FS KKR Capital Corp Q4 FY2022 Earnings Call

Good morning, ladies and gentlemen. Welcome to the FS KKR Capital Corp's Fourth Quarter and Full Year 2022 Earnings Conference Call. 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's fourth quarter 2022 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 November 27, 2023. 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 December 31, 2022. 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 fourth quarter earnings release that was filed with the SEC on February 27, 2023. 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. 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 in the room are Co-Chief Operating Officers, Drew O'Toole and Ryan Wilson. I will now turn the call over to Michael.

Thank you, Robert, and good morning, everyone. Thank you all for joining us for FSK's fourth quarter and full year 2022 earnings conference call. This past year was a year of significant accomplishments for FSK. We continued rotating our investment portfolio into FS KKR originated assets as our investment team originated over $4.5 billion in new investments. We achieved the strategic goals outlined in our September 2021 Analyst and Investor Day. We hosted another successful Investor Day this past November and we issued $500 million of three and a quarter unsecured notes in January of 2022. These efforts, along with the positive impact of rising interest rates, have resulted in meaningful earnings growth as our adjusted net investment income per share for the full year grew over 10% compared to 2021. While 2022 was also a year of market volatility and economic uncertainty, we're pleased to have concluded the year with strong results as we exceeded our quarterly guidance each quarter and rewarded shareholders with both an attractive base and a supplemental dividend every quarter. In terms of our fourth quarter results, we generated net investment income totaling $0.80 per share and adjusted net investment income totaling $0.81 per share compared to our public guidance of $0.74 and $0.75 per share respectively. Our net asset value declined 1.6% quarter-over-quarter as our investment portfolio decline was offset slightly by out-earning our $0.68 per share dividend on accretive share repurchases. During the fourth quarter, our investment team originated approximately $863 million of new investments. Finally, from a liquidity perspective, we entered the quarter with approximately $3 billion of available liquidity. Through February 24, 2023, we have repurchased $87 million of shares under our $100 million share repurchase program. In the fourth quarter, we repurchased $23 million of shares and subsequent to quarter end, we purchased $19 million of shares. As of February 24, we had $13 million remaining under the $100 million program. Based on our positive fourth quarter financial results, our board has declared a first quarter total distribution of $0.70 per share. As part of this distribution, we're also pleased to be raising our quarterly base dividend to $0.64 per share, which represents approximately a 5% increase over our last quarter's $0.61 per share based dividend and approximately a 7% increase in our base dividend from a year ago. The increased quarterly base dividend reflects our positive outlook on the long-term earnings power of the company. Additionally, based on the overall strength of the company's earnings power, we expect our quarterly supplemental distribution to total a minimum of $0.06 per share throughout 2023 and possibly beyond, equating to a minimum of $0.70 per share per quarter of quarterly distributions during 2023. On an annualized basis, our first quarter distribution represents an attractive 11.3% annualized yield on our December 31, 2022, net asset value and an annualized yield of approximately 14.3% based on our share price. I'm extremely proud of the accomplishments of the team during the past 12 months. Based on our experienced team and the significant resources of our platform, I believe we are well-positioned for 2023 and beyond. Before I conclude my remarks, I'd like to comment briefly on the recently announced merger between FS Investments and Portfolio Advisors. While the transaction is a significant one for FS Investments accelerating the growth of our firm, it is important to note that the transaction has no impact on FSK and the FS KKR advisor. 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. As I reflect on the time since the establishment of the FS KKR Advisor, I take great pride in the growth and capabilities of our investment team, as we have originated over $21 billion of new investments in FSK. As Michael mentioned, we are pleased with the performance of these originated assets and how we have positioned FSK to provide an attractive dividend yield to our investors. In terms of the market and economic environment, as we enter 2023, we continue to expect above-average levels of volatility over the near term. Given the Federal Reserve's continued focus on fighting inflation, as well as continued geopolitical issues, certain remaining supply chain constraints, and margin pressures on companies of all sizes, there's still a lot of uncertainty over the direction of inflation and rates in the broader economy, and we believe the macroeconomic environment will likely remain challenging throughout 2023. While we continue to exercise caution with respect to new originations, we believe the increased volatility and economic uncertainty have created compelling investment opportunities for us and other large-scale private debt investors. Sponsors continue to turn to large, stable direct lending platforms as alternatives to the more volatile syndicated debt markets. Additionally, the economics and return opportunities on new originations are extremely attractive to us, driven by spread widening and the increase in base rates. Compared to a year ago, spreads on new originations are approximately 100 basis points higher with enhanced call protection and attractive leverage levels for high-quality companies. With that said, we believe M&A transaction volumes will remain below average until investors can gain confidence that inflation has stabilized and there is more clarity on what the broader economic landscape might look like going forward. In terms of portfolio company performance, we continue to see positive financial results from the majority of our portfolio companies. We attribute these results to our focus on larger companies at the upper end of the middle market, companies with strong competitive positions, resilient cash flows, and businesses in non-cyclical industries. Our portfolio companies reported a weighted average year-over-year EBITDA growth rate of approximately 15% across companies in which we have invested since April of 2018. In addition to this EBITDA growth, by continuing to focus on larger companies, we have increased the weighted average EBITDA of our portfolio companies to $204 million as of the end of the fourth quarter compared to $164 million at the end of 2021. Certain companies in our portfolio have been impacted by a combination of inflation, supply chain issues, and increasing interest rates, which contributed to a meaningful portion of our portfolio depreciation during the fourth quarter. While Brian will speak about specific names in more detail later, we continue to closely monitor financial performance and the positioning of our portfolio companies, leaning on the resources of our experienced investment team and portfolio monitoring units. We are extremely proud of the work we have done to rotate the portfolio over the last several years, and we remain focused on continuing this rotation in 2023. Turning to our quarterly investment activity. During the fourth quarter, we originated $863 million of investments. And similar to the prior few quarters, these primarily focused on fundings and add-on financings to our existing portfolio of companies. Approximately 70% of our originations came from opportunities and companies previously invested in by KKR. During the fourth quarter, our new corporate lending opportunities carried a weighted average coupon of SOFAR plus 660 basis points and a weighted average LTV of 40%. Our new investments combined with $1.1 billion of net sales and repayments, when factoring in our sales to our joint venture equated to a net portfolio decrease of $221 million during the fourth quarter. One new financing worth noting is our new investment in La Pari Foods, a specialty and branded food distributor that sources, manufactures, and distributes into the U.S. grocery market with an emphasis on the premier of the store products. In January 2019, FSK and other funds managed by KKR provided a $615 million unit tranche and DDTL financing to support the buyout of the company. Benefiting from our incumbency position, during the fourth quarter of 2022, we led a $790 million unitranche and DDTL financing to support the acquisition of the company by a new sponsor with more attractive economics and a lower leverage point than our original investment. In terms of interest coverage, at the end of the fourth quarter, our portfolio companies had a median interest coverage of 1.9 times. And while we have seen a slight uptick in amendment activity, we would note in situations where amendments have occurred, we are seeing meaningful equity support from our financial sponsors due to both the long-term viability of the business models of the companies in which we have invested and the recent vintage of funds from which the sponsors have contributed their equity capital. With that, I'll turn the call over to Brian to discuss our portfolio in more detail.

Thanks, Dan. As of December 31, 2022, our investment portfolio had a fair value of $15.4 billion, consisting of 197 portfolio companies. This compares to a fair value of $15.8 billion and 195 portfolio companies as of September 30, 2022. At the end of the fourth quarter, our 10 largest portfolio companies represented approximately 19% of the fair value of our portfolio. We continue to focus on senior secured investments as our portfolio consisted of 60.3% first lien loans and 68.8% senior secured debt as of December 31. In addition, our joint venture represented 9.3% of the fair value of the portfolio and asset-based finance investments represented 12.4%, equating to an additional 21.7%, which is comprised predominantly of first lien loans or secured asset-based finance investments. The weighted average yield on accruing debt investments was 11.4% as of December 31, 2022, compared to 10.4% as of September 30. As a reminder, the weighted average yield is adjusted to exclude the accretion associated with the merger with FSKR. The increase in our weighted average yield during the fourth quarter was primarily associated with the continued rise in base rates as well as higher yields on new originations during the past few quarters. During the fourth quarter, excluding the impact of merger accounting, we experienced net portfolio depreciation on investments of approximately $105 million. The largest negative movers in our portfolio, which were impacted by credit performance-related issues during the quarter were Pure Fishing and KBS. Pure Fishing is a leading global supplier of fishing equipment and gear that experienced weaker results due to retailer destocking as well as inflationary pressures. KBS is a provider of janitorial and facility maintenance services to a variety of end markets typically under multiyear contracts. Performance has been negatively impacted by labor inflation and the roll-off of COVID-related work. At this point, we will characterize the performance issues with both companies as transitory in nature. I'd also like to comment on another investment, Open Door. The company is an online real estate platform that facilitates the purchase and sale of single-family homes. In October of 2021, we led an investment in a $2.2 billion asset-secured mezzanine debt facility, which has since been reduced to $1 billion through a combination of undrawn commitment amount cancellations and debt repayments at par plus the related prepayment premiums which has meaningfully reduced our exposure. As of December 31, 2022, FSK's total investment had a funded principal amount of $71.1 million only compared to a principal amount of $106.6 million and undrawn commitment amount of $53.4 million as of September 30, 2022. In terms of nonaccrual, as of December 31, 2022, nonaccruals totaled 4.9% of our portfolio on a cost basis and 2.4% on a fair value basis, compared to 5% on a cost basis and 2.5% on a fair value basis as of September 30, 2022. And with that, I'll turn the call over to Steven.

Thanks, Brian. As Michael mentioned earlier, we are pleased to be able to reward shareholders with an increase in our base dividend as well as to communicate the company's positive view that our supplemental distribution should equate to a minimum of $0.06 per share per quarter during 2023 and possibly longer, resulting in a total minimum distribution of $0.70 per share per quarter. On an annualized basis, our distribution totals $2.80 per share, representing an 11.3% yield on our December 31, 2022 net asset value of $24.89 per share. Turning to our financial results for the fourth quarter. Total investment income increased by $38 million quarter-over-quarter, driven by increased interest income. The components of our total investment income during the quarter were as follows: Total interest income was $360 million, an increase of $42 million quarter-over-quarter. Dividend and fee income totaled $89 million, a decrease of $4 million quarter-over-quarter. Our dividend and fee income during the fourth quarter is summarized as follows: $53 million of recurring dividend income from our joint venture, other dividends from various portfolio companies totaling approximately $24 million and fee income totaling approximately $12 million. Our interest expense totaled $109 million, an increase of $13 million quarter-over-quarter, largely due to the impact of rising base rates on our secured debt facilities. Our weighted average cost of debt was 4.8% at December 31. Management fees totaled $59 million, a decrease of $2 million quarter-over-quarter. Incentive fees totaled $27 million during the fourth quarter, which is net of the $15 million incentive fee waiver. As previously noted, as part of the FSK, FSKR merger, which closed in June of 2021, the adviser agreed to waive $90 million of incentive fees spread evenly over 6 quarters, which began during the third quarter of 2021. As a reminder, the fourth quarter of 2022 represents the final quarter of the incentive fee waiver. The detailed bridge in our net asset value per share on a quarter-over-quarter basis is as follows: our ending 3Q 2022 net asset value per share of $25.30 was increased by GAAP net investment income of $0.80 per share and was decreased by $0.56 per share due to a decrease in the overall value of our investment portfolio. Our net asset value per share was reduced by our $0.68 per share dividend paid during the quarter and increased by $0.03 per share due to share repurchases. With some of these activities resulting in our December 31, 2022, net asset value per share of $24.89. From a forward-looking guidance perspective, we expect first quarter 2023 GAAP net investment income to approximate $0.77 per share, and we expect our adjusted net investment income to approximate $0.74 per share. Detailed first quarter guidance is as follows: our recurring interest income on a GAAP basis is expected to approximate $365 million. We expect recurring dividend income associated with our joint venture to approximate $53 million. We expect other fee and dividend income to approximate $29 million. From an expense standpoint, we expect our management fees to approximate $58 million. We expect incentive fees to approximate $44 million. We expect our interest expense to approximate $117 million, and we expect other G&A expenses to approximate $11 million. As a reminder, the $0.03 per share difference between our GAAP net investment income and our adjusted net investment income related to the expected accretion of our investments during the quarter due to merger accounting. This difference affects our recurring interest income. All other categories of our revenues and expenses are not affected. In an effort to link our fourth quarter 2022 results through our first quarter 2023 guidance, the primary considerations are as follows: starting with our $0.81 per share of 4Q adjusted net investment income, we subtract $0.05 per share of adjusted net investment income to account for the expiration of the fee waiver. We subtract $0.02 per share of adjusted net investment income to account for the fact that the first quarter has 2 fewer days than the fourth quarter. The expected incremental growth in investment portfolio earnings during the first quarter due in part to higher interest rates is expected to be counterbalanced by lower fee and dividend income as certain dividend-paying portfolio companies tend to pay dividends later in the year. We hope this information is helpful to investors and analysts in terms of creating an accurate starting point for 2023. In terms of the right side of our balance sheet, our gross and net debt to equity levels were 125% and 118%, respectively, at December 31, 2022. This compares to gross and net debt to equity of 128% and 119% respectively, at the end of the third quarter of 2022. At December 31, our available liquidity was $3 billion. At the end of the fourth quarter, approximately 54% of our drawn balance sheet and 42% of our committed balance sheet was comprised of unsecured debt, and our overall effective average cost of debt was 4.8%. 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. In closing, I'd like to thank our team for its continued strong execution throughout 2022, despite the challenging macroeconomic environment that led to significant market volatility during the year. As we look forward, we continue to believe we are well positioned with respect to our investment portfolio, strong capital structure, committed liquidity position, and experienced team. We are optimistic about the company's future and have confidence in our ability to generate strong results for our shareholders, including the continued strategy of sharing outperformance with shareholders on a real-time basis through supplemental quarterly distributions. As a result, we believe the forward opportunity for the shareholders is extremely attractive. Thank you all for joining the call and for your continued interest and support. With that, operator, we'd like to open the call for questions.

Our first question comes from Mark Hughes with Truist. Your line is open.

Yes. Thank you. Good morning. If we get to the scenario where interest rates are higher for longer, do you think the deal activity will pick up? I mean, do the expectations get set properly and the market starts to clear? Are we more dependent on the Fed for interest rates to slow down before you start to see more deals happen?

Mark. That's an interesting question. I think the market, from an M&A perspective, is looking for some comfort that inflation is under control. I think if you are still seeing interest rate increases, which we are expecting, it indicates that the Fed hasn't accomplished the mission that they're trying to do. That said, I think you're starting to see a little bit of green shoots. I mean, it's been difficult the last couple of weeks, but the year started off with some level of normalcy. So I think our belief is M&A is going to continue to be slow for the near term, and you'll probably see some pick up in the latter half of the year.

Then the incentive fees after the expiration of the waiver, is there anything about the trajectory from here that we should think about might be unusual? Or is it kind of steady as she goes depending on the performance of the portfolio?

Yes, it should be more of a steady-as-she-goes point. I think Steven tried to lay out some pretty decent guidance there as related to Q1, but then also building the bridge from Q1 back to Q4 and hopefully, that provides a good starting point for you to consider how you think the rest of the year rolls forward.

And our next question is coming from the line of Erik Zwick with Hovde Group.

First, I just wanted to start as I looked at the composition of the portfolio. There was an increase quarter-over-quarter in asset-based finance. Just curious how you view the opportunity to continue lending in that arena today and whether you would expect that to continue to grow or stay in the current range of its current composition in the total portfolio?

Thank you for the question. I do believe we remain confident from an investing perspective. It's one of the more interesting parts of the market. We like the collateral, we like to generally front-ended sort of cash flows. We think the risk-adjusted returns are quite strong. That said, I think as it relates to FSK specifically, we've talked to the market about a 10% to 15% sort of allocation to asset-based finance; we're in the middle of that range. I think you should probably expect us to stay there, plus or minus a percentage point or two. But again, we do feel quite strongly about the attractiveness of it as an asset class to invest in.

I appreciate the color there. And if I could move to just looking at Slide 10 of the presentation, you mentioned there are some pretty strong improvements in portfolio company EBITDA. Certainly, in the second half of the year looking at that graph, but just due to higher interest rates, the interest coverage coming down in that blue bar in the second half. So if we get to a period where EBITDA is materially impacted, if we get into a recessionary environment, it seems like that would put additional pressure on that interest coverage ratio. So just curious how you view that profitability and how you would manage the portfolio if some of these companies start to be more stressed from interest coverage and potentially operating environment?

Yes, that's a good question. We are quite pleased with the 15% year-on-year EBITDA growth that we discussed. However, it's important to recognize that this figure is backward-looking. As risk managers, we are primarily focused on the future. If a significant recession occurs, there may be a correlation with interest rates declining, which could lead to a stable interest coverage perspective overall. That being said, the numbers we are discussing are averages, and our portfolio management does not rely on averages alone. It's essential for us to focus on the specific situations that may be problematic. In terms of managing these challenges, we have significantly strengthened our team over the past five years, particularly in relation to portfolio management after new deals are made. We have 22 team members whose primary responsibility is to monitor the portfolio and address troubled credits. They play a crucial role in our investment team, and we approach each situation individually to achieve the best possible outcomes.

And our next question is from Ryan Lynch with KBW.

First question I had is you mentioned a slight uptick in amendment activity, which is not surprising in this environment and likely expected to continue going forward. I would just be curious to hear your thoughts on what is really driving that increase in amendment activity? Would you consider that these businesses not able to adjust to the rapid increase in rising rates and support that higher level of interest burden? Or is it more that there's something fundamentally weaker in that business? And then I'd also be curious to hear, you mentioned you're seeing support from the PE sponsor. Does that mean that they're injecting capital? Please explain what exactly you meant by that.

Yes, we are observing a slight increase, but it seems to be more typical business activity than anything concerning. I don't believe there is anything fundamentally wrong with these companies when this activity occurs. However, there may be supply chain issues or inflationary pressures, such as rising wages. Additionally, most of these deals come with covenants that decrease over time, requiring the company to reduce debt. Financial performance metrics often influence this activity, as do credit metrics. Alternatively, it may simply be the standard amortization of the loan. Regarding support, we are pleased with our focus on lending to upper middle market companies, which we believe still hold strong value. We have cultivated genuine relationships with financial sponsors through our origination efforts. While sponsors are not likely to inject capital without reason, they do tend to consider the long-term relationship. Over recent years, we have observed that financial sponsors are more inclined to support new originations with funds that are currently active, as they likely have available capital. This tends to be simpler than with older funds, and that support typically comes in the form of equity dollars.

Okay. That's helpful. And that's the backdrop. The other question I had, you mentioned the two loans this quarter that received a credit-related markdown, Pure Fish and KBS. You gave a background of why those businesses were feeling some pressure. But then you ended it with saying that you consider both of the problems that these businesses are experiencing to be transitory. It wasn't clear to me why you thought that those issues were transitory. If you could explain your thought process behind that comment, that would be helpful.

I'm glad to discuss this. Brian may want to add some insights as well. Essentially, we have confidence in the strength and scale of these companies. On average, they hold about $500 million in equity relative to the loans we've provided. We've noticed this trend in other retailers where there has been excess inventory due to overbuying during a euphoric market phase, and we believe this will eventually be resolved. There are solid brands involved, including KBS, which is a substantial, high-quality business facing challenging conditions due to wage inflation and other factors. We anticipate that they will navigate through these issues. However, we are also acknowledging the current market movements, which is why we brought this up during the call.

And our next question is coming from the line of Casey Alexander with Compass Point.

If we could take a moment to revisit Slide #10, I am interested in understanding the extremes of the portfolio. Could you provide the percentage of the portfolio that is currently below one-time interest coverage? Additionally, based on your forecasting expertise, what proportion of the portfolio is expected to fall below one-time interest coverage at the terminal expected rate?

Yes, thank you, Casey. There are just a few names that would fall under one-time coverage today, amounting to about 2% to 3% of the total portfolio value. I don't have the exact figures right now regarding the terminal rate expectations. Additionally, the information on Slide 10 is crucial for understanding the evolution of the portfolio, but the focus tends to be more on the individual line items. To give some context, the 1.9x on Slide 10 indicates that if we refer to the MAX forward curve and assume no change in earnings, that $1.9 billion would decrease to $1.64 billion. So, it’s possible that a few more names could join that group, potentially increasing the percentage slightly.

And Casey, this is Brian. I think the other point to recognize is that as rates go higher from here on a percentage basis, looking at the base rate plus the coupon, the change gets smaller and smaller, so the impact is less on a go-forward basis versus what it was in the past.

My next question is in sort of a broader context. The folks operating your portfolio companies are not operating in a vacuum. They see the news; they understand what's going on in the environment. How do you feel like your portfolio of companies, I mean, they must be adjusting to an inflationary environment. So even if inflation sticks around for longer, how do you think your portfolio companies are adjusting to that and their ability to manage forward? Don't you think that would ultimately have companies successfully adjusting to that enhance the M&A environment?

Yes. I think it will enhance the M&A environment. I mean, I think the M&A environment probably needs that catalyst first. My gut is that catalyst is some view from the broader investor community that the world is at equilibrium or at a minimum, we've stopped the big inflation move upward. I think that just gets into the simple idea of finding that willing seller and finding that willing buyer. We are still seeing some M&A activity out there; I think, honestly, it's probably skewed more towards the best-in-class businesses because people want those businesses, and they are willing to still pay multiples for them that are strong or high compared to maybe the multiples that would have existed for that business a year plus ago. In terms of the management team, I mean, one thing we have seen focuses on this larger borrower, the upper end of the middle market, we've probably got a better CEO, better CFO, better governance. So the better controls, and more support from their Board. I think that's a positive. But what have we seen? We've seen a fair amount of pricing increases go through. We've seen one company do it nine times; I think we are a little bit mindful or may be concerned that pricing increases are sort of at their last legs, but we've seen companies being able to do that. I think people have looked for where they can take costs out; that's something I think is pretty normal in a time like this. I think those companies that have had some supply chain issues are looking to diversify their supplier base; I think that's a broader theme in the overall market. So I think we've seen management teams do a very good job trying to be very forward-leaning. I think just the reality is maybe two things: One, the moves have been fast and meaningful, right as it relates to rates. Obviously, the wage pressure has been building up for some time, but the wage pressure we think is very real across the market. And like I said, I think they've been doing a good job, and we expect that to continue and hopefully enhance value for these companies going forward.

I didn't mean to chuckle, but when you said the world at equilibrium, all that could occur to me was after 40 years in this business, I'm not sure what the world in equilibrium means. I think it's always in sort of a state of change and flux. We're always stressing this.

That's the word that popped into my mind at the time.

Thanks for taking my questions. I appreciate it.

Ladies and gentlemen, that concludes the conference for today. Thank you for your participation. You may now disconnect.