FS KKR Capital Corp

NYSE:FSK

Earnings Call Transcript 2017-Q4

[Operator]

Good morning ladies, and gentlemen. Welcome to FS Investment Corporation conference call to discuss the formation of a strategic partnership with respect to its investment adviser. [Operator Instructions] Please note that this conference is being recorded.

At this time, Christopher Condelles, Executive Vice President of FS Investments, will proceed with the introduction. Mr. Condelles, you may begin.

[Chris Condelles, executive]

Thank you. Good morning. And just one correction. I'd like to welcome you to FS Investment Corporation's Fourth Quarter and Full Year 2017 Earnings Conference Call. Please note that FS Investment Corporation may be referred to as FSIC, the fund or the company throughout the call.

Today's conference call is being recorded, and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSIC issued on March 1, 2018.

In addition, FSIC has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended December 31, 2017. A link to today's webcast and the presentation is available on the Investor Relations section of the company's website at www.fsinvestmentcorp.com under Presentations and Reports.

Please note that this call is the property of FSIC. Any unauthorized rebroadcast of this call in any form is strictly prohibited.

I would also like to call your attention to the customary disclosure in FSIC's filings with the SEC regarding forward-looking statements. Today's conference call includes forward-looking statements, and we ask that you refer to FSIC's most recent filings with the SEC for important factors that could cause actual results or outcomes to differ materially from these statements. FSIC does not undertake to update its forward-looking statements unless required to do so by law.

In addition, this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures can be found in FSIC's fourth quarter earnings release that was filed with the SEC on March 1, 2018. Non-GAAP information should be considered supplemental in nature and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly named measures reported by other companies. To obtain copies of the company's latest SEC filings, please visit FSIC's website.

Speaking on today's call will be Michael Forman, Chairman and Chief Executive Officer of FSIC; Mike Kelly, President and Chief Investment Officer of FS Investments; and Brian Gerson, President of FSIC and Head of Private Credit of FS Investments. We're also joined by Dan Pietrzak, Cohead of Private Credit at KKR and Chief Investment Officer of Corporate Capital Trust.

I will now turn the call over to Michael.

[Michael Forman, executive]

Thank you, Chris, and welcome, everyone, to FS Investment Corporation's Fourth Quarter and Full Year 2017 Earnings Conference Call. We appreciate your interest in FSIC. On today's call, I will provide an update on the progress we've made since announcing the formation of our strategic partnership with KKR in December. Following my remarks, Mike Kelly will provide perspective on the current lending environment and discuss our financial results. Brian Gerson will then discuss our investment activity for the quarter.

Before turning to the status of our strategic partnership, I'll provide a summary overview of the transaction and the rationale for our partnering with KKR to form the industry's largest BDC platform.

Over the past 10 years, we've seen the direct lending market evolve into a much more competitive and dynamic space. While we believe the scale and breadth of our platform is a significant advantage going forward, we expect increased competition within the direct lending space. To position our platform for future success, we must continue to evolve the financing solutions we offer, leverage our scale, access a broader set of investment opportunities and better serve our portfolio companies and sponsors.

To that end, in December, we announced a partnership with KKR that we believe will create value for our investors and position FSIC to continue to be a leader within the BDC space. Through this partnership, we will create the premier alternative lending platform in the industry with over $18 billion in assets, 150 sponsor relationships and 325 portfolio companies.

The unprecedented breadth and scale of our platform will allow us to become a full solutions provider to sponsors and companies while improving the quality of our investing through the expansion of our origination investment universe.

This new partnership will allow FSIC to coinvest across the KKR Credit platform, providing FSIC with greater access to international sponsors, direct-to-corporate or nonsponsored deals and global asset-based finance. And more diverse set of investment channels with broader financing solutions will help to drive deal flow, increase our ability to optimize FSIC's portfolio and position us to generate better risk-adjusted returns for our stockholders.

By providing a full suite of differentiated lending solutions, including KKR's full-scale capital markets capability, we can better support our borrowers' needs during the lifecycle of their businesses. This will position us to build stronger relationships, improve our asset selection and win more deals.

In addition, greater scale allows us to finance larger transactions in the upper-middle market where competition is more limited and risk-adjusted returns are more compelling, reduce fund expenses and approve cost of capital for the fund. Over time, the combination of our enhanced origination capability, improved lending solution and scale should lead to significant value creation for FSIC investors.

Since filing the definitive proxy statement with the SEC on January 18, 2018, we are closing in on obtaining the necessary approvals. Based on the positive momentum we've seen since commencing the solicitation, we currently expect to receive all necessary approvals across the FSIC franchise ahead of the closing of the proxy with them[indiscernible]. Of those stockholders voting, the overwhelming majority of vote in favor of the proposal to approve both the co-advisory and joint advisory agreements, respectively. We're pleased with the progress made in toward -- progress made toward transitioning the funds and are looking forward to deriving the full benefits of our partnership.

Upon completing the proxy and transition process, we'll focus on optimizing the platform to create value for our investors. As part of that effort, we will consider potential mergers of the 6 BDCs that comprise the FS and CCT franchises. We continue to believe that merging these entities will provide business and operational synergies that will expand long-term shareholder value, specifically through reductions in administrative cost, further expansion and diversification of the investment portfolio and the optimization of our capital structure with lower borrowing costs.

Any merger will, among other things, be subject to market conditions and review and approval from the respective Board of Directors. For the time being, we will continue to focus on ensuring a seamless transition. FS and KKR have been working closely on borrower and sponsor outreach and identifying new investment opportunities under the current sourcing and administrative agreement.

As Brian will discuss, we've made significant progress with sponsors and portfolio companies across our portfolio.

Lastly, as a sign of our continued commitment to FSIC and our confidence in new partnership's ability to bring significant value to our investors, FSIC's Board of Directors recently authorized a stock repurchase program. Under the program, we may repurchase up to $50 million in the aggregate of our outstanding common stock in the open market over the next 12 months. While we have discretion over the timing and pace of share repurchases, we intend to enter into 10b5-1 plan in early March with purchases to commence soon thereafter subject to terms of the plan.

We believe our stock purchase plan, combined with the reduction of our base management fee upon successful completion of the proxy and the implementation of enhanced 3-year high watermark, further aligns our interest with those of FSIC stockholders.

I will now turn the call over to Mike Kelly to discuss market conditions and our investment results during the quarter. Mike?

[Michael Kelly, executive]

Thank you, Michael. I echo your comments on the transition. Making this transition a success for our stockholders is our primary focus and has the full commitment of both FS and KKR resources. We believe the totality of our combined BDC platform will place us in the company of a select number of lenders who are able to provide the certainty and flexibility of capital that our borrowers demand in the evolving market environment.

Over the past several quarters, we've commented on the generally tight yields and competitive environment. Those conditions remained firmly in place during the fourth quarter and throughout 2017 as pricing power skewed to issuers.

New CLO formation and strong investor demand for floating-rate assets more than met 2017's heavy new issuance volumes. More broadly, 2017 was largely a Goldilocks year for the equity markets, shaped by above-trend growth and persistently low inflation.

As we come into the first quarter, the specter of higher inflation along with rising uncertainty about the magnitude of the fed's response has resulted in a spike in equity market volatility. While the leverage credit market remains tight, we have witnessed some spread widening off their cyclical lows. Especially in these markets, careful credit selection and market discipline is critical. We've maintained our focus on first lien senior secured debt and believe the breadth of KKR's diversified asset management platform, together with the purchasing power of our BDC capital base, will provide us with a competitive advantage.

With the portfolio fully invested, we can remain patient and selectively deploy capital as opportunities arise or market conditions change. At the same time, the permanency of our capital base leaves the portfolio well protected should volatility spillover to the leverage credit market and lead to arise in high yields and loan outflows.

Turning to our performance during the fourth quarter. We out earned the distribution of $0.19 per share through net investment income. Net investment income was $0.22 per share compared to $0.21 per share for the third quarter of '17 and $0.21 per share for the quarter ended December 31, 2016. For the full year 2017, net investment income was $0.83 per share compared to $0.85 per share for the full year 2016.

Adjusted net investment income for the quarter was $0.24 per share compared to $0.21 per share for the third quarter of 2017 and $0.23 per share for the quarter ended December 31, 2016. For the full year 2017, adjusted net investment income was $0.85 per share compared to $0.87 per share for the full year 2016.

It's important to note that as we announced last year, the board intends to make a special distribution in the fourth quarter of 2018 to the extent net investment income earned from the fourth quarter of 2017 through the end of the third quarter of 2018 exceeds the current annualized distribution amount of $0.76 per share. In other words, our stockholders will receive the benefits of any outperformance over the current annualized distribution rate.

Fee income during the fourth quarter was higher than the previous quarter primarily driven by prepayment fees from the paydown of NewStar as well as fees from new originations during the quarter. Fee and dividend income totaled $8.7 million in the fourth quarter of 2017 compared to $6.3 million in the third quarter and $17.2 million in the quarter ended December 31, 2016.

The fund's net asset value declined from $9.43 per share as of September 30, 2017, to $9.30 per share as of December 31, 2017, driven primarily by unrealized losses attributed to 3 of our equity positions. While equity investments are not a core focus of our senior debt-focused origination strategy and the majority of our equity investments are restructured equity positions, we remain confident in the long-term return potential of these investments and expect to reduce our equity exposure over the next 12 to 18 months.

I'll now turn the call over to Brian to discuss our portfolio activity during the quarter in more detail. Brian?

[Brian Gerson, executive]

Thanks, Mike. During the fourth quarter, we maintained high underwriting standards in the face of continued competition and a loose lending environment. Nevertheless, we continued to keep FSIC fully invested by executing on our robust pipeline and working on additional financing opportunities with sponsors and existing portfolio companies. This type of activity represented a $127.2 million or 58% of new direct originations during the fourth quarter. This is a positive outcome for the fund and supports our perspective that companies will continue to partner with FSIC over the long term.

During the fourth quarter of 2017 and into the first quarter of 2018, FS and KKR met with or spoke to each of our existing sponsors to discuss the new partnership and our plans to further support the portfolio companies. The response was overwhelmingly positive, and we are in regular discussions regarding upsizing loans to support business growth and new acquisitions.

We've already completed upsizes for a number of our existing borrowers since announcing the partnership with KKR and have a number of additional financings in the pipeline, which we expect to close during the first quarter of 2018.

Our success with existing sponsors and companies highlights the benefits of maintaining an incumbency position across a large portfolio of borrowers. We did not see any meaningful change in the portfolio turnover and expect our portfolio to continue to grow as we partner with KKR across an additional 100 portfolio companies.

Overall, I am pleased with the transition and portfolio activities since the announcement and look forward to recognizing the full benefits of our combined platform.

Let me now turn to our portfolio activity during the quarter. Throughout the fourth quarter of 2017, we continued to use the size and scale of our direct lending platform to structure investments with attractive risk-adjusted return profiles.

Total purchases during the quarter were $262.6 million, 76% of which were in first lien senior secured loans. Exits of $234.6 million during fourth quarter were driven by the repayment of certain directly originated investments. For the year ended December 31, 2017, total purchases were approximately $1.3 billion against total exits of approximately $1.1 billion.

We maintained our focus on investing in senior secured and floating-rate debt, which, at the end of the fourth quarter, represented 73% and 69%, respectively, of the portfolio based on fair value. These measures are both slightly higher compared to September 30, 2017.

As of December 31, 2017, the gross portfolio yields prior to leverage and excluding non-income-producing assets was 10.5%, up from 10.3% for the prior quarter and 10.4% for the quarter ended June 30, 2017. The average leverage for our direct originations due to the respective tranche in which we invested, excluding equity and collateralized securities, was 4.9x, up slightly from 4.8x in the prior quarter.

As of December 31, 2017, we had 2 companies on nonaccrual, which, in aggregate, represented only 0.2% of the portfolio based on fair value and 0.2% of the portfolio based on amortized cost. Equity comprised 13% of the portfolio as of December 31, 2017, based on fair value, down from 14% at the end of the prior quarter. Certain of these positions are in various stages of being actively sold, and we'll announce these realizations during future calls as they materialize.

Let me now turn to our energy portfolio. Energy-related investments as of December 31, 2017, comprised approximately 7% of FSIC's investment portfolio based on fair value, unchanged from the prior quarter. The net change in unrealized depreciation on energy investments during the fourth quarter of 2017 totaled approximately $8.4 million or $0.03 per share.

At quarter end, FSIC's debt-to-equity ratio was 75.4% compared to 74.4% as of September 30, 2017. Looking forward, we will continue to grow our pipeline and seek opportunities to support our portfolio companies and their sponsors. We believe the portfolio is well positioned in the current competitive environment.

Lastly, as Michael mentioned, we've implemented a share buyback plan, which is a reflection of our confidence in FSIC's current portfolio. On a historic basis, FS and KKR have had annual loss rate of less than 1.5% within the FSIC and CCT BDCs. We believe FSIC's current portfolio, which is over 64% invested in first lien senior secured loans and represents 100 borrowers with over $85 million in average EBITDA, is well positioned for credit downturn. At a significant discount to NAV, we believe the current stock price is not reflective of the strength in our current portfolio and the potential earnings power from rotating out of our equity positions and better utilizing our nonqualified bucket.

I will now turn the call back to Michael.

[Michael Forman, executive]

Thanks, Brian. We appreciate everyone's time this morning. I hope you have a better sense of the progress we've made in executing on our transition plan. We're excited by both the opportunities and benefits, we believe, the partnership will create for our investors. As you come to expect from FS, we'll continue to communicate with our stockholders throughout this transitionary period and remain focused on delivering strong results for investors.

With that, we'll now open the call for questions. Operator?

[Operator]

We're now going to open the call for questions. Michael, Scott, Todd and Mike are joined by Dan Pietrzak, CIO of CCT and Cohead of KKR Private Credit; Brian Gerson, Head of Private Credit at FS Investments; and Chris Condelles, Executive Vice President of FS Investments. [Operator Instructions] Your first question comes from Jonathan Bock from Wells Fargo Securities.

[Jonathan Bock, analyst]

The first question is, could you remind us again what is the total AUM for FS, KKR Advisor? And then, also how the allocation policy will work going forward and remind us of the other direct lending funds that might be managed by KKR outside of this partnership?

[Brian Gerson, executive]

So -- this is Brian. The way the allocation policy will work is, we will look to effectively share deals between the KKR and FSIC platform on a pro rata basis effectively based on available capital.

[Jonathan Bock, analyst]

Okay. That's helpful. And are there other funds managed by KKR that have a similar strategy outside of the KKR FS Advisor partnership?

[Daniel Pietrzak, executive]

Jonathan, this is Dan Pietrzak. Yes, we do have a direct lending fund called Lending Partners III that's active, and we do have a couple of SMAs that are focused on this space as well. And then the BDC platform would get to invest as Brian said, through the pro rata across those based upon available capital.

[Michael Forman, executive]

And John, this is Michael. So we're somewhere -- and if you look at all the CCTs and all the FSIC vehicles, it's somewhere around $18 billion of assets under management. As we talked about in our last call, once we close, we'll be able to take advantage of the exemptive relief or fit within the exemptive relief that KKR has. So we'll have access across their entire credit platform.

[Jonathan Bock, analyst]

And then just one final question. Post FS, KKR Advisor transaction. So will the boards be the same for FSIC, the private FS funds and CCT? And I'm curious because of course, these BDCs will be coinvesting in the same deals, but will they also be directed in a similar way from the board level?

[Michael Forman, executive]

We still -- we haven't had the closing yet, Jon. We're looking to close somewhere around the end of the month. We have not made a final determination of the composition of the boards. And I think a lot will depend upon where we go forward with the merger strategy as I discussed during my portion. But we will obviously need to make sure we manage conflicts, have independent directors as we've had in the past.

[Operator]

Your next question comes from Christopher Testa from National Securities Corporation.

[Christopher Testa, analyst]

Just to start off. Just curious how much AUM out of the total KKR Credit do you think that -- if you were able to coinvest today, in other words, would be applicable for both FSIC and CCT to be coinvesting in?

[Daniel Pietrzak, executive]

Just to make sure that we sort answer the correct way, I mean, as Michael said, the combined BDC platform would be about $18 billion of assets and there's probably roughly another $3 billion that sort of available sort of on our side. So that's the total sort of available capacity, which we do think is important as we do think size and scale matter in this market.

[Christopher Testa, analyst]

Right, right. What I was getting at was, when assuming obviously that the advisory agreement is approved, when you're able to come[indiscernible] across the KKR Credit platform, we're talking $54 billion, $55 billion is basically should we look at all of that as being having an addressable opportunity set that fits within the BDCs? Or is there some of that where you'd say, well, that's a different type of credit strategy that doesn't quite fit the bill? That's kind of what I'm getting at with that.

[Daniel Pietrzak, executive]

Fair question. I think that is the correct number for the overall sort of KKR Credit. Obviously, we have multiple strategies in there, the largest being today, at least being our leverage credit platform, but also our distrust. So some of it is not applicable, we'll call for[indiscernible] the BDC platform and the rest of it -- the platform or the BDC platform will get the benefit of at least the skill sets and knowledge and potentially be able to coinvest with.

[Christopher Testa, analyst]

Got it. Okay. That's helpful. And just curious, during the quarter, you guys had a 11%, of your direct originations in senior secured bonds, which was a pretty heavy in bonds contrasted with prior quarters. Just curious how many companies was that split between? Just wondering what the opportunity was there?

[Michael Forman, executive]

I think that was primarily related to Advanced Lighting restructuring. And it was really one investment. We're -- the majority of our investments during the quarter were in senior secured loans.

[Christopher Testa, analyst]

Okay. Got it. And how much of the $13.6 million or so of the discount accretion was accelerated from prepayments during the quarter?

[Michael Forman, executive]

$12.5 million.

[Christopher Testa, analyst]

Got it. Okay. And I appreciate the color on you guys going around and introducing both FS and now that your new partners with KKR to your portfolio companies. I'm curious from the KKR point of view, would your LPs and investors have been saying about this transaction as well?

[Michael Forman, executive]

Yes. So I think we'll leave some of that stuff to the CCT call, which I understand is coming forward. I would say that both partners are extremely pleased with the transition. We're making progress and certainly all of our portfolio companies have looked at this favorably.

[Operator]

[Operator Instructions] And your next question comes from Ryan Lynch from KBW.

[Ryan Lynch, analyst]

First, Dan, maybe can you just talk about the steps that you and KKR have taken to maybe better understand the portfolio and FSIC which is a portfolio that you didn't originate but now you're going to be helping manage and grow?

[Daniel Pietrzak, executive]

Sure. I'm happy to. I mean, as Brian mentioned, there was a meaningful sponsor and borrower kind of outreach program that we did in Q4 as well as throughout Q1. So we spent a lot of time with the individual borrowers and sponsors. Lot of time understanding kind of where those positions sit within their lifecycles sort of performance. And we have a lot of resources dedicated and committed to this and to making sure that we're up to speed. So -- but it's been a very productive time since we announced this deal. And we'll continue that over the coming weeks.

[Ryan Lynch, analyst]

Okay. And then as this portfolio goes forward if we look at it maybe a year or 2 from now, you guys obviously have right now a big concentration of capital goods, commercial and professional services. Do you see there being any material shift in the industry concentration, maybe pulling back out of any large concentrations today or expanding any smaller concentrations in the portfolio?

[Michael Forman, executive]

Look, I think what you'll see is us continuing to diversify the portfolio over time as new direct originations come in place. I think generally, we'll be focused on new senior secured assets and a gradual migration out of our equity positions. I guess, really what excites me about the implementation of our partnership with KKR is having a larger funnel of investment opportunities and utilizing our collective scale to be a solutions provider for our borrowers. So ultimately, our job is to find the best risk reward for our investors and having ability to access the broader set of opportunities really allows us to do just that.

[Ryan Lynch, analyst]

Okay. And then one on a specific portfolio company. I saw in preferred equity piece of Global Jet, you guys had about a $10 million markdown in its fair value this quarter. Can you just speak to what drove that markdown?

[Michael Forman, executive]

I think really that was driven by some quarter-to-quarter moves and appraised value of the underlying aircraft plus some other valuation metrics including comps. That company is actually doing very well, just completed its asset base -- an asset-based securities financing of over $600 million, which has given it a tremendous amount of liquidity to fund its growth.

[Michael Forman, executive]

I don't see any further questions. So there being no further questions, thank you, everybody, for your time and attention this morning. We look forward to continuing our conversations and appreciate the support and loyalty.

[Operator]

This concludes today's conference. You may now disconnect.