Fidus Investment Corporation

and welcome to FIDUS third quarter 2023 earnings call. All participants will be in listen-only mode. If you need assistance, please signal Conference Specialist by pressing the star key followed by zero. After today's presentation, you'll have the opportunity to ask questions. Please note that this event is being recorded. I'd like to turn the conference over to Ms. Jody Bergering. Please go ahead.

Jody Bergering Thank you, Nick, and good morning, everyone, and thank you for joining us for FIDUS Investment Corporation's third quarter 2023 earnings conference call. With me this morning are Ed Ross, FIDUS Investment Corporation's Chairman and Chief Executive Officer, and Shelby Sherrod, 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 Finest Investment Corporation. Although management believes these statements are reasonable based on estimates, assumptions, and projections as of today, November 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. BIDIS 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.

Good morning, Jody, and good morning, everyone. Welcome to our third quarter 2023 earnings conference call. On today's call, I'll start with a review of our third quarter performance and our portfolio at quarter end, and then share with you our outlook for the remainder of 2023. Shelby will cover the third quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions. We delivered strong results for the third quarter, with our portfolio continuing to grow adjusted net investment income, and with adjusted net investment income remaining well in excess of our base dividend. Much like the first half of 2023, deal flow was decent but not robust by any means, as M&A activity remained subdued in the lower middle market. We're patient and we're disciplined, and we're staying focused on our proven strategy of selectively investing in value-added businesses that generate high levels of free cash flow and have 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, increased 46 percent to $18.2 million in Q3 compared to $12.5 million last year. Interest income growth drove this increase, reflecting both higher average loans outstanding and a 170 basis point increase in average debt yields to 14.6%. Taking into account the increase in weighted average shares outstanding resulting from our equity raise during the quarter, adjusted net investment income on a per share basis increased 33.3% to 68 cents from 51 cents. We pay dividends totaling 72 cents per share consisting of a base dividend of 41 cents per share, a supplemental dividend of 21 cents per share, and a special cash dividend of 10 cents per share. As a reminder, we are distributing a special cash dividend of 10 cents per share each quarter this year to satisfy RIC requirements and to bring our spillover income in line with our target level. roughly the equivalent of dividends for three quarters for the fourth quarter on october 30th 2023 the board of directors declared dividends totaling 80 cents per share consisting of a base dividend of 43 cents per share a supplemental dividend of 27 cents per share equal to a hundred percent of the surplus and adjusted nii over the base dividend from the prior quarter and a special cash dividend of $0.10 per share, which will be payable on December 27, 2023, to stockholders of record as of December 20, 2023. That asset value at quarter end was $548.6 million, or $19.28 per share, compared to $483.3 million, or $19.13 per share, as of June 30th. During the quarter, we continue to invest in our portfolio of debt securities that generate recurring interest income and co-invest it in equity securities as a means of adding a margin of safety and creating the opportunity to enhance returns. Originations totaled $56.7 million, consisting of $48.5 million in debt and $8.2 million in equity. First lien investments accounted for $43.1 million, or nearly all of the additions to the debt portfolio. We invested $33.1 million in two new portfolio companies, that were added to the portfolio, financing M&A transactions. The remaining portion of originations was invested in add-ons in support of our existing portfolio companies. Proceeds totaling $69.9 million were slightly higher than originations for the third quarter, reflecting four debt repayments and two equity realizations, including the sale of Hallmark, which occurred earlier than we had expected. From an equity perspective, we received proceeds of $11 million, resulting in realized gains of $9.8 million, most of which came from the sale of our equity investment in Hallmark. Our portfolio of debt investments on a fair value basis was $798 million, or 86% of the total portfolio at quarter end. First lien investments continue to account for the largest piece of the debt portfolio at 65%. Including the fair value of our equity portfolio of $128.8 million, the fair value of the total portfolio at quarter end stood at $926.9 million, equal to 103.5% of cost. We ended the third quarter with 80 active portfolio companies and two companies that have sold their underlying operations. Subsequent to quarter end, we invested $31.8 million in first lien debt and preferred equity in two new portfolio companies, and we had debt repayments in three companies, generating net proceeds of approximately $29.3 million. As we added debt and equity investments to our portfolio, we continue to carefully select high-quality companies that generate excess levels of cash flow to service debt and to structure our investments with a high percentage of equity cushion in an effort to manage downside risk, which is especially important in today's higher-rate environment. For the most part, our portfolio companies have adjusted to current economic conditions. And those with pricing power have generally found ways to prosper despite inflationary cost pressures and higher interest rates. Select portfolio companies are continuing to navigate today's tougher conditions, and we are monitoring them closely. As of September 30th, we had two operating companies on non-accrual unchanged from the second quarter. Non-accruals represented 1.3% of the total portfolio on a fair value basis. In summary, the credit quality of our portfolio overall remains very solid. As we close out the year, the pace of deal activity in the lower middle market has been picking up relative to Q3. Our portfolio remains healthy, and with our strong liquidity, we are well positioned to grow the portfolio. selectively and deliberately, investing in high-quality companies in the lower middle market that possess resilient business models and positive long-term outlooks and generate high levels of cash flow. As always, we are committed to managing the business for the long term and to our goals of preserving capital, generating attractive risk-adjusted returns, and delivering value for our shareholders. Now I'll turn the call over to Shelby to provide some details on our financial and operating results. Shelby?

Thank you, Ed, and good morning, everyone. I'll review our third 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, Q2 2023. Total investment income was $34.2 million for the three months ended September 30th. a 3.6 million increase from Q2, primarily due to a 3.7 million increase in interest income, including PIC, offset by a slight 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 17.5 million for the third quarter, 3.8 million higher than Q2, driven primarily by a $2.7 million increase in the accrued capital gains incentive fee, a $.4 million increase in interest expenses, in part due to incremental SBA debt outstanding, and a $.7 million increase in the base management and income incentive fees. We ended the quarter with $454.3 million of debt outstanding, comprised of $188 million of SBA debentures, $250 million of unsecured notes, and $16.3 million of secured borrowings. Our debt to equity ratio as of September 30th was 0.83 times or 0.49 times statutory leverage excluding exempt SBA debentures. The weighted average interest rate on our outstanding debt was 4.3% as of September 30th, 2023. Net investment income or NII for the three months ended September 30th was 63 cents per share versus 67 cents per share in Q2. Adjusted NII which excludes any capital gains, incentives, accruals, or reversals attributable to realized and unrealized gains and losses on investments with 68 cents per share in Q3 versus 62 cents per share in Q2. In Q3, we realized net gains of 9.8 million, primarily related to the exit of our equity investment in Hallmark Healthcare Solutions. Turning now to portfolio statistics as of September 30th. Our total investment portfolio had a fair value of $926.9 million. Our average portfolio company investment on a cost basis was $11.2 million, which excludes investments in two portfolio companies that have sold their operations and are in the process of winding down. We have equity investments in approximately 76.8% of our portfolio companies, with average fully diluted equity ownership of 3.2%. Weighted average effective yield on debt investments was 14.6% as of September 30th versus 14.5% on June 30th. 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. In Q3, we issued 3.2 million shares at an average share price of $19.54, raising net proceeds of approximately $61.5 million. As of September 30, our liquidity and capital resources included cash of $80.3 million, $22 million of available SBA debentures, and $100 million of availability on our line of credit, resulting in total liquidity of approximately $202.3 million. Now, I'll turn the call back to Ed for concluding comments.

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 Nick for Q&A. Nick?

Thank you. Now begin the question and answer session. To ask a question, you may press star then 1 on your touch-tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To draw your question, please press star then 2. I will momentarily pause to assemble the roster. First question will be from Bryce Roe. B. Riley, please go ahead.

Thanks. Good morning. Good morning, Bryce. Ed, wanted to ask you guys or talk about the ATM usage. Obviously nice to see the stock trade above NAV and give you the ability to raise some equity in the third quarter, you know, pretty substantial amount. Can you kind of delineate between, you know, the opportunistic, being opportunistic with the stock above NAV and, you know, maybe just raising the equity in anticipation of, you know, some more activity, whether it be in the fourth quarter or, you know, into the first part of 24? Sure.

It's a great question, Bryce. You know, from my perspective, first off, I think we're very pleased with our overall performance and, you know, where the stock has been trading. But I think more importantly, you know, what we're pleased with is the opportunities that we are seeing in the market. And, you know, in particular, you know, these are mostly very high-quality companies that we are pursuing. You know, the leverage levels are very reasonable. Loan-to-values are 30% to 50%, if you will. And so we think from a risk-adjusted return basis, this is a great time to invest. And quite frankly, the companies that are coming to market from an M&A perspective are very high-quality companies that we believe can withstand, you know, any of the uncertainties that we're, you know, we're all fearful of.

um but uh you know we feel good about uh the opportunity set and obviously we feel also good about the the fact that our stock's been trading well great that's helpful um and then maybe another question here just on the dividend nice to see uh the bump higher in in the dividend um at least the regular dividend just curious how you're thinking about um you know possibly paying out the excess earnings over and above the base dividend amount, do you expect to continue to pay out the full excess, or will you moderate that a bit as we move into 24? Thanks.

Sure. Great question, Bryce. You know, I think, again, you know, we're thrilled with the performance of the business, and as you know, we've had some very meaningful equity realizations over the last really several years. And so the earnings power of the business is at a higher level. And so we're very pleased to have raised the base dividend. Our current posture is to continue to pay out our excess earnings as we are today. And so that's our current posture and that's our expectation as we move into Obviously, this quarter, Q4, is the last quarter we intend on paying this extra 10-cent special, which we've been paying for the past five quarters, including Q4 of this year. But we do intend on continuing to pay out 100 percent as of our excess earnings in the prior period as we move forward or move into 2024.

That's great. Appreciate the commentary. Great quarter, and I'll jump back in queue. Thanks.

All right, great. Thank you, Bryce. Good talking to you.

Thank you. Next question will be from Mickey Shaline. I'll have Landon's part. Please go ahead.

Yes, good morning, Ed and Shelby. I want to start with a high-level question, perhaps for Ed. In the upper-middle market, we're starting to see spreads come in, just as a function of the amount of private capital that's out there and the lack of M&A volume and we have a supply and demand mismatch. Are you starting to see that trickle down into the middle market and lower middle market where you operate, Ed?

Great question, Mickey. And the short answer to that is a little bit. I would say that spreads have narrowed you know, maybe 25 basis points in certain situations, 50 over the last six months or so. I think there was a period, you know, 12 months ago, nine months ago, where there were certain lenders that were really not in the marketplace at all. Today, there appears to be more competition. It's not crazy at any level. People are being disciplined. But I do think for the high quality situations, which is what we're focused on, that spreads have narrowed a little bit here over the last three to six months. So very similar in nature.

Okay, I appreciate that insight. Going back to the equity issuance question, I just want to understand, are you still expecting to operate the BDC, you know, somewhere between 0.8 and 1.1 times on a total debt-to-equity basis? And is your current level, which is the bottom end of that range, also factoring in some expectation about headwinds for the economy?

Sure. Great question. I think your initial comment of 0.8 to 1.1 is a good one. Where we have operated really has been 0.8 to 1.1. Historically, we are comfortable going over one-to-one as opportunities arise, but, you know, there was an opportunity to raise capital here. We saw that Q4 was going to be active. We also believe 2024 will probably show up a little bit more active than 2023. There's just pent-up demand out there, and there's a need, you know, more of a need for actually transactions to to take place. So we thought being prepared for that made a ton of sense. So I wouldn't say we're concerned. We were raising capital to position the business to withstand, you know, concerns about the economy. It was more to position the business, you know, to handle the opportunities that we think we're going to see here going forward.

Okay, I understand. My last question is a little bit more of a housekeeping question on interest income, which increased 13% quarter to quarter, but the debt portfolio cost actually declined 1%, and your average portfolio yield only increased 10 basis points. So the interest income growth seems high, unless I'm doing my math incorrectly. Was there anything sort of non-recurring and interest income accrued this quarter that we should be aware of?

Sure. I'm going to let Shelby take that. I understand your question, but I'll let her take that.

Okay. No, there were no, you know, kind of particularly unique items. You know, with debt repayments, we will have acceleration of OID, but that's kind of routine, of course, with respect to repayments.

We also had interest income from some of the cash on our balance sheet throughout part of it.

Right.

And I think average loans outstanding were higher during the quarter than they were at quarter end, some of the repayments.

Right, yeah. I was going to just say it. It sounds like it has to do with the cadence of the investments that you made, right?

Correct. That's correct. Okay.

Okay. That's it for me this morning. Thank you for your time.

Thank you. Appreciate it. Good talking to you, Mickey.

Thank you. Next question will be from Robert. Oh, Raymond James. Please go ahead.

Hi, guys, and congratulations on the quarter. Not another year quarter. On the kind of at about, you know, running the ATM because you're seeing more opportunities, Can you tell us about the – I mean, you mentioned here that the quality of deals available now are very high quality. If I look back last quarter, obviously, it varies about whether you're pursuing them or not. But last quarter, some of the available deals in the market you described as hit or miss. So have you seen – A change in kind of the mix of deals that are coming to market that are higher quality, which then justifies running the ATM because if you can – unless you win those deals, it's great for portfolio quality overall. I mean, is there any mix going on at the moment, mix shift?

No, not really. You know, what I would say is, look, deal flow – actually, deal flow wasn't – bad by any stretch of the imagination in Q3. Quality has been hit or miss all year, though, is what I would say. So that's a big piece of the puzzle. And then in terms of our investment activity and In Q3, we had a couple of deals spill over into Q4. And again, we think Q4 will be a stronger investment period than Q3, partly because of that and also just the pickup and activity. From a type of business or mix that we're seeing, it's really largely across the board. Where we're spending time are those companies that have recurring or reoccurring uh revenues um so pretty you know strong stability um backgrounds if you will and um and so that and high free cash flows and so those are the the types of businesses that we are focused on uh and we are seeing a little bit of an uptick but some of that's just q4 versus q3 you know where the summer slows things down a little bit um but you know we are hopeful the next year will be uh and kind of anticipate a little bit of a pickup in M&A activity in 2024.

Got it. Got it. Thank you. And then just where – and obviously credit quality across the portfolio looks fine, but more than fine. Where – One of the reactions, and I've actually read this before, in terms of sponsor interactions, I mean, is anything changing on that front given now we've been in a high rate environment for a relatively prolonged period now? Are they starting to change how they're looking at supporting portfolio companies or is everything just business as usual?

I'm not seeing really any noticeable change. I mean, we've seen some support and, you know, tougher situations that we have where to go through an amendment, we're requiring support. We have a portfolio that's very active from an add-on acquisition perspective, and folks are doing that. I am, what I'm seeing and what we're seeing as a pretty high level of or a pretty high interest in trying to define, you know, high-quality companies, recognizing that rates are higher and maybe, quite frankly, in some cases, private equity groups are paying a little more than they would like to. But, you know, for, you know, A assets, I think that's where there's a flight to quality from an equity perspective and from a debt perspective. And if people can locate and get an opportunity to invest in a very high-quality A-type business, then folks are willing to still pay up for them, quite frankly. And you're seeing that in some of the realizations that we have as well.

Got it. I appreciate that. Thank you.

Thank you, Robert. Good talking to you.

Thank you. Again, if you have a question, please press star, then 1. Next question will be from Paul Johnson of CBW. Please go ahead.

Good morning. Thanks for taking my question. On the Hallmark, just going back to the Hallmark health game sale, I'm just trying to understand kind of obviously that was a successful exit for you guys, just kind of understanding what's going on there with the company. It looks like you have just a little bit of, an equity investment left in the portfolio. Just any color you can kind of get on what perpetuated the sale and what you guys have left remaining in the portfolio with that company.

Sure. Great question, Paul. Paul, this, you know, Hallmark's been a great performer for us. Actually, the company and the sponsor was evaluating a couple of things. One was more of a dividend recap or a sale transaction. And quite frankly, we weren't in the know as much as maybe we would have even liked. So, sale transaction transpired, it was documented legally as a full sale of the whole um you know equity tranche uh having said that um the sponsor a um is rolling over a significant portion uh not up to 50 percent less than 50 but a significant portion of their investment and we followed that lead and so we also uh uh invested uh you know the same uh percentage in the business on a go-forward basis. So it was a full realization, but we invested a significant amount in the go-forward capitalization of the business. Is that helpful?

Yeah, it is very helpful. Thanks for that. It's great color. And obviously, you guys recognize the game on this table. Was that investment also written up during the quarter? Were you able to quantify that at all, impact on that?

Shelby, do you have that at your fingertips, or I'll give a higher level?

I don't have the exact number, but I can confirm that the realization that we had in Q3 was materially higher than the fair value we had it marked at at the end of Q2. Right, okay.

Okay, thanks for that. And then, so last quarter you just kind of gave, I think it was approximation of, you know, I think you said 55% or so of your companies were still growing EBITDA last quarter. Are you able to provide any kind of similar approximation of, you know, the percent of your portfolio that you still see growing revenues or EBITDA at this point?

Sure, sure. It's a great question. You know, the portfolio continues to perform well. I think of the core, lower, you know, middle market businesses that we're invested in, EBITDA, I guess, what's the number, 35 of 56 companies that fall in that category. And we also have some equity, you know, standalone businesses or orphaned equity investments that are not included there. And so, about 63 percent of the companies grew cash flows or EVTA. And then overall, our portfolio grew on an LTM basis this quarter, just less than 5 percent. So, we're seeing still healthy performance and healthy growth. in the underlying portfolio, which we're very pleased with.

Thanks for that. That's very helpful. And then last one at this point, you know, obviously 68 cents was some very strong results this quarter. I'm just curious, you know, at this point, do you kind of see this as sort of the full flow through, if you will, of, you know, higher rates at this point, at least, you know, from an NII perspective in the portfolio? Or, you know, is there a possibility, you know, of continuing, I guess, you know, higher OID amortization, that sort of thing, fees from the payments and such to continue, I guess, generating results, you know, around these levels or possibly even higher? Any kind of color there would also be helpful. That's all for me. Thanks.

Sure. It's a great question, one that's not that easy to answer. But I, you know, I think we are, you know, obviously we're very pleased with the performance this quarter. You know, this next quarter I do want to highlight we will have XI's expense, so that will impact NII and Q4. and which is relevant. I do think interest income, so on the revenue side, it's, you know, it's at a pretty high level. At this point, I don't see that rate going higher. You know, obviously, the Fed, They put in, you know, I actually see a couple higher-yielding investments in our portfolio that'll probably repay. And so I see stability there from a yield perspective. But at the same time, and I do think there'll be continued monetization of certain equity investments. It's not going to be like 2021 where there was, just a, you know, a very robust amount of M&A activity. But M&A is still transpiring, and we expect equity investments to still monetize, if you will. And so, we think the outlook is very good as we move forward. You know, exactly where we end up, do we go above 68? It's clearly possible. It has to do with a lot of things, getting more invested. Our fee, is fee income at a reasonable level that quarter or not? Are there any dividends? All those things, you know, you got to take into account a little bit. But obviously, you know, 68 cents is a great quarter. And we would, you know, we're going to strive to do better. But at the same time, we're focused on portfolio quality and consistency as opposed to just driving the highest earnings we can, so. Hopefully that's helpful, but Q4 will be impacted, and I think that's relevant. Shelby, do you have anything to add to that?

No, you mentioned the excise tax, so that's just kind of an annual accrual that we have, which we'll continue to have this year.

Got it. Thanks, guys. Appreciate the answers, and congratulations on a great quarter.

Thanks, Paul. Good talking to you.

Thank you. This concludes our question and answer session. I'd like to turn the call back over to Mr. Ed Rouse for closing remarks.

Thank you, Nick, and thank you everyone for joining us this morning. We look forward to speaking with you on our fourth quarter call in early March 2024. Have a great day and a great weekend.

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