FS KKR Capital Corp Q3 FY2024 Earnings Call

Good morning, ladies and gentlemen. Welcome to FS KKR Capital Corp's Third Quarter 2024 Earnings Conference Call. Please note that this conference is being recorded. At this time, Anna Kleinhenn, Head of Investor Relations, will proceed with the introduction. You may now begin.

Thank you. Good morning, and welcome to FS KKR Capital Corp's third quarter 2024 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 yesterday. 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 September 30, 2024. 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 is 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 third-quarter earnings release that was filed with the SEC on November 6, 2024. 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, Chief Executive Officer and Chairman; Dan Pietrzak, Chief Investment Officer and Co-President; Brian Gerson, Co-President; and Steven Lilly, Chief Financial Officer. Also joining us on the call today are Co-Chief Operating Officers Drew O'Toole and Ryan Wilson. I will now turn the call over to Michael.

Thank you, Anna, and good morning, everyone. Thank you all for joining us today for FSK's third quarter 2024 earnings call. FSK's financial and operating results showed continued strength during the third quarter as we again exceeded our earnings guidance and over-earned our quarterly base and supplemental distribution. During this third quarter, FSK generated net investment income of $0.77 per share and adjusted net investment income of $0.74 per share as compared to our public guidance of approximately $0.72 and $0.70 per share, respectively. Our net asset value per share at the end of the third quarter was $23.82. On October 8, 2024, we announced that our Board declared a total fourth-quarter distribution of $0.70 per share consisting of our base distribution of $0.64 per share and a supplemental distribution of $0.06 per share. This results in $2.90 per share of total distributions in 2024, which equates to a 12.2% yield on our September 30, 2024 net asset value of $23.82 per share and a yield of approximately 14% based on our recent share price. As Dan will discuss in more detail during his comments, the FSK KKR Advisor continues to maintain its high bar on credit quality and disciplined underwriting process. During the third quarter, we originated approximately $1.1 billion of investments, and we ended the quarter with ample liquidity totaling approximately $4.4 billion. As we begin focusing on 2025, FSK is well-positioned to capitalize on expected market conditions. First, given the recent reduction in interest rates and assuming some level of additional rate cuts over the next 12 months, our portfolio companies should experience improved credit metrics such as interest and fixed charge coverage ratios. Next, based on our expectation for continued improvement in the M&A environment, there should be additional opportunities to rotate out of certain legacy portfolio companies, which have positioned themselves favorably over the last several years. Lastly, we are optimistic about the outlook for new investment opportunities and continue to believe that the KKR credit platform is well-positioned to generate differentiated deal flow across private debt and asset-based finance investments. And with that, I'll turn the call over to Dan and the team to provide additional color on the market and the quarter.

Thank you, Michael, and good morning, everyone. Despite the recent noise surrounding the presidential election, the U.S. economy continues to remain on solid footing. Since the Fed began raising rates in early 2022, the U.S. economy has experienced a 6.8% growth rate in real terms. Recent economic data released through September illustrates that the labor market has remained resilient, boosting income levels for workers, which continues to support consumer spending. At the same time, inflation has declined from 9.1% in June of 2022 to approximately 2.4% today. Both of these inputs create a favorable backdrop for a sustained economic expansion. As Michael alluded to in his comments, we believe that M&A activity will increase meaningfully in 2025 as the market has seen interest rates peak and economic sentiment improve. In line with this, we have seen greater momentum in middle market deal volumes and our pipeline of new investment opportunities continues to grow. The bar remains high when looking for new opportunities to deploy capital. The market continues to be competitive, which has resulted in tighter credit spreads and more borrower-friendly terms. Nevertheless, we remain prudent and disciplined in our underwriting and have continued to pass on opportunities that do not meet our credit standards. We continue to see compelling opportunities in asset-based finance as banks strategically reposition their portfolios, largely due to regulatory requirements. As we have discussed previously, our ABF investments are often structured as fixed rate, which helps offset the impact of declining rates in the direct lending portion of our investment portfolio. During the third quarter, FSK originated $1.1 billion of new investments. Approximately 57% of our new investments were focused on add-on financings to existing portfolio companies and long-term KKR relationships. Our new investments, combined with $1 billion of net sales and repayments when factoring in sales to our joint venture, equated to a net portfolio increase of $185 million. New originations consisted of approximately 84% in first-lien loans and 16% in asset-based finance investments. Our new direct lending investments had a weighted average EBITDA of approximately $211 million, 6.3 times leverage through our security, and a weighted average coupon of approximately SOFR plus 505 basis points. Through our ABF team and the broader KKR network, we have developed deep relationships, which allows us to access niche sectors that we find attractive within the ABF market and to structure deals that many market participants are unable to execute on due to transaction size, complexity, or platform capabilities. One example of an asset-based finance deal that we originated during the quarter was the purchase of an approximately $10 billion pool of seasoned private student loans from Discover Financial Services. This portfolio is focused on prime borrowers or co-signers and has an average FICO score above 750. KKR Credit and another large manager jointly led and structured the multi-billion dollar deal with FSK committing $94 million. The trend of well-performing portfolio companies proactively seeking re-pricings continued during the third quarter. We have also experienced instances of companies seeking overly aggressive price reductions or structural amendments, which don't align with our return or risk thresholds. In those situations, we have proactively chosen to be repaid. When we look at aggregate trends across our portfolio companies, we observed a 13% year-over-year EBITDA growth rate at portfolio companies in which we have invested since April of 2018. Additionally, the weighted average and median EBITDA of our portfolio companies was $237 million and $121 million, respectively, as of September 30, 2024. As of the end of the third quarter, non-accruals represented 3.8% of our portfolio on a cost basis and 1.7% of our portfolio on a fair value basis. This compares to 4.3% of our portfolio on a cost basis and 1.8% of our portfolio on a fair value basis as of June 30, 2024. Brian will provide further details on this during his comments. We also believe it is helpful to provide the market with information based on the FSK assets originated by KKR Credit. Non-accruals relating to the 88% of our total portfolio, which has been originated by KKR Credit and the FS KKR Advisor were 2.2% on a cost basis and 50 basis points on a fair-value basis as of the end of the third quarter. This compares to 2.4% on a cost basis and 60 basis points on a fair-value basis as of June 30, 2024. And with that, I'll turn the call over to Brian to discuss our portfolio in more detail.

Thanks, Dan. At the end of the third quarter, our investment portfolio had a fair value of $13.9 billion, consisting of 217 portfolio companies. This compares to a fair value of $14.1 billion and 208 portfolio companies as of June 30, 2024. Our net leverage remained flat quarter-over-quarter, and the decline in our investment portfolio's fair value was primarily driven by unrealized depreciation relating to three investments: Production Resource Group, Miami Beach Medical Group, and Worldwise. PRG continues to be impacted by the lingering effects of the Ryder strike and its corresponding impact on TV and film, as well as softness in its live performance business due to the delay of certain artists' tours. Miami Beach recently filed for Chapter 11 as part of its anticipated sale to Humana. Over the coming months, should this transaction close, we will exit our position in Seoul. Worldwise has experienced headwinds in its core pet food business due to increased competition from low-cost foreign suppliers. We are actively engaged with the sponsor of Worldwise to negotiate a potential restructuring, and we will provide additional updates as we learn more. At the end of the third quarter, our 10 largest portfolio companies represented approximately 20% of the fair value of our portfolio, which is in line with prior quarters. We continue to focus on senior secured investments as our portfolio consisted of approximately 60% first lien loans and 67% senior secured debt as of September 30. In addition, our joint venture represented 9.9% of the fair value of our portfolio. As a result, when investors consider our entire portfolio looking through to the investments in our joint venture, then first lien loans totaled approximately 69% of our portfolio and senior secured investments totaled approximately 76% of our portfolio as of September 30. The weighted average yield on accruing debt investments was 11.5% as of September 30, a decrease of 50 basis points compared to 12% at the end of the second quarter. The decrease is primarily attributable to lower spreads on new investments, the repayment of certain higher-yielding investments during the quarter, and portfolio company re-pricings. As a reminder, the calculation of weighted average yield is adjusted to exclude the accretion associated with the merger with FS KKR. During the third quarter, Global Jet returned $76 million of capital to FSK, which is used to further reduce our position. This distribution brings our total capital received to $205 million over the last 2.5 years, and we continue to be pleased with the performance of the company. During the quarter, one investment was added to non-accrual status, and three investments were removed. Our subordinated delayed draw position in Miami Beach Medical was added to non-accrual status, contributing $17 million of cost and $8 million of fair value. Five of our income fund, a legacy investment, which has been on non-accrual since 2020, was fully exited, removing $54 million of cost and $2 million of fair value. Lastly, a recapitalization of Belk resulted in the removal of $36 million of cost and $13 million of fair value across two investments. And with that, I'll turn the call over to Steven to go through our financial results.

Thanks, Brian. Our total investment income increased by $2 million during the third quarter to $441 million. The primary components of our total investment income during the quarter were as follows: Total interest income was $356 million, representing an increase of $3 million quarter-over-quarter. A component of interest income, PIK interest, was $66 million as three portfolio companies, ACX, ERG, and KBS paid their interest in the form of PIK. Dividend and fee income totaled $85 million, a decrease of $1 million quarter-over-quarter. Our total dividend and fee income during the quarter is summarized as follows: $46 million of recurring dividend income from our joint venture, other dividends from various portfolio companies totaling approximately $18 million during the quarter, and fee income totaling approximately $21 million during the quarter. Our interest expense totaled $118 million, an increase of $3 million quarter-over-quarter, and our weighted average cost of debt was 5.5% as of September 30. Management fees totaled $54 million, unchanged quarter-over-quarter, and incentive fees totaled $44 million, a decrease of $1 million quarter-over-quarter. Other expenses totaled $10 million, unchanged quarter-over-quarter. The detailed bridge in our net asset value per share on a quarter-over-quarter basis is as follows: our ending 2Q 2024 net asset value per share of $23.95 was increased by GAAP net investment income of $0.77 per share and was decreased by $0.20 per share due to a decrease in the overall value of our investment portfolio. Our net asset value per share was reduced by our $0.70 per share total quarterly distribution paid during the quarter. The sum of these activities results in our September 30, 2024 net asset value per share of $23.82. From a forward-looking guidance perspective, we expect fourth quarter 2024 GAAP net investment income to approximate $0.63 per share, and we expect our adjusted net investment income to approximate $0.68 per share. Detailed fourth-quarter guidance is as follows: Our recurring interest income on a GAAP basis is expected to approximate $332 million. We expect recurring dividend income associated with our joint venture to approximate $52 million, an increase of approximately $6 million quarter-over-quarter. The expected increase is a result of the recent sale of $370 million of assets to the joint venture from FSK's balance sheet. We expect other fee and dividend income to approximate $31 million due to lower non-recurring fee income within our investment portfolio. From an expense standpoint, we expect our management fees to approximate $53 million. We expect incentive fees to approximate $36 million. We expect our interest expense to approximate $117 million, and we expect other G&A expenses to approximate $10 million. During the fourth quarter, we expect our excise taxes will approximate $24 million. We expect the net effect of excise taxes to be partially offset by the accretion of our investments due to merger accounting. The primary drivers of the change from FSK's third-quarter adjusted net investment income of $0.74 per share to our expected fourth-quarter adjusted net investment income guidance of $0.68 per share are the reduction in interest rates by the Federal Reserve in September and lower fee income in the fourth quarter as compared to the third quarter. Turning to our capital structure, our gross and net debt to equity levels were 121% and 109%, respectively, at September 30, 2024, as compared to 119% and 109% at June 30, 2024. As of the end of the third quarter, our available liquidity was $4.4 billion, and approximately 66% of our drawn balance sheet and 46% of our committed balance sheet was comprised of unsecured debt. As a team, we are very focused on managing the right side of our balance sheet and optimizing our capital structure through multiple funding sources. Like certain other BDCs, which took advantage of the lower rate environment in 2019 and 2020, FSK has some lower-cost debt maturing next year. In 2025, FSK has approximately $1.2 billion of unsecured notes maturing, representing approximately 10% of our total debt commitments and carrying a weighted average cost of 5.1%. FSK has been a frequent issuer in the unsecured market with a focus on well-laddered maturities. We will continue to opportunistically assess the unsecured market and we have over $3.5 billion of undrawn capacity under our senior secured revolving credit facility to utilize should we desire to aid with timing differences. And with that, I'll turn the call back to Michael for a few closing remarks before we open the call for questions.

Thank you, Steven. In closing, we are pleased with FSK's third quarter performance as we have further reduced our non-accrual investments and are continuing to see significant new investment opportunities. As we look toward 2025, we believe the next several quarters could yield meaningful opportunities for FSK as the M&A market continues to improve. As we actively pursue well-structured new investments and focus on rotating legacy investments, we believe that 2025 has the potential to be a very active year for FSK. And with that, operator, we'd like to open the call for questions.

Your first question comes from Bryce Rowe from B. Riley Securities. Your line is now open.

Thank you very much. Good morning, everyone. I wanted to start by discussing yields and what you are observing in the market. You mentioned yield compression within the portfolio of 50 basis points for the quarter. I would like to better understand the effects of lower rates and spread compression contributing to that 50 basis points. Additionally, regarding your guidance for the fourth quarter, which suggests lower interest income due to rates, is this entirely related to lower rates, or does it also factor in some spread compression?

Yes, good morning, Bryce. Yes, I think the simple summary is it's a little bit of both, right? And clearly, there was the initial Fed move of the 50 basis points. We have seen from a new deal perspective, your regular way direct lending deal is probably 500 basis points to 550 basis points and that's before kind of fees and original issue discount. We have seen some re-pricings across the book. I think we called that out in our prepared comments. I think for names that we're comfortable with and we like the risk, what we can be supportive of, we have used a couple of those opportunities to just get repaid. It is, I think a little bit of a harder market these days, right? The M&A volumes that everybody has been forecasting, including ourselves, have been a little bit slow to return. I think we've been happy with our deployment numbers, but there's a bit of an imbalance in terms of available capital and kind of deal flow, which I think is driving some of that. All that being said, I think what you are earning on these loans in totality is still north of 10%, and considering I think the quality of the company that we are seeing considering the loan-to-value or the equity tax below us, that is one comforting fact in terms of the total return on these deals.

Yes, that's helpful. I have one more question before I return to the queue. As we consider the guidance, many BDCs are experiencing earnings compression, leading to dividend coverage falling below 100%, particularly when looking at supplemental income in addition to the base. You have a significant amount of spillover income, and you’ve previously indicated that it is adequate to cover any shortfalls. I’m interested in where you see the spillover settling; would you prefer to maintain two quarters of spillover income, or do you aim to keep around the three quarters you currently have?

No, that's a fair question. I think your estimates are pretty much on point. I do believe that the spillover income is quite beneficial in our current environment. I would note that our starting point from an earnings perspective is strong. I think a 12.2% yield on NAV is attractive. As Steven mentioned, we are forecasting lower income in Q4. One thing we will watch is that we believe increased activity in 2025 will occur, which should benefit the fee income line and provide some offset. But yes, we do have nearly three quarters of spillover available in relation to the $0.70.

Thank you, Bryce.

Your next question comes from Casey Alexander from Compass Point. Your line is now open.

Yes, good morning. The income generated this quarter was better than most of us expected, particularly due to a significant increase in PIK income over the past two quarters. Can you share your expectations for its development in the next quarter and in the following quarters?

Yes. Good morning, Casey. I think in terms of the PIK, I kind of frame it in one way, and then maybe Brian will talk about some of the specific deals. You know, while it's a smaller part of our portfolio, we have been active in certain junior debt deals. Athena Health would be an example of that. So of the PIK income, roughly half of that is what I'll call regular way kind of new business. A lot of those companies end up being kind of a larger size, which we like from a risk perspective. I think when we did the Athena deal, as an example, it was like $1 billion of EBITDA. The rest of it, as Steven called out, was related to a handful of names, and those names were using that as they were reinvesting dollars into kind of growth activities, which I think we're supportive of them doing. But I think in terms of the forward outlook, I think we were roughly 15% this quarter. You're probably in and around that range. My guess would be for the next couple of quarters. But Brian, you might want to add to that.

When we restructure businesses, we ensure they have enough debt capacity based on their current projected earnings power. However, these restructurings are needed because the businesses have been underperforming, lacked strategic direction, often need management improvements, and may have been underinvested in selling, general, and administrative expenses or capital expenditures. We have structured these new loans with a payment-in-kind option, which provides us and management with the flexibility to tackle these performance issues. As we have approval on all budgeting matters since we're involved, the payment-in-kind options were deliberately designed and are not surprising. Currently, deals with this option are making use of it. This may answer your question about the future, but keep in mind that a lot of consideration goes into how yields are structured, with a strong focus on achieving the desired outcomes.

Okay, thanks. My next question is, last year around this time, you gave kind of pretty clear indications of, you know, how you sort of intended to manage the dividend for 2024, and it ended up getting broken into kind of three components. I'm curious if you have any view of how you think the Board expects to handle it, especially against, A, rate compression, B, declining base rates. I mean, would it be your expectation that in 2025, investors should think more in terms of the base dividend and then see how things develop through 2025?

Yes, thank you for that, Casey. We aim to be transparent about our dividend policy. You're right that we've divided it into three parts. We wanted to reward shareholders for what we call outperformance on the income side, which was the additional $0.05 we paid out for five consecutive quarters. We've also broken it down into 64% and 6% to reach the 70%. When discussing this with the Board, we consider a long-term outlook. That's why we established the base at 64%. We will continue to evaluate this with the Board. Regarding the potential impact of the presidential election, our initial impression is that while rates will trend down, it might occur more slowly than we anticipated 30 or 60 days ago. We need to observe how deal volume progresses and its effect on fee income. To address Bryce's question, we are at the upper end of the range for spillover, which supports the $0.70 we've been paying out.

And just to be clear and put a fine point on it. The $0.05 was the spillover that we were paying after five quarters and the $0.06 was what reflected the higher rate environment that we've been operating in.

Right. Got it. All right, great. Thank you for taking my questions.

Thank you, Casey.

Your next question comes from John Hecht from Jefferies. Your line is now open.

Thanks very much for taking my questions. Actually, a couple of just were asked. But I'm wondering on the investment pipeline. I mean, Dan, it sounded like there's more activity, but maybe the kind of pipeline of activity growth isn't quite as much as you would have expected. I guess my question is, as you look into 2025, given the forward curve and some anticipated maybe deregulation, do you think that the M&A pipeline and the investment pipeline will grow over the course of the next few quarters or is where we are, where we are?

Yes, thanks, John. We do believe that growth will occur. The reality is that many sponsor-owned deals are being held longer than planned, and limited partners are increasingly focused on getting their capital back from these funds. This creates pressure to sell some of these companies. There's also a significant amount of capital available in private equity that may be further down the line within a fund's lifecycle. Therefore, the potential to acquire these companies remains strong. However, the market has started slower than we anticipated at the beginning of 2024. We noted that for the bid-ask gap to close, market participants needed to feel more confident about inflation being under control, more stable rates, and the removal of fears regarding a hard landing. While all those elements are aligning, we have noticed that many are looking forward to rate reductions, which has contributed to the slower start. That said, when I examine our pipeline and the activity from our deal teams, it’s the highest level we've seen since early 2022, which is encouraging. We expect this trend to continue as we move into 2025.

Okay. That's helpful context. And then maybe just from a credit outlook perspective, is there anything to talk about or maybe call out in terms of EBITDA or revenue trends within the portfolio at the company level?

Yes. I think there are two points to consider. First, we are still experiencing revenue and EBITDA growth, which is a positive sign. However, this growth has been slower compared to previous years, so we are closely observing this trend. Second, all market participants likely recognize that we are currently in an environment where interest coverage ratios are tighter than we would prefer. This situation can lead to challenges, especially if a company loses a customer or faces issues from poor acquisitions, as there is less flexibility to address such problems. While circumstances can change, one advantage of a declining rate environment is that it can enhance cash flow for these companies. Overall, the situation has been generally positive, and the issues we have encountered in the portfolio or market appear to be specific to individual cases rather than indicative of a broader trend.

Yes. The sectors that have been underperforming this year are primarily those connected to retail, which we have limited exposure to. Consumer product companies have struggled because retailers are maintaining much lower inventory levels. There has been a lot of discussion about destocking, but I'm not sure how one can destock for two years; it seems more like a shift to a lower inventory model. In the industrial sector, there are specific areas of weakness, likely due to a more cautious outlook on capital spending this year. However, in a lower interest rate environment, this should work to our advantage.

Great. Thanks very much.

Thanks, John.

Your next question comes from Mark Hughes from Truist. Your line is now open.

Yes, thanks. Good morning.

Good morning.

The repricing activity you've seen, portfolio companies looking for better terms, how has that trended over the last few months? Is that kind of a step-function you see the rates change or is that just flow with the day-to-day interest rates and the spreads?

I believe the situation is a bit more complex. It's related to new deal activity, where there are data points for comparison. Companies can only really make those requests if they've demonstrated consistent performance over time. One positive aspect of the repricing is its strong connection to well-performing businesses. We have a view that as interest rates decline, it may apply some pressure causing spreads to widen, although this won't be a direct one-for-one impact. Generally, in the fixed-income markets, as benchmarks change, credit spreads will also be affected. The benchmark has shifted nearly 500 basis points, and we've observed some spread reduction since January 2022. So, it varies on a case-by-case basis, but we do anticipate some widening of spreads as rates decrease.

Okay. And then have you seen any change in the trajectory on that activity in the recent months or has it been reasonably steady?

Yes. I would say it's probably been a little bit slower, or at least you know, kind of spreads have settled at a level. I think there's a level of where spreads are that on particular deals wouldn't make sense for pools of capital like this. So I think there's a little bit of a floor there. But I think you've seen, let's call it a bit of slowdown or kind of finding kind of that sort of bottom point.

Yes. You mentioned passing on more deals due to pricing issues and maintaining your discipline. When you consider the factors influencing your credit decisions compared to your competitors, what is the typical dynamic? It may be difficult to separate these influences since they are related, but how significant is it in a tighter market, and how does it affect your usual origination activity ratios?

Yes. I'll probably answer it a little bit differently, but tell me if it makes sense. I think we have, as I mentioned, been happy to see, let's call it an uptick of activity. I think the larger lenders like us do benefit from these existing portfolios, you can maintain that incumbency position. We can pass on deals for a multitude of reasons. I mean, sometimes it's just the sector of the credit, we're not going to do it. Those deals probably don't even make it to a screening or an investment committee; it's more of a deskill. There are deals we won't play in because of where it's priced versus where we think it should be priced. That said, I think our primary focus is on credit. And then there are structural pieces, right? I mean, there are certain asks on certain deals that we think is a step too far for private debt or liquid credit, and we've walked away from certain deals after having done a lot of work on it because it's just not comparable structure.

Yes. Look, and I think the other thing to note is that our leverage is currently in the middle of our target range. So there's no pressure to deploy. I mean, we do benefit, as Dan said from those positions, and when re-pricings occur, credit, we maintain it.

Yes. And maybe one last point, Mark. So I think it is important. I think we're very focused on maintaining kind of that broad origination funnel, right? We've always talked about being active in the upper end of the middle-market. We'd probably classify that as $50 million to $150 million of EBITDA. Obviously, when the syndicated loan markets were shut in '22 and '23, we had the opportunity to participate in some larger deals. I think those were kind of very, very good risk-reward. We are prepared to go down to a lower number than that $50 million. The floor is probably $25 million, but there's a very high bar for that. It would be an industry or a sector that we really like. We're probably lending to one of their competitors. So we've got a real view in it that it's going to grow. But we do think it's important to have a broad kind of funnel there. We've got a very active non-sponsor business and we have people dedicated to that. We think that's helpful. We've been active in some of the ABL activity, let's call that receivables and inventory, right? We find those deals quite interesting from a risk-adjusted return perspective. And then our asset-based finance business remains active. We talked about Discover in our prepared remarks, but those deals are generally returning several hundred basis points wide of what we're seeing in direct lending. So I think that broad funnel is an advantage to us, and the ability to deploy across different companies, sponsor, non-sponsor, and things like asset-based finance is quite important.

Yes. Thanks for that perspective. Appreciate it.

Have a good day.

Your next question comes from Kenneth Lee from RBC. Your line is now open.

Hi, good morning. Thanks for taking my question. Just one follow-up on that last comment around the asset-based finance opportunities there. I'm wondering which benchmark rates are they typically keyed off given that they're fixed rates? And it sounds like the spreads are pretty wide right now. Just any kind of additional color there around that? Thanks.

Yes, happy to give. And it is a different, let's call it, return profile in a lot of ways than what you're seeing in direct lending. I think you could either have your loan portfolios that you're buying that the underlying loans themselves are fixed rate. We're usually using the bank market or the capital markets to finance those loan portfolios. So you can generate kind of that, what I'll call, fixed rate return. Even though if it's floating rate loans, if we are financing it, it would be financing with floating rate debts; you're effectively creating that more stable or almost fixed-rate return profile. In that part of the market, I don't think we think about it entirely like spreads; you're acquiring these asset portfolios, thinking about making a kind of targeted return on it that's generally in kind of the mid-teens type context. We remain quite bullish on the market opportunity there. We think that market is approaching $7 trillion of market size. That doesn't mean everything is for us. But that does mean there's a lot of white space because there has not necessarily been a lot of scaled capital raised, and we're fortunate to have 50 people dedicated to that space. There's some pretty good tailwinds there that we expect to continue to be quite accurate.

Got you. Very helpful there. I just want to follow up on the comments regarding the PIK income. Can you clarify how much of the PIK income was originally underwritten as PIK versus electing? Thanks.

Roughly half.

Okay. Got you. That's all I had. Thanks again.

Thank you.

Your next question comes from Melissa Wedel from JPMorgan. Your line is now open.

Good morning. Thank you for taking my questions. I want to follow up on the topic of PIK. I understand that those deals were structured to provide some flexibility during a possible turnaround. I'm interested in how PIK versus cash-paying income will affect your fair value marks over time, especially if you observe certain deals with PIK lasting longer than initially anticipated.

Good morning, Melissa. I think it will really depend on the specific situation. You could say that if a company has to use PIK for a long time, it might indicate underperformance. However, it's also possible that these companies are in the process of turning things around, which could lead to potential revenue growth. Therefore, it's important to evaluate each business based on its financial performance and other factors that influence its valuation. There's not a one-size-fits-all answer, but Brian, feel free to add your thoughts.

Yes, when you own a business, you are continuously making capital decisions and figuring out where to invest money for the highest return. This relates to our focus on flexibility, as we are very much oriented towards long-term outcomes in these matters. Ultimately, our decisions will be influenced by the performance of the companies and whether they continue to pay in kind or not.

Okay. And then to your comments about rates probably likely to trend lower, but the initial thought is maybe they won't go as lower as quickly as we would have thought a few months ago. And does that impact how you're thinking about sort of credit trends across the industry broadly? We think if there's a slower pace of rate decline that a natural trade-off on that would be a bit more, you know, distressed or default activity.? Thanks.

It's a valid question, and our views on this are likely developing, especially given the significant market changes in recent days. We've always anticipated that the Fed would be careful in reducing rates. The Fed has effectively managed to control inflation. However, there are aspects under this Republican administration that might be seen as inflationary. Nevertheless, the key emphasis of the election has been on ensuring inflation remains in check, so I believe there will be a balance. That said, I don't think this means a slower pace will significantly impact credit in the near term. If you were expecting three or four rate cuts over the next 12 to 18 months, you might want to adjust that expectation to potentially one fewer cut. It will be intriguing to see how this unfolds in the upcoming months and quarters.

Yes. Look, I'd add is where it's less constructive is to the equity in these deals. Higher rates have extended the whole period for companies that have had less cash on debt, which is how an LBO works. So if the extent rates stay higher, it could extend, but that's offset by the pressure that LPs are putting on GPs to sell assets and return capital. So there's certainly a balance there.

Got it. Thank you.

That concludes our question-and-answer session. I'd now like to hand back over to Dan Pietrzak for further remarks.

Well, thank you everyone for your time today. We're always available for any follow-up points as needed. We do wish everyone a great holiday season and we'll talk with you next quarter. Thank you.

Thank you for attending today's call. You may now disconnect. Have a wonderful day.