FS KKR Capital Corp. II
Q2 2020 Earnings Call Transcript

Published: 11 Aug 2020

[Operator:]

Good morning, ladies and gentlemen. Welcome to FS KKR Capital Corp. II's Second Quarter 2020 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 second-quarter 2020 earnings conference call. Please note that FS KKR Capital Corp. II may be 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 August 10, 2020. 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 June 30, 2020. 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 we ask that you refer to FSKR's most recent filings with the SEC for important factors 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 second-quarter earnings release that was filed with the SEC on August 10, 2020. 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 Garson, 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 second-quarter 2020 earnings conference call. To start I'd like to say that all of us hope that you, your family, your colleagues and your friends are remaining safe and healthy during this unprecedented time. Like other companies, the second quarter was our first full quarter operating in a COVID world. I'm pleased with how the FSK care team as adapted its operational activities to a fully virtual work environment. The team has been working hard over the past several months on positioning the Company for future success and growth. We have taken a significant step forward during the second quarter as we successfully listed FSKR on the New York Stock Exchange and received shareholder approval to take advantage of the 150% asset coverage ratio as defined by the SEC. With these two milestones we provided liquidity to our existing shareholders and insured FSKR becomes one of the most well-respected BDCs - well-positioned BDCs in the industry with ample growth capital. Also, as I start, I'd like to remind everyone that, as previously announced, during June we effectuated a 4-for-1 reverse stock split for FSKR. As a result, all per-share information contained in this call will take such information into account. In recent weeks, state and local economies across our country have experienced re-openings and renewed challenges all to varying degrees. In the financial world, the public equity markets have rebounded much faster than many observers would have predicted just a few months ago. On the one hand, rising equity markets, thanks in major part to government stimulus plans on a scale not seen since World War II and the Great Depression, are looking through the current operational challenges almost all companies are facing. On the other hand, as Dan will discuss in detail in his comments, the credit markets are providing a different view of the operating world. From a portfolio perspective, our management teams and financial sponsors are intently focused on maintaining liquidity, cutting costs and discerning new growth opportunities. Our view is the credit markets are more accurately pricing risk than the equity markets as the equity markets have almost entirely looked through the realities of the current economic climate and focused on the long term. As is often the case, time will be a primary arbiter of which markets' view is more well-reasoned. In terms of NAV, during the second quarter, our valuation process yielded the following results. First, we experienced depreciation within the majority of our portion of our portfolio which previously was impacted by COVID-related spread widenings and our multiple contraction. Second, we experienced additional write-downs in certain legacy and previously credit-challenged investments, including energy investments and investments that were fully restructured. Third, we experienced a modest amount of further depreciation in a portion of the portfolio that continues to be impacted by the effects of COVID. While Brian will discuss our portfolio valuation in detail during his portion of the call, in summary, the net result was our total investment portfolio declined in value by approximately 0.7% during the second quarter, which resulted in a 1.9% decline in our NAV on a per share basis. Shifting to our quarterly operating results, our adjusted net investment income was $0.48 per share during the quarter. From a liquidity perspective, we ended the quarter with approximately $1.6 billion of liquidity with no meaningful near-term debt maturities. From a forward-looking perspective, we currently expect our third-quarter net investment income per share to range from $0.52 to $0.55 per share, depending on the timing of transactions and fee opportunities. As such, our Board has declared a distribution of $0.55 per share for the third quarter, which equates to an annualized yield of 9.1% on our current NAV per share of $24.22 as of June 30, 2020. In terms of strategic BDC industry updates, we are extremely pleased to see the SEC's recent proposed modification to mutual fund and exchange traded fund disclosure requirements, which include meaningful forward progress with regard to the AFFE rule. For the last several years we have maintained an active voice in Washington on behalf of the BDC industry. We have also maintained a significant presence with both elected and appointed officials over the years. It is gratifying to see tangible results emerge from ours and others' efforts. Before I turn the call over to Dan, I'd like to take a minute to recognize the entire FS KKR reteam. Some of these people, such as the leadership team represented on this call, you know but many of them you have not met. They are an exceptional group of individuals, over 150 strong, who work in their unique - their own unique and individual capacities. They are focused, hard-working and dedicated to work of making the FS KKR BDC franchise an industry leader across multiple metrics. While we acknowledge there is still work to do as we rotate our portfolio, I can assure you that we are closer to achieving our goals because of the quality work of these individuals. And with that I'll turn the call over to Dan and the team.

[Daniel Pietrzak:]

Thanks. Michael. Before I begin my formal remarks, I would like to reiterate Michael's closing comment. We do have a strong team and the work they have done over the last several months has been tremendous. I am proud to be a part of this team. I also hope that you, your family, your colleagues and your friends are remaining safe and healthy during this unprecedented time. While we continue to navigate an uncertain macroeconomic environment, the prospect for substantial economic recovery remains a real possibility over the coming quarters. Actions by the federal government and the Federal Reserve, which are providing unprecedented levels of stimulus and liquidity support to the market, offer pillars of support for an economy which increasingly feels as though it is lurching forward towards its own method of reopening, regardless of governmental and public mandates. As we analyze the leverage loan market and contemplate what the balance of the year may bring. it is helpful to start by framing a few observations associated with the high-yield market. In a somewhat unexpected fashion, the second quarter of 2020 represented a record in terms of quarterly high-yield issuance, $140 billion. On a year-to-date basis, the high-yield activity has also established a record issuance level of $224 billion. However, the details of these headline numbers contain some interesting specifics. Almost one-third of year-to-date high-yield bonds are secured, which represents the highest level of secured bond issuance since 2009. Only 11% of year-to-date high-yield bonds have been used to fund M&A activity, which marks the lowest level since the 2008 financial crisis. And financial sponsor-related activity dropped below the 50% mark for the first time since the financial crisis. Finally, operating companies have been building cash reserves at an unprecedented pace as cash-on-hand as a percentage of total debt increased to 15%. Again, a record level, eclipsing even the fourth-quarter of 2009's level of 14%. Understanding the high-yield market is important because it helps inform us about the leverage loan market. The loan market, which was quite hot in January and early February, saw zero new issuances in March and has been slow to build back as fund flows for loan mutual funds have been steadily negative since that time in a range of between $10 billion and $20 billion of outflows per month. In addition, year-to-date 2020 CLO issuance is down approximately 50% as compared to 2019. Squarely in the middle of these data points are two key items

[Brian Gerson:]

Thanks, Dan. As of June 30, our investment portfolio had a fair value of approximately $7.3 billion, consisting of 164 portfolio companies. This compares to a fair value of $7.5 billion and 179 portfolio companies as of March 31, 2020. At the end of the second quarter, our top 10 largest portfolio companies represented 26% 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 67% of first lien loans and 77% senior secured debt as of June 30. The weighted average yield on accruing debt investments was 8.7% at June 30, 2020, as compared to 8.9% at March 31, 2020. The decline in our weighted average portfolio yields was primarily due to the decline in LIBOR during the quarter. From a nonaccrual perspective, as of the end of the second quarter our nonaccruals represented approximately 11% of our portfolio on a cost basis and 5.4% of our portfolio on a fair value basis. During the quarter we placed four investments on nonaccrual with a combined cost and fair value of $168 million and $124 million respectively. Our largest nonaccrual's during the quarter were two legacy investments, 5 Arch Income Funds and FourPoint Energy. 5 Arch Income Fund provides mortgages for single-family residential real estate fixed and flip investors and is currently in wind down. As such we are applying cash flow receipts to amortize the principal portion of our investment on which we are still expecting a positive return. FourPoint Energy is a legacy E&P investment which has been negatively impacted by commodity prices and is in the process of being restructured. On a combined basis, our new nonaccrual investments account for approximately $0.02 per share of net investment income on a quarterly basis. In terms of industry concentrations which we believe are more sensitive to the effects of COVID we have the following exposures

[Steven Lilly:]

The $27 million decline in our investment income this quarter was related to the following. First, the reduction in LIBOR reduced our quarterly interest income by $9 million. Additionally, we experienced sales and redemptions during the current and previous quarter which reduced our interest income, both cash and PIK, by approximately $8 million. As a reminder 98% of our floating-rate debt investments have floors which average 88 basis points. Nonaccrual assets reduced our interest income by approximately $6 million. Finally, our fee income declined by $8 million as we made significantly fewer commitments of capital during the quarter and our dividend income increased by $4 million owing to an increase in dividends from our joint venture portfolio. Our interest expense declined by $5 million during the quarter as we benefited from the reduction in LIBOR as approximately 86% of our drawn liabilities are floating-rate. Management fees declined by $4 million during the quarter due to a reduction in the overall value of our investment portfolio. The detailed bridge on our NAV per share on a quarter-over-quarter basis is as follows. Our starting 2Q 2020 NAV per share of $24.68 was increased by GAAP reported NII of $0.44 per share. Our NAV per share was reduced by our $0.60 per share dividend and the decline in our investment portfolio's value, about which Brian spoke, which totaled $0.30 per share. The sum of these activities results in our June 30 NAV per share of $24.22. From a forward-looking perspective, the bridge from our second-quarter adjusted NII per share of $0.48, which includes the add back of approximately $7 million, or $0.04 per share of fees associated with our listing on the New York Stock Exchange to our third-quarter NII per share guidance of $0.52 to $0.55, is as follows. Our recurring interest income is expected to be relatively flat with lower LIBOR rates partially offset by modest positive net deployments. We expect fee and dividend income to approximate $31 million during the third quarter, which represents a combined increase of approximately $5 million from the second quarter driven by an increase in expected dividends from our joint venture portfolio and select asset-based finance positions. From an expense standpoint we expect our interest expense will decline by approximately $7 million during the third quarter as we benefit from the reduction in LIBOR. The combination of these activities results in our expectation of NII per share of approximately $0.52 to $0.55 during the third quarter. As Michael mentioned earlier, our Board has announced a $0.55 per share dividend for the third quarter, which equates to a 9.1% annualized yield on our June 30, 2020 net asset value per share. As a reminder, over the long term we expect our dividends per share will equate to a minimum 9% yield on our net asset value per share. Though we acknowledge there will be certain quarters where our annualized yield may be greater or less than this range due to quarter-to-quarter fluctuations in the business from an operational standpoint, such as what we currently are experiencing as COVID-based volatility is resulting in greater swings in NAV on a quarterly basis than what we would expect to experience during more normal periods. In the quarter we began executing our previously announced $100 million share repurchase program. Through July 31, 2020 we have repurchased approximately $11 million of shares under this program. In terms of the right side of our balance sheet, our gross and net debt to equity levels are 81% and 75% respectively. Both are in line with our leveraged levels as of the end of the first quarter of 2020. Our available liquidity of approximately $1.6 billion equates to approximately 22% of the value of our investment portfolio, which is a very comfortable percentage. Our capital structure is approximately 90% secured with an overall weighted average cost of debt of 3.5%. Finally, from an unfunded commitments perspective, as of June 30, 2020, we had approximately $371 million of unfunded debt commitments of which $97 million represented revolver facilities and $247 million of unfunded equity commitments primarily associated with commitments related to our asset-based finance portfolio. During the second quarter we experienced fundings of approximately $24 million under these collective commitments with approximately $11 million of that amount being repaid during the quarter. The majority of our unfunded debt and equity commitments are generally used for capital expenditures or acquisitions and therefore subject to performance or other threshold tests, including in certain situations our specific consent. As a result, while these commitments are disclosed in our 10-Q for informational purposes, we do not believe they will be drawn in any meaningful capacity on a quarter-to-quarter basis. And with that I'll turn the call back to Michael for a few closing comments before we open the call for questions.

[Michael Forman:]

Thanks, Steven. On behalf of the entire FS KKR operating team, I'd like to close by reiterating the positive tilt we believe we are beginning to experience, both in the overall economy as well as within our existing portfolio. The FS KKR platform has originated high quality investments in healthy companies with stable cash flow streams. As we work through the remaining pieces of our legacy investments, we begin to move closer to the point where our investment portfolio and corresponding NAV per share will begin to settle from a valuation standpoint before perhaps beginning to move back in a positive way during future quarters. Our investment team has done an excellent job originating high quality new assets while simultaneously working through certain legacy positions. As the COVID world looks forward to finding a new normal, we also look forward to completing our portfolio transition and fully harnessing the power of our BDC franchise. And with that, operator, we would like to open the call for questions.

[Operator:]

[Operator Instructions]. Our first question comes from Casey Alexander with Compass Point. Your line is now open.

[Casey Alexander:]

I have two questions. One, I think we pulled a pin enough on the first call. I understand how you got this Chinese menu of revolvers on the liability side of the balance sheet. What are the technical difficulties with compressing those into something leaner, perhaps a little - perhaps find a way to drag some interest expense savings out of it at the same time and maybe also generating a little bit more on the unsecured side of the liability structure? Can you give me some color on that, please?

[Daniel Pietrzak:]

I think your comment's fair on the Chinese menu. Obviously, we've put together four entities to form FSKR. I think long-term goals are to continue to work on the liability side here. We were fortunate to get an unsecured deal done in February. I think you should have an expectation those amounts as a percentage sort of go up and really probably start to look more sort of target where we are in FSKR. But I think we've definitely got a goal of optimizing here. I think the good news is the rates on these are fairly attractive, but I think we wanted to be probably a little bit simpler and a little bit more unsecured as we move forward.

[Casey Alexander:]

Okay, great, thank you. And secondly, Michael, I'd like to note FS' leadership as it relates to Washington policy and BDCs. I think a lot of people don't appreciate the level and depth and cost of FS' commitment to that. I was wondering if you could expand a little more on the progress that was made on AFFE and how you see it potentially developing and impacting the industry from this point forward.

[Michael Forman:]

I appreciate that. As you know, we spent a lot of time on the BDC modernization bill and we spent a lot of time on this issue both with elected officials and with the Commission. We're certainly pleased with the direction that this has taken. We appreciate the Commission's leadership and that they're addressing the issue and we are guardedly optimistic. We've had some very constructive conversations with elected officials and they feel strongly about this issue. I think we all believe that solving this issue is in the best interest of the investment community and the investors and we are feeling pretty good about it right now. So, we'll see - we'd like to see something done before the end of the year and we'll continue to stay engaged and take the leadership position that we've always taken.

[Operator:]

[Operator Instructions]. Our next question comes from Finian O'Shea with Wells Fargo. Your line is now open.

[Finian O'Shea:]

Just to follow-up on, again, Casey's question there - are - appreciating your comment on the AFFE developments. Are you suggesting that we'll get - or that the momentum for full-scale AFFE is warming up or is it just as it relates to the recent rule proposal?

[Michael Forman:]

I'm suggesting that there is good positive momentum. And, as Casey indicated, we've been working on this issue for a long time. We think it's something that's really important for the industry and for the investors. And we're pleased to see the Commission taking what we think is constructive action. We do believe that Congress might lean in in the event the Commission doesn't get this done. So, we are working with the Commission and we're working with elected officials to try to get something completed. So, we're not predicting when and we're not predicting what it's going to look like, but we are pleased with the momentum that we're seeing out there. And I think folks recognize that this is something that's really in the investors' best interests.

[Finian O'Shea:]

Yes, absolutely agree. A question on origination. FSKR was, I think, a little lighter and that more obviously has balance sheet or capital capacity. Were there opportunities elsewhere beyond the standard private credit capital markets group? Was there any sort of special six type opportunities that FSKR has been or is looking at or just any other commentary on why the origination was a little lighter? I know you did say FSK, a lot of that was follow-on, so that could be the answer. But any context there?

[Daniel Pietrzak:]

I think you sort of answered your own question there. No real magic to the numbers. A lot of it just relates to follow-ons. If the asset was only in one entity to start, the other entity cannot necessarily play the way the exemptive relief works. We do have, I think, an attractive liquidity position and balance sheet position here in FSKR. We are going to look to be cautious on risk but look to use that. And we've obviously got the capacity to do that. In terms of different deal flows out there, we are looking at things beyond what I would call regular unit tranches are or direct lending. We are open for risk. I think we've got the origination footprint to do that. Hopefully you'll see some of that coming on board in the coming quarters. But nothing really in the numbers other than just follow-ons.

[Finian O'Shea:]

Okay, sure. And just a small question on the fund you set up for employees to invest. Has that been active yet and should we see form force for that?

[Daniel Pietrzak:]

Fair question and obviously you would've seen in the earning supplement some disclosure around the Company-sponsored plan as well as the co-investment plan where the advisor plays. If you recall from our disclosure in the past, that is not a vehicle that we are managing directly. So, it's third-party managed. You wouldn't see the Form 4s as it relates to that. But I would say that the entity has started to accumulate shares.

[Finian O'Shea:]

Okay, thank you. That's all for me.

[Operator:]

Our next question comes from Rick Shane with JPMorgan. Your line is now open.

[Rick Shane:]

You guys are obviously in a unique position of having liquidity and leverage available to invest in this market. I am wondering, given the physical challenges of investment right now, the environment is so different in terms of how you conduct due diligence. Does it shift your approach in terms of sourcing transactions? Does it make participating in KKR broader transactions more attractive? Does it make participating in club or syndicated deals more compelling where there is an agent running the diligence process for you?

[Michael Forman:]

Fair question. Obviously, we are in a bit of unprecedented times here. Just to touch on things, we are obviously not allowed to participate in KKR sort of deals where KKR is the sponsor. But I think two things. I think the team is done a tremendous job of being as active as I think we've been pre-COVID. Obviously, there's some hindrances to working from home and people aren't traveling. But I think we are prepared to get there on risk. It does make things harder. I think we found a handful of what I would call very interesting situations where we are the incumbent lender and that company or that sponsor is looking to grow that business and needs more capital. Those are pretty easy to diligence. We've obviously been in those names for some time. So, I think the reality is we just have to adapt to the environment we are in. It may make certain things a little bit harder, maybe it makes certain things we're not going to get ourselves comfortable with. But I think we will find a way to get deals done that we want to do.

[Rick Shane:]

Got it. And I actually meant transactions where you guys had exemptive release, but that makes sense. And are you finding that the process is - allows you to do the level of work that - look, I know that there is attractive risk that's out there. But do you feel that you are able to capture additional premium because of the information disparities?

[Daniel Pietrzak:]

Well, I would say this. I think maybe there's two points in there. One, I think we're trying to do the same level of work. Obviously, there's been a couple of transactions where there's actually been site tours or plant tours done via Zoom. So, I think people are adapting to the world we live in as well as the technology. I would say that the spreads have moved, documentation and terms have moved all to I would say the lender's favor. I don't think that's about information or diligence. I think that's just about supply/demand. And we've also seen I think a handful of deals that may have been more regular way, syndicated market looking to make their way into private credit - into the private credit space as people are looking for certainty of execution. And pools of capital like this are supposed to capitalize on market environments where there is volatility and dislocation and that is what we are going to look to do.

[Rick Shane:]

Okay, thank you so much. And I think we are all sort of tired of unprecedented times. I'm sure it's exhausting for you guys as well.

[Michael Forman:]

I appreciate that. I think that's right. Hopefully we'll all get back to normal soon.

[Operator:]

I'm showing no further questions in queue at this time. I'd like to turn the call back to Mr. Pietrzak for closing remarks.

[Daniel Pietrzak:]

Thank you, everyone, for taking the time to join today and thank you for your questions. We are always available for any follow-ups that you may have. We do hope that you remain safe and healthy and you enjoy the rest of the summer. Thank you very much.

[Operator:]

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.