Q1 2023 Fidus Investment Corp Earnings Call

Participants

Edward H. Ross; Chairman & CEO; Fidus Investment Corporation

Shelby E. Sherard; CFO, Chief Compliance Officer & 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

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

Presentation

Operator

Good day, and welcome to the Fidus Investment Corporation First Quarter 2023 Earnings Conference Call. (Operator Instructions) And 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 E. Sherard

Thank you, Gavin, and good morning, everyone. Thank you for joining us for Fidus Investment Corporation's 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 5, 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.
With that, I would now like to turn the call over to Ed. Good morning, Ed.

Edward H. Ross

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 at 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.
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 an 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 3/4 of total originations was invested in 3 new portfolio companies. In each case, the investments were made in connection with an M&A transaction, we also continue 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 2 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 one additional company on nonaccrual during the quarter. As of March 31, nonaccruals 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 nonaccrual list. Importantly, our nonaccruals 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.
Now I'll turn the call over to Shelby to provide some details on our financials and operating results. Shelby?

Shelby E. 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 2022.
Total investment income was $29.1 million for the 3 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, a $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 31 was 0.9x or 0.6x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.2% as of March 31, 2023.
Net investment income, or NII, for the 3 months ended March 31 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 and losses on investments, was $0.60 per share in Q1 versus $0.51 per share in Q4.
Turning now to portfolio statistics. As of March 31, 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 during 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 31 versus 13.8% at December 31. 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. As of March 31, 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.
Now I'll turn the call back to Ed for concluding comments. Ed?

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 Gavin for Q&A. Gavin?

Question and Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Mickey Schleien of Ladenburg.

Mickey Max Schleien

Can you hear me all right?

Edward H. Ross

Yes, I can. Yes.

Mickey Max Schleien

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 it may have better ratios and you have almost 1/3 of the portfolio in fixed rate investments. But could you comment on what's supporting that trend, please?

Edward H. Ross

Sure. I think there's a few things there. One is our leverage, right? So our leverage is 4x on an average basis. So 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 and then also some of the newer portfolio companies also kind of improved that ratio, if you will. So I think there's a few factors there. But I do think due to the fact that it's 4x leverage is a big piece of the puzzle. And I...

Mickey Max Schleien

I understand -- a couple of more questions. How exposed are your 5 aerospace portfolio companies to any sort of potential cuts in military spending.

Edward H. Ross

They are exposed for sure. But at the moment, based on the platforms that they're on, and quite frankly, the outlooks are quite strong. So we feel very good about our aerospace portfolio long term. There's the fits and starts, supply chain issues and whatnot, both at their -- at our company as well as at the customer level that -- they are still being worked through, quite frankly. But when I think about our aerospace portfolio long term, it feels very good and very healthy.

Mickey Max Schleien

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 going to recognize a dividend from that investment or a realized gain below the line.

Edward H. Ross

Sure, great question.

Shelby E. Sherard

That will be a realized gain. Effectively, the underlying operations were sold. And so it's effectively a liquidation. So it will be a realized gain on our GAAP financial statements.

Operator

Your next question comes from the line of Robert Dodd of Raymond James.

Robert James Dodd

And congratulations on the quarter. On the nonaccrual commentary -- you said, obviously, isolated company-specific issues. Can you give us any more color on that, maybe not? But also, can you give us any color on what the sponsor response has been so far? Obviously, is the sponsor being supportive? Or is the sponsor being twitchy, form the lack of a better term, and I realize some of that is confidential, but anything will be appreciated.

Edward H. Ross

Sure. No, absolutely. So of the 3 operating companies that are nonaccrual, 2 of them as -- if you include us and another partner, we have been supportive to one of them. And that one is EbLens and that's a tougher situation right now is what I would tell you. The other 2 are owned by financial sponsors in 1 case, 2 financial sponsors, another case 1. And in both cases, these sponsors have been both very active with the portfolio companies as well as supportive from a capital perspective.
So -- and in both cases, we believe in the long term of those businesses as do the sponsors and -- but it's -- they're going through some tougher situations right now, and we're working hard to maximize those outcomes and play them the best way we can for all stakeholders, but in particular, us.

Robert James Dodd

Got it. Got it. And then on the new one, Su Co, it's a relatively newer asset, right? I mean I think you originated it at the end of 2021. So you mentioned isolated company-specific issues. I mean was this something that developed rapidly or just the building burned down? Or is that -- any color on that because it did seem to occur relatively quickly after the original underwriting?

Edward H. Ross

Sure, sure. The Suited Connector's a digital lead generation platform, it's focused on the mortgage sector, home services sector and insurance verticals. And 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. And so it did kind of deteriorate from a performance perspective pretty quickly during last year.
And so -- but the good news is that we believe we have a very good operating company, a very good management team, but tough market conditions. And so it's a strong franchise, but the risk profile of our debt and equity investments are reflected in the valuation of those investments.

Robert James Dodd

Got it. Got it. In terms of just more broadly, I mean, you give excellent market commentary as always. I mean, things are relatively slow, I mean you still deployed $50 million in the first quarter, which is a seasonally slow quarter. So do we need to kind of -- do I need to recalibrate what slow means in the context of your business, which has grown, your portfolio's larger, et cetera? Does a slow quarter for you now mean $50 million, whereas a slow quarter might -- 5 years ago, it might have been $20 million. Or is the scale of the business just so enhanced -- so much enhanced now that the commentary just means something different than it used to a few years ago?

Edward H. Ross

I do think the scale of the business is different than it was 5 years ago in a material way. Slow for us if you think about the fall of last year. In October, November, December, M&A, at least new deal volumes slowed down quite a bit. It was pretty anemic at the end of the day. And that started -- the quarter -- first quarter started out that way. But it has changed since then.
And 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. And to the positive M&A processes have also commenced. And so they're starting, the engagements are starting to take place. So there's a fair number of companies out there that are performing just fine. And I think recognizing where we are in the cycle, a lot of folks are making decisions that, look, this is where we are. Company is performing great, let's go make the most of it.
And so 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. And not going to go crazy. It's not going to be like middle of last year or 2021 at all, but we do expect an increase over time. And I do think that in overall just scale and for us, yes, that was a slower quarter from our perspective.

Operator

Your next question comes from the line of Bryce Rowe of B. Riley.

Bryce Wells Rowe

I 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 3 elements kind of thrown in there. The regular, the supplemental and the special. Quite a good kind of dividend profile or dividend coverage profile that you have. And even in some down rate-type scenarios, you look like you'll comfortably still cover that dividend. So could you talk a little bit about the discussions at the Board level in terms of maybe adjusting that regular or the base higher, would you consider doing that? Or are you kind of comfortable with the current construct the way it is?

Edward H. Ross

Sure. It's a great question, Bryce. And what I would say is we are continuing to spend a lot of time on it and to evaluate the base dividend. I think -- we're pleased that we've increased it quite a bit here over the last 18 months or so. And what we're also pleased about and which gives us less need to make decisions right now is that the way we -- our dividend construct has the shareholders fully participating in all earnings of the company. So we're paying out 100% of the excess. And so that gives us a fair bit of comfort and flexibility.
But your question is a very good one. And yes, we feel very good about the outlook and the performance of the business and it's something that's on our mind. But we thought this quarter, a lot going on and just -- and the shareholders are fully participating in the dividend and we can wait a quarter or 2 to kind of see more results and whatnot. So that's the thinking. I think the positive from our perspective is we're paying out 100% of adjusted NII. And we feel very good about that. So there's no rush to do incremental base dividends, if you will.

Bryce Wells Rowe

Yes. Okay. Okay. And then maybe a question around kind of the market environment and pricing and maybe how you're interacting with some banks. I know you've probably partnered with some banks in the past on some deals. So if you could speak to how that's evolving in this current market? And then maybe just any kind of general commentary around pricing spreads, et cetera.

Edward H. Ross

Sure. So from a market perspective, it was slower, as I just talked about, and we are seeing actually a lot of deal flow right now. Again, quality is a bit hit or miss. And so we expect that, quite frankly, to continue and we expect activity to increase here in the rest of the year, if you will and in particular, in the second part of the year.
From a pricing standpoint, I would say spreads are still wider, I'd say even 100 basis points wider than they were, as I say, pre-COVID, if you will. Leverage levels are lower. Terms are good. We've always in the lower middle market, had obviously very good maintenance covenants that continues. So we view it as a very attractive time to invest. And that's assuming that you can find the opportunities that you want to pursue. So we're working really hard at that. We're always are working hard at that, but we are -- and we're being very selective, as you might imagine.
But, we feel good about -- and then I guess you asked a question about the banks. 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 how aggressive they are and how active they are. And that creates an opportunity for us, quite frankly, in this environment, but 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 banks are not participating for whatever reason. So again, I think it's a good competitive dynamic for us. And obviously, I think it's a good pricing in terms dynamic as well.

Operator

Your next question comes from the line of Erik Zwick of Hovde Group.

Erik Edward Zwick

Wanted to start with a question on the pipeline, maybe kind of a multipart question in terms of -- as you look at the pipeline today, what does the mix look like in terms of industry concentration? And also maybe kind of the second part is asking about kind of your preference today. And Ed, I know you mentioned earlier that you're seeing a lot more deal flow now, but the quality has been hit or miss. So curious if that's kind of FAR specific or maybe there are certain industries that you are shying away from now, maybe seeing some stress or cracks from that perspective. So any color there would be great.

Edward H. Ross

Sure, sure. Great questions, a lot there. So help me through it if I don't remember it all. But from a -- what we're seeing right now, health care services, businesses, we're working on very hard. We just closed on a collision repair business. And then there's a fair number of business service opportunities that we're looking at, some quite frankly, in the software space. So a variety of companies. 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, and there's a variety of places to find those.
And where are we staying away from? And what are we staying away from? Obviously, you think about retail or retail to maybe a lower income consumer-focused retailer, those are definitely an area where we're staying away from, capital-intensive businesses, energy, energy services. We have one portfolio company that's performing very well in that sector. But overall, we're not looking to add to any exposure there. So I think -- and then generally, consumer businesses, there's obviously different ways to play that, but we're -- our portfolio is not focused on the consumer much and we -- from a new addition perspective part on as well. Does that fully answer your question, Erik?

Erik Edward Zwick

Yes, that's great. You hit it all. And just the second one I had today, I was 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 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 good risk-adjusted opportunities, are you okay taking leverage higher? Or would you really look to maybe just kind of hold the portfolio level consistent and use prepayments and then pay downs to fund new opportunities?

Edward H. Ross

Sure. Great question. We're -- obviously, we're under the 1:1 mark. Our long-term target right now is, call it, 1:1. But we are very comfortable going above 1:1 for an interim period of time or an extended period of time. So we're really more focused on trying to find great opportunities to invest. We're obviously not going to get crazy from a leverage perspective. That's not in our nature or our DNA. But we are very comfortable going over the 1:1 leverage mark if it makes sense, but it would be more from an interim perspective, if you will, at this point.
I also would note, obviously, our portfolio relative to 6, 7, 8 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. So we're positioned well to take on more leverage if it makes sense, but I would stick with the target of 1:1 from our perspective.

Operator

(Operator Instructions) And there are no further questions at this time. So I'd like to hand back to Ed.

Edward H. Ross

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

Operator

That does conclude our conference for today. Thank you for participating. You may now all disconnect.