Fidus Investment Corporation (NASDAQ:FDUS) Q4 2022 Earnings Call Transcript

Fidus Investment Corporation (NASDAQ:FDUS) Q4 2022 Earnings Call Transcript March 3, 2023

Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Fidus Q4 2022 Earnings Conference Call. I would now like to turn the call over to Jody Burfening, LHA Investor Relations. Please go ahead.

Jody Burfening: Thank you, Mandeep. And good morning, everyone. And thank you for joining us for Fidus Investment Corporation’s fourth quarter 2022 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 past projections as of today, March 3, 2023, these statements are not guarantees of future performance. Time-sensitive information may no longer be accurate at the time of any telephonic or webcast replay. Actual results may differ materially as a result of risks, uncertainties and other factors, including, but not limited to, the factors set forth in the company’s filings with the Securities and Exchange Commission. Fidus undertakes no obligation to update or revise any of these forward-looking statements. With that, I would now like to turn the call over to Ed. Good morning, Ed.

Ed Ross: Good morning, Jody. And good morning, everyone. Welcome to our fourth quarter 2022 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 discuss our views on market conditions in the lower middle market in 2023. Shelby will cover the fourth quarter financial results and our liquidity position. After we have completed our prepared remarks, we would be happy to take your questions. There is no question that the credit environment was tougher in the fourth quarter than a year ago as deal activity continued to slow down. Nevertheless, from an originations perspective, we had a healthy quarter, once again demonstrating our industry expertise, strong relationships with deal sponsors and ability to provide customized and flexible financing solutions that differentiate us in the lower middle market.

At the same time, we kept our focus on quality over quantity, finding opportunities to selectively invest in high-quality companies that operate in industries we know well, generate cash flow to service debt and possess resilient business models and positive long-term outlooks. Adjusted net investment income, which we define as net investment income, excluding any capital gain incentive fee attributable to realized and unrealized gains and losses was $12.6 million or $0.51 per share compared to $12 million or $0.49 per share last year. Interest income grew due to both a larger investment portfolio and higher debt yields, resulting in an increase in adjusted NII year-over-year. For the fourth quarter, we paid dividends totaling $0.61 per share.

And ended the year with net asset value of $480.3 million or $19.43 per share. As mentioned on last quarter’s call, our dividend policy for 2023, approved by the Board, included a base dividend restored to $0.39 per share, a supplemental dividend and a special cash dividend of $0.10 per quarter. The supplemental dividend will continue to be based on our formula of applying 100% of the excess adjusted NII over the prior quarter’s base dividend. We’re distributing a special cash dividend of $0.10 per share to bring our spillover income in line with our target level over the course of the year. As a result, all else being equal, net asset value will drop by $0.10 per quarter each quarter in 2023. Recently, the Board increased the base dividend for the second consecutive quarter to $0.41 per share in recognition of the improved earnings power of the portfolio.

In addition to the higher base dividend for the first quarter of 2023, the Board of Directors has declared a supplemental dividend of $0.15 per share and a special cash dividend of $0.10 per share for a total cash dividend of $0.66 per share. First quarter dividends will be payable on March 29, 2023, to stockholders of record as of March 22, 2023. In terms of originations for the quarter, we invested $65.9 million, adding to our portfolio of debt securities that generate recurring interest income while continuing to invest in equity securities, which provide us with a margin of safety and the opportunity to generate incremental profits. Debt investments in Q4 were fairly evenly spread among first lien, second lien and subordinated debt. Nearly two thirds or $41.8 million of the total amount of originations was invested in four new portfolio companies.

In addition, we continue to support our existing portfolio companies with add-on investments. In terms of repayments and realizations in the fourth quarter, we received proceeds totaling $65.7 million including $56 million of first lien debt repayments. Repayments were essentially equal to originations for the quarter and the fair value of the portfolio at quarter end was $860.3 million equal to 103.8% of cost. We ended the fourth quarter with 76 active portfolio companies and two companies that have sold their underlying operations. Subsequent to year-end, we invested $40.2 million in debt and equity securities and three new portfolio companies. Over the course of 2022, the total portfolio mix on a fair value basis continued to shift in favor of debt investments on an absolute basis and as a percent of the total, reflecting our success in redeploying the proceeds from equity monetization.

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Debt investments increased from $549.8 million or 77% of the total as of December 31, 2021 to $740.5 million or 86% of the total as of December 31, 2022. First lien debt as a percentage of debt investments was approximately 62% at year-end. Equity investments as a percentage of the total portfolio on a cost basis was 7.3% within the boundary of our target allocation of 10%. From a credit quality perspective, overall, our portfolio is in pretty good shape. The issues our portfolio companies are contending with, higher labor and energy costs, material cost inflation and supply chain challenges, are not new and the playbooks we have developed are enabling them to perform reasonably well. There are exceptions, of course, as you would expect for a portfolio of our size.

But even those situations are manageable from our perspective, especially given the structure of our portfolio. During the quarter, we placed one additional company on non-accrual. As of December 31, non-accruals as a percentage of the total portfolio on a fair value basis was approximately 1.2%. Looking back on 2022, what stands out is our success in building our debt portfolio after experiencing high levels of repayments and realizations in 2021 and late 2020. During that period of exceptionally robust M&A and investment activity, our portfolio structure combining debt investments that produce recurring income, and equity investments that can generate incremental capital gains, has served us well. We have monetized $195 million of equity investments since the beginning of 2020.

In 2022, we enlarged our debt portfolio on a cost basis by $210.3 million or 38%. We have also increased the size of our variable rate debt portfolio on a fair value basis by 39% from $376 million as of December 31, 2021, to $522.9 million as of December 31, 2022. As a result, we entered 2023 with approximately 71% of the debt portfolio comprised of floating rate debt. At the same time, the yields on our debt investments expanded 190 basis points over the last nine months to 13.8% as of December 31, 2022, reflecting higher rates and the benefits of our balance sheet in a widening spread environment. Combination of putting equity proceeds to work, investing in income-producing assets and higher yields has significantly enhanced the earnings power of our portfolio.

As a result, we believe our portfolio remains positioned to generate adjusted NII well in excess of base dividends and to grow net asset value over the long-term. Even though, deal activity is currently slower than it was a year ago. We continue to find attractive investment opportunities. 2023, regardless of macroeconomic conditions, whether we have a recession or a soft landing, our experience of investing through past cycles and strict underwriting standards position us to further build the portfolio and drive adjusted NII growth. As we continue to grow our portfolio, we will stay focused on 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 financial and operating results.

Shelby?

Shelby Sherard: Thank you, Ed, and good morning, everyone. I’ll review our fourth quarter results in more detail and close with comments on liquidity position. Please note, I will be providing comparative commentary versus the prior quarter Q3 2022. Total investment income was $27.5 million for the three months ended December 31, a $2.5 million increase from Q3 primarily due to a $2.8 million increase in interest income, including PIK, and a $0.5 million increase in interest income on the excess cash, partially offset by a $0.4 million decrease in fee income and a $0.4 million decrease in dividend income. The increase in interest income was driven by an increase in average debt investment balances outstanding as well as an increase in the yield on our debt investments, given increase in interest rates on variable rate loans.

Total expenses, including income tax provision, were $15 million for the fourth quarter, $2.7 million higher than Q3, driven primarily by a $1.4 million increase in income taxes related to the annual excise tax accrual, a $0.6 million increase in professional fees related to the ATM program and timing of 2022 audit and tax compliance billings, a $0.4 million increase in the capital gains fee accrual and a $0.2 million increase in interest expense related to incremental SBA debentures outstanding. We ended the quarter with $419.9 million of debt outstanding comprised of $153 million of SBA debentures, $250 million of unsecured notes and $16.9 million of secured borrowings. Our debt-to-equity ratio as of December 31 was 0.9x or 0.6x statutory leverage, excluding exempt SBA debentures.

The weighted average interest rate on our outstanding debt was 4% as of December 31, 2022. Net investment income or NII for the three months ended December 31 was $0.51 per share versus $0.52 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 $0.51 per share in Q4, in line with Q3. For the three months ended December 31, we recognized approximately $0.4 million of net realized gains related to the sale of our equity investments in Midwest Transit Equipment and Ohio Medical Corporation, offset by partial losses on the exit of our debt investments in and former investment in Hilco Plastics Holdings. As Ed mentioned, in 2022, we paid total cash dividends of $2 per share.

In addition, we declared a deemed distribution of $1.65 per share for shareholders of record as of December 31, 2022. When a company designates a deemed distribution instead of a cash distribution paid to common stockholders, the company pays U.S. federal income tax at corporate rates, currently 21%, on the retained net long-term capital gains on behalf of common stockholders. In turn, common stockholders are deemed to have received a capital gain dividend and are deemed to have paid the tax that is actually paid by the company. As a result, common stockholders receive a tax credit that can use to offset their U.S. federal income tax on the deemed distribution or for other purposes, including claiming or refund as appropriate. Common stockholders also increased their adjusted tax basis in the shares of the company by the amount of the deemed distribution, net of the U.S. federal income taxes paid by the company and deemed paid by the stockholder.

The tax effect is the same as if the capital gains have been distributed to the company’s common stockholders in cash who then elected to reinvest their proceeds net of the tax paid by the company, i.e., 79% of the amount received after 21% tax is applied. The total 2022 deemed distribution was approximately $40.8 million. After taxes of $8.6 million, we retained approximately $32.2 million of liquidity, which can be used to reinvest in new debt and equity securities. Turning now to portfolio statistics. As of December 31, our total investment portfolio had fair value of $860.3 million. Our average portfolio company investment on a cost basis was $10.9 million, which excludes investments in two portfolio companies that sold their operations during the process of winding down.

We have equity investments in approximately 74.4% of our portfolio companies with an average fully diluted equity ownership of 4%. Weighted average effective yield on debt investments was 13.8% as of December versus 12.9% 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 non-accrual, if any. Now I’d like to briefly discuss our available liquidity. As of December 31, our liquidity and capital resources included cash of $62.4 million, $17 million of available SBA debentures, and $100 million of availability on our line of credit, resulting in total liquidity of approximately $179.3 million.

Taking into account our subsequent events, we have approximately $141.6 million of liquidity remaining. Now I will turn the call back to Ed for concluding comments.

Ed 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 Mandeep for Q&A. Mandeep?

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Q&A Session

Operator: Our first question comes from the line of Bryce Rowe from B. Riley. Please proceed.

Bryce Rowe: Thanks a lot good morning.

Ed Ross: Good morning, Bryce.

Bryce Rowe: Maybe I’ll start, Ed, just around pipeline and kind of market dynamic at this point. It looks like you’ve already had a fairly active first quarter through the beginning of March, and was hoping you might be able to kind of give us some visibility into what the pipeline looks like and what you’re thinking about from an origination perspective for 2023?

Ed Ross: Sure. Yes. As you know, it’s been interesting. I think Q4 was maybe a low point just in terms of activity in the industry. And quite frankly, January started that way as well. We’ve seen a little bit of an uptick just in activity levels, obviously, and we have also made three meaningful investments in new portfolio companies, mostly first lien investments, almost all along with equity co-investments. What I would say is we are busy, and so it’s €“ activity is at reasonable levels. It’s clearly not 2021, which was extremely robust. But the lower middle market continues to afford us real opportunities to invest, and we are staying focused on high free cash flow and more defensive growth companies. And so we feel good about growth here in 2021 as you can tell, we’ve had no repayments yet.

At the moment, we currently expect one debt and equity realization. So one €“ the sale of one of our portfolio companies, but don’t see a lot of other activity here in the real near-term. So it should be a portfolio €“ I mean, a quarter where we grow the portfolio. And our hope and expectation is to probably continue to grow the portfolio in Q2 as well. I hope that’s helpful?

Bryce Rowe: That’s helpful, Ed. And as we think about kind of balance sheet leverage, obviously, you’ve been able to build back up some net balance sheet leverage. Is there kind of a near-term target in terms of how you’re progressing to that target? And I just want to get a feel for how to model that out, if you wouldn’t mind.

Ed Ross: Sure. Well, as you know, we’ve been, what I would say, under leveraged for quite a while. We have a lot of cash on the balance sheet throughout 2022. And we are starting to get to a point where we’ll be using the line of credit. Though I did mention, we will have a repayment as well. So from a leverage perspective €“ so we have a very good liquidity position and Shelby went over that. From a leverage perspective, our general target is 1:1. Having said that, we’re very comfortable at 0.75 all the way up to 1.25x. So at 1x, 1.10x is a good number, and I think 1 would be the €“ 1:1 would be the target for us on a long-term basis.

Bryce Rowe: I appreciate it. I’ll jump back in queue. Good quarter. Thanks.

Ed Ross: Thank you. Thanks, Bryce. Good talking to you.

Operator: Our next question comes from the line of Robert Dodd from Raymond James. Please proceed.

Robert Dodd: Hi. Good morning and congratulations on the quarter. First, I have keep in mind, if I can, that look’s €“ Shelby, can you tell us how much accelerated amortization was done in interest income this quarter. It looks pretty healthy, like maybe $2.5 million, which obviously isn’t the normal run rate, is that about right?

Shelby Sherard: I might have to look into that and get back to you. You’re talking about accelerated amortization on repayments?