Good day, and welcome to the Fidus Second Quarter 2022 Earnings Call. Today's call is being recorded. I would now like to turn the conference over to Jody Burfening. Please go ahead.

Thank you, Lisa, and good morning, everyone. And thank you for joining us for Fidus Investment Corporation's second 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 Web site 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, August 5, 2022, 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.

Good morning, Jody, and good morning, everyone. Welcome to our second quarter 2022 earnings conference call. On today's call, I'll start with a review of our second quarter performance and our portfolio at quarter end, and then offer you an update of our views on market conditions in the lower middle market. Shelby will cover the second quarter financial results and our liquidity position. After we have completed our prepared remarks, we'll be happy to take your questions. Our second quarter results demonstrates the merits of our strategy of investing in debt securities to generate recurring interest income and an equity securities for incremental profit and a margin of safety. We generated higher interest income from our debt portfolio this quarter and a net realized gain of $18.2 million or $0.74 per share from monetizing a small portion of our equity portfolio. By redeploying equity proceeds, we continue to build carefully and deliberately our debt portfolio, investing in high quality companies that operate in industries that we know well, generate cash flow to service debt and support growth and possess resilient business models and positive long-term outlooks. As a result of this proven investment strategy and philosophy of managing for the long term, our portfolio overall remains healthy, notwithstanding ongoing economic uncertainties and stresses. 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 $10.4 million, or $0.43 per share, essentially unchanged versus $10.4 million or $0.42 per share last year. NAV was $484 million or $19.80 per share. For the second quarter, Fidus paid a base dividend of $0.36 per share and a supplemental dividend of $0.07 per share, equal to 100% of the surplus in adjusted NII over the base dividend from…

Thank you, Ed, and good morning, everyone. I'll review our second 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 Q1 2022. Total investment income was 21.2 million for the three months ended June 30, a $0.6 million increase from Q1 primarily due to $2.1 million increase in interest income, including PIK, offset by a $0.6 million decrease in fee income and a $0.9 million decrease in dividend income. The interest income increase was driven by an increase in average debt investment balances outstanding. Please recall that the majority of Q1 investments closed in March and therefore were more backend weighted in the quarter. Total investments, including income tax provision, were 10.1 million for the first quarter in line with Q1. The capital gains incentive fee accrual decreased by 0.9 million. Note the capital gain incentive fee is accrued for GAAP purposes, however, is only payable annually in arrears to the extent cumulative realized gains exceed realized losses and unrealized appreciation. Excluding the accrued capital gains incentive fee, total expenses in Q2 were approximately 0.8 million higher than Q1 due to a $0.2 million increase in interest expense, a $0.4 million increase in management and income incentive fees, a $0.2 million increase in other G&A expenses, primarily related to proxy solicitation for the annual shareholders meeting, and a $0.1 million increase in taxes offset by a $0.2 million decrease in professional fees. We ended the quarter with 395.8 million of debt outstanding, comprised of 128.5 million of SBA debentures, 250 million of unsecured notes and 17.3 million of secured borrowings. Our debt to equity ratio as of June 30 was 0.8x or 0.6x statutory leverage, excluding exempt SBA debentures. The weighted average interest rate…

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 Lisa for Q&A. Lisa?

Thank you. [Operator Instructions]. We'll take our first question from Robert Dodd with Raymond James. Please go ahead.

Good morning, Ed and Shelby, and congratulations on not just the quarter, but the post quarter as well as the overall performance of the strategy, which has been very, very good. So a couple of questions. I'm going to ask you about the dividend, but you probably knew that was coming. But the first one, on -- your comment, Ed, you kind of went back to this a couple of times, getting deals across the finishing line is more difficult now. Sounds like quite optimistic about pipeline, but what is -- is there a gap between your ask on pricing and the borrowers ask, is there -- is that a problem on the sponsors agreeing on price? Is there more divergence on pricing structure or anything like that? Or is it some other kind of factor that's making people move a little slower right now I'm just curious?

Sure. Great question, Robert. As you can imagine, I think most folks making investments today really want to make sure that the company's performing as expected. And what we've seen in experience -- quite frankly, we've had three deals that we were awarded fall apart in the last 90 days or so. And two were due to purchase price issues. And those came from, I would say, performance issues, maybe missing budget a little bit which obviously gives rise to a purchase price discussion. The other was a structure question for us where we had signed up a term sheet based on a certain structure, and then the company and the borrower did not want to have that structure at the end of the day. And so we backed away. So we're obviously in this environment, but always been very disciplined on how we do things. But it's a tougher environment to get things done. I think everyone is in discovery mode a little bit. And I think that's a good thing, quite frankly, because we want to make sure we feel great about what we're investing in as we close transactions. So it's a good problem to have from our perspective.

Yes, thank you for that. On the opportunities you're seeing, obviously, if we look back over certainly the last several years and even longer term, the IRRs, or however we want to put it, thanks to you it might be an outlier, but even the core assets, your IRRs have been very attractive. Do you think the opportunities that you're seeing today and the structures you're seeing today are set up to meet kind of the core IRR, not just your internal targets, your hurdle rates maybe, but the core IRR that you've delivered historically? Can you still match that or is there anything that shifted on that front?

Great question. From my perspective -- so a little bit of it has to do with portfolio structures. Today, we have about -- 80% of our portfolio companies are coupled with equity investments. And so in those cases, obviously there's an opportunity for higher returns all-in, and we do feel good about the investments we're making today and do think they're very similar to what we've done in the past. So I don't see a change there. The mix of debt only investments for us is maybe a little higher than usual. We may have been closer to 90% at one point in time. And so that may alter returns just a little bit. I don't think it will be enough of a move to be significant. So we continue to see a very attractive environment from a risk adjusted return or on a risk adjusted return basis. We continue to like the equity opportunities that we are uncovering, but obviously it takes hard work and discipline and being patient. And we're going to continue the same strategy that we've always deployed.

Got it. I appreciate that. Thank you for that color. I got to ask you on the dividends. Yes, I realize you said that you'll have more information on the next call. But that's three months from now. In the past when you've had large realized gains, you've utilized the full spectrum. You've done everything, deemed distribution to a special dividend to supplementals. Can you give us -- and obviously it's a Board decision, but you are a member of the Board. Can you give us any color kind of which -- deemed distribution allows you to retain some capital, but you've got a lot of capital, equity proceeds coming in versus just paying out large specials, you don't necessarily get full credit from the market. So can you give us any thought about which way potentially you lean right now without -- not going to set your feet in concrete on this?

Let me give some thoughts on just actually why we postponed things a little bit as well as just maybe highlight the different options that are on the table. But as you might imagine, Robert, I've been careful with what I say.

Yes, fair enough.

But also, as you might imagine, we spent a lot of time at the Board level thinking about distributions and dividend policy questions. And also, as you know, our spillover position at 630 is very high at $2.37 per share. And as you also know, the gains early here in Q3 will only further increase that spillover position. So what we've done is, given the fact that we're only seven months into the year, we believe it only makes sense to be patient, at least until the Q3 earnings call to discuss further 2022 dividend decisions. The Q3 and Q4 dividend declarations that we announce are expected to satisfy the RIC distribution requirements related to the 2021 investment company taxable income, or ICTI. So we expect to be discussing these things a lot over the next 90 days until we have our next call. Lastly, what I'll say is, look, our top priority is to perform well for shareholders over time. And for us, that means delivering stable to growing dividends to shareholders while also growing NAV over the long term as well. So as it relates to our spillover position, we're evaluating a number of options. It includes making special select cash distributions, includes increasing the base dividend and/or supplemental dividend policy. It may make sense to retain a healthy level of spillover still for a rainy day. And then lastly, a deemed distribution is definitely on the table as well, which would enable us to retain capital at the BDC level in order to continue to grow NAV as well as earning over the long term. So there's three or four things, I guess four, that are on the table from our perspective, and it's probably some combination of a few of those at the end of the day. I hope that's helpful, but I got to be obviously careful with what I say.

That is very helpful. Thank you. And I apologize for the background.

No problem. Thanks, Robert. Nice talking to you.

We'll take our next question from Ryan Lynch with KBW.

Hi. Good morning.

Good morning, Ryan.

The first question I had was kind of following up on Robert's question, because it kind of struck me as well when he talked about deals having a harder time getting across the finish line in this environment. I think that's maybe the first time I've really heard that on the conference calls for the BDC sector this quarter. And so -- because most others out there talked about really the improving deal environment and what I would call maybe some more lender friendly terms that they're been able to achieve now versus six months ago or so. Obviously, the economic environment is still very uncertain going forward. So that does present some challenges. So I'd love to just -- if you could just unpack, is there something that's particularly unique in kind of the lower middle market where maybe terms aren't shifting as quickly as maybe the core middle or upper middle market that would cause you to make those statements?

Sure. Great question, Ryan, and not an easy one to answer quite frankly. But I think terms are shifting to a certain degree. I think spreads are stable to widening. So we are experiencing the same trend, maybe it's not as much as in the liquid markets, but covenants have always been a positive for the lower middle market, and they continue to be and help us -- and leverage levels are clearly not out of bounds and probably are coming down just a little bit as well. Again, those are for very high quality situations. From a deal flow perspective, I thought Q2 was a little slower than Q1 for sure. And I think there was a lot of price discovery going on and a lot of just credit discovery going on. But what I would also say is today in the last three to four weeks, deal flow has been very strong. And so we are starting to see a fair number of high quality situations. So we're excited about the rest of the year, quite frankly. With regard to harder to get stuff across the finish line, your comment surprises me a little bit, maybe just people didn't say it. But I think a little bit that is just a product of our experience where we did have in the last 90 days three deals fall apart for the reasons I just talked about. And I think that's healthy. If things aren't as expected, then I'd rather wait and see as opposed to go ahead and close the transaction. But the long and short of it is, is we're continuing to see a fair number of opportunities, high quality opportunities. And we do think it's a more lender friendly environment than previously. There's less competition. There's some lenders that have pulled back, quite frankly. And so that's a good thing as well for us and for the lower middle market. I hope that helps.

Yes, that's helpful. And I completely agree that being thoughtful and discipline and having deals fall, backing off on deals if they're not right, it makes complete sense. And also you could also be right that maybe other companies aren't explicitly stating that. And there are deals that are sort of not getting done, maybe just the deals that are getting done are in better terms, but there could be maybe a lot of other deals that are not getting across the finish line as well. So that's fair. The other question I had was, congrats on your partial monetization of a fast deal in third quarter. Can you talk about what was the nature of that partial monetization? And why was it only a partial monetization versus a full monetization? What was the nature behind that?

Sure. Well, this is a company that we've been invested in now for, call it, 10 years or so around a little bit. Very high quality company. The monetization from our perspective was a negotiation with the primary owner of the business. And from our perspective, getting partial liquidity made sense. So we ended up selling less than half of our position. And the reason for that is we feel good about the long-term prospects of our investment as well as for the company. It's a very high quality company. And so we're pleased to be able to retain that equity ownership and see how it goes in the future. But we're also very pleased with the partial realization as we thought it made sense to do that. Hopefully, that makes sense. But we liked that. We just think a partial liquidity event was a smart thing to do for our shareholders.

Yes, it makes sense just taking a few chips off the table on a really successful investment. Just the last one I had, which is very hard to predict, but maybe for Shelby. Dividend income dropped significantly this quarter. I know it's really hard to predict on a quarter-to-quarter basis, but -- that can be kind of lumpy. But do you have any preliminary thoughts on what we should be expecting in the third quarter for that?

Yes. What I would just say is Q1 was probably larger than what I would expect on a run rate basis. We have a few select portfolio companies that maybe make an annual dividend. And so that's kind of what caused Q1 to be more outsized. Kind of going forward, I would expect things to be more in line with Q2.

Okay, that's helpful. I appreciate the time today and appreciate you taking my questions.

Thank you, Ryan. I appreciate it. Good talking to you.

You too.

[Operator Instructions]. We'll take our next question from Mickey Schleien with Ladenburg.

Good morning, everyone. Ed, I wanted to ask you a risk management question. There's this theory out there that the only way the Fed's going to get inflation under control is just to kill the consumer given how much the consumer represents as part of the economy, the domestic economy. I've also heard arguments that the middle class and the -- upper, middle class are fine. It's the lower middle class that the folks that are living paycheck to paycheck that might be struggling under the current economic conditions. And so perhaps there's not as much risk there as is perceived. So given the Fed's struggle with inflation, how much risk is there in your portfolio with respect to the consumer? And in particular, I think I heard you say you invested in a thrift shop? And does that -- is that in line with my comments?

Sure, it's a great question. With regard to the thrift shop, we just committed to that. The deal should close later in the quarter. It's a great business, pretty well diversified and performing very well also in this environment. So we feel like, we obviously looked at previous cycles when we looked at, and this company has performed pretty well through all those cycles. So it's a stable business from our perspective and one we feel very good about in this environment as well. So it's differentiated from that perspective. I agree, to a certain extent, with your comments about maybe the more lower income bracket, if you will, I do think they are being impacted more by things like higher gas prices, higher food prices, more staples day to day living type of spending and taking market share from more discretionary items, if you will. We experienced that in Evelyn's [ph] quite frankly. Evelyn's is probably focused on a consumer that's more focused on urban areas, if you will. So I agree with your comments. And the last question I think you asked, or one of the questions you asked was how exposed is our portfolio? And I would say, we have some consumer exposure, but it's very limited, quite frankly. And so we feel like we're well positioned as we move forward. It's really maybe a handful of names that have exposure. And I think we're feeling some pressure a little bit right now on two of the companies, one of them being Evelyn's. So overall, we feel great about our portfolio construction and feel very good about the outlook of our portfolio, notwithstanding that it's a difficult operating environment.

I agree. That's it for me this morning. I appreciate your time. I hope you have a good weekend. Thank you.

Thanks. You too, Mickey.

And that does conclude the question-and-answer session. I would like to turn the call back over to Ed Ross for any additional or closing remarks.

Thank you, Lisa, and thank you everyone for joining us this morning. We look forward to speaking with you on our third quarter call in early November 2022. Have a great day and a great weekend.

And that concludes today's presentation. Thank you for your participation. And you may now disconnect.