities. Overall, our portfolio from a credit perspective remains solid with no change in the companies we have on nonaccrual from the fourth quarter. While the performance of the 2 operating companies on nonaccrual continued to improve, each of them remain higher risk situations. As a percentage of the total portfolio on a fair value basis, nonaccruals represented under 1% for the first quarter.
The health of our portfolio is attributable to our strict underwriting discipline focused on carefully investing in businesses with strong and sustainable cash flow generating business models and positive long-term growth prospects. With capital preservation in mind, we remain very deliberate in our investment selection process.
As we look ahead to the remainder of 2024, we are positioned to continue to grow the portfolio. Deal flow and M&A activity is at reasonable levels, and slowly improving relative to 2023.
That said, quality is spotty at the present time. As a result, originations for the second quarter are expected to be meaningfully lighter than the first quarter. Nevertheless, our portfolio is healthy and positioned to continue to generate adjusted NII well in excess of our base dividend to generate attractive risk-adjusted returns and grow net asset value over the long term. Now I'll turn the call over to Shelby to provide some details on our financial and operating results. Shelby?

Shelby Elizabeth Sherard

Thank you, Ed, and good morning, everyone. I'll review our first 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 Q4 2023. Total investment income was $34.7 million for the 3 months ended March 31, a $1.7 million decrease from Q4, primarily due to a $1.3 million decrease in interest income, including PIK, a $1.2 million decrease in fee income given higher prepayment fees in Q4.
The decrease in interest and fee income was offset by a $0.1 million increase in dividend income and a $0.7 million increase in interest income on excess cash, which was due to the new investments in Q1 being back-end loaded as approximately 72% of invested capital in Q1 closed in March.
Total expenses, including income tax provision, were $17 million for the first quarter, $2.3 million lower than Q4, driven primarily by a $1.4 million decrease in the capital gains fee accrual and a $1 million decrease in income taxes related to the annual excise tax accrual in Q4.
We ended the quarter with $463.1 million of debt outstanding, comprised of $175 million of SBA debentures, $250 million of unsecured notes, $22.5 million outstanding on the line of credit and $15.6 million of secured borrowings. Our debt-to-equity ratio as of March 31 was 0.8x or 0.5x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.6% as of March 31, 2024.
Net investment income, or NII, for the 3 months ended March 31 was $0.57 per share versus $0.58 per share in Q4. Adjusted NII, which excludes any capital gains, incentive fee accruals or reversals attributable to realized and unrealized gains and losses on investment was $0.59 per share in Q1 versus $0.65 in Q4, which includes an increase in the weighted average shares outstanding and a decrease in the capital gains fee accrual in Q1.
For the 3 months ended March 31, we recognized approximately $1.7 million of net realized gains, primarily related to the sale of our equity investments in Applied Data Corporation.
Turning now to portfolio statistics. As of March 31, our total investment portfolio had a fair value of over $1 billion. Our average portfolio company on a cost basis was $11.8 million, which excludes investments in 4 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 average fully diluted equity ownership of 3.5%.
Weighted average effective yield on debt investments was 14% as of March versus 14.2% at year-end 2023. 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 Q1, we repaid the remaining $35 million of outstanding SBA debentures in our second SBIC Fund, completing the wind down of this fund. As of March 31, our liquidity and capital resources included cash of $27.1 million and $77.5 million of availability on our line of credit resulting in total liquidity of approximately $104.6 million. Now I will turn the call back to Ed for concluding comments.

Edward H. 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 Chuck for Q&A. Chuck?

Question and Answer Session

Operator

(Operator Instructions) And the first question will come from Robert Dodd with Raymond James.

Robert James Dodd

Congratulations on the quarter. Several questions. On the deployment outlook -- I mean, you flagged Q2 will be down versus Q1, which is a very large number. What are your expectations kind of for the year? And obviously, it's hard to predict the further you get out. But is it -- could '24 be the first time you ever doing $400 million in originations for year given the start you had to this year? Or is that (inaudible) reach too far. We're still looking in the 300s for this year, just kind of ballpark?

Edward H. Ross

Sure. Great question. And as you know, originations and timing of deals are very hard to predict. I mean, yes. And what I would say, when you talk about Q1, we had a reasonable level of deal flow. We also had some holdover transaction opportunities from Q4, which helped the activity levels, if you will. So we were fortunate, right, to have a very strong quarter, which was great. Q2 deal flow has been solid, I would say, quality has been a bit spotty. We do have an expectation that deal flow will pick up here a little bit. M&A, there's just a lot of discussion around it. We think actually there is transaction activity that's starting to increase.
For us, this quarter, probably it's going to be lighter than Q1 by a good bit. And that's okay. What I would say is our portfolio continues to be acquisitive. So that's part of our investments. And then new transaction activity, we're working on a couple of deals very seriously right now. I don't know if they'll close or not, but that's our hope. So we definitely are very busy, but it's not like Q1. And so when I look out to the rest of the year, I expect an increase in activity levels over Q2.
Do we get to $400 million like you asked, there's a possibility of that. Over the last 12 months, I think we've been near that number, but that's a pretty aggressive number at the same time. So I would get something shy of that, but it's also a distinct possibility.

Robert James Dodd

Understood. Yes, yes. No, it's not what we had to say. On the repayments side, I mean, you have deployed a lot of capital over the last 12 months (inaudible) a lot of the portfolio is relatively young as a result. I mean you said Q1 repayments were light and they were. But at the same time, should we expect that to continue for a while given how much the portfolio is relatively fresh? Or do you think there's a different dynamic that's going to play out in the payment level?

Edward H. Ross

Sure. Another great question. I wish I had a crystal ball. But what I would say is, we do have several companies, probably more than several, that are evaluating strategic alternatives at the moment. It's unclear if any of those are Q2 or they kind of push into Q3 and which ones actually transact.
The other piece of the puzzle is some of those portfolio companies are equity-only investments and not the real large ones, for instance. And so I'm not, at the moment, expecting a real high level of repayments here in Q2. The current expectation, based on what we know today is, it's less than Q1. Having said that, we do have an expectation that repayments will pick up in Q3 and Q4. As you know, the market is more aggressive. And also, we do see transactions from a realization perspective, company sale, M&A type stuff taking place in Q3, Q4 for us. Hopefully, that (inaudible).

Robert James Dodd

Understood. That is very helpful, although one comment, if I can. Shelby, your color on 72% capital was deployed in March, very helpful for figuring out direction spreads, et cetera, et cetera, would be really helpful if color like that was in the press release. So thank you. And that's it for me.

Operator

The next question will come from Mickey Schleien with Ladenburg.

Mickey Max Schleien

Ed, LSEG is reporting that middle market spreads have declined about 50 basis points over the last year, but they're still above pre-COVID levels. So when we think about how resilient the economy has remained and the fact that there's plenty of debt capital available out there, what's your outlook on spreads in your bread and butter business?

Edward H. Ross

It's a great question. Spread -- if you think about from a year ago, it's a bit of night and day, right? The banks were struggling. There was a banking crisis just 12 months ago. Today, banks are active, direct lenders are active, SBIC funds, BDCs, you name it. Everyone is pretty active today. And that's very different than it was 12 months ago. And with that comes a decline in spreads. Also, as you mentioned, the economy is showing a fair bit of resilience and people are getting pretty comfortable with where we are. So spreads have declined.
We, just given the uncertainty levels, have focused very much, as we always do, on quality, with that has been some first lien investments, [$1] -- if you do $1 investments, your yields are a little bit lower. So that's been a bit of the puzzle for us, but we're focused on quality and attractive risk-adjusted returns and not pushing the envelope, obviously.
I would expect -- yields today are, depending on the deal, 50 to 100 basis points lower than they were a year ago. And in the larger markets, say the middle market and above, we're seeing spreads that are even narrower than that, I'd say, even 150 basis points. And so it's much more aggressive in the upper market than it is where we are. But spreads have come in, and you're seeing that in the originations of our investments. And if you think about last quarter, and again, it was weighted towards first lien, our originations were at yields that were equal to 12.9%. And our repayments average more like 13.7%, so that gives you a little color on why our yields declined. So I would expect, going forward, our yields to be stable to slightly declining, just given what's going on in the marketplace today.

Mickey Max Schleien

That's really, really helpful, Ed. And if I could follow that up. You mentioned the, I don't remember what you want to call it, frothiness in the upper middle market, but let's just say a very active upper middle market. I mean part of your playbook is to invest in companies that will grow and succeed. And I imagine some of your portfolio companies have done that pretty well and could look to potentially refinance into the upper middle market. How concerned are you about that refinancing risk in your portfolio?

Edward H. Ross

Not terribly. I mean those are investments. I think you're exactly right. We have some companies, and we continue to support those companies that are performing extremely well. And could they get refinanced at lower rates at some point in time in the future and the next 12 months or what have you. The answer to that is, yes. I think -- at the same time, we add a lot of value to portfolio of companies. We've got strong relationships, but they're built on trust and adding value. And so -- but your point is a good one. That is a part of the market today. And so it is our expectation that there'll be some of that activity, whether it's Q3 or Q4 or into next year. That's a piece of the puzzle for sure. It's not alarming to us. It's just -- it's part of the equation I think.

Mickey Max Schleien

I understand. And my last question regarding balance sheet leverage. You're still below your target, which I believe is debt to equity of 0.8 to 1.1. I understand that, that takes into account a lot of different moving parts. But with the discussion you just had about pressure on portfolio yields, are you hoping to increasing balance sheet leverage to continue to deliver financial performance at the BDC?

Edward H. Ross

Great question, Mickey. The answer to that is, yes. We're trying to do what makes sense for our shareholders on a long-term basis. As you know, there's been some turmoil in the debt markets here recently, in particular, the unsecured and the treasury markets, which impact those markets. We do have other ways to access capital, right? We have our revolver, which has a strong liquidity position. And then we also have the ability to increase the size of the revolver. I'd say, if you look at our capital structure, the revolver is probably smallish in nature relative to most other BDCs. So -- and then we have the SBIC application. We obviously applied for that in December, and we knew it was going to take a while. We were told that. And that continued -- we continue to be in the queue there, but that will be part of the equation for us as well.
So the answer is yes, absolutely. But we're trying to do it in a methodical manner and do what's right for our shareholders over the long term. If that makes sense.

Operator

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

Bryce Wells Rowe

I wanted to maybe follow up just on those comments you made, Ed, about the SBA license and maybe expanding the credit facility, maybe any color around where you'd like to see the credit facility go in terms of commitment. And then I think last quarter, you talked about the SBA license, the newer one, maybe being in place by the middle of this year. Is that still your expectation from a timing perspective?

Edward H. Ross

I think the SBA license is a tough one. I think the SBA, they told us it was going to take a while, and it's just hard to predict. I think June, if I sit here today where I don't have any real new information, I'd say, hey, that's a little aggressive. I do think things are moving along, but timing is very tough to predict and probably June is a little aggressive. I would assume Q3 or Q4 at this point.
From a credit facility perspective, I don't know that we have a specific target, but I will say that we are looking to -- we're thinking about, as we sit here today, increasing the size of the facility. I think that makes sense. And going back to strategy from a capital structure perspective, I think diversity is important. So having secured -- piece of the puzzle is important, having unsecured being a large piece of it and that includes SBIC debentures. I mean all of those are pieces of the puzzle that we like. And I think we've got an ability to increase leverage in all 3 areas. It's just a matter of kind of picking the time, if you will.

Bryce Wells Rowe

Okay. Okay. I wanted to maybe follow up on that adjective to use 'spotty' in terms of kind of quality that you're seeing in the market today, what does that mean in particular?

Edward H. Ross

For us, we're looking for pretty high quality, high free cash flow, generally high multiple -- meaning EBITDA multiple transactions, so high value-add businesses. And in terms of the stars aligning where the sponsor wins and we're well positioned. There's just less of those opportunities this quarter relative to last quarter. And so it's just -- it's little bit of -- it's just mix. And I do think luck is not the right word, but sometimes it's just good fortune, things kind of fall in place and other times, they don't as much. But we are being very, very careful. We're looking at the cream of the crop from asset quality perspective, and there are fewer of those companies out there. And then if we don't have the right equation, if you will, whether the sponsor doesn't win or we don't have the right financing facility, then maybe that transaction doesn't happen.
And so that's just -- the quality for us has been a very important marker always. But we're sticking to our knitting and really focusing on those types of businesses and hopefully that's helpful, but that's really what I'm getting at.

Bryce Wells Rowe

Yes. Yes. Maybe one here on credit quality. Any way to kind of quantify where leverage in the portfolio is -- weighted average leverage and what you're seeing from a kind of a weighted average loan-to-value perspective at this point, too?

Edward H. Ross

Sure. So leverage for our core lower middle market portfolio, absent a couple of investments in the larger world, if you will, DSL world, our leverage is at 4.37x, I think. So debt-debt EBITDA -- and then interest coverage was at 3.1x. And what was the last question?

Bryce Wells Rowe

I think -- you talked about kind of loan to value within the portfolio in the past?

Edward H. Ross

Yes. Loan to value is pretty stable. It's just under 40% in the quarter.

Operator

The next question will come from Paul Johnson with KBW.

Paul Conrad Johnson

Kind within the marks on the equity portfolio, you mentioned the one gain this quarter. That was nice. But is there any other significant notable movements or marks within the equity portfolio?

Edward H. Ross

Were there -- I just want to make sure I heard you correctly. Were there notable marks changes, is that the question, Paul?

Paul Conrad Johnson

Yes.

Edward H. Ross

Yes. So nothing -- I mean, overall, the equity portfolio performed quite well. We did have a write-down in Pfanstiehl, which is our largest position, and that company continues to kind of weather the pharma destocking trend. But that -- we're kind of at the end of that, we believe. And so we expect performance to start to improve. That continues to be a very high-quality business with a very good outlook. It's going through this inventory destocking trend in the pharma space, and it's kind of at the tail end of that.
The rest of the portfolio really is quite stable and performed well. I mean I think the equity portfolio, despite what I just mentioned with Pfanstiehl appreciated in the quarter as did the debt portfolio. So it was a good quarter, very stable and very solid performance.

Paul Conrad Johnson

Thanks for that. And then just in terms of the deal flow you're seeing in the markets, wondering, trying to get your thoughts on kind of what you think of the relative value of the first lien sort of structure opportunities that you see versus any kind of subordinated opportunities that are out there today and that's something that you're even seeing and that makes sense?

Edward H. Ross

Sure. Sure. It's a great question and it's a tough one, too. I think the market, as you well know, has moved very much to more of a first lien solution. Having said that, mezzanine investments are still a part of the market -- a core part of the market. Just from a market share perspective, it's lower. And in today's world, mezzanine continues to show up for us. And so we made 2 mezzanine investments last quarter in very high-quality companies. And so we're going to continue to look for those types of situations where we like the debt and the equity of those prospective portfolio companies. But what I would suggest is the first lien solution is a large majority of the market in what I would -- and I would also expect that to continue to be a large majority of our investments as we move forward. But we are actively looking for attractive mezzanine opportunities.

Operator

Your next question will come from Erik Zwick with Hovde Group.

Erik Edward Zwick

I wanted to first just start with a bit of a follow-up. You mentioned the active -- the market is fairly active at this point and competition is, I guess, somewhat intense, that's impacting spreads. Curious if you're seeing any deterioration in the market on the structure side, if you're finding that you're losing any deals where you're sticking to your guns, so to speak, in terms of your credit quality standards and underwriting and others are starting to bend at all?

Edward H. Ross

Sure. Great question. We haven't really seen structural changes. One of the things we like about the lower middle market is we have real maintenance covenants. Many times, we have 2 covenants, both the leverage and a fixed charge. That's a large majority of our situations in our investments. And that's different than the upper market, if you will, the larger market, very different. And I would say the spreads to those maintenance covenants are also narrower.
So we like the ability to have a seat at the table, and we have not seen any real changes from that perspective. Clearly, pricing and spreads narrowing is a part of the market in the business today, but structures have not started to change yet, which is a good thing. And to be honest, in the lower middle market, you don't really see a deviation away from pretty strong structures at the end of the day. So again, it's one of the things we really like about the lower middle market and our ability to risk manage our investments, if you will.

Erik Edward Zwick

Thanks, I agree with you. That's good to hear. And then the last one for me. I think you mentioned in your comments for the 2 existing non-accruals, the situations there are improving but remain at high risk. Wondering if you could just -- maybe provide a little bit more color to the term 'improving,' if it's kind of the underlying financial metrics and trends at the companies or just progressing towards some sort of resolution? And what you're kind of referring to there with that comment?

Edward H. Ross

Sure. Great question. What I'm referring to there is really the EBITDA level. So EBITDA levels in both cases are growing and improving on current basis and on a last 12-month basis and in a meaningful way. But at the same time, these businesses had some idiosyncratic issues that were meaningful as well. And so the EBITDA performance is improving. We do not expect any quick resolutions or anything like that in either case. And so we're just managing through kind of the situation, trying to work through an improved outlook in both cases. And I would also say we've got supportive equity sponsors in both those cases as well, which is great.
There is a lot of work being done to try to improve the overall position of both assets, but we've got a ways to go.

Operator

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

Edward H. Ross

Thank you, Chuck, and thank you, everyone, for joining us this morning. We look forward to speaking with you on our second quarter call in early August 2024. 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.