Fidus Investment - Q1 2023
May 5, 2023
Transcript
Operator (participant)
Good day, welcome to the Fidus Investment Corporation First Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press Star followed by the number one on your telephone keypad. If you would like to withdraw your question, please press star one again. For operator assistance throughout the call, please press star zero. Finally, I would like to advise all participants that this call is being recorded. Thank you. I'd now like to welcome Shelby Sherard to begin the conference. Shelby, over to you.
Shelby Sherard (CFO, Chief Compliance Officer, and Corporate Secretary)
Thank you, Gavin. Good morning, everyone. Thank you for joining us for Fidus Investment Corporation First Quarter 2023 earnings conference call. Fidus issued a press release yesterday afternoon with the details of the company's quarterly financial results. A copy of this 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 5th, 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 undergoes no obligation to update or revise any of these forward-looking statements. I would now like to turn the call over to Ed. Good morning, Ed.
Ed Ross (CEO)
Good morning, Shelby, and good morning everyone. Welcome to our first quarter 2023 earnings conference call. On today's call, I'll start with a review of our first quarter performance and our portfolio quarter-end, and then give you an update on our views about market conditions in the lower middle market for the rest of 2023. 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. Our first quarter results demonstrate the enhanced earnings power of our portfolio, which derives from our success in building our portfolio of income producing assets last year and from higher yields.
Our first quarter performance also demonstrates the efficacy of our experience, industry knowledge and relationships with deal sponsors as we continue to build our portfolio without sacrificing quality even though credit conditions remain tough and deal activity remained relatively slow in the lower middle market. Our strategy of selectively investing in high quality companies with defensive characteristics and positive long-term outlooks that operate in industries we know well and generate strong free cash flow continues to produce a healthy and high performing portfolio. We generated 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 40.2% to $14.9 million, or $0.60 per share, compared to $10.6 million or $0.43 per share last year. A 52% increase in interest income drove this performance and reflected the positive combination of higher average debt investments and a debt yield of 14.3%, which is 240 basis points higher than the debt yield for the first quarter last year.
Shelby Sherard (CFO, Chief Compliance Officer, and Corporate Secretary)
Oh my God.
Ed Ross (CEO)
For the first quarter, we paid dividends totaling $0.66 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.15 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 second quarter on May 1, 2023, the board of directors declared dividends totaling $0.70 per share, consisting of a base dividend of $0.41 per share, a supplemental dividend of $0.19 per share equal to 100% of the surplus and adjusted NII over the base dividend from the first quarter, and a special cash dividend of $0.10 per share, which will be payable on June 28, 2023 to stockholders of record as of June 21, 2023. Including the special cash dividend of $0.10 per share, we ended the quarter with a NAV of $484.6 million or $19.39 per share.
In terms of originations for the quarter, we invested $51.5 million, further expanding our portfolio of debt securities that generate recurring interest income while also continuing to execute our strategy of co-investing in equity securities to add a margin of safety and the opportunity to generate incremental profits. This quarter, $40.2 million or a little more than three-fourths of total originations was invested in three new portfolio companies. In each case, the investments were made in connection with a M&A transaction. We also continued to support the M&A activity of our existing portfolio companies. In terms of repayments and realizations in the first quarter, we received proceeds totaling $15.9 million, including $15.7 million in first lien debt repayments.
With net originations of $35.6 million for the quarter, the fair value of the portfolio at quarter end grew to $897.3 million, equal to 103.7% of cost. We ended the first quarter with 78 active portfolio companies and two companies that have sold their underlying operations. Subsequent to quarter end, we invested $2.5 million in debt in a new portfolio company and exited our debt and equity investments in Rhino Assembly Company, recognizing a net realized gain of approximately $2.1 million. In terms of the total portfolio mix on a fair value basis, we ended the first quarter with debt investments of $772.8 million and equity investments of $124.5 million.
Debt investments accounted for 86% of the total portfolio, with first lien debt representing the majority of the debt portfolio. Overall, our portfolio remains healthy from a credit perspective. Cost pressures and supply chain challenges are showing signs of easing. By and large, our portfolio companies are performing reasonably well, doing what they need to do to navigate current economic uncertainties, especially those with pricing power. We are, however, dealing with select company performance issues, which led us to place 1 additional company on non-accrual during the quarter. As of March 31, non-accruals represented 2% of the total portfolio on a fair value basis. As a reminder, we have residual debt investments in 2 legacy portfolio companies that were previously sold as part of the non-accrual list. Importantly, our non-accruals are all isolated company-specific issues versus related to macroeconomic factors applicable to the entire portfolio.
As always, we are managing our overall portfolio in a proactive manner and more specifically, working closely with the financial sponsors and management teams of our portfolio companies. In summary, thus far, 2023 is unfolding as we thought it would, and our proven investment strategy and underwriting standards continue to serve us well. Although the pace of new deal activity in the lower middle market has been slower than it was in 2021 and most of 2022, we are continuing to find attractive opportunities to invest in high quality, high cash flow generating companies and grow our portfolio.
With an expanding portfolio of income producing assets and the benefits of our balance sheet in a widening spread environment, our portfolio remains very well positioned to generate adjusted NII in excess of base dividends and to grow net asset value over the long term, supporting our long-term goals of preserving capital and generating attractive risk-adjusted returns for our shareholders. I'll turn the call over to Shelby to provide some details on our financials and operating results. Shelby?
Shelby Sherard (CFO, Chief Compliance Officer, and Corporate Secretary)
Thank you, Ed. 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 2022. Total investment income was $29.1 million for the three months ended March 31, a $1.6 million increase from Q4, primarily due to a $1.9 million increase in interest income, including PIK, and a $0.2 million increase in dividend income, partially offset by a $0.6 million decrease in fee 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 tax provision, were $14.3 million for the first quarter, $0.7 million lower than Q4, driven primarily by a $1.4 million decrease related to the annual excise tax accrual that occurs in Q4, offset by a $0.6 million increase in income incentive fee and a $0.3 million increase in interest expense related to incremental debt outstanding, both SBA debentures and borrowings under our line of credit. We ended the quarter with $446.6 million of debt outstanding, comprised of $165 million of SBA debentures, $250 million of unsecured notes, $15 million outstanding on our Line of Credit, and $16.6 million of secured borrowings. Our debt-to-equity ratio as of March 31st was 0.9 times or 0.6 times statutory leverage, excluding exempt SBA debentures.
The weighted average interest rate on our outstanding debt was 4.2% as of March 31st, 2023. Net investment income, or NII, for the 3 months ended March 31st was $0.59 per share versus $0.51 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 investments, with $0.60 per share in Q1 versus $0.51 per share in Q4. Turning now to portfolio statistics. As of March 31st, our total investment portfolio had a fair value of $897.3 million. Our average portfolio investment on a cost basis was $11.1 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 76.3% of our portfolio companies with an average fully diluted equity ownership of 3.9%. Weighted average effective yield on debt investments was 14.3% as of March 31st versus 13.8% at December 31st. 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 non-accrual, if any. I'd like to briefly discuss our available liquidity. As of March 31st, our liquidity and capital resources included cash of $36.4 million, $5 million of available SBA debentures, and $85 million of availability on our Line of Credit, resulting in total liquidity of approximately $126.4 million. I will turn the call back to Ed for concluding comments. Ed?
Ed Ross (CEO)
Thanks, Shelby. As always, I'd like to thank our team and the board of directors at Fidus for their dedication and hard work and our shareholders for their continued support. I will now turn the call over to Gavin for Q&A. Gavin?
Operator (participant)
Reminder, if you would like to ask a question, please press star, then the 1 on your telephone keypad. That is star one to ask a question. We'll pause for just a moment to compile the Q&A roster. Your first question comes line of Mickey Schleien of Ladenburg Thalmann. Your line is open.
Mickey Schleien (Managing Director, Equity Research)
Yes, good morning, Ed and Shelby. Can you hear me all right?
Ed Ross (CEO)
Yes, I can. Yeah. Hey, good morning. How are you, Mickey?
Mickey Schleien (Managing Director, Equity Research)
Good. Thank you. Ed, I see that the portfolio's cash interest coverage ratio increased, which is a bit of a surprise considering the increase in interest rates. I do see that most of your net investments were in first liens, and they may have better ratios, and you have almost a third of the portfolio in fixed rate investments. Could you comment on what's supporting that trend, please?
Ed Ross (CEO)
Sure. I think there's a few things there. One is our, you know, our leverage, right? Our leverage is 4 times on an average basis. It's much more than what you see in some of the bigger companies. I think that's part of it. Interest rates didn't really start to rise until last year, late last year, second half. I think that's part of the equation. Also some of the newer portfolio companies also kind of improved that ratio, if you will. I think there's a few factors there. I do think-
Mickey Schleien (Managing Director, Equity Research)
Okay.
Ed Ross (CEO)
The fact that it's only four times leverage is a big piece of the puzzle.
Mickey Schleien (Managing Director, Equity Research)
I understand. Thank-thanks for that, Ed. A couple more questions. How exposed are your five aerospace, portfolio companies to any sort of potential cuts in military spending?
Ed Ross (CEO)
They are exposed for sure, at the moment, based on, you know, the platforms that they're on, and quite frankly, the outlooks are quite strong. We feel very good about our aerospace portfolio long term. There's, you know, the fits and starts, supply chain issues and whatnot, both at, you know, our company as well as at the customer level that are still being worked through, quite frankly. When I think about our aerospace portfolio long term, it feels very good and very healthy.
Mickey Schleien (Managing Director, Equity Research)
All right. That's good to hear. Lastly, one sort of technical question. I think in the press release, you mentioned you received a distribution on your Rhino equity, and I'm just curious whether you're gonna recognize a dividend from that investment or a realized gain below the line.
Ed Ross (CEO)
Sure. Great question.
Shelby Sherard (CFO, Chief Compliance Officer, and Corporate Secretary)
Mickey, that'll be a realized gain. Effectively, the underlying operations were sold, and so it's effectively a liquidation, so it'll be a realized gain on our GAAP financial statements.
Mickey Schleien (Managing Director, Equity Research)
Okay, that's helpful. That's it for me. Thanks for your time.
Ed Ross (CEO)
Thank you, Mickey. Good talking to you.
Operator (participant)
Your next question comes the line of Robert Dodd of Raymond James. Your line is open.
Robert Dodd (Managing Director, Senior Equity Analyst)
Hi, congratulations on the quarter. On the non-accrual commentary diet that is back online. You said obviously isolated company-specific issues. Can you give us any more color on that? Maybe not. Also can you give us any color on what the sponsor response has been so far? Obviously, you know, is the sponsor being supportive, less of a word, or is the sponsor being twitchy? For lack of a better term. I realize some of that's confidential, but.
Ed Ross (CEO)
Sure. Sure.
Robert Dodd (Managing Director, Senior Equity Analyst)
Anything would be appreciated.
Ed Ross (CEO)
Sure. No, absolutely. Of the three operating companies that are on non-accrual, two of them, if you include us and another partner, we have been supportive of one of them. That one's Edmentum, and that's a, you know, that's a tougher situation right now, is what I would tell you. The other two are owned by financial sponsors. In one case, two financial sponsors, another case one. In both cases, the sponsors have been both very active with the portfolio companies as well as supportive from a capital perspective. In both cases, we believe in the long term of those businesses as do the sponsors and, you know.
They're going through, you know, some tougher situations right now, and we're working hard to maximize those outcomes and, you know, play them the best way we can for, you know, for all stakeholders, but in particular us.
Robert Dodd (Managing Director, Senior Equity Analyst)
Got it. Got it. On the new one, SuiteConnector, it's a relatively newer asset, right? I mean, I think you originated it at the end of 2021. You mentioned isolated company-specific issues. I mean, was this something that developed rapidly or, you know, just did the building burn down or is that, or, you know, any color on that? It did seem to occur relatively quickly after the original underwriting.
Ed Ross (CEO)
Sure. SuiteConnector is a digital lead generation platform. It's focused on the mortgage sector, home services sector, and Insurance verticals. You know, what I can tell you is, right, the mortgage sector has not been hot to say the least, and nor has the insurance vertical for different reasons. You know, it did, you know, kind of deteriorate from a performance perspective pretty quickly during last year. And so, you know. The good news is that we believe we have a very good operating company, a very good management team, but tough market conditions. It's a strong franchise, but the, you know, the risk profile of our debt and equity investments are reflected in the valuation of those investments.
Robert Dodd (Managing Director, Senior Equity Analyst)
Got it. Got it. Thank you for that. In terms of just, you know, more broadly, I mean, you give excellent market commentary as always. I mean, if things are relatively slow, I mean, you still deployed $50 million in the first quarter, which is a seasonally slow quarter. Do we need to recalibrate what slow means in the context of your business, which has grown, your portfolio is larger, et cetera? Does a slow quarter for you now mean $50 million? Whereas a slow quarter might have, you know, 5 years ago, it might have been 20 or...
Is the scale of the business just so enhanced and so much enhanced now that, I mean, the commentary just means something different than it used to a few years ago?
Ed Ross (CEO)
I do think the scale of the business is different than it was five years ago in a material way. you know, slow for us, so if you think about the fall of last year and, you know, October, November, December, M&A leased new deal volume slowed down quite a bit. It was pretty anemic at the end of the day. That started the first quarter started out that way, but it has changed since then. I will tell you at the moment, deal flow has actually picked up quite a bit. Quality is a little hit or miss, but deal flow has picked up quite a bit. To the positive, M&A processes have also commenced, they're starting or engagements are starting to take place.
There's a fair number of companies out there that are performing just fine. I think, recognizing where we are in the cycle, a lot of folks are making decisions that, look, this is where we are. Company's performing great. Let's go make the most of it. We expect, though it was slower in the first quarter for sure overall, we do expect as the year progresses for transaction volumes to increase. Not gonna go crazy. It's not gonna be like the, you know, middle of last year or 2021 at all. We do expect an increase over time. I do think that.
Robert Dodd (Managing Director, Senior Equity Analyst)
Got it. Thanks, Tom.
Ed Ross (CEO)
Overall just scale and for us, yeah, that was a slower quarter from our perspective.
Robert Dodd (Managing Director, Senior Equity Analyst)
Got it. I appreciate it. Thank you.
Ed Ross (CEO)
Absolutely. Good talking to you, Robert.
Operator (participant)
Your next question comes from the line of Bryce Rowe of B. Riley. Your line is open.
Bryce Rowe (Senior Research Analyst)
thanks. Good morning. wanted to maybe just start or talk about the dividend construct, Ed. I mean, you obviously have a pretty powerful dividend at this point with all three elements kind of thrown in there, the regular, the supplemental, and the special. you know, quite a good kind of dividend profile or dividend coverage profile that you have. You know, even in some down rate type scenarios, you look like you'll comfortably still cover that dividend. Could you talk a little bit about, you know, the discussions at the board level in terms of, you know, maybe adjusting that regular or the base higher?
Would you consider doing that or are you know, kind of comfortable with the, with the current construct the way it is?
Ed Ross (CEO)
Sure. It's a great question, Bryce. You know, what I would say is we are continuing to spend a lot of time on it and to evaluate the base dividend. I think, you know, we're pleased that we've increased it quite a bit here, you know, over the last 18 months or so. What we're also pleased about, and which gives us less need to You know, to make decisions right now is that the way our dividend construct has the shareholders fully participating in all earnings of the company. We're paying out 100% of the excess. That gives us a fair bit of comfort and flexibility. Your question's a very good one.
Yes, we feel very good about the outlook and the performance of the business, and it's something that's on our mind. We thought, you know, this quarter, a lot going on, and the shareholders are fully participating in the dividend and we can, you know, wait a quarter or two to kind of see more results and whatnot. That's the thinking. You know, I think the positive from our perspective is we're paying out 100% of adjusted NII and, you know, we feel very good about that. There's no rush to do incremental base dividends, if you will.
Bryce Rowe (Senior Research Analyst)
Yep. Okay. Okay. Then maybe a question around kind of the market environment and pricing and maybe, you know, how you're interacting with some banks. I know you've probably partnered with some banks in the past on some deals. If you could speak to, you know, how that's evolving in this current market, then maybe just any kind of general commentary around pricing spreads, et cetera.
Ed Ross (CEO)
Sure. You know, from a, you know, from a market perspective, it was slower as I just talked about. We are seeing, you know, actually a lot of deal flow right now. Again, quality is a bit hit or miss. We expect that, quite frankly, to continue, and we expect activity to increase, you know, here in the, you know, the rest of the year, if you will, and in particular in the second part of the year. From the pricing standpoint, I would say, you know, spreads are still wider. You know, I'd say even 100 basis points wider than they were, you know, as I say, pre-COVID, if you will. You know, leverage levels are lower. Terms are good.
We've always in the lower middle market had, you know, obviously very good maintenance covenants. That continues. We view it as a very attractive time to invest. And, you know, that's assuming that you can, you know, find the opportunities that you wanna pursue. We're working really hard at that. We've always are working hard at that, but we are. We're being very selective, as you might imagine. We feel good about, you know. Then I guess you asked a question about the banks. You know, banks have clearly, regional banks have pulled back. It doesn't mean they're out of business because they're not out of business, but they have pulled back from in a how aggressive they are and how active they are.
That creates an opportunity for us, quite frankly, in this environment. At the same time, they're still in business and we are working with them on new transactions from time to time and also, quite frankly, taking advantage of situations where, you know, banks are not participating for whatever reason. Again, I think it's a good competitive dynamic for us. Obviously, I think it's a good pricing and terms dynamic as well.
Bryce Rowe (Senior Research Analyst)
Got it. Okay. Appreciate the commentary.
Ed Ross (CEO)
Absolutely. Good talking to you, Bryce.
Operator (participant)
Your next question comes line of Erik Zwick of Hovde Group. Your line is open.
Erik Zwick (Director, Equity Research)
Thank you. Good morning. Wanted to start with a question on the pipeline, maybe kind of a multi-part question in terms of, you know, as you look at the pipeline today, what does the mix look like in terms of industry concentration? Also maybe kind of the second part is asking about kind of your preference today. You know, Ed, I know you mentioned earlier that you're seeing a lot more deal flow now, but the quality's been hit or miss. Curious if that's kind of bar specific or if maybe there's certain industries that you are shying away from now, maybe seeing some stress or cracks from that perspective. Any color there would be great.
Ed Ross (CEO)
Sure. Sure. Great question. There's a lot there, so help me through it if I don't remember it all. From a, you know, what we're seeing right now, you know, healthcare services businesses we're working on very hard. We just closed on a collision repair business. There's a fair number of business service opportunities that we're looking at. Some, quite frankly, in the, in the software space. A variety of companies. You know, generally we're staying away from, as you might imagine, more capital-intensive businesses. We're looking for companies with predictable revenues and sustainable revenues, quite frankly. There's a variety of places to find those. You know, where are we staying away from? You know, what are we staying away from?
Obviously, you think about retail or retail to, you know, maybe a lower income consumer-focused retailer. Those are definitely an area where we're staying away from. Capital-intensive businesses, energy services. We have one portfolio company that's performing very well in that sector, but overall, we're not looking to, you know, add. I think, you know, generally, you know, consumer businesses, there's obviously different ways to play that, but our portfolio is not focused on the consumer much and we, you know, from a new edition perspective, aren't as well. Did that fully answer your question, Erik?
Erik Zwick (Director, Equity Research)
Yeah. That, that's great. You hit it all. Thank you so much. And just the second one I had today was, you know, looking at your leverage profile. I'd say you have a more conservative kind of stance than some others in the industry. And just curious, you know, how you think about that today. You mentioned that kind of the rest of the year, you would expect more opportunity for originations going forward. And if you do see, you know, good risk-adjusted opportunities, are you okay taking leverage higher or would you know, really look to maybe just kind of hold the portfolio level consistent and then use prepayments and then pay downs to fund, you know, new opportunities?
Ed Ross (CEO)
Sure. Great question. You know, obviously, we're under the one-to-one mark. You know, our long-term target right now is call it one to one. We are very comfortable going above one to one for, you know, an interim period of time or an extended period of time. We're really more focused on trying to find great opportunities to invest. We're obviously not gonna get crazy from a leverage perspective. That's not in our nature or our DNA. We are very comfortable going over the one-to-one, you know, leverage mark if it makes sense. It'd be more from an interim perspective, if you will, at this point.
I also would note, you know, obviously our portfolio relative to, you know, six, seven, eight years ago is much more, first lien weighted, and so it's easier and more comfortable to leverage up a little bit more, which is okay as well. We're positioned well to take on more leverage if it makes sense. I would stick with the target of 1:1 from our perspective.
Erik Zwick (Director, Equity Research)
Great. Thanks for taking my questions.
Ed Ross (CEO)
Absolutely. Good talking, Erik.
Operator (participant)
Once again, if you would like to ask a question, please press star followed by one on your telephone and wait for your name to be announced. There are no further questions at this time. I'd like to hand back to Ed.
Ed Ross (CEO)
Thank you, Gavin. Thank you everyone for joining us this morning. Look forward to speaking with you on our second quarter call in early August. Have a great day and a great weekend.
Operator (participant)
That does conclude our conference for today. Thank Thank you for participating. You may now all disconnect.