FS KKR Capital Corp. (FSK) Q2 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Welcome to FS Investment Corporation's Second Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note, this conference is being recorded. At this time, Marc Yaklofsky, Senior Vice President of FS Investments, will proceed with the introduction. Mr. Yaklofsky, you may begin.

Good morning, and welcome to FS Investment Corporation's Second Quarter 2018 Earnings Conference Call. Please note that FS Investment Corporation may be referred to as FSIC, 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 our press release that FSIC issued on August 9, 2018. In addition, FSIC has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended June 30, 2018. A link to today's webcast and the presentation is available on the Investor Relations section of the company's website at www.fsinvestmentcorp.com under presentation and reports. Please note that this call is the property of FSIC. Any unauthorized rebroadcast of this call in any form is strictly prohibited. I would also like to call your attention to the customary disclosure in FSIC's filings with the SEC regarding forward-looking statements. Today's conference call includes forward-looking statements, and we ask that you refer to FSIC's most recent filings with the SEC for important factors that could cause actual results or outcomes to differ materially from these statements. FSIC 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 FSIC's second quarter earnings release that was filed with the SEC on August 9, 2018. 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 FSIC's website. Speaking on today's call will be Todd Builione, President of FSIC; Daniel Pietrzak, Chief Investment Officer of FSIC; and Mike Kelly, President and Chief Investment Officer of FS Investments. We're also joined by Brian Gerson, Head of Private Credit of FS Investments. Michael Forman, Chief Executive Officer of FSIC, will not be on the call due to traveling conflicts, but he will continue to lead the calls going forward. I will now turn the call over to Todd.

Thank you, Marc. On today's call, I'll provide update on the progress we've made since announcing the partnership FS Investments and KKR in December of last year. Following my remarks, Dan Pietrzak will provide perspective on the lending environment and discuss our investment activity, and then Mike Kelly will discuss our financial results. We pride ourselves on doing what we say we will do. In that spirit, we plan to continue to articulate our strategy to drive near- and long-term value for our investors and then diligently execute upon that strategy. In the 4 months since we closed the partnership between FS and KKR, we've been busy executing. First, we remain disciplined in our underwriting approach and selectively allocated capital during the quarter, given today's competitive lending environment. Second, we made significant progress towards optimizing and streamlining FSIC's capital structure. Yesterday, we closed a $685 million revolver for FSIC as part of a $3.4-plus billion 5-year omnibus revolving credit facility that will be used by FSIC, FSIC II, FSIC III and CCT. More than 20 lenders participated in this syndicate. Proceeds from the new revolving credit facility will be used to refinance FSIC's existing revolving credit facilities. This new revolver provides many key benefits to FSIC. It provides cheaper financing, allows us to consolidate our existing leverage facilities, provides greater flexibility to originate assets across many different asset types, allows us to more efficiently manage cash and extends the maturity of our revolver to August of 2023. At $685 million, FSIC's new revolver is more than double the size of the existing revolver, and the rate of LIBOR plus 175 is 50 basis points lower than the cost of one of the existing revolvers and 75 basis points lower than the other existing revolver. We believe raising the $3.4-plus billion dollar omnibus revolving credit facility, which is the largest revolver arranged for a BDC franchise, is an example of the strength of the new FS/KKR partnership. Third, we committed to reducing our exposure to equity and other nonincome-producing investments and redeploying that capital to help increase portfolio yield. During the second quarter, we fully exited 3 equity investments and will seek opportunities to further reduce our exposure over time. Fourth, we've repurchased over $47 million in shares out of the $50 million authorized amount, and we intend to fill the remaining amount in short order. These repurchases were executed at a weighted average share price of $7.61, which is below the fund's NAV, and therefore, were immediately accretive to shareholders. Finally, we announced the merger of FSIC and CCT on July 23. We believe that merging these entities will provide business and operational synergies in the near term as well as longer term that will expand shareholder value, specifically through reductions in administrative costs, further expansion and diversification of the investment portfolio and the optimization of our capital structure with lower borrowing costs. We recently filed a preliminary joint proxy statement with the SEC, hope to begin the proxy solicitation process in September and expect to close before year-end, subject to shareholder approval and, of course, the satisfaction of other closing conditions. We'll continue to provide updates on these initiatives in the coming months. With that, I'll turn the call over to Dan to discuss our portfolio activity during the quarter.

Thank you, Todd. Over the past several quarters, we have commented on the generally tight conditions that continue to prevail in today's marketplace. Especially in markets like these, careful credit selection is critical as is focusing on structural protections within transactions. Despite the overall market trend favoring covenant-like transactions, all of our direct origination activity in the second quarter included both incurrence and maintenance covenants. We maintained our focus on investing in senior secured and floating rate debt, which, at the end of the second quarter, represented approximately 76% and 70% of the portfolio, respectively. Based on fair value, up from 73% and 69%, respectively, as of March 31, 2018. With the continued emphasis on floating rate assets, our portfolio remains well positioned to benefit from a rising rate environment. Commitments to direct originations during the quarter were $163 million compared to $79.6 million in the first quarter, 92% of which were in first lien senior secured loans. Loans to 6 new borrowers accounted for $141 million of the total $163 million, representing 86% of direct origination activity, while in the previous quarter, add-on financings to existing borrowers accounted for all of the origination activity, highlighting the momentum the FS/KKR partnership has gained with sponsors and borrowers in just a short amount of time. Exits of $288 million during the second quarter were driven by both repayments and the sale of certain equity investments. The majority of the repayments of loan positions was driven either by company sales or capital markets refinancing, as opposed to competitor refinancings. And as Todd mentioned, we have continued to focus on reducing our equity exposure. During the second quarter, we fully exited positions in 3 names, including The Stars Group and SECO industrial products, generating total proceeds of approximately $73 million. The results were positive as these equity sales comprised the majority of the $31 million of net realized gains during the quarter. Additionally, we expect to fully exit our common equity investment in PSAV at a realized gain in the third quarter in conjunction with the announced sale of the company. Following the exits during the quarter, equity investments comprised approximately 11% of the portfolio based on fair value as of June 30, 2018, or $386 million, down from 13% as of the end of the first quarter or $468 million. And as we stated last quarter, equity investments are not a core part of our origination and investment strategy. And as we actively work to reduce this exposure, we believe the strength of the current equity markets may present attractive exit opportunities. Turning more broadly to the portfolio. The gross portfolio yield prior to leverage and excluding nonincome-producing assets was 11.1% at quarter's end, up from 10.9% for the prior quarter and 10.5% for the quarter ended December 2017. The increase in FSIC's gross portfolio yield was driven by an upsize in existing directly originated portfolio investments as well as an increase in LIBOR. As of June 30, 2018, we had 2 companies on nonaccrual, which, in aggregate, represented less than 1% of the portfolio on both a fair value and amortized cost basis. During the second quarter, our second lien investment in Logan's Roadhouse was placed on nonaccrual, making it the only new nonaccrual asset for the quarter. The position totals approximately $6.1 million based upon fair value and $22.1 million based on amortized cost. Additionally, EV energy was removed from nonaccrual status following its restructuring in June. Our ownership in the restructured entity is reflected in our investment in the common shares of Harvest Oil & Gas Corp. Now before I turn it over to Mike, I wanted to make some comments about the market generally as well as our pipeline activity. As we mentioned before, the competitive environment continues to intensify. In this market where upper middle market borrowers have access to the capital markets and there is strong competition in the lower part of the middle market, we believe it's critically important to have broad origination capabilities to be highly selective and have the ability to provide a wide range of creative solutions to sponsors and their portfolio companies. To put some numbers around this, year-to-date, the KKR team has reviewed 740 private credit transactions. On an annualized basis, that's approximately 1,500 transactions compared to 760 in total for all of 2017. While deal flow can be lumpy quarter-over-quarter, we believe our continued investment in the KKR credit platform has resulted in a meaningful uptick in deal flow. When -- we recognize that volume alone doesn't translate into higher future returns. However, it does allow us to be selective in the current environment, which we believe is critical in maintaining our underwriting discipline and serves as a competitive advantage. I'll now turn the call over to Mike to discuss our financial results for the quarter.

Thanks, Dan. During the second quarter, we fully covered the distribution of $0.19 per share through net investment income, which was also $0.19 per share. This compares to $0.21 per share for the first quarter of 2018 and $0.19 per share for the quarter ended June 30, 2017. Adjusted net investment income for the quarter was $0.19 per share compared to $0.21 per share for the first quarter of 2018 and $0.19 per share for the quarter ended June 30, 2017. Fee and dividend income totaled $3 million in the second quarter of 2018 compared to $9.8 million in the first quarter of 2018. Fee and dividend income was lower quarter-over-quarter due to more measured direct origination activity as well as the recognition of a large dividend payment from PSAV during the first quarter and the repayment of assets that were beyond their call period or stepping down in protection. The fund's net asset value declined from $9.16 per share as of March 31, 2018, to $8.87 per share as of June 30, 2018, driven primarily by mark-to-market unrealized losses in our investments in ThermaSys, Advanced Lighting, Hudson Technologies, Logan's Roadhouse and Global Jet Capital, partially offset by realized gains on our equity investments in SECO Industrial Products and the Stars Group as well as the positive impact of share repurchases. The mark-to-market unrealized losses were primarily driven by financial underperformance relative to budget and underwriting in each of these investments. We are proactively working with the company's respective sponsors and management teams to maximize our returns on these assets. As Dan stated, nonaccruals are low and have been for several quarters. The funds and asset value decline has been driven primarily by idiosyncratic company-specific reasons, as in ThermaSys, as well as smaller EBITDA companies, such as Advanced Lighting and Logan's Roadhouse, as well as volatility in the prices of our equity investments. We are working closely with the management teams of these companies to address their operational and/or liquidity needs as well as seeking ways to accelerate the monetization of our equity portfolio. Furthermore, we expect to focus our origination efforts on upper middle market companies, which we believe are less volatile overall. One final point on leverage. Our position with respect to incremental leverage has not changed from what we stated last quarter. And we are pleased to note that S&P and Fitch affirmed FSIC's investment-grade credit rating and stable outlook following the announcement of the merger. Finally, as we announced last year, the board intends to make a special distribution in the fourth quarter of 2018 to the extent that net investment income earned from the fourth quarter of 2017 through the end of the third quarter of 2018 exceeds the current annualized distribution amount of $0.76 per share. In other words, our stockholders will receive the benefits of any outperformance over the current annualized distribution rate. I'll now turn the call back over to Todd.

Thanks, Mike. We appreciate everyone's time this morning. We're excited by the benefits we believe this partnership is creating for our investors, and we remain relentlessly focused on delivering the BDC industry's premier platform. With that, we'll now open the call up for questions.

[Operator Instructions] Our first question comes from Fin O'Shea with Wells Fargo Securities.

Just first one on the broader platform-wide credit facility. What kind of impact does this have on the remainder of the debt structure, assuming a lot of assets will have to be uniquely pledged? Correct me if I'm wrong there, just a kind of outlook on your debt capital structure going forward.

Sure, Fin. It's Todd Builione. Thanks for the question, it's a good one. So a few points, and all these relate to FSIC only, FSIC's portion of the broader omnibus revolver. I guess, first point is that we expect about $2 million of annual savings. It’s a LIBOR plus 175 facility. At close, $685 million committed for FSIC and $201 million drawn. FSIC is going to use those initial proceeds to pay down $84 million of the existing revolver, which is more expensive at LIBOR plus 225. $67 million will be used to terminate one of the ABL facilities, which is currently at LIBOR plus 250, and then $50 million will pay down another ABL facility, which is at LIBOR plus 268. And there's a few other just advantages given that we're on the revolver in terms of the impact on the platform beyond cheaper financing. It's, obviously, as you can see, going to allow us to consolidate some of the existing facilities; get rid of some of the complexity; certainly gives us greater flexibility to originate many different types of asset classes, more efficient capital or cash management, given that you can call the capital the same day; and it extends the maturity of the revolvers to August of 2023, which, for FSIC, is a 2.5-year extension.

Okay. And then just to clear things up, there were, of course, a few regime changes on the fee structure surrounding the advisory merger. What -- with the incentive fee, you're still at about 19.2% incentive fee on pre -- as a percentage pre -- as incentive fee on NII. What's holding back the lookback of kicking in at this point? Is it starting from a low starting period? Or is there a delay in the lookback kicking in?

Our next question comes from Terry Ma with Barclays.

Wait, wait, wait, no. Sorry. So I mean, the punchline is -- Fin, thanks for that question too. We expect it could kick in next quarter. We've kind of had the benefit of prior gains rolling off in prior quarters. But certainly, there'll be some benefit of that in prospective quarters.

Our next question comes from Terry Ma with Barclays.

Can you just talk or a give a little bit more color on your equity exposure? Is there a general time line for just whittling debt, rotating out of that? And also, out of the $386 million, can you maybe just talk about how much of that is actually under your control to monetize versus not?

Yes, good question. This is Dan Pietrzak. I mean, just to refresh, I mean, on the last call, we talked about that being a real focus for us, trying to take down that equity exposure of these nonincome-producing assets. I think we're happy with the results of the quarter with Stars and SECO Industrial. The PSAV deal actually closed yesterday. I think money is coming in, sort of, today. So that will sort of continue down. The rest of it is a mix of things that I would say, to be honest, are in our control, although we might not be a majority owner. So it could be a more bespoke sort of sales process. Some of it is equity co-invest that we may have very well made in conjunction with regular way loans. I think the latter piece is one where the focus for us will not be more on the positions that are more sort of stand-alone and we will sort of look to move. I think in terms of time line, there's nothing fixed. I think where the equity markets are, where valuations are, I think there's some decent opportunities to do so. But I think you should continue to see that being a focus for us next quarter and the coming quarters.

Got it. And then you just talked about overall competition and how you guys are highly selective. Can you just may be talk about what your ROE or IR is on the new investment today versus what it was maybe a year ago, and how that's trended?

Yes, and that's a very fair question. I think we have been very focused on building the team and making our origination footprint as broad as possible. I think we're under no illusion that the market has a fair amount of competition these days. You have lenders pushing on terms and conditions, you have equity valuations sort of high. So I think the biggest mitigant to us is that ability to be selective, which is why we quoted those numbers in that script. We have seen pricing come down. I'll give you kind of a -- we'll call it a regular way direct lending loan these days. That, we'll call it, a year ago on a -- you would've been priced at sort of LIBOR plus 700. That could very well be LIBOR 625 today. Now there's some good news in there, though. Rates are up. So most of these loans do have LIBOR floors. So it's not up, so we'll call it the full 180 basis points to sort of 200 basis points. But you're still all in with amortization of fees, probably around $9 million sort of plus unlevered. That's just for a regular way directly originated first lien loan. So I think that's held up actually pretty well from this market, but obviously, from the benefit of rates. And then as Todd talked about, we are pretty focused on the liability side here. And this revolver is a big deal. And we're quite happy it got done, and that'll just help the overall returns.

[Operator Instructions] Our next question comes from Paul Johnson with KBW.

My question is just kind of on that facility. I'm just curious, are there any sort of secured ratios or any other covenants within that facility that apply at the BDC level?

Thanks, Paul, for the question. It's Todd. There's a minimum asset coverage ratio of 2x, which is consistent, as you know, with our current stance on leverage, which is keeping it to 1:1 debt to equity.

Okay. And then my last question was just on your investments in ThermaSys. I was just wondering if you guys could provide any sort of outlook or color on that investment, just given it was marked down pretty substantially.

Sure. It's Brian. ThermaSys is a manufacturer of heat exchangers, basically radiators and coolers and condensers that go into various industrial end markets. We have $148 million face value of 11.5% notes, which are behind a senior term loan. The company has faced some headwinds in performance over the last couple of quarters. We're continuing to work with management and the sponsor on maximizing our value on this loan. But I think, generally, it's a company that we're keeping a very close eye on. And we're hoping for -- we expect to see some better results later in this year, but the mark reflects what we've seen so far.

[Operator Instructions] And I'm not showing any further questions at this time. I'd like to turn the call back over to our hosts.

Thanks, everyone, for joining this morning. We really appreciate it. We appreciate the great questions and the focus, and we look forward to continuing forward with the partnership and adding value to shareholders over time, keeping everyone updated. Hope everyone has a great weekend.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.