FS KKR Capital Corp

NYSE:FSK

Earnings Call Transcript 2021-Q2

[Operator]

Welcome to the FS KKR Capital Corp second quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question and answer session. To ask a question during this session, you will need to press star, one on your telephone. Please be advised that today’s conference is being recorded. If you require any further assistance, please press star then zero.

I would now like to hand the conference over to your speaker today, Robert Paun, Head of Investor Relations. Please go ahead.

[Robert Paun, Head of Investor Relations]

Thank you. Good morning and welcome to FS KKR Capital Corp’s second quarter 2021 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 on August 9, 2021. 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 June 30, 2021. 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 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 second quarter earnings release that was filed with the SEC on August 9, 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 FSK’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.

[Michael Forman, Chairman, Chief Executive Officer]

Thank you Robert, and welcome everyone to FS KKR Capital Corp’s second quarter 2021 earnings conference call.

The second quarter was significant for FSK in two respects. First, the quarter represented an extremely positive period from both an investing and operational perspective. During the quarter, we materially out-earned our quarterly dividend due to strong originations as well as positive portfolio company performance, which included a significant one-time portfolio company dividend payment. Second, on June 16 we successfully closed the merger of FS KKR Capital Corp II with and into FSK, with FSK continuing as the surviving entity. This merger creates a leading BDC with approximately $16 billion in assets coupled with the market reach to become a leader within the rapidly growing specialty finance sector.

As I look back on the last three and a half years of the FS KKR partnership, I take pride in the accomplishments of our team: six separate BDCs combined into a single entity, eight bond transactions, arranging one of the industry’s largest secured revolving credit facilities, working to transition a legacy investment portfolio, and investing over $12 billion of new capital to support over 300 middle market companies with tens of thousands of employees. As I look forward, I believe the newly combined FSK will be an industry leader through its ability to commit and hold in size, through its expanded balance sheet which should create cost of capital advantages over time, through the simplification of our corporate message as we operate a single entity, and through the increased liquidity provided by the expanded float in our stock. All of these benefits combine to create what we believe is a compelling opportunity for FSK at a time in the market where the BDC industry is coming into its own from both a shareholder awareness and a capital markets standpoint.

From an operational perspective, during the second quarter our investment team originated $2.3 billion of new investments on a pro forma combined basis for the merger. We experienced an increase in our net asset value and we again out-earned our target 9% annualized dividend yield on our net asset value. I’m happy to say that the second quarter of 2021 represents the sixth consecutive quarter since the establishment of our current dividend policy that we have over-earned our target annualized yield.

During the second quarter, our adjusted net income was $0.74 per share, which was $0.14 per share above our quarterly dividend of $0.60 per share. Looking forward to the third quarter, while we expect our one-time fee and dividend income to return to a normalized level, we expect our adjusted NAI to be $0.61 per share. We also expect our previously announced $100 million board-approved stock buyback and program to begin during the third quarter. Finally, consistent with our variable dividend policy of seeking to provide shareholders with an annualized 9% dividend yield on our NAV over time, we are committed to paying out additional levels of NAI during quarters where our portfolio generates additional income. As a result, during the third quarter our dividend will be $0.65.

Steven will cover the details associated with our adjusted net investment income as well as our forward guidance later in the call; nevertheless, it’s exciting to be able to make the announcement of an increased dividend specific to the third quarter as we welcome the former FSKR shareholders to the FSK shareholder base.

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, Co-President, Chief Investment Officer]

Thanks Michael. As we’ve passed the midpoint of 2021, in many respects economic activity seems to be playing out in the manner we forecasted a few quarters ago. The Fed’s comments in July regarding their belief of the transitory nature of many of the inflationary pressures currently affecting certain industries dovetails with our own views, as we expect many issues caused by COVID-related supply chain disruptions to be resolved over the ensuing quarters.

As the labor market continues to rebound during the second half of 2021 and into 2022, we believe certain industries, including hospitality, retail and food service perhaps will be affected in longer term ways as workers push for higher levels of compensation. The near term interplay between experienced employees seeking higher wages and first-time entrants in the labor market willing to work for lower wages will in large part determine much of the operational paradigm across these industries for the next several years.

From an FS KKR advisor perspective, we continue to be encouraged by the opportunities we are seeing across our investing platform. As we contemplate the future of the newly combined FSK franchise, on behalf of the entire KKR credit team I am proud of the steps we have taken over the last three-plus years to rotate the FSK investment portfolio.

For those investors who are newer to our company, our efforts have centered around three primary areas: first, rotating into stronger companies in less volatile industries, including investing in companies with higher levels of sustainable EBITDA while simultaneously focusing on diversification across both industries and issuer position sizes. The second area of focus for us has been to preserve or create as much value as possible in those legacy investments which we have actively restructured. For example in the case of Sound United, we already have refinanced a new investment we made at the time of restructuring approximately a year ago. In addition, we received a meaningful dividend this quarter and we still retain our equity upside for the future. The third area of focus for us has been to position our investment portfolio to take advantage of KKR’s broader capabilities within private credit. Through the establishment of our joint venture, we now have a discrete investment portfolio which on a standalone basis is nearly $3 billion in size, which provides us the opportunity to invest in attractive, differentiated opportunities as well as certain lower coupon off-balance sheet investments for larger companies.

The recurring quarterly dividend income from our joint venture is a valuable source of investment income for us which occurs with a high level of stability on a quarter to quarter basis. Also, our asset base finance business has grown over the last three years to become 10% of our investment portfolio. These investment structures, which are typically accretive to our overall weighted average yield, involve the financing of portfolios of financial and hard assets. KKR Credit has built a team of 35 professionals which specialize in asset-based finance. From a forward-looking perspective, we view this vertical quite attractively.

Post closing of the merger, we’d like to offer investors the following views from a portfolio construction perspective. First lien senior loans will likely represent between 50% and 60% of our portfolio. We will make second lien loans on an opportunistic basis, and these loans typically will be made to larger companies. Second line loans will represent approximately 15% of our portfolio over time, though these percentages can and will vary quarter to quarter given the opportunistic manner in which we view these investments. We expect our asset-based finance investments to total between 10% and 15% of our portfolio. Our joint venture will likely represent 10% to 15% of our portfolio, and equity investments likely will represent approximately 5% of our portfolio.

From an origination perspective, during the second quarter we originated approximately $2.3 billion of new investments on a pro forma combined basis across our BDC platform, spread across 47 companies and 11 industries. New investments during the quarter carried a weighted average yield of 7.9% and were predominantly in first lien senior secured structures. During the first half of the year, our closer rate approximated 3% which compares to our historical closer rate of approximately 4%. Approximately 30% of our originations this quarter came from opportunities and companies previously invested in by KKR, again illustrating the power of incumbency and our relationships.

Our $2.3 billion of total investments combined with $1.7 billion of net sales and repayments when factoring in sales to our joint venture equated to a net portfolio increase of $557 million during the quarter.

From a repayment perspective, we like other large BDC platforms continue to experience the repayment of certain assets as sponsors and portfolio companies took advantage of the strength of the syndicated markets during the first half of the year. While we continue to believe the syndicated loan markets will ebb and flow in terms of demand, we also believe, as we have discussed in prior earnings calls, that the private credit market is continuing to grow significantly as sponsors and management teams are increasingly dependent on larger, well funded BDC platforms as traditional sources of financing.

Before turning the call to Brian to discuss our portfolio activity in detail, I’d like to mention one investment. During the second quarter, it was announced publicly that Home Partners of America was acquired. Excluding the asset-owning joint venture positions, FSK invested a total of $179 million in Home Partners, of which $102 million was invested in equity and the rest in debt and warrants. Based on the announced value of the transaction, FSK’s equity investment is worth 2.6 times our original cost basis. We are pleased to have such a successful outcome on this investment and we look forward to reinvesting the proceeds in the future.

With that, I’ll turn the call over to Brian to discuss some investment portfolio specifics associated with our recently expanded portfolio.

[Brian Gerson, Co-President]

Thanks Dan.

In terms of color around a few of our investments during the quarter, KKR Credit was the lead arranger and committed $325 million of senior secured financing to support MSD Private Capital’s acquisition of Woolpert, which operates a variety of critical data collection, data analysis, data management, and engineering services for federal, state and private customers. On a pro forma combined basis, FSK committed to approximately $220 million of the financing while other KKR Credit-advised accounts committed to the balance of the facility.

KKR Credit was also the lead arranger and committed $338 million of senior secured financing to support HIG’s acquisition of General Datatech, an IT solutions provider with core expertise in networking and data center modernization, serving customers in a variety of industries. On a pro forma combined basis, FSK committed to approximately $206 million of the financing while other KKR Credit-advised accounts committed to the balance of the facility.

Finally, KKR Credit committed $550 million of a $2.5 billion second lien credit facility to support the combination of three of Vista Equity Partners’ portfolio companies: Solera, Omnitracs, and DealerSocket, which provides software to the automotive and trucking industries. On a pro forma combined basis, FSK committed to approximately $300 million of the financing while other KKR Credit-advised accounts committed to the balance of the KKR Credit commitment.

A little over a year 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 June 30, 2021, we have originated approximately $12.7 billion of new investments across the BDC platform and have experienced 73 basis points of cumulative appreciation. We continue to be pleased with the investment performance our team has been able to deliver and we believe these data points continue to illustrate the manner in which we have taken measurable steps, as Dan detailed earlier in the call, to turn 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 12 in our investment presentation on our website.

As of June 30, our investment portfolio had a fair value of $14.7 billion, consisting of 195 portfolio companies. This compares to a fair value of $6.5 billion and 152 portfolio companies as of March 31, 2021, which obviously was prior to the closing of our merger with FSKR. At the end of the second quarter, our top 10 largest portfolio companies represented approximately 20% of our portfolio, which represents a slight decrease from prior quarters given the integration of the FSKR portfolio.

As Dan said, we continue to focus on senior secured investments, as our portfolio consisted of 56.4% of first lien loans and 70.1% of senior secured debt as of June 30. In addition, our joint venture represented 9.5% of the portfolio and our asset-based finance investments represented 12.9%, equating to an additional 22.4% 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 June 30, 2021 as compared to 8.6% at March 31, 2021. The weighted average yield in the second quarter of the year is adjusted to exclude the accretion associated with the merger of FSKR. The slight decline in our weighted average yield during the quarter was primarily associated with the retainment of higher yielding assets during the quarter and new lower yielding investments which closed during the quarter. Including the effects of the investment activity we experienced during the quarter, as of June 30, 2021 approximately 80% of our yielding investment portfolio is now comprised of investments originated either by KKR or the FS KKR Advisor.

During the quarter, excluding merger accounting, we experienced net portfolio appreciation of $125 million. The total amount of realized and unrealized appreciation we experienced across the portfolio during the quarter was $301 million, and our realized and unrealized depreciation totaled $176 million during the quarter. During the second quarter, we placed one investment on non-accrual, ATX Networks. ATX design radio frequency, optical and other video networking equipment used primarily by cable operators. The company’s earnings have been negatively impacted by lower cable company capex spend. We owned $80 million of the $227 million first lien term loan marked at 64% of cost as of June 30, down from 69% of cost as of March 31.

The company, a group of first lien lenders holding more than two-thirds of the first lien term loan, and other parties in the capital structure have made significant progress on a resolution of ATX’s breach of its Q1 financial covenant, and we expect the transaction resolving such breach to close in the third quarter. The anticipated impact of this potential transaction has been factored into the Q2 mark. As a result of these activities, our non-accruals currently represent approximately 4.4% of our portfolio on a cost basis and 3% of our portfolio on a fair value basis compared to 6.8% on a cost basis and 3.6% on a fair value basis as of March 31, 2021.

With that, I’ll turn the call over to Steven to discuss our financial results in more detail.

[Steven Lilly, Chief Financial Officer]

Thanks Brian. The discussion regarding our financial results this quarter is more detailed due to the closing of the merger. We believe there are two primary points of interest for investors with regard to the merger accounting. The first is the presentation of the fair value of our investments on our schedule of investments, or SOI. The second is the reconciliation of net investment income.

In terms of our SOI, the merger was accounted for in accordance with the asset acquisition method of accounting, as detailed in Accounting Standards Codification 805-50, Business Combinations. The fair value of the consideration paid was allocated to the assets acquired and liabilities assumed based upon their relative fair values as of the date of the acquisition. FSK issued approximately 161 million shares of FSK stock, which was trading at a 16% discount to its then current net asset value, resulting in a purchase price of approximately $3.65 billion for FSKR’s approximately $4.32 billion of net assets. As a result, on the closing date of our merger this discount was primarily applied to the fair value of FSKR’s investments, resulting in an approximate 8% reduction in the cost basis of those investments. Other assets, including cash and trade receivables, were acquired at their stated carrying amount.

For accruing debt investments, the difference between the par value and the time of merger cost basis will be accreted into income utilizing the effective interest method through the maturity date of each respective investment. The accretion associated with these investments is recorded as additional non-cash income on our P&L and therefore increases our net investment income and cost basis. The quarterly increase in the cost basis of the asset acquired flows through our investment gains and losses as a change in unrealized appreciation, therefore our net results are unchanged and our net asset value is unaffected as the fair value of our investments does not change due to this accretion.

From our discussions with investors regarding these concepts, which were disclosed in our proxy statement for the merger, some had the view that our net investment income is more accurately stated by including the accretion of the newly acquired assets. Their logic is that we effectively purchased these assets from the market at a time where FSK was trading below its net asset value and therefore it is appropriate for the accretion to enhance our net investment income. However, given the accretion is non-cash in nature, we believe investors should be able to analyze what our net investment income would have been without the effects of the merger. As a result, each quarter we will be presenting our net investment income in accordance with merger accounting guidelines, but we also will provide investors a reconciliation to what we are calling adjusted net investment income, which normalizes our NII for the effects of the merger and other one-time items. The presentation of NII and adjusted NII will be included in our publicly available information on a quarterly basis.

With those topics outlined, I’ll now turn quickly to our quarterly results.

Our total investment income quarter-over-quarter was impacted by the following. We experienced an increase of $20 million in our interest income primarily due to the contribution of FSKR’s results from the closing of the merger on June 16 to the end of the quarter, as well as the investment activity about which Dan and Brian spoke. Our fee and dividend income increased $35 million quarter-over-quarter. The largest components of our fee and dividend income included $22 million of dividend income from our joint venture during the quarter. Other dividends from various portfolio companies totaled approximately $32 million during the quarter, of which $20 million was from our investment in Sound United. Finally, fee income totaled $23 million during the quarter, representing an increase of $12 million quarter-over-quarter with the change directly tied to our origination and repayment activity during the quarter.

Our interest expense increased by $4 million quarter-over-quarter and management fees increased by $5 million during the quarter due to the higher amount of average gross assets during the quarter compared to the prior quarter. Incentive fees totaled $8 million during the second quarter and, as previously announced, beginning the first full quarter after the merger, the advisor will waive $90 million in incentive fees spread evenly over the next six quarters. This waiver equates to $15 million per quarter, and for clarity, the advisor will not earn an incentive fee on the incremental accretion due to the merger accounting that I mentioned earlier.

The detailed bridge in our net asset value per share on a quarter-over-quarter basis is as follows. Starting 2Q 2021, NAV per share of $26.03 was increased by GAAP NII of $0.77 per share and was increased by $0.87 per share due to an increase in the overall value of our investment portfolio. Our NAV per share was reduced by our $0.60 per share dividend and $0.23 per share related to merger adjustments, including certain deferred costs and prepaid assets and the mark to market fair value of FSKR’s 4.25% notes due in 2025. The sum of these activities results in our June 30, 2021 net asset value per share of $26.84. The bridge in the change of our net asset value from the date of our merger closing on June 16, 2021 of $26.77 and June 30 relates predominantly to positive changes in portfolio valuations totaling approximately $0.07 per share.

From a forward-looking guidance perspective, we expect our third quarter GAAP net investment income to approximate $0.69 per share and we expect our adjusted net investment income to approximate $0.61 per share. Detailed third quarter guidance is as follows. Our recurring interest income on a GAAP basis is expected to approximate $275 million. We expect recurring dividend income associated with our joint venture to approximate $44 million. We expect other fee and dividend income to approximate $33 million during the third quarter.

From an expense standpoint, we expect our management fees to approximate $58 million. We expect incentive fees net of the $15 million quarterly waiver to approximate $18 million. We expect our interest expense to approximate $68 million, and we expect other G&A expenses to approximate $10 million. The $0.08 per share difference between our GAAP net investment income and our adjusted net investment income relates to the expected accretion of our investments during the quarter due to merger accounting. This difference affects our recurring interest income. Other categories of our revenues and expenses are not affected.

From a forward-looking dividend perspective, as Michael indicated, our third quarter dividend will be $0.65 per share, with the increase in this quarter’s dividend being tied directly to the additional net investment income we generated during the second quarter. All else being equal, given that we expect our third quarter adjusted NII to approximate $0.61 per share, we believe it is reasonable for investors to expect that should we achieve our adjusted NII guidance for the third quarter, that our fourth quarter dividend would be $0.60 per share; however, I should note that dividends are subject to the discretion of our board and applicable legal requirements, and this forward guidance, while intended to be helpful to investors, should not be interpreted as a formal dividend announcement.

In terms of the right side of our balance sheet, our gross and net debt to equity levels were 101% and 90% respectively as of June 30, 2021. This compares to gross and net debt to equity of 113% and 100% respectively at the end of the first quarter, prior to the merger.

During the second quarter, we issued $400 million of 2.625% unsecured notes maturing in January of 2027. Our available liquidity of $3.6 billion equates to approximately 24% of the value of our investment portfolio, which is a very comfortable percentage and allows for meaningful future portfolio growth. At June 30, approximately 35% of our committed balance sheet and 48% of our drawn balance sheet was comprised of unsecured debt, and our overall effective average cost of debt was 3.38%.

With that, I’ll turn the call back to Michael for a few closing remarks before we open the call for questions.

[Michael Forman, Chairman, Chief Executive Officer]

Thanks Steven.

The second quarter of 2021 was a landmark quarter for FSK. Not only did we continue to experience operational momentum within the base business, but we also closed on a transformational merger with FSKR. We stand now as a single operational entity poised to be a leader in both the BDC industry and also across the specialty finance landscape.

To our employees, to our advisor and to our shareholders, I’d like to say thank you for your ongoing support.

With that, Operator, we would like to open the call to questions.

[Operator]

[Operator instructions]

Our first question comes from the line of Casey Alexander with Compass Point. Your line is open, please go ahead.

[Casey Alexander, Compass Point]

Yes hi, good morning. I have a couple questions specifically for Dan.

First of all, any feel for the cadence of originations in the third quarter, and in terms of the types of companies that you’re investing in, it almost doesn’t feel like--you know, we’ve always talked about BDCs in middle market investing. It doesn’t feel like middle market investing anymore - you know, it used to be companies with EBITDA of $5 million to $100 million, now we’re talking about investing in companies with EBITDA of a billion. Are we entering a new category in a new form of investing, especially in upper middle market BDCs?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes Casey, good morning and thanks for the questions. I think in terms of the first point, pipeline for us remains quite strong. I think in many ways, we’re as busy as we’ve ever been. Obviously the economic environment is active, there’s deals getting done. Roughly we’ve done a billion dollars of originations since the end of Q2, so I think the quarter’s off to a good start.

In terms of market positioning, we made a call going back four or five year ago where we wanted to be focused on the upper end of the middle market. We were defining that as $50 million to $100 million of EBITDA in the companies that we lent to. That was strategic for a couple reasons: one, we did see less competition there, but we also felt from a risk perspective these were companies with, more likely than not, better management teams, less customer concentration, less supplier concentration, just at the end of the day more levers to pull if something went wrong.

I think that has played out. I think we saw that during COVID. That said, I think there are a handful of larger lenders who have been able to take that even further. I think over the last several quarters, we’ve either led or participated in nine unit tranches that were north of a million dollars. We did two second lien deals in the second quarter that were each north of a billion dollars of EBITDA, so I do think those players who have size and scale, which is something you’ve heard us talk about for many quarters, do have a pretty broad playing field now, still playing in that definition of middle market which, again, we were calling more $50 million to $100 million, but even these bigger deals where instead of accessing the syndicated market, folks want to access the private credit market.

[Casey Alexander, Compass Point]

All right, thank you for that. My last question, and then I’ll let some other people ask, previously when we were either one BDC or two BDCs when FSKR came out, the target for the JV was 10%. That seems to have expanded now to 10% to 15%. What makes you comfortable with taking a larger chunk of the portfolio into the JV?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, that’s a good question. I don’t view there was a big move in the 10 to 15. That said, I think we’ve been very happy with what we’ve seen from the performance there. Obviously it’s been a strong contributor to our recurring dividend income.

I would think in many ways this isn’t us taking different risks. It’s really allowing us to access the broader KKR origination network in a more wholesome fashion. It allows us to expand that non-EPC bucket, so I think from just general risk matter, I feel we’re consistent whether it’s inside the regular BDC balance sheet or the joint venture, but I think it’s giving us other advantages that we want to exploit and we want to continue to drive that recurring dividend number, so not really that much of a change but a good pick up.

[Casey Alexander, Compass Point]

All right, great. Thank you. I’ll give some others a chance now.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Thanks Casey.

[Operator]

Thank you. Our next question comes from the line of John Hecht with Jefferies. Your line is open, please go ahead.

[John Hecht, Jefferies]

Morning guys, and congratulations on a good quarter and all the accomplishments of the last several months.

First Dan, I’m wondering maybe if you can comment on the pipeline. You gave us a breakdown of how you see the mix of the portfolio overall, but what’s the current pipeline look like in the context of that mix, and maybe can you discuss just the general investment environment overall?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, I’ll maybe start with the latter. I think from a macro perspective, everything we’re seeing is quite positive inside the portfolio companies we have, when we look at the consumer, you look at housing, you go right down, I think, all the metrics out there, so I think the investment environment feels good. I think we feel like there’s a couple years, maybe even more, of tailwind on the back of this new cycle. That being said, we are being cautious and deliberate on our underwriting. One of the real conversations we have these days is about sustainability of EBITDA - you know, if people had some benefits from COVID, what’s the real number, how do we think about that vis-à-vis structure, how do we keep discipline around structure, which has definitely been a topic.

I think the environment’s good. I do think it requires a certain amount of caution, though, and making sure you’re building the portfolio in a manner that you’re happy with.

I think as we went through on the call with the targets, that was just more to refresh for folks where we see things from a portfolio construction perspective. We are, as you know, John, mainly focused on that unit tranche and sort of first lien product. That said, you should expect us to add second liens, especially for these larger companies. I think we’re seeing that play out in the market we’re in today, so we feel good participating in that.

As per Casey’s question, I think the JV will continue to grow and we’re quite fond of what we’re seeing in the asset-based finance space from both a relative value perspective but just a general risk perspective. We think that is quite accretive to the overall return of FSK.

[John Hecht, Jefferies]

Okay, and then second question, you’ve given us the mix of the assets. Can you talk about relative--like, what are relative yields, like first to second lien, and what would be a recurring type of yield for the JV versus ABS portfolios right now?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, I’m happy to do that. I think for the ABS bucket and the JV bucket, I think we’re targeting, let’s call it 10% to 12% in terms of what we’re trying to earn there. Obviously the JV has the benefit of leverage, obviously the asset-based finance space is a space that’s a little bit less trafficked, so maybe some more yield there. Spreads have been tighter. I think spreads are through pre-COVID levels. I think the regular way unit tranche these days, maybe on sort of an average basis is somewhere LIBOR plus 6. That LIBOR floor is probably 75 to 100 basis points.

We would like to see the second liens--now, the second lien is obviously behind a syndicated first, the syndicated first maybe was down around sort of 400, the second lien’s probably 350 back of that syndicated to the first, so for the right sized company we think that’s pretty attractive relative value, and as I mentioned in the comments to Casey, the two large second liens we did do in Q2, each had an average--each had an EBITDA of north of a billion dollars.

[John Hecht, Jefferies]

Wow, okay. Then the last question I have is the $0.08, should the difference between the GAAP and then the adjusted NII, that $0.08 I think is next quarter, will that be consistent over the duration of the portfolio or are there term dates that cause that fluctuation--that will cause that to fluctuate?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, Steven should answer this to make sure I’m right. I think it should be a certain amount of consistent, but as assets do repay, that number should trend downward.

Steven, please?

[Steven Lilly, Chief Financial Officer]

Yes John, it’s a good question, but it’s tied specifically to each asset and the maturity date of each debt asset. I should be specific just to say debt assets - there’s nothing to amortize, it’s on the equity assets that we have, so it will change over time. But from a proxy standpoint, I guess that $23 million, $25 million for the next couple quarters is probably not unreasonable. That’s sort of the amount that you would analyze the difference in terms of our guidance for the third quarter.

[John Hecht, Jefferies]

Great, thank you guys very much.

[Operator]

Thank you, and our next question comes from the line of Finian O’Shea with Wells Fargo Securities. Your line is open, please go ahead.

[Finian O’Shea, Wells Fargo Securities]

Hi everyone, good morning. Dan, first question on the activity this quarter, it looks like there were a pretty good amount of software deals. Those are of course widely sought after and celebrated in today’s market, and wasn’t one of the historical focuses of your platform there. Can you talk about if there’s a push into getting a hold of this origination, if you view that as sort of a risk at this point in the game, and also how you’re able to achieve that sort of deal flow?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, sure. Happy to, Fin. I think two things. If you have a chance, if you look at Slide 5 of our investor presentation, you see the sector breakdown - you know, software and services I think is 15%, 16% there. We did make a strategic push to get that up over the last handful of quarters and years. We were probably hovering close to this 10%, 11%. We felt like it needed to be increased. Obviously our coverage footprint, we feel quite good about. It was, for lack of a better word, easy to target, spend time in there, but you are correct - it is a competitive overall environment, so I think we feel quite good about the risk we put on there.

One part of the market we probably have played in less has been these annual recurring revenue deals, or ARR deals. We’ve done a handful. We’ve been concerned a little bit about those from a risk perspective - the bar is just pretty darn high. I think you should expect that we will do a handful of those and build a bit of a position there, but they’ll probably be well diversified, sized to a bit of a smaller level. I think people have done a really good job in that space over the last handful of years. I think we made a deliberate risk call, but I think we’re happy with where we sit - you know, roughly 16% of the portfolio in software and services.

[Finian O’Shea, Wells Fargo Securities]

Thank you, that’s helpful. Then just a follow-up on Steven’s guidance on the G&A of $10 million a quarter. I guess first, it doesn’t feel like there’s much scale achieved there through the merger, and also that’s about $40 million a year. Can you describe the major parts of that in terms of the essential G&A for the BDC?

[Steven Lilly, Chief Financial Officer]

Fin, one of the things, just first on the synergies, I think we had said prior to the merger closing that you should expect that to flow through really during the first year or two from closing, so it doesn’t all get achieved at one time. We’ve said somewhere, I think in that $5 million to $7 million range of synergies is appropriate.

The other sort of operating expenses outside of the normal management fees, so board expenses are in there and other kind of outsourced service providers, accounting expenses, things like that.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Just one other point, and I think we’ve talked about this on prior calls, we did try to be pretty deliberate and pretty aggressive to reduce those costs along the way. I think Drew and Ryan have done a very good job of being focused there. Obviously we had a little bit of the bite of the apple to do that as we were doing some of these mergers along the way, so some of those were sort of prior but I think Steven’s comments are spot on.

[Finian O’Shea, Wells Fargo Securities]

Got it, thanks so much.

[Operator]

Thank you, and our next question comes from the line of Bryce Rowe with Hovde. Your line is open, please go ahead.

[Bryce Rowe, Hovde]

Thanks, good morning. Dan, wanted to follow up on the discussion around relative yields that John Hecht asked, and then maybe how it kind of interplays with the competitive environment, especially in the upper middle market. As you see new originations come in, can you speak to the competitive environment and the relative stability of pricing on newer deals as we move forward to the back half of ’21?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, happy to. I think the market is competitive, right? I don’t think there’s any other way to describe it. That said, I think--I’m not really sure of a time in my Wall Street career where the market hasn’t been competitive in one way or another. There’s been a fair amount of money raised for private credit overall. That definitely has gotten some headlines. I think the couple points there, though, as I mentioned before, I do like the part of the market that we’re playing in. I do like being a player with size and scale, both from a capital to deploy perspective but also just the size of the team.

I think on the other side of that, probably more money has been raised from middle market private equity, which has given some real tailwind to the origination flow, and then as private credit has just become a more regular way product, it’s just another financing source versus someone accessing the syndicated loan market, there’s just more and more deal flow coming this way, so I think it’s creating a nice balance.

As I said, I’m not sure that we’ve ever been as busy in terms of just the pipeline and deal flow perspective. That said, I think the world is generally pretty punchy right now, both as it relates to valuations, pricing on debt instruments, etc., hence why I did make the comment pricing is through pre-COVID levels. We’re seeing a little bit of pressure on LIBOR floors - I mean the market used to hold pretty firm at one, you now see some deals getting done at 0.75, so there is definitely some pricing pressure there.

I think inside of FSK, we capture some of that back vis-à-vis the revolver, being a LIBOR sort of revolver. You look at our weighted average cost of debt, it has gone down and I think there’s going to be some opportunities in the coming quarters to reduce some higher priced debt that we have on there, some nearer term maturities which will add to the bottom line, so I think it all does play together.

But I think in summary, we do view it as a competitive market. We think we’ve got the team to compete there.

[Bryce Rowe, Hovde]

Okay. Maybe switching gears a bit, you just mentioned in your comments about the right side of the balance sheet, so just curious how you all are thinking about the liability structure. You obviously took advantage of the wide open debt capital markets and raised equity here--or raised debt capital in the quarter, so just curious how to think about the evolution of the liability structure and do you think it kind of gets cleaned up as we move forward here? Thanks.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, and we’ve talked about this on some of the prior calls, I think we made quite good strides on FSK. I think there’s probably still some clean-up from some of the things that are in FSKR. That being said, I think we’re trending towards this place of having this very large multi-year--you know, really when it gets extended, it’s always a five-year revolver, it’s a very diversified bank group, we think it’s a good partnership with us and the banks but also very attractive to us as a platform.

We’ve been active in the unsecured space. Obviously to your point, we accessed the markets in June. I think you should expect us to continue to do that. We do have, I think, two near term maturities in ’22. We’d probably want to continue to get our percentage of unsecured up. That said, and this is kind of detailed on Slide 9 of the investor presentation, we’re roughly 47% of drawn of these unsecured investment grade notes - I think that’s quite a good number, quite an achievement from where we came from, but I think we’ll continue to look to add there.

[Bryce Rowe, Hovde]

Okay, great. That’s it for me. Appreciate the time.

[Operator]

Thank you. Our next question comes from the line of Ryan Lynch with KBW. Your line is open, please go ahead.

[Ryan Lynch, KBW]

Hey, good morning guys, and really nice quarter and definitely a really big quarter on several fronts in your overall business. The question I had, the first one was regarding your JV - it looks like today it’s at about 0.75 times net leverage. Where do you guys want to operate that JV with--and then I was also kind of surprised because it seems like it’s under-leveraged. There was only $58 million of sales down into the JV in the quarter, so it seems pretty light. I’m not sure if that had to do something with the timing of the two JVs merging together and the merging with FSK and FSKR, or why those sales were kind of on the light side relative to where that vehicle is leveraged.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes Ryan, thanks for the nice words on the good quarter. I think you’re right - I mean, at 0.75 times, that’s probably under where we want to be. I think we want to be sort of 1 to 1.25, sort of inside the joint venture, so I think that’s quite a positive as it relates to portfolio growth, hence recurring income growth.

Nothing out of the ordinary in terms of sales and activity down to the JV. I think there may have been some additional repayments, but I’m looking at Ryan in case there’s anything else to add there, but I don’t think so.

[Ryan Wilson, Co-Chief Operating Officer]

No. We closed the merger of the JVs just after the merger of FSK and FSKR, and so some of our normal activity got pushed into July.

[Ryan Lynch, KBW]

Okay.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Was that helpful, Ryan?

[Ryan Lynch, KBW]

Yes, yes. That makes sense.

Then the other one that I have is just regarding the buyback you guys announced. A couple questions on that. I that a programmatic or more of a discretionary buyback, or some combination in between? Then also, and my next question on that definitely interplays together, but do you guys have any anticipation of the cadence of when you guy would like to go through and achieve that buyback? Then on that point, I’m looking at your stock price given the strong quarter, up 5% today, is there a point where the valuation of your stock is going to substantially or completely eliminate the accretiveness or the attractiveness of doing the share repurchase?

[Steven Lilly, Chief Financial Officer]

Yes, so good to hear on the stock price - thanks for that. I think we’ve historically done these, Ryan, under a 10b5-1 plan. I think the expectation is we will continue to do that. I think going almost essentially exactly to your last point, we’ve probably thought about that more in the environment than if the stock was trading materially down, you want to try to be buying more if it was trading closer to book. We think that is starting to get into the numbers about it potentially being less attractive.

I think we’ve been quite happy with and proud of what we’ve done in the past. We thought it was important as part of this merger to put another plan together, but I Think you should have the expectation it will be done under a 10b5-1.

[Ryan Lynch, KBW]

Okay, understood. That’s all the questions I had today. Appreciate the time.

[Steven Lilly, Chief Financial Officer]

Thank you.

[Operator]

Thank you, and our next question comes from the line of Robert Dodd with Raymond James. Your line is open, please go ahead.

[Robert Dodd, Raymond James]

Hi guys, good morning. Congrats on getting the merger done.

On the ABL space, obviously the return on capital there can be pretty attractive comparable to the JV, as you said. It’s 13% of the portfolio right now, but in your prepared remarks you mentioned you expect retail to be stressed from wage inflation potentially, etc., which could make it a very attractive market to lend into ABL because of the hard inventory collateral. Would you--should we expect, or would you hope to increase the ABL portion of the portfolio above 13, maybe above 15% given the pretty high, in my opinion, risk-adjusted returns in that market segment and what sounds like a macro environment where you think there could be opportunities?

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, a couple different pieces in there, so let’s go through that. I think we would agree with you, there does feel to be what I’ll call real or sort of continued market opportunity there that we want to address; and Robert, for your benefit, we actually did make a senior hire who started during the quarter to really help build that out for us. I think we’re excited about that.

I think just for nomenclature perspective, that ABF bucket is more financial portfolios of financial and hard assets. The ABL, or asset-based lending, which could be in inventory receivables probably would fall into the regular way senior secured buckets, as it will be a corporate recourse facility generally. I would probably separate that from maybe a portfolio construction point.

That said, while we continue to view that ABF bucket quite attractively, I think you’re spot on - we do believe there’s going to be an opportunity there. We’ve played in that a bit but probably not as much as we would like, and hence the senior hire to address it, and clearly we’ve got the origination footprint [indiscernible].

[Robert Dodd, Raymond James]

Yes, understood. Thank you. Then if I can, one on the guidance for Steven. Obviously the guidance was $0.61 adjusted based on recurring dividend income. If we look back at last quarter, obviously--and you exceeded the guidance you gave last quarter, the Sound United dividend recap had already been announced before you gave the guidance last quarter, obviously, not necessarily paid but announced. Is there a--under what conditions would you factor in non-recurring dividend income, if you know it’s coming, into guidance? It sounds like the $0.61 is the base number, obviously. There could be more if there’s non-recurring, but sometimes the non-recurring’s already happened, so under what conditions would you factor that into guidance?

[Steven Lilly, Chief Financial Officer]

Sure. I think, just personal clarity, the Sound United dividend was not in our guidance for the second quarter, so that--just for level-setting purposes, that was a positive surprise and we were certainly appreciative of it. In terms of a go-forward basis, we really have been--I think if you look back over the last several quarters, our results have been very close to our guided amounts, and so this is--it’s not really a cushy number we’re trying to guide low and then come in materially above. I think it’s at this point in the quarter what we really expect to happen.

To your point, there are portfolio companies that do provide a non-recurring dividend just in certain quarters, and so there is some level of that, call it non-recurring activity that can’t happen every quarter, if that makes sense, from various companies. We try to incorporate that into the guidance, and that’s the main reason we break out our JV dividend separately from our other dividend and fee income in our guidance, so for the third quarter when we say the JV dividend will be $44 million approximately, and then we expect other dividend and fee income to approximate $33 million.

So we’re not trying to under-sell you there and come in high, we’re thinking that’s really a pretty accurate number.

[Robert Dodd, Raymond James]

Understood. I wasn’t trying to imply that. One-off dividends are very difficult to predict, as you know, so I understand. Thank you.

[Operator]

Thank you, and our last question comes from the line of Kenneth Lee with RBC Capital Markets. Your line is open, please go ahead.

[Kenneth Lee, RBC Capital Markets]

Hi, thanks for taking my question. Just one follow-up on the opportunities within asset-based finance on the previous question. Wondering if you could just talk a little bit more about specifically what factors could be driving these kinds of opportunities over the near term. Thanks.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Ken, happy to do it. Again, just to think about the backdrop of that, the last question was more talking about receivables and inventory, thinking about challenges that may be in retail or other places. The ability to lend against that, we do think is there today. We do think banks are taking a step back for that.

I think we’ve had a large investing thematic for the last five years inside of our asset-based finance activities. We’ve been fortunate there to build a very good team of 35 people. I think we’ve got broad coverage across both the consumer space, the mortgage space, other forms of hard assets. We’ve liked some thematics around leasing there and longer dated cash flows. We think the consumer is in a very, we’ll call it strong financial condition. We’ve had a very positive view on U.S. housing - you’ve seen some deployments there, you’ve seen the larger announcement on Home Partners, so I think those thematics hold true.

We do have a fairly opportunistic approach, though - if we don’t’ like one segment, we’ll spend time in another, but I think that’s the way we’re thinking about that and the overall space. I think clearly lending against things with collateral, no matter what they are, is pretty interesting in the environment you’re in today.

[Kenneth Lee, RBC Capital Markets]

Great, and one follow-up if I may, wondering if you could just share with us thoughts on how leverage could trend over the near term. Thanks.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Yes, I think that’s a really good question. We’re at the end of this quarter roughly 0.9 times net. Our stated goals or targets there remain the same, really a range of 1.0 times to 1.25 times with probably a sweet spot around 1.1 times. We’ve got some room to grow there. We think that was one clear benefit of the merger. I think that can translate into additional deployment growth, additional income growth. I think we feel good about that, and then going back to the prior question, I think we feel quite good about the liability side of our balance sheet, how that all sort of stacks up.

I think we feel good with the dry powder we have. We do feel good about the macroeconomic environment, but I think we also want to be ready to play if there’s volatile times, and where we stand at our current leverage definitely allows us to do that. But you should expect us trending up to the one time-plus target over the coming quarters.

[Kenneth Lee, RBC Capital Markets]

Great, thank you very much.

[Dan Pietrzak, Co-President, Chief Investment Officer]

Thank you.

[Operator]

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

[Dan Pietrzak, Co-President, Chief Investment Officer]

Thank you everyone for your time today and your support. Have a safe and healthy rest of the summer and we look forward to speaking with you soon.

[Operator]

This concludes today’s conference call. Thank you for participating. You may now disconnect. Everyone have a great day.