FSK Q1 2021 Earnings Call
Operator: Good morning, ladies and gentlemen. Welcome to FS KKR Capital Corp. II’s First Quarter 2021 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded. At this time, Robert Paun, Head of Investor Relations will proceed with the introduction. Mr. Paun, you may begin.
Robert Paun: Thank you. Good morning and welcome to FS KKR Capital Corp. II’s first quarter 2021 earnings conference call. Please note that FS KKR Capital Corp. II maybe referred to as FSKR, the fund or the company throughout the call. Today’s conference call is being recorded and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSKR issued on May 10, 2021. In addition, FSKR has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended March 31, 2021. A link to today’s webcast and the presentation is available on the Investor Relations section of the company’s website under Events and Presentations. Please note that this call is the property of FSKR. 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, including risks associated with the possible impact of COVID-19 that could affect FSKR or the economy generally. We ask that you refer to FSKR’s most recent filings with the SEC for important factors and risks that could cause actual results or outcomes to differ materially from these statements. FSKR does not undertake to update its forward-looking statements unless required to do so by law. In addition, this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures can be found in FSKR’s first quarter earnings release that was filed with the SEC on May 10, 2021. Non-GAAP information should be considered supplemental in nature and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly named measures reported by other companies. To obtain copies of the company’s latest SEC filings, please visit FSKR’s website. Speaking on today’s call will be Michael Forman, Chairman and Chief Executive Officer; Dan Pietrzak, Chief Investment Officer and Co-President; Brian Gerson, Co-President; and Steven Lilly, Chief Financial Officer. Also joining us on the phone are Co-Chief Operating Officers, Drew O’Toole and Ryan Wilson. I will now turn the call over to Michael.
Michael Forman: Thank you, Robert and welcome everyone to FS KKR Capital Corp. II’s first quarter 2021 earnings conference call. The first quarter represented another positive stable quarter for FSKR. During the quarter, our investment team originated $719 million of new investments, we experienced an increase in our net asset value and we again outearned our $0.55 per share quarterly dividend. Again, I congratulate our team for achieving these solid results, especially during such a volatile period. During the first quarter, our net investment income was $0.57 per share, which was $0.02 per share above our quarterly dividend of $0.55 per share and also $0.01 per share above our public guidance at the end of the fourth quarter. From a liquidity perspective, we ended the quarter with approximately $2.2 billion of available liquidity with no meaningful near-term debt maturities. Looking forward to the second quarter, assuming the proposed merger between FSK and FSKR closes before the end of the second quarter, we plan to file a single combined 10-Q for the quarter for the surviving entity, FSK. From an FSKR dividend perspective, our Board has declared a distribution of $0.55 per share for the second quarter, which equates to an annualized yield of 8.7% on a net asset value per share of $25.33 as of March 31, 2021. Assuming the proposed FSK and FSKR merger closes on schedule, on our second quarter earnings call, we will provide detailed guidance with regard to our near-term operating expectations for FSK. However, based on the positive feedback we have received from the market regarding our existing dividend policy, assuming current market conditions remain relatively intact, we currently expect to continue to target a 9% annualized dividend yield for FSK. As we prepare for the closing of the proposed merger of FSK and FSKR, the Board and I are extremely pleased with how the FS/KKR team is performing and how well our investment portfolio is positioned for the future. As a result, we believe that the proposed merger of FSK and FSKR will be consummated at an opportune time. And with that, I will turn the call over to Dan and the team to provide additional color on the market and the quarter.
Dan Pietrzak: Thanks, Michael. In early November of last year, on our third quarter 2020 conference call, we shared our belief that the fed’s primary focus was reducing unemployment with a secondary goal of targeting inflation at around 2% per year. At that time, unemployment was 6.9%. Today, just 2 quarters later, unemployment is 6.1%, an impressive decline in its own right but even more so when one accounts for the number of eligible workers still choosing not to work due to lingering pandemic-related concerns as well as the extra financial support provided by the most recent stimulus package. Going forward, we believe fed policymakers will continue to lead with the primary focus on the labor market and then hiring in certain – that hiring in sectors such as travel, hospitality and leisure, infrastructure and homebuilding will lead to a continued near-term drop in unemployment with wage growth perhaps occurring sooner than many observers may expect. In our conversations with financial sponsors and portfolio companies, we have been encouraged by their operating and financial performance, which has included meaningful increases in both revenues and EBITDA on a quarterly basis for the last three to four quarters. Going forward, we believe the coming quarters will be marked by continued improvement in free cash flow growth across many sectors, offset only partially by the effects of expected higher near-term inflation. Over the intermediate term, while we continue to believe that modest inflation is healthy for the overall economy, we believe inherent structural forces, including technology and demographic trends, will help balance longer-term inflationary pressures. From an investing perspective, we, like other large BDC platforms continue to experience the repayment of certain assets as sponsors and portfolio companies take advantage of the strength of the syndicated markets. While repayments are normal in our business, we recognize the market’s focus on our ability to reinvest. To this end, we continue to be encouraged by the significant growth, which has occurred in the private credit markets over the last several years as both sponsors and portfolio companies have come to depend on larger, well-funded platforms as traditional and regular way of sources of financing. As we move forward in 2021, we will continue to be highly selective in our underwriting as we adhere to our internal view that we want to be well downside protected in this market. Also later in the call, Brian will speak about a few repayments of legacy positions, which were originated prior to the establishment of the FS/KKR Advisor, where we played active roles with both the portfolio companies and their sponsors to create positive outcomes. In terms of new investing activity during the first quarter, the FS/KKR Advisor closed on approximately $1.1 billion of total investments across our BDC franchise, $719 million of which were within FSKR. From a volume standpoint, the first quarter began slowly as it frequently does. As our transaction pipeline began to expand, we continue to exercise caution by being highly selective, focusing only on investment opportunities which meet our criteria. During the quarter, our closure rate approximated 2%, which compares to our historical closure rate of approximately 4%. Approximately 40% of our FSKR originations during this quarter came from opportunities and companies previously invested in by KKR, again illustrating the power of incumbency and our relationships. Our $719 million of total investments combined with $1.15 billion of net sales and repayments equated to a net portfolio decline of $434 million during the quarter. During April, we closed $380 million in investments, and we experienced $493 million in repayments. As we said during our fourth quarter call, we continue to forecast a higher-than-average level of repayments over the next few months, given the continued strength and abundant liquidity within the syndicated markets. In terms of color around a few of our investments during the quarter, KKR credit was the lead arranger and committed $320 million through a $505 million first lien delayed draw term loan for MB2 Dental Solutions, a dental service organization with a total of 266 practice locations across 21 states. FSKR’s portion of the commitment was $156 million, while FSK and other KKR managed accounts committed the remainder. KKR credit also committed $175 million to a second lien financing for Peraton Corporation, a large government services IT business focused on intelligence and defense. The sponsor, Veritas Capital, acquired another government services IT business and merged it with Peraton. The combination creates a scaled leader in the government IT services sector with a particular focus on higher end cybersecurity and product development work with over 10,000 employees. FSKR committed $127 million to the financing, while FSK and other KKR-managed accounts committed the remainder. This financing is an example of an investment opportunity with a larger company, where we believe the dynamics of the second lien structure are compelling. Both of these investment opportunities are examples of the types of transactions we find attractive, well-capitalized, solid operating companies that appear well positioned for future growth. About a year ago, we began providing detailed investment performance metrics for the FS/KKR Advisor. The updated information is summarized as follows: since the FS/KKR Advisor was formed through March 31, 2021, we have originated approximately $5.7 billion of new investments in FSKR and have experienced 9 basis points of cumulative appreciation. We continue to be pleased with the investment performance our team has been able to deliver. And we believe these data points continue to illustrate the manner in which we have taken measurable steps to turn the investment portfolio toward what we believe to be more conservative investment structures in companies with more defensible operating positions. This information is detailed on Slide 23 in our investor presentation on our website. And with that, I will turn the call over to Brian to discuss some investment portfolio specifics.
Brian Gerson: Thanks, Dan. As of March 31, our investment portfolio had a fair value of $7.6 billion, consisting of 153 portfolio companies. This compares to a fair value of $8 billion and 155 portfolio companies as of December 31, 2020. At the end of the quarter, our top 10 largest portfolio companies represented approximately 23% of our portfolio, which remains in line with our results for the last several quarters. We continue to focus on senior secured investments as our portfolio consisted of 65.5% of first lien loans and 75.8% senior secured debt as of March 31. In addition, our joint venture represented 8.4% of the portfolio, and our asset-based finance investments represented 11% equating to an additional 19.4% of the portfolio, which is comprised predominantly of first lien loans or asset-based finance investments, which we believe have meaningful principal protection. The weighted average yield on accruing debt investments was 8.4% as of March 31, 2021 as compared to 8.5% at December 31, 2020. The modest decline in our weighted average yield during the quarter was primarily associated with the repayment of higher yielding assets during the quarter and new lower yielding investments which closed during the quarter. In terms of color surrounding the repayments we experienced during the quarter, approximately 22% of our repayments were related to investments made by the FS/KKR Advisor since its establishment in April 2018. The other 78% of our repayments were associated with legacy investments. As Dan mentioned, two of these legacy investments are highlighted as follows: first is Kodiak Building Partners, which distributes building products to commercial builders and/or modelers. The investment was originated in December 2017 when Court Square purchased Kodiak, American Builders and two small tuck-in acquisitions. We provided the full $174 million unit tranche and $52 million accordion to support the business. Since the time of FSKR’s original investment, Kodiak completed more than 10 acquisitions. In August 2018, we increased our investment by providing an incremental $100 million commitment to the company’s delayed draw term loan to fund the company’s growth. In February of this year, the business completed a dividend recapitalization to the syndicated market, and our investment was repaid in full at a call price of 101. Another sizable legacy investment that was repaid during the quarter was All Systems. The company is a human capital solutions provider in the U.S., serving a diverse set of blue-chip customers. The investment in All Systems was originated in October 2016 when THL Partners acquired the business and was highly acquisitive during our hold period. In July 2019, we opportunistically refinanced the company with a new unitranche facility. This refinancing allowed us to repay the first-out lender in full, thereby improving our financing position. Our loan was repaid in full at par in January of this year upon the sale of the company. Including the effects of these and other recent repayments, as of March 31, 2021, approximately 74% of our yielding investment portfolio is now comprised of investments originated by KKR. Turning back to our existing portfolio, during the first quarter, we experienced net portfolio appreciation of $35 million. The total amount of realized and unrealized depreciation we experienced across the portfolio during the quarter was $96 million, and our realized and unrealized depreciation totaled $61 million during the quarter. During the first quarter, we placed one investment on non-accrual, Sequel Youth and Family Services. Sequel provides residential and community based behavioral health services for children, adolescents and adults with behavioral challenges and has been on our watch list. As a result, at the end of the first quarter, our non-accruals represented approximately 4.3% of our portfolio on a cost basis and 2% of our portfolio on a fair value basis compared to 3.5% on a cost basis and 1.8% on a fair value basis as of December 31, 2020. And with that, I’ll turn the call over to Steven to discuss our financial results in more detail.
Steven Lilly: Thanks, Brian. In terms of color behind our financial results, the $9 million decline in our total investment income quarter-over-quarter was impacted by the following: our interest income declined by $1 million quarter-over-quarter, and we experienced a decrease of $8 million in our fee and dividend income. The largest components of our fee and dividend income included $17.5 million of dividend income from our joint venture during the quarter. Other dividends from various portfolio companies totaled approximately $5 million during the quarter. Finally, fee income totaled $17 million during the quarter, representing a decrease of $5 million quarter-over-quarter with the change tied directly to our origination and repayment activity during the quarter. Our interest expense and management fees remained relatively flat quarter-over-quarter, and other operating expenses decreased by $5 million during the quarter, primarily due to certain investment banking fees related to the proposed FSK and FSKR merger, which were recognized during the fourth quarter. The detailed bridge in our NAV per share on a quarter-over-quarter basis is as follows: our starting 4Q 2020 NAV per share of $25.10 was increased by GAAP net investment income of $0.57 per share and was increased by $0.21 per share due to an increase in the overall value of our investment portfolio. Our NAV per share was reduced by our $0.55 per share dividend. The sum of these activities results in our March 31, 2021, NAV per share of $25.33. From a forward-looking guidance perspective, we expect our second quarter net investment income prior to any effects of the proposed merger with FSK to approximate $0.56 per share. The bridge from our $0.57 per share of net investment income during the first quarter to our second quarter guidance is as follows: our recurring interest income is expected to approximate $137 million which is $10 million lower quarter-over-quarter. The decline is due to a combination of the following: anticipated repayments of certain higher-yielding assets during the second quarter and the effects of the lower origination volumes we experienced during the first quarter. We expect recurring dividend income associated with our JV to approximate $18 million during the second quarter. We expect other fee and dividend income to approximate $26 million during the second quarter. From an expense standpoint, we expect our interest expense will decline by approximately $2 million quarter-over-quarter. We expect our quarterly management fee will decline by approximately $3 million during the second quarter based on the lower average value of our investment portfolio during the quarter, and we expect other G&A expenses to approximate $7 million during the second quarter. In terms of the right side of our balance sheet, our gross and net debt to equity levels were 80% and 74%, respectively as of March 31, 2021, as compared to gross and net debt-to-equity levels of 93% and 85%, respectively, at the end of the fourth quarter. Our available liquidity of $2.2 billion equates to approximately 29% the value of our investment portfolio, which is a very comfortable percentage and allows for future portfolio growth. Our capital structure is approximately 91% secured with an overall weighted average cost to debt of 2.9%. And with that, I’ll turn the call back to Michael for a few closing remarks before we open the call for questions.
Michael Forman: Thanks, Steven. The first quarter of 2021 represent a strong start to what we believe will be an active year from an investment standpoint. In addition, our team has been preparing for our proposed merger with FSK and we continue to be excited by the strategic opportunities a single BDC platform will provide our shareholders. The last few years has represented a time of change across our platform from the establishment of what has proved to be an excellent partnership with KKR to repositioning our investment portfolio to a broadening and deepening our team to fortifying our balance sheet, we are well positioned for the future. On behalf of our entire team of more than 200 professionals, we look forward to keeping you informed of our progress, and we appreciate your interest and support. And with that, operator, we would like to open the call for questions.
Operator: [Operator Instructions] Our first question comes from Gary Mandell with LPL Financial. Your line is open.
Gary Mandell: Hi. Good morning. Thank you very much for the call. You mentioned that investment income, if you will, declined a little bit. You’re maintaining the dividend. I imagine there is still a lot of legacy assets at a high interest rate that are going to be repaid in the near future, which would further decrease the investment income, but you’re maintaining your dividend. And after the merger, you’re anticipating a higher dividend yield at 9%. So I’m just curious how, with all of these higher-paying assets coming off of the books, you’re being able to maintain or even increase the dividend after the merger.
Dan Pietrzak: Thanks, Gary, for the question. I think a couple of things. I mean, your points are fair in terms of where we’re seeing some of those repayments and where we’re seeing us putting on new risk in terms of a yield perspective. I think the one thing that we feel quite good about, while sort of repayments, we’re sort of mindful about. But if you look at where we are net leverage for this vehicle, or even net leverage when you think about sort of the pro forma side, that does give us a fair amount of runway to be able to deploy capital, which we’re happy about in this market, right? We haven’t been sort of chasing deals here but a $1.1 billion origination quarter. If you heard the prior call, I think we’ve been pretty happy how we’ve invested in our origination team. So I think that, that runway will provide us some pretty good cover. And then we have been focused on rotating out of non-income-producing assets. I think we’ve got a bunch of line items done over the last several quarters. I think we’re going to continue sort of that focus, but that will also provide some tailwinds.
Gary Mandell: Is there a way to quantify given, for lack of a better term, the legacy assets that are still on there. Is there a way to quantify the negative effect of those ongoing repayments will have on investment income over the next several quarters.
Dan Pietrzak: It’s probably a little bit hard to quantify. I mean, I think you can see where overall yields did move this quarter. If you look at the prepared remarks, I think it was roughly sort of 10 basis points portfolio wise. And then you have to remember, there is a little bit of a mix here, right? Because when we are getting repaid on certain assets that generally could be accretive to fee income. If you looked at our fee income, specifically in FSKR over the last couple of quarters, we had a fairly large origination number Q4, quite strong origination number sort of here for Q1. So I think there is a fee income on the other side of that to offset.
Gary Mandell: Alright. Thank you very much. I appreciate it.
Dan Pietrzak: Thank you.
Operator: [Operator Instructions] Our next question comes from Finian O'Shea with Wells Fargo Securities. Your line is open.
Finian O'Shea: Hi everyone. Good morning. Just first small question. I think, Brian, you mentioned was 76% originated by KKR and then I think also on my notes here, you also give the percent originated by the FS/KKR adviser as well. Can you refresh us on both those numbers?
Brian Gerson: Yes. 76% is a good number. I think the FSKR joint venture is – I don’t have the number in front of me. I think it’s close to 80%.
Dan Pietrzak: I was going to say, just to put that in context, I mean, the numbers are different by sort of vehicle. Obviously, the entities that came together that form this entity, that number would have been much closer to almost entirely non-KKR in April 2018.
Finian O'Shea: Right. The CCT is the difference? I thought…
Dan Pietrzak: Yes.
Finian O'Shea: Okay. And on the dividend at 9% target yield is that – I know there is going to be a little bit of a spillover payout maybe other credit facility changes, I’m not sure, but what do you in terms of the FSKR $0.55 level translated to FSK shares and so forth? Do you see this dividend holding up? Is that – is it – is this $0.55 reflects 9% of what will perform post-merger assuming that plays out?
Dan Pietrzak: Yes. And Fin, I think you had a couple of points in there and let me try to answer those and then Steven Lilly, feel free to sort of add to this. I mean I think we’ve been happy with the response that we’ve gotten on the overall sort of dividend policy and going back to the sort of prior question here, I think we do feel good about being sort of under sort of target leverage I think this is the market where we actually feel pretty good being sort of under target leverage. I think – I think the point you were getting at is you are correct, FSKR would have to sort of pay out sort of any and all spillovers as part of the merger being completed. I think our estimate is that, that $0.55 sort of payout that’s been declared should really cover most, if not all, of that.
Finian O'Shea: So the $0.55 this quarter will be – okay. That’s helpful. I guess, a final question on the Global Atlantic merger, correct me if I’m – apologies if it’s – that’s not the arrangement. I’ve only casually looked at that. But it does say that’s a significant amount of private credit inflow to the platform – presumably your part of the platform. Can you tell us how – or what kind of impact you expect? How much of this will be investing alongside of you versus elsewhere? And anything else that do you think we should consider?
Dan Pietrzak: Yes. No, sure, happy, Fin. And just for context, obviously, that was – Global Atlantic is now a subsidiary of KKR, and you can look at the all the various kind of public statements out there, we own roughly just north of 60% of that. As with most insurance companies, their main focus is not middle market lending, right? Their main focus is mainly investment-grade sort of corporate and other forms of secured transactions from a capital perspective, kind of IG is the focus. So we do believe it’s quite accretive to the whole sort of platform when thinking about our ability to have size and scale and grow sort of staffing. But again, just the focus of that entity is really not in that middle-market sort of lending bucket. There can be some deals that they might participate in, but it will be on the smaller side.
Finian O'Shea: Okay. Thanks helpful. Thank you.
Dan Pietrzak: Thank you, Fin.
Operator: Our next question comes from Casey Alexander with Compass Point. Your line is open.
Casey Alexander: Yes. Good morning. I’m just kind of wondering, I’ve always been kind of struck by the disparity of the liability structure of the two BDCs. As you consider the merger of the two BDCs noting that FSKR has a much more secured credit facility oriented liability structure and FSK, more unsecured debt. How do you look at the balance between the two of those, once you have the entities merged? And what type of opportunities are there to continue to drive down your cost of capital?
Dan Pietrzak: Yes. And Casey, very good question. I think we’ve acknowledged that in the past out of FSKR, they haven’t had the same necessarily runway as others to issue right, harder to do when you’re sort of non-traded. They were obviously smaller until sort of merged together and then the rating agencies who cover FSKR, just not as broad of a set of sort of agencies. So I would think about on a pro forma go-forward basis, us targeting a capital structure that looks more like FSKR – I’m sorry, FSK. I think we’ve been very happy with the long-dated and flexible nature of the revolver, I think we will continue to be interested in tapping that unsecured market. I think we’ve been happy that we’re able to sort of access the CLO market. So I think we like kind of our mix, but I think you should assume it’s trending more towards what FSK looks like today.
Casey Alexander: Okay, thank you.
Operator: There are no further questions. I’d like to turn the call back over to Dan Pietrzak for the closing remarks.
Dan Pietrzak: Well, thank you to everyone for taking the time for the call this morning. We look forward to talking with you again in the coming months. Have a good day.
Operator: Ladies and gentlemen, this does conclude the program. You may now disconnect. Everyone, have a great day.