Fidus Investment Corp (FDUS) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Fidus Investment Corporation's Third Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. I'd now like to introduce your host for today's conference, Ed McGregor of LHA. Sir?

Thank you, James, and good morning, everyone. Thank you for joining us for Fidus Investment Corporation's Third Quarter 2017 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 details of the company's quarterly financial results. A copy of the press release is available in the Investor Relations page of the company's website at fdus.com.

I'd like to remind everyone that 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 in the Investor Relations page of the company's website at 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 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 flow of Fidus Investment Corporation. Although management believes these statements are reasonable, based on the estimates, assumptions and projections as of today, November 3, 2017, 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 the 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.

With that, I'd like to turn the call over to Ed Ross. Ed?

Thank you, Ed, and good morning, everyone. Welcome to our third quarter 2017 earnings call.

I will start our call by commenting on our financial results for the third quarter. I'll then provide some comments about investment activity and the performance of our investment portfolio before offering our views about the remainder of 2017. Shelby will go into more detail about our third quarter financial results and liquidity position. After that, we will open the call for questions.

Overall, we were pleased with the performance of our portfolio this quarter. Net investment income increased to $9.2 million or $0.38 per share and our adjusted net investment income, which we define as net investment income, excluding any capital gains, incentive fees attributable to realized and unrealized gains and losses, rose 37.4% year-over-year to $9.8 million or $0.40 per share.

We also realized $6.3 million of gains in the period. We believe these numbers clearly demonstrate both the overall quality of our portfolio and the effectiveness of our underwriting discipline, which emphasizes capital preservation, risk-adjusted returns and quality over quantity. As of September 30, 2017, our net asset value was $391.2 million or $15.97 per share, up $0.10 on a per share basis from Q2 2017.

On September 22, 2017, Fidus paid a regular quarterly dividend of $0.39 per share. At September 30, estimated spillover income or taxable income in excess of distributions was $11.9 million or $0.49 per share.

For the fourth quarter of 2017, the Board of Directors has declared a regular quarterly dividend of $0.39 per share as well as a special dividend of $0.04 per share, both of which are payable on December 27, 2017, to stockholders of record on December 20, 2017.

Our third quarter of 2017 was very active both in terms of new investments as well as repayments and realizations. For the quarter, we invested $68.5 million in debt and equity securities. Of this amount, $45.6 million was channeled to 5 new portfolio company investments. Three of these, ControlScan, Inc., Marco Group International OpCo, LLC and Tile Redi, LLC, we disclosed at subsequent event in our second quarter earnings release. Let me briefly recap the remaining 2 new portfolio company investments.

We invested $4.3 million in subordinated notes and preferred equity of Rhino Assembly Company, LLC, a leading value-added distributor of high-performance assembly tools and material handling equipment used in heavy manufacturing. We committed $1.5 million in additional subordinated notes, which was unfunded at close.

We also invested $10.5 million in subordinated notes and preferred equity of Viverae, Inc., a provider of comprehensive health management solutions that help corporations reduce health care costs through improved employee health.

In addition, we invested $22.9 million of capital in existing portfolio companies, including as previously disclosed in conjunction with the exit of our investment in EbLens. We invested $10 million in new subordinated notes and common equity; $8.4 million in an add-on to our subordinated notes and common equity of Accent Food Services, LLC, in support of recent acquisitions; $3.6 million in an add-on to our subordinated notes of Hub Acquisition Sub, LLC, doing business as Hub Pen related to a dividend recapitalization; and $0.9 million in new preferred equity of US Pack Logistics LLC in support of an acquisition. On the repayments and realization side, proceeds totaled $66 million, with roughly half of the total attributable to portfolio exits and the remainder coming from repayments of debt, including the following:

As previously discussed -- disclosed, we exited our investment in Anatrace Products, LLC, and received payment in full of $6.5 million on our debt investment. We received $3 million on our equity investment in EbLens related to the sale of the company resulting in a realized gain of $2.2 million. Additionally, in Q3, we received payment in full of $21.2 million on our debt investments and received $4 million from the sale of our equity investments in Lightning Diversion Systems, LLC, resulting in a realized gain of $4 million. We received payment in full of $16.7 million on our debt investments in Rohrer Corporation. We received payment in full of $7.3 million on our debt investment in FAR Research Inc. And we received partial payment of $6.3 million on our debt investments in SES Investors, LLC, doing business as SES Foam.

As reported in the third quarter press release, subsequent to quarter end, we exited our debt and equity investments in Brook & Whittle Limited. We received payment in full on our subordinated notes and sold our equity for a realized gain of approximately $1 million. The fair market value of our investment portfolio at September 30, 2017, was approximately $560.9 million, equal to approximately 104% of cost.

We ended the quarter with debt and equity investments in 58 active portfolio companies. The breakdown on a fair value basis between debt and equity remained fairly stable with 83% in debt and 17% in equity investments, providing us with high levels of current and recurring income from our debt investments and the continued opportunity to realize capital gains from our equity-related investments.

In terms of portfolio performance, we tracked 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 rating based on our internal system. Under our methodology, a rating 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 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 companies combined ratio of total net debt to Fidus' debt investments to total EBITDA. From the third quarter, this ratio was 3.6x compared to 3.1x for the same quarter last year.

The third measure we track is the combined ratio of our portfolio companies total EBITDA to total cash interest expense, which is indicative of the cushion our portfolio companies have in aggregate to meet their debt service obligations to us. In the third quarter, this metric was 3.7x compared to 3.8x for the same quarter last year.

The soundness of these metrics reflects our philosophy of maintaining significant cushions to our borrowers' enterprise value in support of our capital preservation and income goals.

As of September 30, one of our investments Restaurant Finance Co, LLC, remained on nonaccrual status. As we look to the final quarter of 2017, we see a relatively healthy market environment for us at this point, supported by an economy that is currently exhibiting stability and slow growth. M&A fundamentals continue to be sound. Competition remains robust in all the debt markets, in particular, in the broader markets; and overall activity remains healthy, including some deals that hopefully will fall our way toward the end of the quarter.

As we evaluate investment opportunities, we will continue to adhere to our underwriting disciplines; investing in companies that have meaningful defensive characteristics, high free cash flow and positive long-term outlooks. As always, we rely on our time-tested core strengths, including our relationships, our industry knowledge and our ability to offer flexible capital solutions. We continue to invest and manage the business for the long term, with the goal of growing in a deliberate manner and further diversifying our investment portfolio, while maintaining an acute focus on generating attractive risk-adjusted returns and capital preservation.

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 2017.

Q3 results exceeded our expectations with new investments slightly outpacing repayments and higher-than-anticipated fee and dividend income. Total investment income was $18 million for the 3 months ended September 30, 2017, up $0.7 million increase over Q2, 2017. Interest income increased by $1.1 million, primarily related to more assets under management, which was offset by a $0.2 million decrease in fee income and a $0.2 million decrease in dividend income as compared to second quarter. Total expenses, including income tax provision were $8.8 million for the third quarter versus $8.3 million in Q2, a $0.5 million increase primarily related to accrued capital gains fees.

Interest expense increased by $0.1 million, base management and income incentive fees increased by a total of roughly $0.2 million and accrued capital gains incentive fees increased by $0.4 million, while G&A expenses decreased by $0.2 million. Interest expense includes the interest paid on Fidus' debentures on line of credit as well as any commitment fees. As of September 30, 2017, the weighted average interest rate on our outstanding debt was 3.6% versus 3.7% in Q2.

As of September 30, we had $216.3 million of debt outstanding. The third quarter is generally a lighter quarter for routine G&A expenses. In the fourth quarter, we will incur annual excise tax expense.

Net investment income, or NII, for the 3 months ended September 30, 2017, was $9.2 million or $0.38 per share versus $0.39 per share in Q2 2017. Adjusted NII was $0.40 per share in Q3, in line with Q2. Adjusted NII is defined as net investment income, excluding any capital gains incentive fees expense or reversal attributable to realized and unrealized gains and losses on investments. A reconciliation of NII to adjusted NII can be found on our earnings press release that was issued yesterday afternoon and is also posted on the Investor Relations page of our website.

For the 3 months ended September 30, 2017, Fidus had $6.3 million of net realized gains, primarily related to the exit of our equity investments in EbLens and Lightning Diversion Systems. Our net asset value at September 30, 2017, was $15.97 per share, which reflects payment of a $0.39 per share regular dividend in September.

Turning now to portfolio statistics. As of September 30, our total investment portfolio had a fair value of $560.9 million. Consistent with our debt-oriented investment strategy, our portfolio on a cost basis was comprised of approximately 83% subordinated debt, 6% senior secured loans and 11% equity securities. Our average portfolio company investment on a cost basis was $9.3 million at the end of the third quarter, which excludes 5 investments in portfolio companies that sold their operations during the process of winding down. We have equity investments in approximately 87.3% of our portfolio companies, with an average fully diluted equity ownership of 6.8%.

Weighted average effective yield on debt investments was 13.3% as of September 30. The weighted average yield is computed using the effective interest rate for debt investments at cost, including the accretion of original issue discount and loan origination fees, but excluding investments on nonaccrual, if any.

Now I'd like to briefly discuss our available liquidity. As we discussed on our last earnings call, in Q3, we used excess cash at Fidus

Mezzanine Capital or FMC, our first SBIC fund to pay down approximately $17 million of SBA debentures with interest rates ranging from 5.3% to 6.4%, and maturity dates ranging from September 2018 to March 2019. As of September 30, our liquidity and capital resources included cash of $46.9 million, unfunded SBA commitments of $42 million and $50 million of availability on our line of credit, resulting in total liquidity of $138.9 million.

Approximately $25.9 million of cash was held in FMC, which is in the process of winding down.

Now I will 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'll now turn the call back over to James for Q&A. James?

(Operator Instructions) Our first question comes from Robert Dodd with Raymond James.

I'll do the easy one first, I think. On the NII, the excise tax, which obviously does negatively impact NII. The -- based on your spillover at the end of -- estimated spillover at the end of Q3, you are at 4% excise tax. I'd presume you're looking at about mid -- if nothing else changes in Q4, which is always above that, about $480,000 in excise tax in Q4, which would obviously lower NII in the ballpark?

It's actually going to be, I'd say probably little bit lower than that in part just because we're going to get a refund from our 2016 return. So I think of it in terms of kind of maybe $0.01 per share.

Okay. Got it. Then just in general, obviously, really early repayment activity, I meant, total exits and early repayments were very high in Q3. And that was very, very hard to predict. Tend to happen -- doesn't look like any have happened so far in Q4. But can you give us any color on what you think of the environment? Obviously, it's pretty competitive out there in terms of being able to refinance. What do you think of the environment in terms of how that high level that's been going on for a while may continue? Or what could trigger it to moderate? Obviously, it can be volatile quarter-to-quarter, but it's been pretty elevated.

Sure. Robert, it's a great question. I did want to clarify one thing if I heard you correctly. We did -- we have had one realization this quarter already, and that would be Brook & Whittle. So we've had one repayment as of -- at this point in time. What I would say is, the M&A market in my mind continues to be quite healthy. It's not overly robust. And I think in absolute number of deals, I think it's down a little bit relative to '16 and '15. But it's still a healthy market when you think about it from the fundamentals of stability in the economy. The outlook is for continued stability, at least the near-term outlook. There's plenty of equity capital. There's plenty of debt capital. And so if you're thinking about selling a company, then you're probably going to do it in this market. So that is -- I think that's a positive from our perspective. What we're doing -- and competition is robust, and so we are continuing to execute it in the manner we have in the past. We're trying to be as patient. And then when we find the right deals, we're trying to go after those and execute them. So our investment amounts on a quarterly basis are going to continue to vary. So when I look at originations, as I sit here today, we are very busy today both with portfolio companies as well as new investment opportunities. It's unclear how much activity will ultimately come from that activity, but -- or how much investment activity will come out of it, but we're hopeful that the second half of the quarter will have some real investment activity. We do expect some additional repayments. But if I were a betting man, I would think this quarter, just based on what I see today, this could change easily. We would have more investment activity on the new investment side than we would from a repayments perspective. But it continues to be, what I would say, a healthy and active market. Hopefully, that's helpful.

Yes, that is helpful. In terms of the -- you are seeing opportunities, et cetera, I mean, and the fact that nothing is closed so far, which is actually unusual, I mean things tend to happen later in the quarter. But could you -- what are you seeing on -- it's kind of 2 different parts, I'll ask them separately. What are you seeing on terms, when I see your net debt to EBITDA went up to 3.6x versus 3.1x a year ago, but a lot of things have moved that, but obviously your cash interest coverage was basically flat, right? So everything looks very robust on one side, there's a little increase on the other. Is that mix? Is that new investments that are being done at slightly higher attachment points, which could be a size thing, could be an industry thing? Can you give us any color on that?

Sure. I think it's going to be general statements, Robert. But what I would say is, we have strategically, we're still doing the smaller EBITDA portfolio company investments, but we are trying to increase the number of, what I would say, larger EBITDA business at least within our strike zone, which is again $3 million to $20 million. And so we're trying -- we have strategically, at least internally, tried to focus on some larger companies, meaning greater than $10 million in EBITDA, and we've had some success. And usually, with that comes some higher leverage and attachment points. And then, we did support one company that we have a -- it's a larger investment with some acquisition capital. And they used more debt than they did equity, and as a result, the leverage went up there as well. So we've -- hopefully, that gives you some color, but that's what's going on, truly a mix issue. But some of it is strategic initiative that we're -- at least internally that we're exercising.

Understood, understood. And then the other question on potential implications, the timing of -- are you hearing anything in the market regarding tax reform or anything like that about whether people may sit on their hands, wait and see what happens, maybe close late this year if something does happen, if not, wait until next year. Is that having any effect in the market right now?

To be short, I would say, no. I think what we're seeing right now is decisions made by companies probably late this summer to put themselves up for sale. And those M&A processes are kind of coming to fruition, and hopefully, by year-end. I do think there is clearly hope that the tax reform is helpful to those sellers, but I don't think it's impacting the market in a material way at this point.

(Operator Instructions) We do have a question coming in from Ryan Lynch with KBW.

First one, when I look at your historical leverage you guys run at, if I look at kind of the 2015 to 2016 range, you guys were running at a much higher level around 0.8x debt to equity. Now over the last 12 months, you guys are running around 0.5x to 0.6x. And within that time period, there are couple of equity raises that lowered that debt to equity. So just on a go-forward basis, what is your target equity debt that would range you guys think is kind of optimal to run the BDC at?

Great question, Ryan. What I would say is, we are -- just from a comfort perspective, we're comfortable going one-to-one because of the large majority of our debt is SBIC, which is treated as equity for regulatory purposes. But I would say that's not the target. The target's more in the 0.7x to 0.8x range, long term. We have made some obviously equity raises and that was done for a variety of reasons, but to help facilitate in particular just to transition out of FMC; one, as we pay that down and move to other financing sources, including hopefully FMC III. So meaning, SBIC fund. So I'd say, 0.7x to 0.8x would be a target for us.

So one thing I would add, and Ed alluded to it is, we are in the process of winding down FMC. And so what that practically means is, as we get repayments in that SBIC fund, unfortunately, I'm sitting on idle cash for some period of time, up to 6 months. And so as I mentioned, I'm currently sitting on about $26 million of idle cash at FMC, some of which I could upstream to the holding company, but the majority of which I'll need to use to repay down debentures by the end of February of next year. Little bit in terms of cash management.

That make sense. One of the things that we had always heard is that one of the benefits of being in the lower middle market is, you're investing in smaller companies, which can inherently, not always, but can inherently have some additional risk versus larger companies, but the benefits of that are, there's lower leverage on these companies, typically higher coupons, better terms and not covered in light structures. With the competition that we're seeing definitely in the middle market and certainly the upper middle market, we've heard that, that covenant-lite packages are getting pressed further and further down to lower and lower EBITDA levels. Are you guys seeing any increase in deal flow with covenant-lite packages or other terms you don't like, maybe kind of ridiculous EBITDA add-backs or anything like that?

Great question, Ryan. What I would say is, a true covenant-lite package, we only have one portfolio company that has that. And it was a company that we grew -- we have grown with since 2007, so we stayed invested in it. Now very, very large EBITDA outside of our typical range. In terms of the bigger companies that we're pursuing within our target range, we're ones that maybe are going for very high valuations, call it over 10x EBITDA because of their growth outlooks and their cash flow characteristics. In those cases you do see just tougher terms. But we still -- it's not covenant-lite and we still have covenants. It's just people are pushing you on covenants a little bit in terms of how deep -- and before they actually have an event of the fall, that kind of thing. But that's on the larger, very highly valued situations where people are pushing the envelope for the most part. That's how I see it.

We do have a follow-up from Robert Dodd.

Just basically following up in relation to Ryan's question. How much total is left in the first SBIC? The September 20s, the last pool that's in that one, that will have eventually obviously -- the $14.75 million for February. And then there is couple of others. It is the September 20, so where's the cut-off in this? I'm looking on the Q on Page 29, right? There's -- if you could tell us where the cut-off is for the first one, and that gives us an idea how much left of it to do within that one versus the others?

So if I understand your question, we currently have about $108.3 million of debentures outstanding in the first fund that we will need to pay down. So we fully borrowed our capacity and we're just now in the wind down mode or paying down that $108 million as we receive repayment. And on the second fund, we have the capacity to borrow an additional $42 million.

I'm showing no further questions in queue. So I'll turn the conference back over to Mr. Ross.

Thank you, James, and thank you, everyone, for joining us this morning. We look forward to speaking with you on our fourth quarter call in early March of 2018. Have a great day, and a great weekend.

Ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.