FS KKR Capital Corp. (FSK) Q3 2020 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to FS KKR Capital Corp II's Third Quarter 2020 Earnings Conference Call. Your lines will all be in a listen-only mode during the remarks from FS KKR's management. At the conclusion of the company's remarks, we will begin the question-and-answer session. [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, please begin.

Thank you. Good morning, and welcome to FS KKR Capital Corp II's third quarter 2020 earnings conference call. Please note that FS KKR Capital Corp II may be referred to as FSKR 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 FSKR issued on November 9, 2020. In addition, FSKR 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, 2020. A 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 a property of FSKR. 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, including risks associated with the possible impact of COVID-19 that could affect FSKR or the economy generally. We ask that you refer to FSKR'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. FSKR 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 FSKR's third quarter earnings release that was filed with the SEC on November 9, 2020. 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 FSKR's website. Speaking on today's call will be Michael Forman, Chairman and Chief Executive Officer; Dan Pietrzak, Chief Investment Officer and Co-President; Brian Gerson, Co-President; and Steven Lilly, Chief Financial Officer. Also joining us on the phone are Co-Chief Operating officers, Drew O'Toole and Ryan Wilson. I will now turn the call over to Michael.

Thank you, Robert, and welcome, everyone to FS KKR Capital Corp II's third quarter 2020 earnings conference call. First, let me offer my continued well wishes to each of you, your loved ones and your co-workers as our country continues to adapt to a post-COVID world. The FS KKR team continues to function largely in a virtual work environment. Thanks to the ongoing dedication of our investment and operating teams, the day-to-day cadence of our business somehow has begun to seem almost normal. I continue to be extremely proud of the job our team is doing during these extraordinary times. In recent weeks, our country has been almost entirely consumed by events leading up to the presidential election. The uncertainties associated with the election, combined with the effects of the pandemic and social unrest, seem to have permeated every aspect of our society. Our hope is that as we move towards the Thanksgiving holiday season in just a few weeks that our country will begin the process of healing by recognizing we are stronger together than we are divided. Across our investment portfolio, we have seen management teams and sponsors continue to make well-informed business decisions focused on positioning their companies for long-term value creation. These decisions have included such things as building cash reserves, streamlining operations, communicating proactively with customers and realigning supply chains to maximizing time to market for products. These decisions are manifesting themselves in tangible ways as the value of our investment portfolio appreciated during the third quarter, resulting in an increase in our net asset value per share of 1.8% as of quarter end. The FS KKR investment team has done an exceptional job working closely with these companies. From an operating perspective, our net investment income was $0.52 per share during the quarter, which was in line with the guidance range we outlined in last quarter's earnings call. From a liquidity perspective, we ended the quarter with approximately $1.8 billion of available liquidity with no meaningful near-term debt maturities. During the third quarter, we began executing our previously announced $100 million share repurchase program. Through October 31, 2020, we have purchased approximately $39 million of shares under the program. Looking forward, we currently expect our fourth quarter net investment income to approximately $0.52 to $0.55 per share. Like last quarter, we are providing a range of net investment income per share given the inherent uncertainties associated with growing our investment portfolio during these extraordinary times. Our board has declared a distribution of $0.55 per share for the fourth quarter, which equates to an annualized yield of 8.9% on our NAV per share of $24.66 as of September 30, 2020. This dividend levels and keeping with our long-term targeted yield of NAV of 9%. And with that, I'll turn the call over to Dan and the team to provide additional color on the market and the quarter.

Thanks, Michael. From a macro perspective, many of the trends we highlighted in our second quarter earnings calls have continued to develop, including a rebuilding of our investment pipeline alongside a re-emergence of M&A activity. And while the market is still not back to pre-COVID levels in terms of transaction volumes, we believe it has recovered to approximately 75% or 80% of those levels. Another topic we discussed in detail in our second quarter call, the disconnect between the markets and the general U.S. economy continues to raise meaningful questions and still concerns us with regard to near-term economic performance and ongoing recovery. The high-yield market continues to experience record monthly issuance levels as illustrated by year-to-date 2020 cumulative issuances of $338 billion through September 30, which is only $7 billion below the full year annual issuance record of $345 billion the market set during 2012. The high-yield market continues to be fueled by a record level of refinancings not seen since the Great Recession. In the leveraged loan market, the record level of monthly issuances in January and February evaporated in March and remained depressed through July. However, in both August and September, the leveraged loan market has returned to record levels of issuances as borrowers have accessed the market with a healthy balance of LBO, M&A and refinancing activity. Pricing for these leveraged loans has been aggressive in many instances driven in part by the low overall yield environment and a desire by many managers to put money to work in an effort to generate current yields. From a KKR perspective, we continue to believe that the Federal Reserve's stated goal of reducing unemployment from the current level of 6.9% to the Fed's long-term target of 4.1% while simultaneously targeting inflation of around 2% per year. Illustrates clearly the Fed's focus on recovery of jobs first with inflation targeting a distinct second. As a result, we believe significant levels of government stimulus will continue well into 2021 and possibly beyond. Across the FS KKR platform, we are participating in a number of active processes relating to new investments, but we are continuing to invest with a narrow credit lens during this unprecedented time. While our goal is to generate attractive risk-adjusted returns, given the still fragile nature of many aspects of the economy, we are exercising caution from an underwriting perspective. Additionally, the renewed health of the financing markets, especially in the upper end of the middle market where we focus, has created strong demand for perceived high-quality transactions. In some cases, we are seeing pricing and structural terms return to pre-COVID levels. Across the FS KKR platform, we benefit significantly from our incumbency positions with existing borrowers as well as our deep relationships with key sponsors. These positions and relationships have allowed us to see our fair share of new opportunities, while still maintaining a selective bias which hinges on the protection of principal first and yield second. As a result of these fundamental drivers, during the second quarter, we originated $264 million in new investments, which is still below our capabilities from a processing or capacity standpoint. Our $264 million of total investments combined with $214 million of net sales and repayments, when factoring in sales to our joint venture, equated to net portfolio growth of approximately $50 million during the quarter. I should mention that during the period from October 1 to November 4, FSKR closed an additional $475 million in investments. As a result, even though we believe we have remained disciplined from an origination perspective. We think we are well positioned from an overall portfolio standpoint as we move into the last few months of the year. Last quarter, we began providing detailed investment performance metrics for the FS KKR Advisor. This information is detailed on Slide 23 of our investor presentation on our website. The updated information is summarized as follows. Since the FS KKR Advisor was formed through December 31, 2019, we made approximately $3.2 billion in new investments, and we experienced 62 basis points of cumulative depreciation. And from the same starting point through September 30, 2020, we have originated approximately $4.2 billion of new investments and have experienced 2.71% of cumulative depreciation, which includes the effects of COVID. We continue to be satisfied with the investment performance our team has been able to deliver over this time period, and we believe these data points illustrate the manner in which we are turning the investment portfolio toward what we believe to be more conservative investment structures in companies with more defensible operating positions. Lastly, on this point, as of the end of the third quarter, approximately 55% of our portfolio has been originated by the FS KKR Advisor, and 61% has been originated by KKR. From a forward-looking perspective, we believe the federal government will continue to find ways to support the economy until either an effective COVID vaccine is developed or herd immunity is achieved. We believe the broader market, which has been in receipt of stimulus dollars and government support, will continue to function somewhat in line with where we are today, that is, liquidity will continue to exist for both borrowers and lenders, some level of corporate M&A activity will continue and the public markets will continue to function within a band of relative normalcy. Of course, these assumptions, in large part, depend on investors' and operators' collective trust in the future actions of the federal government. We also believe government intervention in the economy will be increasingly difficult to unwind in a non-disruptive manner, the longer the monetary support is required. As a result, we are pleased with the performance of our investment portfolio this quarter. And while we are confident that the investment decisions we currently are making are based on thorough analysis and diligence, we have to acknowledge that the operating world which we find ourselves is still far from normal. These observations lead us to conclude that the road back to full recovery may, at times, be volatile. And for no other reason than the significant dependence the capital markets has placed on our federal government for the foreseeable future. Nevertheless, we are pleased with the quarter, and believe we are well positioned as we begin to look forward to 2021. And with that, I'll turn the call over to Brian to discuss some investment portfolio specifics.

Thanks, Dan. As of September 30, our investment portfolio had a fair value of $7.3 billion, consisting of 160 portfolio companies. This compares to a fair value of $7.3 billion and 154 portfolio companies as of June 30, 2020. At the end of the third quarter, our top 10 largest portfolio companies represented 26% of our portfolio, which remains in line with our results to the last several quarters. We continue to focus on senior secured investments as our portfolio consisted of 67% of first-lien loans and 77% senior secured debt as of September 30. The weighted average yield on occurring debt investments was 8.6% at September 30, 2020, as compared to 8.7% at June 30, 2020. The decline in our weighted average portfolio yield was primarily due to the change in certain investment spreads and maturity coupled with LIBOR contracts which reset at lower levels during the quarter. From a non-accrual perspective, as of the end of the third quarter, our non-accruals represented approximately 9.2% of our portfolio on a cost basis , and 4.2% of our portfolio on a fair value basis, compared to 11% and 5.4% as of June 30. During the quarter, we placed two investments on nonaccrual. Belk, a mall based retailer for the cost basis and fair value of $42 million and $19.2 million, respectively, as well as Intelsat Jackson, the communications satellite provider, with a cost basis and fair value of $3.5 million and $2.4 million respectively. From an overall valuation perspective, our investment portfolio increased by approximately 1% or $59 million during the quarter. The details associated with our quarterly valuation results are as follows. The total amount of realized and unrealized appreciation we experienced across the portfolio during the quarter was $336 million. A quarterly appreciation includes the reversal of $207 million of unrealized appreciation associated with certain portfolio company restructurings, including Borden Dairy, FourPoint, Mood Media and Arena. Our remaining 129 million in portfolio appreciation primarily was driven by a combination of positive operating results and improved valuation inputs during the quarter for specific investments initially impacted by spread widening and general market conditions during the first and second quarters, but which continued to recover. Our realized and unrealized depreciation totaled $277 million during the quarter. Over 93% of our unrealized depreciation was related to certain legacy investments, many continuing to be impacted by the effects of COVID, including our investment in production resource group, which was marked down by $67 million. In addition, approximately $217 million depreciation related to realize losses primarily from the previously mentioned restructuring. While we discussed many of the specifics of these investments on our second quarter earnings call, having a series of completed restructurings across the legacy portion of our portfolio represents a meaningful step for us from both an operating and valuation perspective. Taking our dedicated workout group was instrumental during these complicated and time consuming processes, which we believe demonstrates the value of having a dedicated internal team of investment professionals able to work seamlessly alongside our investment teams from navigate these challenging situations. And with that, I'll turn the call over to Steven to discuss our financial results in more detail.

Thanks Brian. My comments will be less focused on the reporting financial metrics already contained in our earnings press release in 10-Q, but rather focus more on the color behind our results. Hopefully linking them in a more transparent and informative way to the broader comments on which Michael, Dan and Brian have touched. First, the $4 million increase in our investment income this quarter was related to an increase of $12 million in dividend income from both our joint venture and asset based finance investments, which was partially offset by a decrease of $2 million and fee income and $6 million of interest income. As a reminder, 98% of our floating rate investment portfolio has floors which average 91 basis points, our recurring dividend income from our JV totaled $21.9 million during the quarter. As many of you know we typically expect this recurring dividend to approximate between $17 million and $22 million on a quarter-to-quarter basis. Our interesting expense declined by $9 million during the quarter as we've benefited from the reduction in LIBOR as approximately 86% of our drawn balance sheet is floating rate. Management fees decreased by $1 million during the quarter due to the lower amount of average gross assets during the quarter compared to the prior quarter. The detailed bridge in our net asset value per share on a quarter-over-quarter basis is as follows. Our starting 3Q 2020 net asset value per share of $24.22 was increased by net investment income of $0.52 per share and was further increased by $0.35 per share due to an increase in the overall value of our investment portfolio. Additionally, our net asset value per share was positively impacted by share repurchases of $0.12 per share during the quarter. And our net asset value per share was reduced by our $0.55 per share dividend. The sum of these activities results in our September 30 net asset value per share of $24.66. From a forward-looking perspective, the bridge from our third quarter net investment income per share of $0.52 to our fourth quarter recurring net investment income per share guidance of $0.52 to $0.55 is as follows. Our recurring interest income is expected to be $5 million higher due to overall growth in our investment portfolio. We expect recurring dividend income associated with our JV to approximate $21 million. We expect other fee and dividend income to approximate $14 million during the quarter which flat quarter-over-quarter. From an expense standpoint, we expect our interest expense will increase by approximately $2 million during the fourth quarter due to an increase in origination activity. We expect management fee and other general and administrative expenses will remain relatively flat during the quarter. As a reminder, over the long-term we expect our dividends per share will equate to a 9% yield on our net asset value per share. Though, we acknowledge there will be certain quarters where our annualized yield maybe great or less than this range due to quarter-to-quarter fluctuations in the business from an operational standpoint. That being said, we are pleased that during the first three quarters of 2020, despite the far-reaching effects of COVID and the resultant [Audio Gap] investment portfolios, we have been able to exceed our 9% target dividend yield. Obviously, our dividend policy of achieving a 9% target dividend yield on our net asset value means that, overtime, it would be normal for our quarterly dividend to fluctuate somewhat in concert with the quarter-to-quarter change in our net asset value. In terms of the right side of our balance sheet, our gross and net debt to equity levels are 78% and 73%, respectively. These leverage levels represent a modest decline from our leverage levels during the first and second quarter of this year. Our available liquidity of $1.8 billion equates to approximately 25% of the value of our investment portfolio, which continues to be a very comfortable percentage. Our capital structure is approximately 90% secured with an overall weighted average cost of debt of 3.1% Finally, from an unfunded commitments perspective, as of September 30, 2020, we had approximately $465 million of unfunded debt commitments, of which $128 million represented revolver facilities and $210 million of unfunded equity commitments, primarily associated with commitments related to our asset-based finance portfolio. As we said during both our first and second quarter earnings calls, the majority of our unfunded debt and equity commitments are generally used for capital expenditures for acquisitions and therefore subject to performance or other threshold tests including, in certain situations, our specific consent. As a result, while these commitments are disclosed in our 10-Q for informational purposes, we do not believe they will be drawn in any meaningful capacity on a quarter-to-quarter basis. And with that, I'll turn the call back to Michael for a few closing comments before we open the call for questions.

Thanks, Steven. As we have mentioned throughout this call, there is no shortage of issues our world currently faces. And we believe the federal government will continue to play an active role in the economy for the foreseeable future. That said, we continue to believe the long-term benefits that we believe would accrue to investors from the establishment of the FS KKR platform are beginning to materialize in tangible ways. From deep sponsor relationships to the rigor of investment committee decision-making, to proactive portfolio management, to broad-based dedicated workout teams, to seasoned BDC industry operators, the best of what we structured and planned for as we establish the FS KKR Advisor seems to be coming to fruition at a very opportune time. We will look forward to continuing to update you on future progress. And with that, operator, we would like to open the call for questions.

[Operator Instructions] And our first question comes from the line of Rick Shane with JP Morgan. Your line is open. Please go ahead.

In terms of the sales nonaccrual, that had been on nonaccrual at FSK previously, and I believe it's two different securities. Can you just talk about the decision to move to security at FSKR on to nonaccrual as well, please?

Thanks, Rick. And you're correct, it is a different security. I think there's nothing a scholar specific about the name other than being kind of a mall based retailer. Obviously impacted by COVID. We actually don't have any knowledge of them, not expecting to pay in the near term, they've actually made all of their recent payments up and down the capital structure both first and secondly, including amortization payments. So we thought the prudent thing to do is have this on nonaccrual.

That's helpful color especially the continued payments. And then obviously, the other big move during the quarter was the restructuring or production resource from a loan to an equity investment. When we look at the history of that nonaccrual that seems to be given the timing of going on nonaccrual in the first quarter, a COVID related challenge, is that correct? And when you look forward on the path given the equity investment and potentially the COVID sensitivity. How do you think that plays out? Is this a recoverable investment?

It's very much a COVID impacted name, I mean, just to level set, it is sort of, and industry leader, the industry leader in providing in production services lighting sort of volume et cetera. Broadway's in a big focus for them. Obviously, with the status of large scale events and Broadway in particular, the business has been challenged. I think we're quite happy with where we've gotten to on this. It's been a lot of hard work, I think we're quite happy with the team there. And what their footprint is. I think their road to recovery will be -- we'll call dictated by what happens with the pandemic, and when things start to open up, but we think -- we think a lot of hard work still in front of them. But I think, we're satisfied with where we sit today being cognizant of the meaningful impact that COVID has had on this thing.

Thank you. [Operator Instructions] And our next question comes from Finian O’Shea with Wells Fargo Securities. Your line is open. Please go ahead. Finian O’Shea: Just a question on the CLP's credit facility that was amended to a higher interest rate, Alpha Street 30. Which is a little bit against the trend. Obviously, by July 30 a lot better by understanding, those processes can be in place for some time. So any color you can provide on why those -- yes, I guess lending conditions may have gotten more tight on the joint venture?

Yes, Finian it's a fair question. I think a lot of it is timing related. I think we've used -- we've seen a euphoria in the market as it relates to financing spreads on deals like this. But that's probably even more, post-August of the middle of August. The terms here, here were agreed in what's called a bit of a harsher environment and in the middle of the summer. That said, I think it was it's a one year extension, I think we continue to optimize, and in some ways kind of clean up the overall liability structure of FSKR. So it's a one year extension. But I think your point is right, with where we sit today versus when that would have been specifically negotiated. Finian O’Shea: And I guess just a follow up on a higher level? I think it's IPO about six months ago, maybe less. But on any, obviously, you have a history of some merging the BDC vehicles together, understanding so expensive thing to talk about. But any, like higher level direction on how you view these vehicles being separated. Is it still a medium to long term desire to have them come together? And anything, any sort of color on the journey that, that you need to go through before that would happen?

Now, it's a good question. And we've obviously got that question a bunch of times on this call last quarter, or sort of along the way. I mean, we've obviously been focused on kind of performance and getting FSKR deployed. I think we're very happy. This is, the first kind of full public quarter as a public entity, so it's clearly something that remains in our minds. And I think the color we've gotten for many years it's something that can make a lot of sense. I think we've just been focused on this sort of quarter now. But it's a very fair question to ask.

Thank you. And I'm showing no further questions at this time and I would like to turn the conference over to Mr. Dan Pietrzak for any further remarks.

Thank you. We want to thank everyone again for your time today. We do hope that you and your families remain safe and healthy. And we do look forward to talking with you again soon. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.