Fidus Investment Corporation (FDUS) Q1 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fidus Investment Corporation's First Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. John Heilshorn of LHA. Sir, you may begin.

Thank you, and good morning, everyone. Thank you for joining us for Fidus Investment Corporation's first quarter 2019 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 like to remind everyone today that this call is being recorded. A replay of today's call can be available by using the telephone numbers and conference ID provided in the earnings press release. In addition, an archived webcast replay will be available on the Investor Relations page of the company's website fdus.com following the conclusion of this conference call. 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 3, 2019, 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 like to now turn the call over to Ed. Good morning, Ed.

Good morning, John and thank you and good morning, everyone. Welcome to our first quarter 2019 earnings conference call. I'll start today's call with a high level perspective on our first quarter results, and then I'll cover our investment portfolio performance and conclude with comments regarding our view of the market and activity levels, as we move ahead in 2019. Shelby will go into more detail about the first quarter financial results and liquidity. Once we have completed our prepared remarks, we'd be happy to take your questions. Our first quarter performance was very much in line with our expectations. Originations and realizations were at high levels due in part to a holdover from the fourth quarter, as we discussed on last quarter’s call. In addition to continuing to proactively manage our portfolio, we stayed focused on our investment strategy of selectively building a well-diversified portfolio of debt, and to a lesser extent, equity investments in lower middle market businesses that have defensive characteristics and positive long term outlooks that operate in industries we know well and that generate excess free cash flow for debt service and growth. We continue to maintain high levels of underwriting discipline, which positions us to remain focused on our goals of preserving capital and generating attractive risk adjusted returns. Above all, we stayed focused on our primary goals of growing net asset value per share over time and delivering stable dividends. Adjusted net investment income, which we define as net investment income, excluding any capital gains incentive fee, attributable to realized and unrealized gains and losses, increased 9.9% year-over-year to $10 million or $0.41 per share. As of March 31, 2019, our net asset value or NAV was $404.8 million, or $16.55 per share. On March 22 2019, Fidus paid a regular quarterly dividend of $0.39 per share. At March 31, estimated spillover income, or taxable income in excess of distributions, were $17.9 million or $0.73 per share. On April 29, the Board of Directors declared a regular quarterly dividend of $0.39 per share, which will be payable on June 21, 2019 to stockholders of record as of June 7, 2019. In the first quarter, we invested $80.5 million in debt and equity securities, including $62.7 million in four new portfolio companies. As you may remember from our call last quarter, we disclosed in our list of subsequent events debt and equity investments totaling $57.2 million in three new portfolio companies. We invested $28.3 million in BCM One Group Holdings Inc., $18.4 million in BCC Group Holdings Inc., and $10.5 million in Diversified Search, LLC. A fourth new portfolio company, Bedford Precision Parts LLC is a leading distributor and assembler of replacement parts, accessories and kits for spraying equipment industry, in which we invested $5.5 million in first lien debt and common equity. Additionally, we made add on investments totaling $15.3 million in six existing portfolio companies. Consistent with our emphasis on providing flexible and customized financing solutions, the new investments span the balance sheet, ranging from first lien debt to common equity with approximately 96% of Q1 originations invested in debt. We continue to position our portfolio to provide us with a high level of current and recurring income, along with the opportunity for some incremental profits and a margin of safety from equity investments. In this way, we are maintaining a well-diversified portfolio that is structured to preserve capital and generate attractive risk adjusted returns. From a repayments and realizations perspective, we received proceeds totaling $57.4 million. Of that amount, last quarter, we disclosed repayments in full totaling $47.2 million in our list of subsequent events, which consisted of exits of our debt investments, including Gurobi Optimization, LLC, K2 Industrial Services, Inc., Fiber Materials, Inc., and Tile Redi, LLC. In Q1, we recognized an additional $7.7 million from repayments and realizations, including a partial debt repayment of $6.7 million from NGT Acquisition Holdings, doing business as Techniks Industries. Turning to our portfolio of construction and metrics, the fair market value of our investment portfolio as of March 31, 2019 totaled $670.5 million, equal to 107.7% of cost. The breakdown on a fair value basis between debt and equity was 81% in debt and 19% in equity investments. We ended the quarter with 61 active portfolio companies and four companies that have sold their underlying operations. As of March 31, 2019, we had debt investments in one portfolio company on non-accrual status, US GreenFiber and a last out debt investment in one portfolio company, Oaktree Medical Center on pick only nonaccrual status. Together, these two investments represent 1.9% of our portfolio on a fair market value basis. We are actively managing both of these situations. Moving to portfolio performance, we track several quality measures on a quarterly basis to help us monitor the overall quality, stability and performance of our investment portfolio. First, we track the portfolio's weighted average investment rating based on our internal system. Under our methodology, a rating of one is outperform and a rating of 5 is an expected loss. At March 31, the weighted average investment ratio for the portfolio was 2 on a fair value basis, in line with prior periods. Another metric we track is the credit performance of the portfolio, which is measured by our portfolio of companies’ combined ratio of total net debt through Fidus’s debt investments to total EBITDA. For the first quarter, this ratio is 4.5 times compared to 3.8 times for the same quarter last year and compared to 4.5 times for the fourth quarter of 2018. And like the fourth quarter, largely reflects the average leverage of the deals we invested in over the past 12 months. The third measure we track is the combined ratio of our portfolio of companies total EBITDA to total cash interest expense, which is indicative of the cushion our portfolio of companies have in aggregate to meet their debt service obligations to us. For the first quarter, this metric was 3.5 times compared to 3.4 times for the same quarter last year. We believe the soundness of these metrics reflect our debt structuring philosophy of maintaining significant cushions to our bar’s enterprise value in support of our capital preservation and income goals. Before discussing business conditions in our target market, I want to touch on our capital structure. Since our last earnings call, we have achieved a significant milestone with the receipt of our third SBIC license, which gives us access of up to $175 million in long term debt capital and we have also completed an amendment to our senior credit facility, which increases the commitment from $90 million to $100 million, expands the accordion feature to $250 million and extends the maturity date to April 2023. Our now strengthened and elongated capital structure aligns well with our cautious and deliberate approach to investing in businesses we believe will perform well over the long term. It gives us the flexibility to continue executing our differentiated strategy of offering customized financing solutions to high quality middle market companies that meet our strict underwriting standards. In addition, on April 29, our board approved a minimum asset coverage ratio of 150%, in line with past legislation that allows BDCs to operate with greater leverage, increasing the debt to equity regulatory cap from 1 to 1 to 2 to 1. Given our current asset mix, our goal remains to stay within a leverage range of 0.7 to 1 times. So real no change for us. So no real change for us. Now, turning to business conditions in our target market. M&A activity during the first quarter was relatively slow in the aftermath of the capital markets disruption in the fourth quarter. We have been active in evaluating deals. However, quality has been sporadic. Although M&A activity appears to be picking up, originations are expected to be lower in the second quarter compared to the first quarter. While every quarter is different from an originations and realizations perspective, we continue to proactively manage the business and selectively invest for the long term, focused on delivering value to our shareholders through stable dividends and growing net asset value per share over time. 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 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 2018. Total investment income was 20.3 million for the three months ended March 31, 2019, a 1.9 million decrease from Q4 2018. Interest and fee income increased by 0.8 million, primarily due to the collection of past due interest from K2 Industrial Services, which had been on non-accrual status. Fee income increased by 0.1 million. Dividend income in Q1 was 0.3 million, a 2.7 million decrease versus Q4, primarily due to a 2.5 million dividend from our equity investment and synergy declared in Q4. Total expenses, including income tax provision, were 10.7 million for the first quarter, approximately 0.4 million lower than the prior quarter. Base management and income incentive fees decreased by 0.4 million. Total G&A expenses increased by 0.4 million. Accrued excise taxes decreased by 0.7 million, offset by a slight increase in interest expense and accrued capital gains incentive fee. Interest expense increased by 0.1 million versus the prior quarter. Interest expense includes interest, as well as any commitment and unused line fees. As of March 31, 2019, the weighted average interest rate on our outstanding debt was 4.4%. As of March 31, we had 290.3 million of debt outstanding, comprised of 171.3 million of SBA debentures and 119 million of public notes. Our debt to equity ratio was 0.7 times or 0.3 times statutory leverage, excluding exempt SBA debentures. Net investment income or NII for the three months ended March 31, 2019 was 9.6 million or $0.39 per share versus $0.45 per share in Q4. Adjusted NII was $0.41 per share in Q1 versus $0.46 per share in Q4. Adjusted NII is defined as net investment income, excluding any capital gains incentive fee expense or reversal attributable to realized and unrealized gains and losses on investments. A reconciliation of NII to adjusted NII can be found in our earnings press release that was issued yesterday afternoon and is also posted on the investor relations page of our website. For the three months ended March 31, 2019, Fidus had approximately 1.6 million of net realized losses, primarily related to the exit of our equity investment in K2 Industrial Services, and Consolidated Infrastructure Group. Our net asset value as of March 31, 2019, was $16.55 per share, which reflects payment of the $0.39 per share regular dividend in March. Turning now to portfolio statistics. As of March 31, our total investment portfolio had a fair value of 670.5 million. Consistent with our debt oriented investment strategy, our portfolio on a cost basis was comprised of approximately 9% first lien debt, 61% second lien debt, 20% subordinated debt and 10% equity securities. Our average portfolio company investment on a cost basis was 10.2 million at the end of the first quarter, which excludes investments in four portfolio companies that sell their operations under the process of winding down. We have equity investments in approximately 94% of our portfolio companies with a weighted average fully diluted equity ownership of 6%. Weighted average effective yield on debt investments was 12.4% as of March 31. The weighted average yield is computed using the effective interest rates for debt investments at costs, including the accretion of original issue discount and loan origination fees, but excluding investments on nonaccrual if any. Now, I’d briefly like to discuss our available liquidity. As mentioned on our last earnings call, in Q1, we completed a public debt offering of 69 million in aggregate principal of 6% notes due 2024, raising net proceeds of approximately 66.5 million, including the exercise of the over allotment option. As of March 31, our liquidity and capital resources included cash of 26.2 million and 90 million of availability on our line of credit, resulting in total liquidity of 116.2 million. As Ed mentioned, we've been granted a third SBIC license, which provides access to up to 175 million of long term debt capital, subject to SBA regulatory requirements and approval. Subsequent to quarter end, we upsized our credit facility from 90 million to 100 million and extend the maturity to April 2023. Now, I’ll turn the call back to Ed for concluding comments. Ed?

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 Lauren for Q&A. Lauren?

[Operator Instructions] And our first question comes from Robert Dodd with Raymond James.

Hi, a few questions. First of all, on the double leverage question, Ed, I mean, why now? I mean, obviously, you said you don't actually plan with your asset mix to actually change it much. But why did the -- any color on why the decision was made by the board to give that approval now rather than six months ago?

Sure. Great question. And quite frankly, I think we've been watching the industry and listening and learning. As you know, we don't have any great need for it, given the amount of SBIC debt that we have. But I think, the board and I believe very much that it's just prudent from a risk management perspective, long-term. And I think it's also a good thing for the shareholders long term. And, lastly, and I'm thinking very long term, if there is a need, meaning for flexibility to utilize that leverage, then, we'll have the ability to do that. It's not something in our plans at the moment, especially given our current asset mix. But it's just, from our perspective, prudent risk management, good corporate governance.

Kind of on that mismanagement thing. I mean, obviously, you get the average attachment point of 4.5. I mean, a year ago, it was 3.8, but last quarter, it was 4.5. Can you give, do you have anything like the average EBITDA for your borrower today versus where they were a year ago? Because obviously, bigger borrowers get larger attachment points. So, can you give us any context to go with that 4.5, which obviously is up year-over-year, but you've done more first lien since then? So?

Sure, let me give you a little context, just on kind of how it did move up, which I think will be helpful as well. The calculation we use in average debt is average debt to average EBITDA. We had, as you're aware, in particular in the fourth quarter, we had a large number of debt repayment last year, the average leverage of our repayments was 2.2 times in Q4. So, what I would say is very mature investments. We also had a big year of new investments, including 67 million in new originations in Q4 and 80 in Q1. The average leverage of our new investments has been around 4.5 times here, over the past 12 months. So we also encountered a high level of portfolio company acquisitions, which serves as a re-leveraging of our investments in some of those companies, at least most of the time as sponsors continue to use debt when feasible. All these facets that I just mentioned caused the ratio to change. A couple other points I'd make. As I mentioned on prior calls, we continue to focus on slightly larger companies from an investment perspective and sort of if you look at our average EBITDA, I do think it's risen. But it's not up dramatically, but it's up -- it's over $10 million today. And I think there was -- that's very different than it was, say four years ago. As you can imagine, larger companies, safer and more durable, theoretically, usually have higher leverage points as well. And that's to the point that you're asking. We feel great about the portfolio today. I will also add that the equity cushion for our portfolio, if you looked at it for -- our whole portfolio as one company, possesses an equity cushion of approximately 50%, provides us with what we believe a very high level, high margin of safety, for our debt investments. So hopefully, that's helpful, but the average has definitely gone up. And it's been a very, quite frankly, deliberate action by Fidus over the last several years to really focus on a little bit larger businesses in our core market.

Got it. That is very helpful, Ed. Thank you. A couple of more. I don’t mean to laugh, but I mean your comment that you'd expect Q2 originations to be below Q1. Any more color you can, I mean, obviously, your Q1 originations were all time high for Q1, you've done higher Q4s, but you never hit this kind of level for Q1 before. So, Q2 being lower than an all-time high for the period, I don't think is unexpected. The question I guess is Q2s may be average 30 million, 40 million? I mean, is that the kind of the scale you're talking about, given Q1 was so strong? Or is Q2 going to be better than average as well, but maybe not a record high like Q1 was?

No. I think, I mean, let me start with kind of why and what's going on in the market, I think, the M&A market in particular is open and healthy due to the economy continues to juggle on, which is a great thing. Having said that, I think the disruption in the capital markets in Q4 really slowed, I think M&A activity down in terms of new entrants in the market. And, even January, there were still uncertainty. And so, I think there's been a delay, and somewhat of a natural delay in an M&A activity. It is picking up, as we sit here today. The other thing that I would say is, quality has been and I'm, has been sporadic and hit or miss, and we're continuing to be very, very careful with the types of business that we invest in, with the level of risk that we're taking. And so all that's driving lower activity levels, as we sit here today. I think the numbers you mentioned are probably reasonable and pretty good ones. But, as you know, sitting here today, we have not closed any new investments this quarter. And anything can happen in any deal. So it's really hard to stay or really put out there. Here's what I think it's going to be, but I think the range that you talked about is a fair range.

Couple more if I can, just a couple of portfolio assets. And I know, you don't like to give too much detail about these, but like, for example, FDS Avionics, it got marked down a little bit more in this quarter, I think. And, it's been on your book since ‘14, and I think it's been -- the control investment now. I think it's been a problem asset for you a couple of years ago as well. So without disclosing necessarily what you don't want to know about them, are you changing -- is there anything that you’re looking to do differently with an asset like that that's been a, if I remember, like a problem asset in the past and looks like it might be having a few issues now as well.

Sure, let me just touch on the situation with not too much, but the, this is a aerospace parts company, it’s primarily electronics. It serves the general aviation, the commercial, and the military end markets, so there's some diversity there. It's been lumpy historically. And it also was in need of a product refresh, whereby customers really wanted to wait for certain new products versus buying some of the legacy products. We continue to believe in, I'd say, the value proposition of the business. And as such, we made a control equity investment, probably 20 months ago now. And so the valuation of our investment reflects the current risk level, though we are very active in this situation and supportive of it and think of it more in terms of medium to longer term exit, so we're working and building the business is what I would say.

Our next question comes from Paul Johnson with KBW.

I’ve got a few questions. I wanted to go back to the 2 to 1 leverage if we could. Obviously, it's not something that you're looking to utilize, at least anytime soon. But I'm curious, I mean, does your strategy change at all? Especially as you get a little bit higher, within that leverage range? And also, are there any sort of restrictions on the liability side that would prevent you from accessing anything above 1 to 1 debt to equity?

Sure, Paul. Great questions. On the restriction side, I'll probably ask Shelby to touch on that. I think from a strategy standpoint, there's no change in our strategy at all. We go to market today as a solution provider, financing lower middle market companies that need capital of really $100 million and less in most cases. That's a majority of our business. And so we continue to want to have the flexibility to execute that strategy, and focus on the same marketplace that we have for a long period of time, but it does not -- we aren't changing our strategy at all. We just believe this is good corporate governance, and it's prudent risk management at the end of the day. So no change at all. From restrictions, I think we do in our credit facility.

So, as you would imagine, in our credit facility, we have a variety of financial covenants. And so one of those is an asset coverage ratio, which is currently limited to 200%. So per our credit agreement on a regulatory basis, we are limited to one times leverage.

Yeah. And I agree with you on the corporate governance, I think it's definitely a good thing to have. Also, on the 2 to 1 leverage, I'm curious, are you guys considering eventually reducing fees, if you were to leverage assets above 1 to 1, and even if you're not really looking to access that or push leverage any higher than that today, are you considering putting it in there, just simply from the standpoint that it looks good.

At this point, we haven’t addressed that. Again, our intent is not to go above 1 to 1. So we have not addressed it from that perspective. If we make the decision long term to go above 1 to 1 and operate at those levels for whatever reason, again, that's not on the table at all today, then we would consider that and most likely do something is what I would say. But there's, in our mind, there's really no need to do it at this point.

Sure. The last thing on 2 to 1, are you guys planning on putting this to shareholder vote at all or just basically waiting it out until it’s effective next year?

No, again, there's no need for it from a timing perspective. So there's no rush and so we just approved it at the board level are going to use that as the way to approve it. We think it's in the best interest of the shareholders. And, but again, we don't plan to use it. So it's just good corporate governance and proven to do it just as basically the whole industry has or a large majority has.

Sure. And then my last question, just more of a sort of housekeeping thing, but curious, do the – and congratulations, by the way on the third SBIC license. Do the debentures from SBIC One need to be repaid before you begin drawing down on the SBIC Three Debentures?

They do not. So as you mentioned, we're in the process of winding down our first fund, as we receive repayments in that fund, but there is no restriction on our ability to borrow under the third SBIC license that we just received.

Our next question comes from Owen Lau with Oppenheimer.

So there were some markups in your equity position, including fiber and synergy, given the recent comeback of public equity market you just mentioned, and also some robust IPO recently, how do you see the opportunity to monetize your equity investments for the rest of this year?

Great question. It's a lot more than just those two that have had some positive changes or quite frankly, more importantly, considering some kind of strategic options that could monetize equity investments, and so I think the M&A market is open as I've mentioned earlier. I do think more mature investment opportunities are ripe for some kind of sale, in many cases, not in all, but in many and so we do have more than a couple, so we have several portfolio companies that are evaluating strategic alternatives, which would entail selling our equity position. So, we do see an opportunity for some realizations this year. It doesn't mean it's going to be very near term, but there are more than a couple of situations of being worked on and we're hopeful that some of the equity is realized. It is a strategic focus of ours. We recognize as we sit here today, it's a nice problem to having, given the equity portfolio is performing very well, but monetizing it or to the extent we have the ability to, it makes a lot of sense in certain situations. And so we plan to do what we can to help monetize some of the investments. Hopefully that's helpful, but?

That's very helpful. Thank you. Another question for Oaktree Medical. So again, without getting into too much detail about the company, but it's more like an idiosyncratic event. And in relation to that, do you have an updated view of where we are in the credit cycle? Are we in the eighth innings or 12th innings or even going back to 5th innings?

Sure, well, I wish I had a crystal ball, but I don’t. But, what I would tell you is, I think it's very hard to know where we are in the credit cycle. As we're sitting here today, our portfolio is continuing to show slow revenue growth and slow EBITDA growth. So I think it's a very sound environment, very stable, which is what you read about quite frankly in the newspapers. And so that is a good thing from our perspective. What we are doing though, is we're managing the business, as if we're in the bottom of the night. And we have been doing that for a long time in terms of the types of assets that we are adding to the portfolio and the risk levels that we're taking, and so we're trying to invest and have been for several years, quite frankly, in companies that we believe will withstand a cycle and a cycle as bad as the one we just saw. And that's, as we're looking forward and making new investments, that's how we're thinking about the world. And secondarily, and I think importantly, we're also being very proactive on the risk management side and trying to exit deals that we think, okay, they stub their toe and this could get difficult in a bad environment and we’re trying to exit those if we can, can always exit it when you want to, but that is one of the things we have been doing for quite a while as well. To your question on Oaktree real quickly, business has been in the portfolio for a while. It's a pain management business and also a toxicology testing business. Company has experienced some stress over the years, due primarily to a drop in reimbursement rate risk for several services, but incrementally and more recently, by certain unexpected exogenous events and so, company has been making some sound progress here recently. But the unexpected events that have taken place with regard to this investment has required us to be very active in this situation and obviously the valuation reflects the current risk profile of those investments. So hopefully that's helpful.

Our next question comes from Mickey Schleien with Ladenburg.

I just have a couple more follow up questions on financing. First, given that you're not going to put the higher leverage option on the shareholder meeting agenda, you have to wait a year for that to go into effect. Is it reasonable to assume that you go back to the banks over the course of the next year to amend the credit facility for higher leverage?

I don't think that's in our plans right now. I think down the road, it may make sense, but again, what I said is, it's not, we don't tend to use it. And if you look at our capital structure, we have a fair bit of SBIC or SBA debt on it, and that's treated as equity for regulatory purposes. And so with that level of cushion, I don't think there's any need to do that at this point.

Okay. And I'm not sure Shelby followed up with the question about whether the unsecured notes accommodate higher leverage. Can you just clarify that?

They do.

They do?

Yes.

Okay. And lastly, Shelby, just in terms of capitalizing fund 3, I understand the equity and fund one is, let's say, in quotation marks still trapped until that's one down immediately. And I believe you need SBA approval to extract that equity. So, how do you intend to fund the equity and fund 3 in the meanwhile?

We have the capacity at the parent company to fund 3. So we have ample capacity there today. And then as you suggested, over time, as we continue to wind down the first fund, that will free up additional equity capital.

Okay. And at what pace do you expect to capitalize fund 3?

It will be very modest in terms of making investments and capitalization. So, initially, I'd probably expect us to put about 25 million of equity capital into the first fund, and then lever that. And then once we get that to work, then we would start taking another call at 25 million bytes of equity capital, but it will be something that will ramp up over several years.

Okay. And will the -- do the SBA regulations allow immediate 2 to 1 leverage on that initial 25 or does the fund need to sort of season before you're allowed to do that?

We’ll get 1 to 1 leverage on the first 25 and then ramp up from there.

Okay, that's very helpful. Those are all my questions for this morning. I appreciate your time.

[Operator Instructions] Okay. And I'm not showing any further questions at this time. I’d now like to turn the call back to Mr. Ed Ross, CEO for any further remarks.

Thank you, Lauren. 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.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone, have a wonderful day.