Fidus Investment Corp (FDUS) 2014 Q3 法說會逐字稿

Good day ladies and gentlemen, and welcome to Fidus Investment Corporation third quarter 2014 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 is being recorded. I would like to introduce your host for today's conference. Ms. Stephanie Prince from LHA, please go ahead.

Thank you Sam. Good morning everyone, and thank you for joining us for the Fidus Investment Corporation's third quarter 2014 earnings conference call. With me 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 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 would like to remind everyone this today's call is being recorded. A replay of today's call will 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 at FDUS.com, following the conclusion of this conference call.

I would also like to call your attention to the customary Safe Harbor disclosure regarding forwards-looking information, included in the earnings release. The conference call today will contain certain forward-looking statements, including statements regarding the goals, strategies, beliefs, future potential, operating results, and cash flows of Fidus Investment Corporation. Although management believes those statements are reasonable based on estimates, assumptions and projection as of today, November 7, 2014, 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 SEC. Fidus undertakes no obligation to update or revise any of these forward-looking statements. I would now like to turn the call over to Ed Ross. Ed.

Thank you Stephanie. Good morning everyone. Welcome to our third quarter 2014 earnings call. For today's call, I will start by highlighting our results for the third quarter, before discussing current market conditions, investment activity, and the performance of our investment portfolio. I will then turn the call over to Shelby, who will go into more detail about the financial results and liquidity position, before we open up the call for questions.

Turning to third quarter highlights, we generated strong financial results, producing net investment income of $5.6 million, or $0.41 per share. Our 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 was $5.6 million, or $0.40 per share this quarter. As of September 30, 2014, net asset value increased to $15.18 per share, and on September 30, we successfully completed a follow-on equity offering above NAV, which increased our liquidity position by $32.4 million.

For the fourth quarter, the Board of Directors has declared a quarterly regular dividend of $0.38 per share, which is payable on December 19, 2014 to stockholders of record on December 5, 2014. In addition, the Board declared another special dividend of $0.10 per share, also payable on December 19, 2014 to stockholders of record on December 5, 2014. Over the last five quarters we have declared five special dividends that together total $0.62 per share. At September 30, estimated spillover income, or taxable income in excess of distributions was $13.7 million. Please note that we will incur a modest excise tax expense in the fourth quarter for any remaining spillover on our balance sheet at year end. Since the beginning, our primary objective has been to deliver long-term value to our shareholders in the form of stable and growing dividends, including periodic special dividends. We also have a goal of increasing our net asset value on a per share basis over time. Balancing these goals is important to us and the Board, who will as before consider these objectives when making distribution decisions.

Throughout 2014 we have seen an increase in M&A activity levels in our target lower middle market. M&A pipelines are reported to be strong, and we expect to benefit from these higher levels of activity. Keep in mind when deals are M&A driven there are multiple constituents involved, which can often result in a lengthening of transaction closing cycles we have experienced this year. As we said before, at Fidus we are patient and disciplined investors, and we remain focused on capital preservation, and performing well over the long-term. This discipline outweighs many other considerations, as a result the number of new investments we close will vary from quarter to quarter.

Now I would like to discuss our investment portfolio. As of September 30, we had debt and equity investments in 37 portfolio companies, and a total fair value of approximately $336 million, which equates to approximately 98% of costs. As a reminder, an important part of our investment strategy is to maintain meaningful equity positions in our portfolio companies, which can provide upside to our investment returns. Currently, we have equity positions in roughly 89% of our portfolio of companies. In the third quarter, we invested approximately $38 million, increasing the value of our investment portfolio by 23% on a cost basis year-over-year.

The third quarter investments include two new portfolio companies. In July we invested $10.5 million in ordinary notes and common equity of US Green Fiber LLC, a leading manufacturer of residential recycled fiber insulation products across the United States. And in early August we invested $20 million in second lien nodes in Pinnergy, a leading provider of fluid management and drilling services for oil and gas wells located throughout Texas and Louisiana. Proceeds from repayments and realizations during the quarter totaled $13.1 million, including $9.1 million from Brook Furniture Rental, as payment in full on our subordinated notes and warrant investment. These repayments were driven by the sale of the company. Also in the third quarter we realized the loss on our investment in SB Restaurant, or Elephant Bar.

Subsequent to quarter end we have invested a total of $23.7 million in three new portfolio companies. These investments are in the retail energy marketing, the food service equipment manufacturing, and the aircraft component manufacturing industries. Furthering the diversification of our portfolio which continues to be an important goal at Fidus. At quarter end our debt investment in Avria remained on nonaccrual, and our debt investment in Paramount Building Solutions remained on PIC non-accrual status.

Turning to portfolio performance, we track several quality measures on a quarterly basis to help us monitor the overall stability, quality, and performance of our investment portfolio. In the third quarter, these metrics remained strong, and in line with prior periods. First, we track the portfolio's weighted average investment weighting based on our internal system. Under our methodology a rating of 1 is outperform, and a rating of 5 is an expected loss. As of September 30, the weighted average investment rating for the portfolio was 1.9 on a fair value basis, in line with prior periods.

As many of you know from a debt structuring perspective, we look to maintain significant cushions to our borrowers enterprise value, in support of our capital preservation and income goals. One metric that we track is the credit performance of the portfolio, which is measured by the portfolio company's combined ratio of total net debt to Fidus' debt investment to total EBITDA. For the third quarter this ratio was 3.6 times, consistent with past quarterly levels, and which we believe is a prudent level of risk for our portfolio. The third measure we track is the combined ratio of our portfolio companies total EBITDA to total cash interest expense, which is an indicator that our portfolio of companies as a whole has significant cushion to meet their debt service obligations to us. In the third quarter this metric was 3.4 times which is also consistent with past levels. Overall, we believe these metrics reflect our long standing cautious and deliberate investment approach, and when evaluating our portfolio as a whole, we remain pleased with the overall quality and makeup of the portfolio.

In closing, we continue to emphasize capital preservation with an eye towards selectively growing and further diversifying our investment portfolio. Our focus remains on companies that we believe will perform well over the long-term, with an emphasis on companies that operate in industries we know well, that generate excess free cash flow for debt service and investment and have positive long-term outlooks.

Our investment strategy is supported by strong foundation, including our relationship base, industry knowledge, and ability to offer flexible capital solutions. In looking forward, our target lower middle market continues to be active and attractive, as it is generally less competitive than the broader markets, due to its sheer size and fragmentation. This approach has served our shareholders well, and we believe that it will continue to result in both strong deal flow for investments, and a generation of attractive risk adjusted returns for our shareholders. Now I will turn the cull over to Shelby, to provide some details on our financial and operating results. Shelby.

Thank you Ed. Good morning everyone. I will review our third quarter results in more detail and close with comments on our liquidity position. In an effort to provide more color around any unusual or one-time items that occurred during the current quarter, I will be providing comparative commentary versus the prior quarter Q2 2014. Total investment income was $11.3 million for the three months ended September 30, 2014, an increase of $0.7 million over the $10.6 million of total investment income for the second quarter of 2014. Incremental interest income was the primary driver due to the increase in the size of the investment portfolio. Total expenses were $5.7 million for the third quarter, an increase of $0.6 million versus the prior quarter, due to a $0.1 million increase in interest expense, and a $0.5 million increase in incentive fees. In the second quarter of 2014 we reversed $0.4 million of capital gains incentive fees, due to incremental unrealized depreciation, primarily related to non-accrual investments. Excluding capital gains incentive fees, expenses increased by $0.1 million in Q3. Interest expense includes the interest paid on Fidus' SBA debentures, as well as commitment fee on our line of credit, which was put in place in mid-June. As of September 30, 2014, the weighted average fixed interest rate on our SBA debentures was 4.5%. Net investment income, or NII for the three months ended September 30, 2014 was $5.6 million, or $0.41 per share, slightly above second quarter. Adjusted NII was $0.40 per share in Q3 versus $0.37 per share in Q2. Adjusted NII is defined as net investment income excluding any capital gains incentive fee expense, or reversal attributed 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 IR page of our website.

For the three months ended September 30, 2014, Fidus realized gains of $1.3 million related to the realization of our warrant investment in Brook Furniture, and other escrow payments which were offset by the $8.0 million of realized losses related to EBAR. Recognizing the loss on EBAR resulted in net realized losses, which are offset by the reversal of unrealized depreciation on the statement of operations. As a result in Q3 Fidus recorded a net loss on investments of approximately $0.3 million, versus a net loss of $2.1 million in Q2. Our net asset value as September 30, 2014 was $15.18 per share, which reflects payment of the $0.38 per share regular dividend in June, and two special dividends of $0.05 each in July and August. Turning now to portfolio statistics. As of September 30, our total investment portfolio had a fair value of $336.5 million, or approximately 98% of costs. Consistent with our debt oriented investment strategy, our portfolio on a cost basis was comprised of approximately 65% subordinated debt, 21% senior secured loans, and 14% equity in warrant securities, in line with second quarter. Our average portfolio company investment on a cost basis was $9.3 million at the end of the third quarter, we have equity investments in approximately 89% of our portfolio companies, with an average fully diluted equity ownership of 7.8%. Weighted average yield on debt investments was 13.8% as of September 30.

The weighted average yield is computed using the effective interest rate per debt investments at cost, including the accretion of original issue discount and loan origination fees, but excluding investments on nonaccruals. Repayment activity over the past 18 months has impacted the portfolio yields, as some higher yielding loans have been paid off and replaced with loans priced at current market rates, which are lower than rates on the more mature loans. As of September 30, our liquidity and capital resources included cash and cash equivalents of $8.5 million, and unfunded SBA commitments of $29.5 million. In addition we have access to $50 million of SBA leverage, and a $30 million line of credit. On September 30, we issued 2 million shares above NAV in a secondary offering at an offering price of $17 per share.

Please note that while the shares were issued on September 30, the net proceeds of $32.4 million are a receivable as of quarter end, and were received on October 3. Subsequent to quarter end, the underwriters purchased 83,414 additional shares of the Company's common stock to cover over allotment, which generated additional net proceeds of approximately $1.4 million. Also subsequent to quarter end, we borrowed $11.5 million of SBA debentures, enabling us to fund additional SBA eligible investments. Taking into account the equity offering and investment activity subsequent to quarter end, we currently have roughly $134 million of liquidity. Now I will turn the call back to Ed for concluding comments. Ed.

Thanks Shelby. As always, I would 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 back over to Sam for Q&A. Sam.

Thank you. (Operator Instructions). Our first question comes from Chris Kotowski with Oppenheimer. Your line is open.

Hi. I guess two things. One is I was kind of a tumultuous quarter in terms of credit spreads on the more widely syndicated loans, and I would like your thoughts on that, in terms of both A, does it reflect any fundamental deterioration in the economy as you see it through your portfolio of companies? And then B, I guess has it affected the spreads on new loans in a positive way, or has it thus far not been an event in your market?

Sure, sure. Well, the last actually statement you just mentioned I think is pretty relevant. As you know, the broader market is a very different market than the market that we are playing in. And so I think there is a pretty big difference. I would say in the lower middle market what we have seen of late is what I would call stability. But it is stability at lower rates, as you know than maybe 12 months ago, and for sure 24 and 36 months ago. But I think there is prudent and rational behavior if you will, but we are seeing yields that are lower than they were 12 months ago. Our hope is that stability, and that things stay rational and prudent, and leveraged levels stay at the levels that they are today, because quite frankly what we are seeing are pretty attractive opportunities, just at the lower rates.

Okay.

Hopefully that is helpful, I think the broader market is different, it reacts differently for sure. There is still ample capital in our market, but what we are seeing is pretty rational behavior at this point.

Okay. The other obvious big event of the quarter was the decline in energy prices, and you do have a couple of energy credits in the portfolio. So I wonder if you could talk about the exposure to the weakness in oil prices?

Sure. It is a very good question, and one we are focused on. I think that the good news at this point is I guess a couple of things. Both the companies that we have exposure to, have definitely exposure to oil prices but also natural gas, which have not been hit like the oil market in particular. I think at the moment we feel very good about both those companies, their position in the marketplaces that they serve, and also their relative, or our relative risk position. So I think I will leave it there. But it is a very good question, one we will remain focused on here, and the Q will be focused on, but at the moment we like the construct of the portfolio, but in particular those investments as well.

Okay. That's it for me. Thank you.

Absolutely. Good talking to you, Chris.

Thank you. Our next question comes from Vernon Plack with BB&T Capital Markets. Your line is open.

Thank you, good morning Ed. Just notwithstanding the lumpiness of this business, I'm curious in terms of some of your comments, and given your latest equity raise, and given the strong third quarter that you had in terms of new investments, could we expect to see perhaps your investment pace pick up here over the next, say three or four quarters? I know just looking back you did $85 million in originations in 2012. You did $149 million in 2013, 2014 I think it is around $62 million year-to-date, and it seems as though maybe the pace is going to pick up at least over a four quarter basis?

Sure, sure. It is a great question, Vernon. What I would say is a couple of things. And as you noted and we have discussed, the first half of this year I think was more of an anomaly. It was pretty slow for us, but there were more than a couple of surprises on the new investment front, where deals just didn't take place that we thought would happen.

Yes.

I think we remain pretty active right now. We have obviously invested in three companies this quarter, and we are looking, we have some portfolio companies that are being acquisitive, and we also have new investment opportunities that we are working hard on. From that perspective, we are excited about the opportunities we are seeing, and we are excited about the opportunity to hopefully participate in this increased level of M&A activity. Offsetting that and worth discussing, right, it is hard to predict if the deals are ultimately going to close, number one. And so it is just lumpy and unpredictable.

The second piece is we have a portfolio that is continuing to mature, and so repayments is a natural part of the business going forward. And we do have several companies that are also looking to participate in this more active M&A environment, which we don't think is a bad thing. But it does offset the ultimate growth in the portfolio when that happens as you well know. We have that to deal with as well. So there is a balance but I do think our in investment pace, I think the first half of the year was somewhat of an anomaly. I don't think that will be the norm at all. I do think we are excited about the opportunities that we are seeing right now. But we will have some repayments as well, which will ultimately offset some of that growth.

And any changes to your equity participation in these deals? Has there been any change in terms of your ability to participate on the equity side?

It is a very good question, Vernon, and one we actually looked at this quarter quite a bit. I think our ability to participate has remained intact. But I will tell you there is a difference on some, if it is a larger opportunity, let's say a $15 million mezzanine opportunity, and the equity check for a certain situation is $40 million to $50 million, those funds kind of look at things a little bit differently, the guys that are writing $50 million checks, than a fundless sponsor deal where they are looking for help from an equity perspective and they are looking for institutional capital and support. So we have a blend in our portfolio of both funded sponsored deals, fundless sponsor deals, and also no sponsors. And quite frankly the equity opportunities are as good or better for sure in these fundless and no sponsor opportunities. The only place where I see us not participating in the equity is when there is not an opportunity. So maybe when we are refinancing a balance sheet, or undergoing a recapitalization where there is just not an opportunity to invest in the equity, and for the right risk adjusted returns we will do that as well. It is more just what the quality of the underlying company and asset, if you will.

Okay. That is helpful. Thank you.

Sure. Thank you. Good talking to you, Vernon.

Likewise.

Thank you. Our next question from Robert Dodd with Raymond James. Your line is open.

Hi everybody. Following on from Vernon's question with a little bit of shorter, obviously Q4 started off very strongly, in the past a quarter has gone from being, the range is anything from very back end loaded to not back end loaded at all, usually when there is some kind of tax, or some other kind of event. This time we have got obviously the elections turning out a different way. Do you think that the politics are likely to result in some delays in the hopes that maybe tax policy changes in more favorable to sellers, or do you think that is just not a factor?

My view would be it is not a factor, just in short. I think when I think about the activity level this is going on now, and really started much earlier in the year in the second quarter, even though we had good, we feel like we had very strong origination, actually starting February. But the second quarter there was a noticeable uptick in M&A activity, and typically what you see, and in second and third quarter it continued and even today it is continuing, with the idea a lot of those opportunities we are planning on trying to close in the fourth quarter, and many of them actually in December. So I think that is what is driving today's market. I would not expect the people that have decided to sell their company, I would not expect for them to push off and hope for a better tax situation. I think the driver today is that there is a fair bit of equity capital out there. A fair bit of strategic interest in a lot of assets, and there is a lot of debt capital. It is a good time to be a seller, and that is what is driving it. I don't see tax changes, or potential tax changes changing the kind of decision-making if you will of owners of companies at this point.

Thank you.

But I could be surprised, but that would be my view.

Okay. Secondly, you just mentioned again in the response, I mean the opportunities in fundless and non-sponsored transactions in principle are for better returns, in terms of obviously this harvest as well. How would you characterize the flow of information from portfolio companies in those different situations? Obviously if there is a fully mature established sponsor, I would think you would get better information about the relative status of the company as it is ongoing, versus a non-sponsored deal not only in principle risk worth, but in hindsight obviously. Speaking of one of your competitors sometimes you don't get as good quality of information, you see problems coming as soon. Is that fair to say that? More prone to surprises in one than the other? And how does that affect your underwriting approach to those kind of opportunities as well?

Well, you started with the point that there is I think there is a better return opportunity but there is a more risk typically in those situations, because we are in most cases acting as an institutional supporter of that company. Not that we aren't as a mezz, but when you a sponsor involved, they are looked upon for those types of circumstances, where you need incremental capital. What I would tell you is on fundless sponsor deals, on every deal, our approach is pretty hands on, and we attend quarterly Board meetings with every portfolio company, maybe other than a couple orphaned equity opportunities in our portfolio. And so and we receive monthly financial results, and when things aren't going well, we are in contact or discussions with both the sponsor and the management team often, as often as we need to be. And so from my perspective, there is not a difference in information flow, and it may get, some of these smaller companies sometimes it is harder to get information, and when that is the case you have to, from my perspective you have got to be working with the company closely, visiting the company and really touching it, versus just relying on information. So it comes, and every situation is different, but we are pretty hands on from a portfolio management perspective. Especially when things aren't going exactly right.

Okay. Perfect. Thank you. And just one final housekeeping one if I could, on the excise tax for the fourth quarter about $0.5 million, give or take?

That is about right, give or take. Particularly given that we have $13.7 million of spillover today, and had the special dividend that will obviously reduce the spillover. That gets you in the right ball park, not taking into account for quarter activities.

Thank you.

Thank you Robert, good speaking with you.

Good talking to you.

The next question from Bryce Rowe with Robert W. Baird. Your line is now open.

Thanks. Good morning.

Good morning, Bryce.

How are you?

Doing well, thanks.

Shelby, could you help me walk through the math of change and spillover income quarter-over-quarter from an absolute dollar perspective?

Yes, if I try to simplify it in terms of kind of typically it is the amount of special dividends that if you kind of assume we basically cover, it is the amount of special dividends this is really driving the decline in the spillover, so if we kind of take spillover of $13.7 million as of 9/30, with a special dividend of $0.10 on approximately 16 million shares, that would reduce the existing spillover by $1.6 million to get to us an adjusted spillover of $12.1 million.

And if we think about it from the end of the second quarter to the end of the third quarter, does the net realized losses impact the level of spillover income I'm to assume then?

I think and you can correct me, you know this better than I do, so when we realize the EBAR loss, the tax years for Rick are not calendar year, they are October year end. And so we had that happen before October, and so some of the gains that we had at the end of last year, were kind of lumped in with the loss on EBAR, so when you add those together that reduced us from a higher level, I think we were more in the 17 range, down to 13. But we have now passed that October month end. Is that the right way to think about it?

That's right. With the realization of the EBAR loss in the third quarter offset some gains that we had in the fourth quarter of last year, so from a net capital gain-loss perspective we are now kind of flat, and so really the kind of remaining spillover we are carrying forward is related to the investment company taxable income, and then it is a discussion of dividend reductions.

That is helpful. And so the timing of the exit on Elephant Bar, was it tied in any way to being able to push the loss into that year, or that year in terms of the accounting?

The reality of it is I don't know I'm sure you haven't followed that, EBAR went into bankruptcy in June and exited in August, and sadly, we are still for sure bothered by it, but the company has just really struggled. It was a place where the senior debt was also impaired in a meaningful way, and so that is what happened here in the third quarter. That was the driver, there just wasn't any value there. It did help with the situation, yes.

Okay. That's helpful. And then any commentary on the kind of the weighted average yield for newer investment so far here in the fourth quarter? And have you had any repayment activity up to this point?

Very good question, Bryce. Let me look at something here. The yields thus far have been very much in the, call it just over I would say on a blended basis, just over 12%, and when we look at what has happened through Q3, our rates were over 12% as well on a blended basis. So I would say in what we are looking at is kind of 12% to 12.5%, or maybe even a little bit higher as we move forward through the quarter, depending on what happens.

Okay. That's helpful. And then again any repayment activity thus far into November 7?

No, there has not been.

Alright.

There has not been yet. But again, I made this comment earlier, we do have several companies that are evaluating strategic alternatives. Just like originations, it is really hard to predict, both the timing and whether the transactions take place. But we would expect repayment over the next two to five months, or several repayments over the next two to five months for sure.

Okay. And then the last question on the SBA, here early into the fourth quarter obviously you haven't drawn on new SBA debentures in quite some time. Curious as to how you thought about timing there? And also wanted to ask if all of your investments over the last year or so could have fit into the SBIC area, even if you didn't use the debentures?

I will start with the that last one real quickly. Not all of them would fit in the SBIC. So our second quarter investment did not and, I know of a large add-on we did in January, a significant piece of that did not. So it is a blend. But by and large, I would say, 80% of the opportunities that we ultimately close typically do. And don't hold me to that percentage, but that is what it feels like, but clearly there are some that do not for different reasons. From a strategy standpoint, we have had cash on the balance sheet over the past year. We have had repayments which creates liquidity to reinvest if you are at the SBIC levels. Or at those fund levels, if you will. As we go forward when an investment opportunity does fit the SBA criteria, we are clearly going to try to invest those dollars at an SBIC subsidiary. We like having liquidity, it is a holding company for opportunistic investments, as well as opportunities that may be larger in size, and we may want to split up the investment, and put part in the SBIC and part at the holding company. When possible, we are investing at the SBIC level. And then the other point would be, is sometimes depending on repayment levels from what fund, you may or may not have cash available to invest at a certain fund. So that moves things around a little bit, which drove some of the decision making quite frankly here recently. Does that make sense?

I appreciate it. Good talking.

Good talking to you as well.

Thank you. At this time there are no further questions. I would like to turn the call back over to Ed Ross for further remarks.

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

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may all disconnect.