FS KKR Capital Corp. (FSK) Q4 2020 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Welcome to FS KKR Capital Corp. II's Fourth Quarter 2020 Earnings Conference Call. Your lines will be in listen-only mode during remarks by FSKR'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, you may begin.

Thank you. Good morning, and welcome to FS KKR Capital Corp. II's fourth 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 March 1, 2021. 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 December 31, 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 the property of FSKR. Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today's conference call includes forward-looking statements and 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 fourth quarter earnings release that was filed with the SEC on March 1, 2021. 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 fourth quarter 2020 earnings conference call. Given the enormity of the events which occurred during 2020, we continue to feel humble as we gather to discuss our financial and operating results. We also acknowledge that while there are compelling reasons for many in the world to have hope for return to normalcy, the world never will be the same for those whose lives have been directly impacted by the effects of COVID-19. The fourth quarter of 2020 was without question a positive quarter for FSKR. During the quarter, our investment teams originated approximately $1.3 billion of new investments. We experienced an increase in our net asset value and we out earned our $0.55 per share dividend. In addition to those successes, we announced the proposed merger of FSK and FSKR in November, which was a significant step forward toward our long-term strategic goal of creating a premier middle market lending franchise and interesting leading BDC, and we believe a significant step forward for our shareholders. From an operating perspective, our adjusted net income was $0.61 per share during the fourth quarter, which was $0.06 per share above our quarterly dividend of $0.55 per share and also roughly $0.08 per share above the midpoint of our public guidance range we outlined in our last quarter’s earnings call. From a liquidity perspective, we ended the fourth quarter with approximately $1.75 billion of available liquidity with no meaningful near-term debt maturities. Looking forward, we expect our first quarter net investment income to approximate $0.56 per share. As such, our Board has declared a distribution of $0.55 per share for the first quarter, which equates to an annualized yield of 8.8% on our net asset value per share of $25.10 as of December 31, 2020. From a merger perspective, we anticipate the proxy solicitation period will begin this month, and we'll conclude at each of FSK’s and FSKR’s shareholder meetings scheduled for May 21, 2021. We should expect the proposed merger to close shortly after receiving approval by FSK and FSKR shareholders and other customary closing conditions. Assuming the timeline remains as scheduled, we expect the proposed merger to close during the month of June. As we turn to 2021, we do so not only with gratitude for the many accomplishments of our team over the last year, but with enthusiasm for what is to come as we plan to combine FSK and FSKR. The combination will create a single BDC with a size, scale, market reach, balance sheet strength and investing discipline to become a premier provider of capital to companies operating in the upper middle market. 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. In our recent earnings calls, we have focused on certain macro observations. Our views that the high-yield markets would continue to be robust, that the re-emergence of corporate M&A activity would lead to a rebuilding of BDC investment pipelines, and that governmental intervention in the economy would continue, are playing out largely as we expected. As we move into 2021, we believe sustained governmental investment and spending on initiatives and education, infrastructure, healthcare, supply chain resilience, and clean energy will continue to garner focus and attention. Combining these elements of governmental involvement in the economy with an expected rebound in consumer spending, inflation targeting by the Federal Reserve and an outlook for operating companies, which includes relatively easy year-over-year comps, we believe 2021 has many of the key ingredients to be a year filled with meaningful economic growth opportunities. Within the BDC industry, we believe company and platform size increasingly will lead the way as strategic differentiators. According to a recent study by Dechert LLP, 49% of private equity firms surveyed reported they utilized private credit interchangeably with the syndicated loan markets. And these same firms reported a 35% increase in their use of private credit over the last three years. Statistics like these illustrate how competitive private credit alternatives can be when they are able to be delivered on a scale, which is relevant to larger borrowers. We believe the KKR credit platform, which is one of the few platforms able to operate at such scale, is poised to continue attracting this new transaction volume, thereby leading to more attractive long-term growth prospects. As private credit continues to grow as a distinct asset class, our goal is to position ourselves as favorably as possible to capture more than our fair share of the corresponding increase in transaction volume. During the fourth quarter, the FS/KKR Advisor closed on approximately $1.9 billion of total investments across our BDC franchise, $1.3 billion of which were within FSKR. Despite the significant volume of investments we originated during the quarter, we remained very focused on structure and investment quality. Our closure rate as compared to transaction screened of under 3% during 2020 is actually a little bit lower than our historical closure rate of approximately 4%. In addition, approximately 44% of our FSKR originations this quarter came from opportunities and companies previously invested in by KKR, illustrating the power of incumbency and our relationships. Our $1.3 billion of total investments combined with $587 million of net sales and repayments, when factoring in sales to our joint venture, equated to net portfolio growth of $712 million during the quarter. During January and February 2021, we closed $489 million in investments, and we experienced $460 million in repayments. While it's impossible to be precise, like other larger platforms, we do expect a higher than average level of repayments during the first part of 2021, given the current elevated levels of liquidity in the syndicated markets. A few quarters ago, we began providing detailed investment performance metrics for the FS/KKR Advisor. 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 in FSKR and we experienced 62 basis points of cumulative depreciation. And from the same starting point through December 31, 2020, we've originated approximately $5.1 billion of new investments in FSKR and have experienced 45 basis points of cumulative depreciation. We continue to be pleased with the investment performance our team has been able to deliver for the last three years. And we believe these data points continue to illustrate the manner in which we are turning the investment portfolio toward what we believe to be more conservative investment structures, and companies with more defensible operating positions. This information is detailed on Slide 23 in our investor presentation on our website. And with that, I'll turn the call over to Brian to discuss some investment portfolio specifics.

Thanks, Dan. As of December 31, our investment portfolio had a fair value of roughly $8 billion consisting of 155 portfolio companies. This compares to a fair value of $7.3 billion and 160 portfolio companies as of September 30, 2020. At the end of the quarter, our top 10 largest portfolio companies represented approximately 24% of our portfolio, which remains in line with our results for the last several quarters. We continue to focus on senior secured investments, as our portfolio consisted of 66% of first lien loans and 76.5% senior secured debt as of December 31. In addition, our joint venture represented approximately 8% of the portfolio and our asset based finance investments represented approximately 10% equating to an additional 18% of the portfolio, which is comprised predominantly of first lien loans or asset based finance investments which we believe have meaningful principal protection. The weighted average yield on accruing debt investments was 8.5% as of December 31, 2020 as compared to 8.6% at September 30, 2020. In terms of color surrounding the repayments we experienced during the quarter, approximately 40% of our repayments were related to investments made by the FS/KKR Advisor since its establishment in April 2018. While we dislike losing these assets, we appreciate the markets view of their quality. One asset in particular was our investment in Pretium Packaging, which was originated in January 2020. Pretium is a designer and manufacturer of rigid plastic packaging focused on small-to-medium sized production volumes. We originally led $650 million term loan financing package to fund the acquisition of the business by a financial sponsor. Our $110.6 million investment was repaid in full during the fourth quarter as the company refinanced its capital structure based on strong performance. And we rolled a portion of the proceeds into a new second lien term loan. Another investment Athenahealth, was repaid during February of this year. Athenahealth is a cloud based IT health care technology company, offering electronic health records and revenue cycle management software to ambulatory and hospital companies. In February 2019, we co-lead a $800 million second lien, and $600 million preferred equity investment to support the acquisition of the company by a group of financial sponsors. FSKR's $129 million second lien and $81.5 million preferred investments were repaid in full pursuant to a comprehensive refinancing of the company's balance sheet. These types of investments and outcomes are exactly the type of investing model and track record we are seeking to build. During the fourth quarter, we experienced net portfolio appreciation of $60 million. The total amount of realized and unrealized depreciation we experienced across the portfolio during the quarter was $359 million and our realized and unrealized depreciation totaled $299 million during the quarter. As Dan alluded to in his comments, the 57% of the investment portfolio, which is attributed to the FS/KKR Advisor has recovered 100% of the depreciation we experienced earlier in the year due to COVID. We are pleased with these results, just as we are pleased with significant progress we made during the year restructuring, certain legacy investments and positioning the portfolio for future growth. Finally, from a nonaccrual perspective, as of the end of the fourth quarter, our nonaccruals represented approximately 3.5% of our portfolio on a cost basis, and 1.5% of our portfolio on a fair value basis compared to 9.3% on a cost basis, and 4.3% on a fair value basis as of September 30. The decline in nonaccruals was primarily related to the removal of three investments, Production Resource Group PRG, CDS U.S. Intermediate Holdings and Chisholm. PRG and CDS were restructured during the quarter and Chisholm was sold. We did not place any new investments on nonaccrual in the fourth quarter. 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 framed primarily on the color behind our results, thereby hopefully framing them in a transparent and easily understandable manner. First, the $24 million increase in our total investment income quarter-over-quarter was impacted by the following. We experienced an increase of $10 million in our interest income primarily due to the significant investment activity about which Dan spoke, offset by repayments of average yielding assets across our investment portfolio. Our fee and dividend income increased by $12 million during the fourth quarter as compared to the third quarter. The largest components of our fee and dividend income included $18 million of dividend income from our joint venture during the quarter. As many of you know, we typically expect this recurring dividend income to approximate between $15 million and $20 million on a quarter-to-quarter basis. Other dividends from various portfolio companies totaled approximately $8 million during the quarter as dividend paying portfolio companies continue to recover from the COVID related events of last spring. Finally, fee income totaled $22 million during the quarter, representing an increase of $17 million quarter-over-quarter. The increase was directly tied to our origination and repayment activity during the fourth quarter. Our interest expense increased by $3 million during the quarter, largely due to the increased leverage we utilized during the quarter. Management fees increased by $2 million during the quarter due to the higher amount of average gross assets during the quarter compared to the prior quarter. The detailed bridge in our NAV per share on a quarter-over-quarter basis is as follows: our starting 4Q 2020 NAV per share of $24.66 was increased by GAAP, NII of $0.59 per share, and was increased by $0.35 per share due to an increase in the overall value of our investment portfolio. Additionally our NAV per share was positively impacted by share repurchases of $0.04 per share during the quarter. Our NAV per share was reduced $0.55 per share of dividend. The sum of these activities results in our December 31, 2020 NAV per share of $25.10. From a forward looking guidance perspective, we expect our first quarter NII per share to approximate $0.56. The bridge from our $0.61 per share of adjusted NII during the fourth quarter to our first quarter guidance is as follows. Our recurring interest income is expected to approximate $150 million which is $2 million higher quarter-over-quarter. The expected increase is due to the impact of the $1.3 billion of origination activity we experienced during the fourth quarter, coupled with additional investments we have and we'll close in the first quarter. This will be partially offset by anticipated repayments of certain higher yielding assets, as well as the fact that there are two fewer days of interest income during the first quarter, as compared to the fourth quarter. We expect recurring dividend income associated with our JV to approximate $17 million during the quarter. We expect other fee and dividend income to approximate $19 million during the first quarter. From an expense standpoint, we expect our interest expense will remain relatively flat quarter-over-quarter. We expect our quarterly management fee will increase by approximately $1 million during the first quarter, based on the higher average value of our investment portfolio during the quarter. And we expect other G&A expenses to approximate $5 million during the first quarter. In terms of the right side of our balance sheet, our gross and net debt-to-equity levels were 93% and 85% respectively as of December 31, 2020. These leverage levels represent an increase from our leverage levels of 78% and 73% respectively at September 30, 2020. Our available liquidity of 1.75 billion equates to approximately 22% of the value of our investment portfolio, which remains a very comfortable percentage. Our capital structure is approximately 91% secured with an overall weighted average cost of debt of 2.9%. And with that, I'll turn the call back to Michael for a few closing remarks, before we open the call for questions.

Thanks, Steven. As I referenced earlier in the call, we are in the enviable position of looking back on 2020 with a feeling of significant accomplishment. Like many companies, we experienced challenges. However, our management team was disciplined and forward looking. As we enter 2021, I'm extremely pleased with the performance of our investment team, the strength of our balance sheet, and the rotational dynamics of our investment portfolio which continue to improve. As we look forward to closing of our proposed merger with FSK later this year, the FS KKR franchise will become a single BDC with approximately $16 billion in assets on a pro forma basis as of December 31, 2020. In an industry, which is growing rapidly and becoming a major part of the U.S credit markets, I am truly excited by our long-term prospects. And with that, operator, we would like to open the call for questions.

Thank you. [Operator Instructions] Our first question comes from Casey Alexander of Compass Point. Your line is open.

Hi, good morning. My question leads to the liability structure, which as you mentioned is 91% secured and really credit facility heavy. Most BDCs would like to have certainly more unsecured debt on their balance sheet. And is that something that you would look to address before the merger? Or is that something that you would like to clean up in all these disparate credit facilities post the merger?

Hey, Casey, it’s Dan. Thanks for that, and a good question. I think we've gotten off to a start here of – we got the initial unsecured deal done. I mean, from a target perspective, you can clearly see what FSK looks like in terms of a mix. So I think we are underweight here. We do have a little bit of labor costs issuance, either challenge or disadvantage with just how this entity is sort of rated. So I think our minds continually on looking at that liability structure, whether it's now or thinking about it sort of after a merger could be complete. But I think we do value the unsecured. We think it's important. The only thing I would note is we do feel quite comfortable with the revolver we have and we like the position we're in with no upcoming near-term debt maturities, but the unsecured will be our focus.

I mean, in this upcoming quarter, you still have room to expand the balance sheet. Do you feel constrained by the fact that everything is at this point kind of driven by capacity on credit facilities? Or are you comfortable continuing to expand the balance sheet heading into the merger?

No, we're comfortable. And I think we are pretty happy with the origination volume we saw inside of Q4. I think we’re also pretty happy with just the available liquidity that we do have.

All right. Great. I'll step out and let some others ask some questions. Thanks very much.

Thank you, Casey.

Thank you. Our next question comes from Finian O’Shea of Wells Fargo Securities. Your line is open. Finian O’Shea: Hi, good morning. Thanks for having me on. First question on the COP, I think you said there's 17 recurring, which is consistent, but that portfolio looks to have made at least somewhat significant shifts to first lien as those yields came down a bit across the space mostly we saw improving yields in this quarter. So if you just want to provide some color there, Dan if you agree with my comments and is the 17% something you continue to expect to hopefully produce?

Yes. I think the 17% is fair. I think we've been happy that we've been able to ramp the JV here and we've always talked about the target for the JV being roughly 10%, maybe a little bit more percent of the overall sort of entities. I think we got a little growth to do on the JV side inside of FSKR so maybe there's a little bit of room to grow there, but I think that 17% is a fair assumption. Finian O’Shea: Okay. Thank you. And then another sort of related question. The asset-based finance strategy has been a growing part of your book in both BDCs, you're fairly close to 30%, a little bit of room, but not too much anymore. So would – and that's obviously where the asset-based finances, pretty sticky stuff you generally control it. So is this something you can or intend to create a more headroom for, or would you say that this part of your book is more or so built out and complete?

Yes, I mean, just, if you think about sort of portfolio construction and public guidance, we've given. I think we've talked about the ABF bucket, the Asset Based Finance bucket is sort of 10% to 15%. So we're sort of there. I think we've been happy with what we've seen deal flow wise. We think there's additional yield available there. We like the downside protection. Obviously the joint venture does help us manage that 30% bucket. I think we're going to – always look to see if we can create a little bit more room there, but we're probably getting, what I'll say pretty mature. I think you're right. It is stickier but we do see you still a decent amount of activity in that part of the market. Finian O’Shea: Okay, great. I'll hop back in the queue as well.

[Operator Instructions] Thank you. I'm showing no further questions at this time. I'd like to turn the call back over to Dan Pietrzak for any closing remarks.

Thank you. And thank you all for joining the call today and thank you for your support. We look forward to talking with you again in the spring. And we do hope that you and your families remain safe and healthy. Thank you.

Thank you. Ladies and gentlemen, that does conclude today's conference. As you all participating, you may all disconnect. Have a great day.