FS KKR Capital Corp. (NYSE:FSK) Q3 2023 Earnings Call Transcript

FS KKR Capital Corp. (NYSE:FSK) Q3 2023 Earnings Call Transcript November 7, 2023

Operator: Good morning, ladies and gentlemen. Welcome to FS KKR Capital Corp’s Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded. At this time, Robert Paun, Head of Investor Relations, will proceed with the introduction. Mr. Paun, you may begin.

Robert Paun: Thank you. Good morning and welcome to FS KKR Capital Corp.’s third quarter 2023 earnings conference call. Please note that FS KKR Capital Corp. may be referred to as FSK, the Fund or the Company throughout the call. Today’s conference call is being recorded and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSK issued yesterday. In addition, FSK has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended September 30, 2023. The link to today’s webcast and the presentation is available on the Investor Relations section of the company’s website under Events and Presentations.

Please note that this call is the property of FSK. Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today’s conference call includes forward-looking statements and are subject to risks and uncertainties that could affect FSK or the economy generally. We ask that you refer to FSK’s most recent filings with the SEC for important factors and risks that could cause actual results or outcomes to differ materially from these statements. FSK does not undertake to update its forward-looking statements unless required to do so by law. In addition, this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures can be found in FSK’s third quarter earnings release that was filed with the SEC on November 6, 2023.

Non-GAAP information should be considered supplemental in nature and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly named measures reported by other companies. To obtain copies of the company’s latest SEC filings, please visit FSK’s website. Speaking on today’s call will be Michael Forman, Chief Executive Officer and Chairman; Dan Pietrzak, Chief Investment Officer and Co-President; Brian Gerson, Co-President; and Steven Lilly, Chief Financial Officer. Also joining us in the room are Co-Chief Operating Officers, Drew O’Toole and Ryan Wilson. I will now turn the call over to Michael.

Michael Forman: Thank you, Robert and good morning, everyone. I’d like to start by acknowledging the tragedy in the Middle East and the loss of innocent lives. Like so many of you, I was shocked by the invasion of Israel. To the many people who have had family, friends and loved ones impacted by these devastating and tragic events, our hearts go out to you. And now, turning to FSK’s results for the third quarter. Our financial and operating results showed continued strength as we exceed our earnings guidance and outearned our quarterly base and supplemental distribution. During the third quarter, we generated net investment income totaling $0.84 per share and adjusted net investment income totaling $0.80 per share as compared to our public guidance of approximately $0.79 and $0.76 per share, respectively.

Our net asset value per share at the end of the third quarter was $24.89 which is equal to our net asset value per share at the start of the year. During the third quarter, our net asset value per share increased by approximately 1%. Based on our positive operating results, our Board has declared a fourth quarter regular quarterly distribution of $0.70 per share. consisting of our base distribution of $0.64 per share and a supplemental distribution of $0.06 per share. As many of you will recall, in May of this year, we declared a series of 3 special distribution payments totaling $0.15 per share. The third $0.05 per share installment will be paid at the end of this month. Based on our continued strong performance, coupled with our positive earnings outlook, I’m pleased to announce that our special distribution will continue for the next 2 quarters and amount totaling $0.10 per share.

Consistent with our corporate view of sharing additional earnings with our investors on a real-time basis, this special distribution will be paid in 2 equal installments of $0.05 per share in the first and second quarters of 2024 and will be on top of our quarterly base and supplemental distributions which currently total $0.70 per share. From a solid-looking perspective, we continue to be optimistic about the growth in the private credit sector which provide significant tailwinds for our industry. In general, our portfolio companies have been adjusting well to the higher interest rate environment as we have not seen significant increases in credit stress or defaults. FSK continues to generate strong earnings and has ample liquidity to take advantage of new, high-quality investments as well as to support our existing portfolio companies through add-on investments.

And with that, I’ll turn the call over to Dan and the team to provide additional color on the market and the quarter.

Dan Pietrzak: Thank you, Michael. In the wake of continued inflationary pressure and higher for longer interest rates, private credit continues to be an attractive asset class due to its directly negotiated transactions, predominantly floating rate infrastructures and significant issuer diversification. As a result of these and other positive attributes, private credit is continuing to become an increasing allocation for institutional investors. As we mentioned on last quarter’s call, we have seen an increase in deal flow as M&A activity continues to ramp. In addition, there are recent signs that the syndicated markets are beginning to stabilize, with activity picking up in that part of the market as well. At the same time, we are seeing some pressure on spreads in the upper end of the middle market as spreads have tightened by 25 to 50 basis points during the quarter.

With private equity funds holding more than $2 trillion of dry powder, we continue to believe sponsors will utilize private credit solutions to finance transactions. Turning to investment activity; during the third quarter, we originated $504 million of new investments. Over 65% of our investments were focused on add-on financings to existing portfolio companies and long-term KKR relationships. Our new investments combined with $386 million of net sales and repayments, when factoring in sales to our joint venture equated to a net portfolio increase of $118 million. In terms of recent deployment opportunities, 1 new investment of note is a partnership with PayPal. KKR Credit has agreed to purchase approximately €40 billion of PayPal’s consumer receivables originated in Europe.

FSK has committed approximately €80 million towards the transaction. Having the ability to work exclusively with a strategic partner like PayPal is a testament to the strength and maturity of KKR Credit’s asset-based finance business. In terms of interest coverage, at the end of the third quarter, our portfolio companies had a median interest coverage of 1.5x. For clarity, this calculation uses base rates as of June 30, 2023, to align with portfolio company financials. While the higher rate environment has impacted certain companies, overall credit performance continues to be stronger than many market observers anticipated. As companies in the larger end of the private credit market have demonstrated their ability to pass along price increases while simultaneously navigating their labor and other input costs.

Despite the challenging macro environment, we continue to see portfolio company revenue and earnings growth. We remain focused on large, high-quality borrowers with strong operating margins and deep equity cushions. The weighted average EBITDA of our portfolio companies was $212 million as of September 30, 2023. Additionally, our portfolio companies reported a weighted average year-over-year EBITDA growth rate of approximately 6% across companies in which we have invested in since April of 2018. And with that, I’ll turn the call over to Brian to discuss our portfolio in more detail.

Brian Gerson: Thanks, Dan. As of September 30, 2023, our investment portfolio had a fair value of $14.7 billion, consisting of 200 portfolio companies this compares to a fair value of $14.8 billion and 195 portfolio companies as of June 30, 2023. At the end of the third quarter, our 10 largest portfolio companies represented approximately 19.5% of the fair value of our portfolio which is consistent with prior quarters. We continue to focus on senior secured investments as our portfolio consisted of approximately 60% first lien loans and 68% senior secured debt as of September 30. In addition, our joint venture represented 9.6% of the fair value of our portfolio. As a result, when investors consider our entire portfolio, looking through to the investments in our joint venture then first lien loans total approximately 68% of our total portfolio and senior secured investments totaled approximately 76% of our portfolio as of September 30.

The weighted average yield on occurring debt investments was 12.2% as of September 30, 2023, compared to 12.1% as of June 30. As a reminder, the calculation of weighted average yield is adjusted to exclude the accretion associated with the merger with FSKR. Similar to recent quarters, the increase in our weighted average yield during the third quarter was primarily associated with the continued rise in base rates, including the effects of our investment activity during the third quarter as of September 30, 2023 and approximately 86% of our total investment portfolio is comprised of investments originated either by KKR Credit or the FS/KKR Advisor. During the third quarter, excluding the impact of merger accounting, we experienced net portfolio appreciation on investments of approximately $23 million.

During the quarter, we placed 1 debt investment on nonaccrual. The company is named Barry Farming and it is 1 of the largest vertical farming businesses in the U.S. a smaller position in our portfolio as the first lien loan has a cost basis of $52 million and a fair value of $13 million as of September 30. We also received a $15 million pay down at par during the quarter. As of September 30, 2023, non-accruals represented 4.8% of our portfolio on a cost basis and 2.4% on a fair value basis compared to 4.8% on a cost basis and 2.5% on a fair value basis as of June 30, 2023. We believe it is helpful to provide the market with information based on the assets originated by KKR Credit. As of the end of the third quarter, non-accruals related to the 86% of our total portfolio which has been originated by KKR Credit and the FS/KKR Advisor were 2.3% on a cost basis and 0.6% on a fair value basis.

Additionally, since the start of the FS/KKR Advisor almost 6 years ago, the adviser has originated over $22 billion of investments and has experienced an annualized cost basis nonaccrual rates of less than 1%. And with that, I’ll turn the call over to Steven to go through our financial results.

Steven Lilly: Thanks, Brian. Our total investment income increased by $3 million quarter-over-quarter, to $465 million. The primary components of our total investment income during the quarter were as follows: total interest income was $374 million, a decrease of $2 million quarter-over-quarter primarily driven by the $500 million in asset sales we mentioned last quarter. Dividend and fee income totaled $91 million, an increase of $5 million quarter-over-quarter as our joint venture experienced approximately $3 million in onetime fees and dividends. Our total dividend and fee income during the quarter is summarized as follows: of recurring dividend income from our joint venture, other dividends from various portfolio companies totaling approximately $21 million during the quarter and fee income totaling approximately $12 million during the quarter.

Our interest expense totaled $117 million, a decrease of $1 million quarter-over-quarter due to the decline in net debt to equity from 113% at June 30 to 110% at September 30. Our weighted average cost of debt was 5.3% as of September 30. Management fees totaled $56 million and incentive fees totaled $47 million, both unchanged quarter-over-quarter. Other expenses totaled $11 million during the third quarter, a decrease of $1 million. The detailed bridge in our net asset value per share on a quarter-over-quarter basis is as follows: our ending 2Q 2023 net asset value per share of $24.69 was increased by GAAP net investment income of $0.84 per share and was increased by $0.11 per share due to an increase in the overall value of our investment portfolio.

Our net asset value per share was reduced by our $0.70 per share quarterly distribution and the $0.05 per share special distribution. The sum of these activities results in our September 30, 2023, net asset value per share of $24.89. From a forward-looking guidance perspective, we expect fourth quarter 2023 GAAP net investment income to approximate $0.74 per share and we expect our adjusted net investment income to approximate $0.77 per share. Detailed fourth quarter guidance is as follows: our recurring interest income on a GAAP basis is expected to approximate $377 million. We expect recurring dividend income associated with our joint venture to approximate $53 million. We expect other fee and dividend income to approximate $23 million as we expect normal course asset-based finance dividends to be incrementally lower in the fourth quarter.

From an expense standpoint, we expect our management fees to approximate $56 million. We expect incentive fees to approximate $42 million. We expect our interest expense to approximate $117 million and we expect our other G&A expenses to approximate $10 million. During the fourth quarter, we expect our excise taxes will approximate $22 million. We expect the net effect of excise taxes to be partially offset by the accretion of our investments due to merger accounting which is why our projected fourth quarter GAAP net investment income is $0.04 per share below our anticipated adjusted net investment income. Our gross and net debt to equity levels were 115% and 110%, respectively, at September 30, 2023, compared to 118% and 113% at June 30, 2023.

At September 30, our available liquidity was $3.6 billion. Approximately 59% of our drawn balance sheet and 42% of our committed balance sheet was comprised of unsecured debt. In October, we further enhanced our liquidity and debt maturity profile by closing an amendment to our senior secured revolving credit facility. The amendment provides for, among other things, an increase in total commitments to $4.67 billion and an extension of the maturity date to the fourth quarter of 2020. We were very pleased to complete this amendment as it is reflected both of the strength of the FSK platform as well as the long-term relationships we are fortunate to maintain with the investment community. And with that, I’ll turn the call back to Michael for a few closing remarks before we open the call for questions.

Michael Forman: Thanks, Steven. In closing, we are pleased with our third quarter results and our year-to-date performance as our net asset value at the end of the third quarter was flat compared to the start of the year. Our adjusted net investment income in the quarter exceeded both our public guidance as well as our total dividend. Our underlying portfolio companies are performing well from a credit perspective and we deployed capital into compelling new transactions. With available liquidity of $3.6 billion and a strong balance sheet, we have ample capital to invest in attractive risk-adjusted opportunities we are seeing in the market. On behalf of the team, we thank you all for joining the call and for your continued support. And with that, operator, we’d like to open the call for questions.

Operator: [Operator Instructions] Our first question comes from John Hecht with Jefferies.

John Hecht: One of you guys talked — and I think it’s kind of the second time early talked about the pipeline activity increasing. I’m wondering if you can kind of describe — I mean, we’ve heard of, I guess, some increase in M&A activity and maybe some LBO activity. I’m wondering, can you characterize the kind of sources of the pipeline? And then what’s the competition around that pipeline? Is that shifting at all relative to the last 4 to 6 months as well?

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Q&A Session

Dan Pietrzak: John. I’d put it into a couple of different sort of buckets of terms of the pipeline activity. One of it’s just been we’ll call it, sort of live processes, albeit that’s probably still not maybe to the level that you would expect in any sort of normalized market but a certain amount of green shoots there. And then some of it has also been, we’ll call it, either early reads or companies that we know are kind of gearing up for a sales process as we get further into ’24. So my sense is you’re going to see the — and we said this on the last call, it will take, I think, several quarters for us to kind of get through the system where things kind of actually fund. But I think you’ll see the majority or at least where we’re sitting today, the majority of that activity in kind of probably Q2 through Q4 of ’24 in terms of additional kind of actual closed and funded deal flow.

In terms of competition, I’m assuming that means kind of who’s kind of funding the deals. I do think the market is decently competitive right now. I think that’s a little bit of the technical. There just hasn’t been a lot of deals and people kind of want to do some and stay funded and get to their target leverage or sort of deployment numbers. But I think the quality of those deals remains very high and having the ability to earn kind of plus 12% on them for kind of good, large companies, 1 sort of risk with good sized equity checks. We still feel quite constructive on the market opportunity.

John Hecht: Okay, that’s helpful. And then, second question is maybe just could you give us an update on the asset-based finance pocket or pool and as well as the credit opportunities partners. I just — I know particularly asset-based finance, you’ve been particularly busy this year. I wonder, is that activity persisting?

Dan Pietrzak: Yes. I mean so on the asset-based finance side, it has been a very kind of busy time for us there. I think our platform is meaningfully built out with over 50 people dedicated to the space. We’ve got a fair amount of AUM dedicated to that space and the ability to kind of play up and down the capital structure which I think is a real nice competitive advantage for us. I think we always think about that market as having a lot of white space. We estimated sort of $5 trillion today, sort of on its way to $7 trillion. So that’s sort of quite positive. But what’s been going on with the regional banks has been a real sort of tailwind to that, either in allowing us to acquire asset portfolios or essentially fill the void from where they’ve taken a step back.

So I think we’ve been quite happy with what we’ve seen there. I think on the joint venture, I think the team has done a good job of in seeing that sort of continue to grow in terms of assets. I think we’ve got quite a strong liability sort of structure there. I think we like the returns that is still being sort of put from that or sort of off of that joint venture. And it just has real size and my number might not be perfect here. But we’d be, I think, maybe the seventh largest BDC if we were on a stand-alone basis, just sort of our joint venture. So I think we like the size and scale we have there as well.

Operator: Our next question comes from Casey Alexander with Compass Point Research & Trading.

Casey Alexander: Yes. Just one question, maybe two. How to position Solera that was picking in the second quarter and was supposed to pick for two quarters, we’ve now moved into the fourth quarter. Has that 1 reverted now back to cash pay? And how is that company doing?

Dan Pietrzak: Casey, the position has reverted back to cash pay. It did that at the end of Q3 but you won’t see the impact kind of really, we’ll call it come through the numbers. So that’s why the pick income would have been sort of elevated in the quarter as it was in the second quarter. You will see that it’ll move entirely to sort of cash pay and that was I think, almost 30% are out of the sort of total sort of pick amount and the company performance is strong in our mind.

Casey Alexander: Yes. Okay, good. Great. Secondly, are you willing to add some on balance sheet exposure? I mean most of the exposure that you’ve added over the last several quarters has all gone to the JV. The JV is now at about 10% — and maybe you addressed this a little bit but where can you grow the overall portfolio? Do you still have to go to the JV? Or can you add some to the on-balance sheet exposure?

Dan Pietrzak: No. I think you should expect to see the on balance sheet number sort of grow as well. Just I think we did add 2 89 to the joint venture this quarter. I don’t think anything went to the joint venture for the last quarter. I think we’re kind of well inside our target leverage number at FSK, I think we’re pretty happy with what we see in terms of dry powder in the entity, including the revolver sort of extended. So I think you should expect to see while still with inside that sort of target range, as kind of continuing to add assets on FSK’s balance sheet as we sort of move forward.

Operator: Our next question comes from Kenneth Lee with RBC Capital Markets.

Kenneth Lee: In terms of the upper middle market segment, I wonder if you could just talk a little bit more about what you’re seeing in terms of trends around covenants or terms for some of the more recent investments and whether you’re seeing any change there?