Q4 2023 Fidus Investment Corp Earnings Call

Participants

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

Jody Burfening; IR Contact; Fidus Investment Corporation

Shelby Elizabeth 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 morning, and welcome to the Fidus Fourth Quarter 2023 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.
I would now like to turn the conference over to Jody Burfening. Please go ahead.

Jody Burfening

Thank you, Drew, and good morning, everyone, and thank you for joining us for Fidus Investment Corporation's fourth 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. 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, March 1, 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 fourth quarter 2023 earnings conference call. On today's call, I'll start with a review of our fourth quarter performance and our portfolio at quarter end, and then share with you our outlook for 2024. Shelby will cover the fourth quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions.
Our strong fourth quarter performance reflects the benefits to Fidus of our strategy of both serving the lower middle market, which has remained reasonably active in a less robust environment, and selectively investing in companies that possess resilient and strong cash flow generating business models and positive long-term outlook.
Our patience during the year has paid off with the typical year-end push and deal activity, originations totaled $132.7 million, and proceeds from repayments and realizations totaled $112.5 million for a net origination of $20.2 million, and we grew the total portfolio to $957.9 million on a fair value basis.
Adjusted net investment income increased 49% to $18.8 million in Q4 compared to $12.6 million last year. As was the case for each quarter in 2023, interest income growth drove this year-over-year increase, reflecting both higher average debt balances and higher weighted average yields. Taking into account the higher average share count resulting from the equity raises we completed during the year, adjusted net investment income on a per share basis increased 27.5% to $0.65 from $0.51.
We paid dividends totaling $0.80 per share, including a base dividend of $0.43 per share. For the year, we distributed a total of $2.88 per share to shareholders consisting of regular dividends of $1.66 per share, supplemental dividends of $0.82 per share and special dividends of $0.40 per share. Adjusted NII of $2.56 per share comfortably covered base dividends.
As a reminder, we distributed a special cash dividend of $0.10 per share each quarter of 2023 to satisfy RIC requirements and to bring our spillover income in line with our target level, which is roughly the equivalent of the base dividend for 3 quarters.
For the first quarter of 2024, the Board of Directors declared dividends totaling $0.65 per share, consisting of a base dividend of $0.43 per share and a supplemental dividend of $0.22 per share, equal to 100% of the surplus and adjusted NII over the base dividend from the prior quarter, which will be payable on March 27, 2024, to stockholders of record as of March 20, 2024.
Net asset value at quarter end was $589.5 million, or $19.37 per share, a meaningful increase as compared to $548.6 million or $19.28 per share as of September 30, 2023.
During the quarter, we grew our portfolio investing, as always, in high-quality companies that generate excess levels of cash flow to service debt and structuring our investments with a high level of equity cushion to give us an added margin of safety. Originations totaled $132.7 million, consisting of $123.5 million in debt and $9.2 million in equity.
First lien investments accounted for $110.5 million or approximately 90% of the additions to the debt portfolio. We invested $94.6 million or about 3/4 of total originations in 6 new portfolio companies, which were added to the portfolio through financing of M&A transactions. The remaining $38.1 million was invested in add-ons in support of existing portfolio companies, almost all of which was M&A driven.
Proceeds from repayments and realizations totaled $112.5 million for the fourth quarter, reflecting exits and some strategic pruning of the portfolio on our part. We received $87.2 million in debt repayments, primarily due to M&A activity, and received proceeds of $25.3 million from the sale of equity investments, resulting in net realized gains of $19.8 million.
Our portfolio of debt investments on a fair value basis was $832.8 million or 87% of the total portfolio at quarter end. First lien investments continue to account for the largest portion of the debt portfolio, now at 69%. Including the fair value of our equity portfolio of $125.1 million, the fair value of the total portfolio at quarter end stood at $957.9 million, equal to 102.3% of cost. We ended the fourth quarter with 81 active portfolio companies.
Subsequent to quarter end, we invested $17 million in first lien debt and equity in 2 new portfolio companies, and we had a debt repayment and equity realization in 1 company generating net proceeds of approximately $24.3 million and a realized gain of $1.5 million.
Overall, our portfolio from a credit quality perspective remains solid. As of December 31, we had 2 operating companies on nonaccrual, unchanged from the third quarter. Nonaccruals represented approximately 1% of the total portfolio on a fair value basis. The vast majority of our portfolio companies continue to capture growth opportunities and sustained profitability, supported by resilient business models.
We do, of course, have a few companies that are experiencing difficulties for a variety of reasons that there is no one market condition that is weighing on their operations. Looking ahead, we are well positioned to build on our successes in 2023.
During 2023, we expanded our portfolio of debt and equity investments on a fair value basis by nearly $100 million to $957.9 million, despite subdued levels of M&A activity in the lower middle market. This performance speaks to our experience, our relationships with financial sponsors and industry knowledge that, together, enable us to remain highly selective, investing in high-quality companies that meet our investment criteria.
By building our portfolio of income-producing assets and with an assist from widened spreads, we enhanced the earnings power of our healthy and high-performing portfolio, generating a 46.4% increase year-over-year and adjusted NII to $67.5 million. Our strategy of co-investing in equity investments continue to work well for us, producing approximately $22.4 million in net realizable gains for the year.
Finally, we continue to deliver value for -- to our shareholders, distributing 100% of our earnings and demonstrating our ability to generate gains in excess of losses, while maintaining an overall healthy portfolio, thanks to our rigorous underwriting standards.
While we are positioned to build on our successes of 2023, we remain committed to managing the business for the long term, to our underwriting disciplines in selecting investments and to our long-term goals of growing net asset value over time, preserving capital and generating attractive risk-adjusted returns for our shareholders.
Now I'll turn the call over to Shelby to provide some details on our financial and operating results. Shelby?

Shelby Elizabeth Sherard

Thank you, Ed, and good morning, everyone. I'll review our fourth 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 Q3 2023.
Total investment income was $36.3 million for the 3 months ended December 31, a $2.1 million increase from Q3, primarily due to a $0.4 million increase in interest income, including PIK; a $1.3 million increase in fee income due to higher levels of investment activity; and a $0.5 million increase in interest income on excess cash.
The increase in interest income was driven by an increase in average debt investment balances outstanding, partially offset by a decrease in yield on new debt investments and the repayment of 2 higher yielding debt investments.
Total expenses, including income tax provision, were $19.4 million for the fourth quarter, $1.8 million higher than Q3, driven primarily by a $1 million increase in income taxes related to the annual excise tax accrual, a $0.3 million increase in professional fees and a $0.4 million increase in the capital gains fee accrual.
We ended the quarter with $475.9 million of debt outstanding comprised of $210 million of SBA debentures, $250 million of unsecured notes and $15.9 million of secured borrowings. Our debt-to-equity ratio as of December 31 was 0.8x, or 0.5x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.3% as of December 31, 2023.
Net investment income, or NII, for the 3 months ended December 31 was $0.58 per share versus $0.63 per share in Q3. Adjusted NII, which excludes any capital gains, incentive fee accruals or reversals attributable to realized and unrealized gains and losses on investments, was $0.65 per share in Q4, which includes a $0.03 per share excise tax accrual versus $0.68 in Q3.
For the 3 months ended December 31, we recognized approximately $19.8 million of net realized gains related to the sale of our equity investments in Power Grid Components, Aeronix, Road Safety Services and Comply365, offset by realized losses on the exit of our debt investment in K2 and equity investment in Techniks Industries. As Ed mentioned, in 2023, we paid total cash dividends of $2.88 per share versus $2 in cash dividends in 2022.
Turning now to portfolio statistics. As of December 31, our total investment portfolio had a fair value of $957.9 million. Our average portfolio company investment on a cost basis was $11.6 million, which excludes investments in one portfolio company that sold its operations and is in the process of winding down.
We have equity investments in approximately 79.3% of our portfolio companies, with an average fully diluted equity ownership of 3%. Weighted average yield on debt investments was 14.2% as of December versus 14.6% at September 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 Q4, we issued approximately 2 million shares under our ATM program at an average share price of $19.79, raising net proceeds of approximately $38.7 million. As of December 31, our liquidity and capital resources included cash of $119.1 million and $100 million of availability on our line of credit, resulting in total liquidity of approximately $219.1 million.
Subsequent to year-end, we repaid the remaining $35 million of outstanding SBA debentures in our second SBIC Fund. We have submitted a new license application to the SBA for a fourth SBIC license, which, subject to SBA approval, will provide us with access to $175 million of additional SBA debentures.
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 Drew for Q&A. Drew?

Question and Answer Session

Operator

(Operator Instructions) The first question comes from Robert Dodd with Raymond James.

Robert James Dodd

And congratulations on another really good quarter. A couple of questions. On the -- Ed, you mentioned strategic pruning of the portfolio during your opening remarks. Could you give us any more color on that?
I mean, a decent chunk of that sounds like it was equity. Was it people requesting different recaps you weren't comfortable with that drove you to prune it? Or can you give us any color on the reasons that you decided to do that?

Edward H. Ross

Sure. There was one equity investment that was -- you could argue was strategic pruning in nature, Robert, and that was -- I mean, it was an equity investment that we did very well on. I think we made 8x our money or something like that. So we had an opportunity to stay in, and we chose to go ahead and exit and saw risk greater than the opportunity, quite frankly.
But really, what that was kind of meaning to talk about was a couple of debt investments. They weren't huge, but they were ones that -- risk levels were higher than we were comfortable with. And so we made kind of the strategic decision to work -- to exit those investments. And in both cases, we were able to accomplish it in Q4. So it was more debt oriented than equity, but there was one equity investment we did make that decision.

Robert James Dodd

Got it, got it. On the credit situation, there seems -- I mean, obviously, there's clearly no broad-based problem, so you wouldn't be lighting it up anyway. And you said the vast major of portfolio companies is performing fine. No single reason for that maybe a handful that aren't.
Are those idiosyncratic issues of the company? Or is it the labor market or anything? Could you give us more color on how comfortable you are that those problems are being managed and aren't showing [massive] signs of deterioration maybe or something like that?

Edward H. Ross

Sure. And what I was really kind of generally referencing are the non-accruals, which have been there for a few quarters. And those are companies that are both supported by private equity groups. They are going through idiosyncratic-type situations and in both cases, improving, but we've got a ways to go. So that's really what we're referencing, primarily.
In terms of other companies that are underperforming, again, kind of one-off type reasons for it, and we feel very good about our portfolio. There's always a chance for another nonaccrual, but that's not our expectation. And we clearly hope that we can keep managing the rest of the businesses in the way that we have in the past.

Operator

The next question comes from Bryce Rowe with B. Riley.

Bryce Wells Rowe

Maybe I'll start on the capital structure. And Shelby, appreciate the commentary around SBA license #2 and kind of trying to re-up with a fourth license.
How do you think about kind of timing of that fourth license and maybe access to that additional capital kind of relative to where the balance sheet -- how the balance sheet looks today? You're sitting on a lot of cash, and so just trying to think about how you work through that cash with the pipeline that you see in front of you.

Edward H. Ross

Sure. Great question, Bryce. As we think about the SBIC Fund that we applied for, as you know, that takes some time. And I think about it in terms of kind of a 6-month window or so. So that's what our expectation is. Our hope is that in 2024, we'll be able to start utilizing that license. But obviously, we're still in the application mode.
With regard to the cash, obviously, we did prepay debentures in Fund II. But the other piece of the puzzle is we -- this quarter is actually shaping up from our perspective, assume things go as we expect, to be a very active investment quarter, but it is going to primarily be in March.
And so we are currently in the execution phase, diligence and final execution phase of numerous investment opportunities. And I would also say our portfolio continues to exhibit acquisition-type activity as well. So it's shaping up to be a pretty active new investment quarter.
And then from a repayment perspective, we actually think it's probably going to shape up to be a lighter quarter. We've obviously had one sizable realization, meaning almost $25 million. But the -- it doesn't appear that the calendar is very robust the rest of the quarter.
We do have a few companies that are evaluating strategic alternatives. At the moment, we view those investments as probably more Q2 realizations. And they also aren't the ones that we're aware of. They aren't very large investments at the same time. So we think a fair bit of the cash that we have on the balance sheet today will actually go to new investments here as we move forward here over the next 4 to 8 weeks.

Bryce Wells Rowe

Okay. That's helpful. And Ed, beyond, I guess, we've heard M&A activity picking up from many of your peers in the lower middle market. Does that M&A trend that you're seeing and experiencing, does that continue beyond this March period? Are we going to continue to see it in the second, third quarter just based on kind of what you're hearing at this point?

Edward H. Ross

It's a really good question, Bryce. I think it's a little unclear. I mean, look, in the lower middle market, one of the reasons we like it, there's more activity than the broader market in terms of number of deals. It's fragmented, which we like, gives us a chance to kind of choose what we really are interested in.
But activity levels are still well below 2021, and I'd say below normal activity levels. But there has been a little bit of an uptick here in Q4. In Q1 as well. In January, we obviously had some pretty robust deal flow in some high-quality situations.
I think it's unclear on how long -- how sustainable that is. But the expectations is more of a market expectation is for continued M&A activity at reasonable levels and above last year. And so that's our hope. And so that's what we're planning for, but there's no guarantee of that, obviously.

Bryce Wells Rowe

Got it. All right. Last one for me, Ed. It looks like the new activity in the fourth quarter from a, I guess, pricing perspective, it looked like most of those debt investments were straight up first lien. No last out structure to them.
I might be wrong there, but that's the way I read the schedule of investments. Anything to kind of read into that? Or is that more just kind of flow of what happened in the quarter relative to kind of what we've seen over the last couple of years in terms of structuring those debt investments?

Edward H. Ross

Sure. No, nothing strategic. It's more we start with, I think, as you know, just what's the quality of the underlying business and then try to figure out what the opportunity is. And in this case, it was more just a mix towards dollar one type investments.
The only thing I would say, we are very focused on quality, right? And so we're willing to sacrifice a little yield if we find the right quality investment, if you will. And so I'd say there's a little bit of both of those that go into the decision making. But it starts with trying to find very high-quality businesses to invest in, and then we figure out how we can do it. And so hopefully, that's helpful.

Operator

The next question comes from Mickey Schleien with Ladenburg.

Mickey Max Schleien

Ed, it sounds like some of the repayment activity in the fourth quarter was due to refinancings, which certainly is in line with what we're seeing broadly. So I'd like to get your take on how much more prepayment risk you see in the portfolio.

Edward H. Ross

Sure. It's a great question, Mickey. I think in terms of repayments, we haven't seen a lot of repayments that are just trying to get a lower price. In fact, I look at the 3 companies that were repayments for us, 2 of them were strategic in nature by us and then 1 of them was a very large acquisition, and we just chose to exit that situation from a debt and equity perspective.
So I -- we haven't seen a lot of just getting taken out, if you will, of our debt investments. Having said that, I think we're in an environment where competition has increased over the last 12 months. Yields have come down a little bit. And our -- so I would expect that piece of the puzzle to show its face a little bit here in 2024, more so than the last couple of years. That's how I -- that's how we currently think about it.

Mickey Max Schleien

I understand. I just wanted to follow up on the fourth SBIC license. I'm not clear on exactly what's going on because Fund III already has regulatory capital of $175 million. So what debt commitments has the SBA made to Fund III? And why does that necessitate a Fund IV?

Edward H. Ross

Sure. Shelby, do you want to take that one?

Shelby Elizabeth Sherard

Sure. So let me just start -- let's talk about Fund II. And so I made the comment that we repaid $35 million of SBA debentures, and that was really just to avoid a situation where we would end up with trapped cash. And so given some of the repayments that we had in 2023 and, quite frankly, a subsequent event in 2024, our second SBIC license had a fair amount of excess cash.
And so the best way to utilize that cash was just to repay $35 million. That completes the wind down of Fund II. Any further repayments in that fund, we can fully redeploy cash on a go-forward basis, whether it be making investments out of the BDC or using some equity capital to contribute to a new fourth SBIC license once it's approved by the SBA.
So that really -- with that repayment, that leaves us with one SBIC license Fund III that has been fully deployed, meaning we fully borrowed and invested $175 million cap per SBIC license for Fund III. So that necessitated the need to go ahead and get another SBIC license.
So we submitted that application at the end of December. And as Ed mentioned, we kind of like to think that -- hopefully, that will definitely be in 2024. My hope would be first half. If not, shortly thereafter of 2024, so we can start deploying new capital into that fourth SBIC license because of the attractive rates on SBA debentures given other alternatives in this market environment.

Mickey Max Schleien

No. I agree that the rates are attractive. So Fund III is limited to debt to equity of only 1x rather than 2x.

Shelby Elizabeth Sherard

No. It's 2x. So we have the 2x fully deployed. The $175 million is the 2x.

Mickey Max Schleien

Okay. And how has the increased allocation to first lien and unitranche over time impacted your target debt-to-equity number?

Edward H. Ross

Great question, Mickey. At the moment, we're kind of sticking with our 1:1 target leverage from a GAAP perspective. We are okay if, from time to time, we go above that. But generally, the target would be 1:1.
And so it really hasn't changed our focus. Clearly, we have the ability. And as you know, the SBIC funds are -- as drop-downs are levered more 2:1. We feel very comfortable with higher leverage. But from just a strategy perspective and how we think about it, I think being kind of more conservative and just thinking about 1:1 makes more sense to us at this juncture.

Mickey Max Schleien

And Ed, does that reflect some concern you have about the economy and you still have a meaningful allocation to second lien and subordinated debt? Or is it something else that's on your mind?

Edward H. Ross

No. I think we prefer to operate in a kind of less than market leverage. We don't think we need to use leverage to perform well. And so it's -- we kind of like a little bit less than market leverage just overall. But it does -- it's not a reflection of concerns in the portfolio or recession or what have you. It's more just kind of how we've operated in the past, and we don't see a need to change that at this point.

Operator

(Operator Instructions) The next question comes from Erik Zwick with Hovde Group.

Erik Edward Zwick

Wanted to start first with just a question on the PIK income. It looks like it was down quarter-over-quarter in Q4. So wondering if it's just maybe some positive development with a company or 2 that had been a PIK income before, then returned to cash pay? Or kind of maybe what moved that quarter-over-quarter?

Edward H. Ross

Sure. Great question. I think the primary driver there was exactly what you just said. One of our strategic pruning situations was a company that had moved to PIK during the third quarter. And we obviously worked to try to exit that credit, and we're successful in doing so. So that's the biggest driver. I don't -- I'm not sure there are other big drivers in there. I think that's the main one.

Erik Edward Zwick

Got it. That makes sense. And then just turning to kind of the pipeline and the opportunities you're seeing today. We've heard from other BDCs that operate further upmarket, the upper middle market and middle market, that competition has become a little bit more intense. Curious what you're seeing kind of in your lower middle market focus in terms of spread, leverage covenants relative to maybe 6 or 12 months ago. Have you noticed a market change there?

Edward H. Ross

I do think relative to 12 months ago, I mean, it's a different environment. There was -- 12 months ago, there were a lot of folks that were -- think about banks, quite frankly, there are a number of private lenders that were not far from just being on the sidelines.
That situation has changed. And I think most people, other than certain banks that have retracted, are in the market. And so there is an increased level of competition from 12 months ago.
And I think you are seeing that in spreads. And spreads, if I were to pick a number, it's probably 50 basis points. And it depends on what structure is right for us, whether it's a dollar one first lien investment or if it's a first out, last out structure.
But generally speaking, there is an increase in the level of competition because I think people a year ago were very, very worried about what's next. And now, just given the resiliency of the economy, I think folks are more both from an acquisition, M&A perspective on the equity side as well as the lending side. I think folks are more interested in transacting and kind of see the resilience of the economy are comfortable with that.

Erik Edward Zwick

Got it. And then last one, just thinking about interest rate sensitivity. I know you've got a portion of the debt investments that are fixed. So I think the market is still trying to figure out exactly when the shape of the kind of curve or the future kind of short rate, interest rates go down, but seems to be that, that's more likely than going up. So wondering if you could just kind of remind me the sensitivity to earnings for maybe like each 25 basis point potential cut, how that would impact earnings.

Edward H. Ross

Shelby, do you want to take this one? Or do you want me to do it? Either...

Shelby Elizabeth Sherard

Why don't you take a shot it? And then the other thing, Erik, I would point, we do have -- for more details, we do have a sensitivity chart disclosed in our 10-K where you can kind of see some calibrations based off of various increases or decreases in underlying interest rates.

Edward H. Ross

So Erik, just taking a shot. The 25 basis points would probably create a reduction of, call it, $1 million in a quarter. These are estimates. Reduction in our NII, assuming no movements in the incentive fees. So you double that to 50 basis points, it would be $2.5 million, and 100 basis points would be $5 million. So that's how I -- hopefully, that's helpful. And I do think there's a sensitivity table in the 10-K that hopefully would be helpful as well.

Shelby Elizabeth Sherard

Yes. And the only thing I would add, Erik, is that it's not entirely linear just because we do have some floors on a variety of our debt investments.

Erik Edward Zwick

No. That's great color, too. I'll check out the table. And I would like to ask to just because as we know those sensitivity analysis, you've got to make some assumptions in terms of the shock or more gradual, and then if there's twists and a curve, things of that nature. So I appreciate the commentary.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Edward Ross for any closing comments.

Edward H. Ross

Thank you, Drew, and thank you, everyone, for joining us this morning. We look forward to speaking with you on our first quarter call in early May. 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.