FS KKR Capital Corp (FSK) 2017 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to FS Investment Corporation's Second Quarter 2017 Earnings Conference Call. (Operator Instructions) Please note, that this conference is being recorded.

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

Thank you. Good morning, and welcome to FS Investment's Second Quarter 2017 Earnings Conference Call. Please note that FS Investment Corporation may be referred to as FSIC, the fund or the company throughout the call. Today's conference call is being recorded and audio replay of the call will be available for 30 days. Replay information is included in a press release that FSIC issued on August 9, 2017.

In addition, FSIC has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended June 30, 2017. A link to today's webcast and the presentation is available on the Investor Relations section of the company's website at www.fsinvestmentcorp.com under Presentations and Reports. Please note that this call is the property of FSIC. Any unauthorized rebroadcast of this call in any form is strictly prohibited.

I would also like to call your attention to the customary disclosure in FSIC's filings with the SEC regarding forward-looking statements. Today's conference call includes forward-looking statements, and we ask that you refer to FSIC's most recent filings with the SEC for important factors that could cause actual results or outcomes to differ materially from these statements. FSIC does not undertake to update its forward-looking statements unless required to do so by law. In addition, this call includes certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures can be found in FSIC's second quarter earnings release that was filed with the SEC on August 9, 2017. 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 the website -- FSIC's website.

Speaking on today's call will be Michael Forman, Chairman and Chief Executive Officer of FSIC; Brad Marshall, Senior Portfolio Manager of FSIC and a Senior Managing Director at GSO/Blackstone, FSIC's Investment subadvisor; and Jerry Stahlecker, President of FSIC. We'll then open the call for questions.

I will now turn the call over to Michael.

Thank you, Chris, and welcome, everyone, to FS Investment Corporation's Second Quarter 2017 Earnings Conference Call. We appreciate your interest in FSIC. On today's call, I'll provide a summary of FSIC's key highlights and strategies, after which Brad will provide an overview of our investment activity. Then Jerry will discuss our financial results in greater detail. Net investment income for the second quarter of 2017 was $0.19 per share compared to $0.22 per share for the first quarter of 2017 and $0.23 per share for the quarter ended June 30, 2016. Adjusted net investment income for the second quarter of 2017 was $0.19 per share compared to $0.22 per share for the first quarter of 2017 and $0.24 per share for the quarter ended June 30, 2016.

As of June 30, 2017, FSIC's total accumulated undistributed net investment income on a tax basis was approximately $0.59 per share. FSIC's net asset value as of the end of the second quarter was $9.30 per share compared to $9.45 per share as of March 31, 2017. The decline in NAV was driven primarily by unrealized depreciation in certain of our energy and equity investments. It is important to note that we, along with our board of directors work with independent third-party valuation service providers to mark 100% of the investment portfolio to market each quarter. During the second quarter, we observed further tightening of spreads and loosening credit standards in the syndicated loan market as corporate borrowers continue to take advantage of current market conditions to push out maturities to reduce their cost of capital. This issuer friendly -- in this issuer-friendly environment, we continue to focus on investing at the top of the capital structure and avoided moving down the capital structure in search of yield. As many of you already know, our exposure to nonincome-producing equity from certain restructurings has placed pressure on FSIC's net investment income in recent quarters. Despite our continued effort to improve the position of our portfolio, the timing associated with rotating out of these positions and into income-producing investments remains uncertain. This uncertainty combined with persistently difficult investing conditions, I just discussed, have created an environment, in which we have been forced to evaluate the sustainability of our current distribution. Due to these and other factors, we, in consultation with FSIC's board of directors, have made the decision to rightsize FSIC's distribution rate. Beginning with the fourth quarter distribution, the board intends to reduce FSIC's quarterly cash distribution to $0.19 per share from approximately $0.22 per share. In our view, we have fallen short of the high standards we set for ourselves. We share our investor disappointment with our recent performance and believe it is appropriately to financially align ourselves with stockholders during this challenging period. To that end, effective October 1, 2017, and through September 30, 2018, FB Advisor has agreed to waive a portion of the base management fee, to which it is entitled so that the fee received equals 1.5% of the average value of FSIC's gross assets. Additionally, in conjunction with the expected distribution reduction, the board intends to make a special distribution in the fourth quarter of 2018 that equates to the cumulative amount of net investment income earned during the 12 months following October 31, 2017, that is in excess of $0.76 per share, which represents our expected fourth quarter distribution on an annualized basis. In other words, for that period, our stockholders will receive the benefits of any outperformance over the expected new annual distribution rate. Lastly, we and the board continue to evaluate the timing of benefits of the merger of FSIC and FSIC II, which remains a key focal point and could be a 2018 event. With that, I will now turn the call over to Brad to discuss our investment activity during the quarter. Brad?

Thank you, Michael. Second quarter remains very active for us with the balance of new transactions, add-on financings and several realizations. We continue to see a fairly competitive deal environment, as capital flows into risk assets. In our market, this can translate into spread compression, higher leverage levels and weaker credit terms. This theme has continued into the third quarter, and we remain acutely aware of the current playing field. On the other hand, the overall global economic landscape remains relatively healthy and our portfolio companies and their operating results during that quarter support that. Total purchases for the quarter were $298.7 million, 80% of which were first-lien senior secured loans. Exits of $310.6 million during the second quarter were driven by the repayment of certain direct investments. Portfolio activity in the third quarter is off to a strong start, despite the overall market conditions highlighted earlier.

As of June 30, 2017, approximately 98% of the fair value of the total investment portfolio was allocated to our core investment strategies. This level of investment in our core strategies has remained relatively unchanged for the past several quarters and approximates our target allocations. We've also remained -- maintained a focus on investing in senior secured and floating rate debt, which at the end of the second quarter represents approximately 71% and 67%, respectively, of the portfolio based on fair value. These measures increased slightly relative to March 31, 2017.

We continued to use the size and scale of our direct-lending platform and FSIC's capital base to identify, source and structure investments with attractive return profiles. As of June 30, 2017, the gross portfolio yield prior to leverage and excluding nonincome-producing assets was 10.4%, up from 10.2% and 10.1% for the prior quarter and end of 2016, respectively. The average leverage for our direct originations through the respective tranche, in which we invested, excluding equity in collateralized securities is 4.7x, up from 4.5x in the prior quarter.

As of June 30, 2017, we had 2 companies on nonaccrual, which in aggregate represented only 0% of the portfolio based on fair value and 0.7% of the portfolio based on amortized cost. Since the end of the second quarter, we exited our position in one of these companies at the conclusion of our restructuring process. We work hard as an equity owner and have many tools at our disposal in order to maximize our recoveries in the event of default. Equity comprised approximately 13% of the portfolio as of June 30, 2017, based on fair value, unchanged from the prior quarter. Approximately 1/3 of those position are in various stages of being actively sold, and we'll announce those realizations during future calls as they materialize. Of our top 15 equity holdings, 13 of them are meeting or exceeding our expectations. In fact, the DSO advantage program is engaged with 12 of these 15 companies and has boosted EBITDA by an average of 4%, which will contribute to our equity value upon realizations. And we now turn to our energy portfolio. Energy-related investments as of June 30, 2017, comprised approximately 7% of FSIC's investment portfolio based on fair value, unchanged from the prior quarter. The net change in unrealized depreciation on energy investments during the second quarter of 2017, totaled approximately $19.1 million or $0.08 per share. We want to emphasize that this depreciation was largely driven by movement in commodity markets, which impacted the valuation of our positions. Importantly, the operating results of these businesses are by and large very strong and FSIC has a history of producing positive returns in its energy investments.

I will now turn the call over to Jerry to provide additional details on our results.

Thanks, Brad. Net investment income for the second quarter of 2017 was $0.19 per share compared to $0.22 per share for the first quarter of the year. Adjusted net investment income for the second quarter was also $0.19 per share compared to $0.22 per share for the quarter ended March 31, 2017.

Fee income this quarter was lower than the previous quarter, primarily due to lower direct originations and prepayments. Fee and dividend income totaled $9.5 million in the second quarter of 2017 compared to $19.6 million in the first quarter and $16 million in the quarter ended June 30, 2016.

In the second quarter of 2017, we declared a regular quarterly distribution of approximately $0.22 per share, which is paid on July 5, 2017. For the third quarter of 2017, we also declared a regular quarterly distribution of approximately $0.22 per share to be paid on or about October 3, 2017, to stockholders of record on September 20, 2017. As Michael mentioned, NAV declined to $9.30 per share as of June 30, 2017, compared to $9.45 per share as of March 31. Net change in unrealized depreciation on investments during the second quarter of 2017 totaled approximately $13.9 million or $0.05 per share, which was primarily attributable to depreciation in certain of our energy and equity investments. Net realized losses during the second quarter were $14.1 million or approximately $0.06 per share, driven primarily by the restructuring of new Aluminum. At quarter end, FSIC's debt-to-equity ratio was 75.3%, down from 79.5% as of March 31, 2017. I'll now turn the call back to Michael.

Thanks, Jerry, and thank you to everyone on the phone for your trust and investment in FSIC. We remain committed to our investors, and we'll work hard in over half of the coming quarters to position the portfolio to generate strong returns. With that, we will now open the call for questions.

(Operator Instructions) And your first question comes from the line of Rick Shane with JPMorgan.

Look, I don't think it's a coincidence that dividend cuts about 15%. The cut in management fee is about 14.5% back of the envelope or 14% back of the envelope. My question is, do you think that the management fee waiver that you put in place will persist as long as the dividend stays at these levels? Or could you see it rebound before the dividend goes back to the historical level?

Well, Rick, it's Jerry. And what we've done is we put the fee waiver in place over the next 12 months with the idea that if market conditions change, and if we outperform that distribution level, we'll pay out special distributions. And at the end of that 12-month period, we'll evaluate where the portfolio is and where the income generation capacity is and make a determination about the appropriate, whether we can increase the dividend from that point forward. And where we are in terms of our management fees, and we'll make a decision and communicate it at that point in time.

Okay. And then, follow-up question. Last quarters -- 3 quarters have shown some pretty significant realized losses that seems to be slowing down, but I am curious, is there anything expected through the remainder of the year in terms of realizations, especially losses?

Yes, Rick, this is Brad. Those realized losses are a result of restructuring. So I guess, to some degree they're not necessarily realized, but for accounting purposes, we have to treat them as realized losses. So that's what you're seeing behind those numbers. And then, in terms of the balance of the year, we continue to work on those assets that are going through balance sheet issues. And if we need to restructure them, we'll restructure them. But again, we don't necessarily view those as realized losses, but they may be treated as so for accounting purposes. I think if anything on the realized gain side, you'll see those come through, through our equity sales when they materialize.

And your next question comes from the line of Jonathan Bock with Wells Fargo.

Given the limitations, I'll ask and then, certainly try to hop back in queue. But one actually extends from a question, Michael, that I asked you last quarter, that I was hopeful you would have an answer for. As it relates to the data-driven answer to the question. Of the deals that GSO submits to you, how many deals either early or late in the process do you at FS reject, given you are the final investment authority?

Sure, Jon. I've asked Chris to kind of walk through that process. So why don't you go ahead, Chris?

Thanks, Michael. Thanks, Jonathan for the question. We've spoken about this online and off-line, and while we appreciate the desire to drive towards the metric, I continue to say, and we believe that keeping score -- ultimately coming up with a metric, we view it as keeping score and that's a way to undermine the foundation of the teamwork and collaboration that's led to our success. Both parties have worked hard to refer relationships into our deal funnel and establish a teamwork and collaboration that's allowed us, as FSIC to deliver for our sponsor relationships and generate the deal flow necessary to provide the best set of opportunities. And we think your original assessment that FSIC works hard with GSO throughout the origination process and plays a substantial part in the investment process are really the key aspects of this. But you've heard it from us. I think it may make sense to have Brad talk about it from his perspective.

Yes, I was going to chime in. Thanks, Chris. Listen, I think, Jonathan, the initial and certainly the ongoing success of this fund clearly would not exist without FS, GSO and the partnership that we’ve created together. And together we've originated, structured managed investments, credit facilities in all aspects of the fund and our partnership really starts a frequent, open, collaborative dialogue on the fund strategy and then follows through the partnership-oriented origination and underwriting process, where we work hand in hand with the FS team to ensure that FSIC executes on the best opportunities, as we're seeing in the market at any one time. And listen, we’ve work closely together towards the success of the fund. And just to use some examples, think about Global Jet Capital, which was a startup company, we put in place a couple of years ago. Invested over $350 million in that. That investment is a big, actually part of our equity portfolio, has generated a 17% return on equity. And that was really done through structured and executed through our partnership with FS team. So listen, I appreciate the questions too, but it's very much a collaborative process. We recently went through, just to give another example, a decision on whether we should sell an equity position and given we've got a fairly large equity concentration, and we sat down with the FS team, and we went through all the pros and cons and the valuation metrics as a team to decide what to do there. We decided not to sell. I think, it was a good decision in the long term, but it's a collaborative process and I think, that's led to the success of the fund.

All right. Sure. I appreciate the color. I guess, the one item is -- a small follow-up would be, Michael, there’s a quote on your website that says that FS is proud to set the standard for transparency and best practice. And so I'm trying to understand how your inability to answer a fairly straightforward question really sets the standard for transparency? There needs to be no answer to that.

(Operator Instructions)

Maybe just to finish as Blackstone/GSO. I think, transparency has been the hallmarks of the success of FSIC. Just even taking the fact that we mark 100% of the portfolio every quarter. I think, investors have very good visibility into the valuations of the portfolio. No different than our investment process, which has always been a collaborative process. So I don't think there's any new metric there other than the performance of the fund, which has proven to be very strong over the past 9 years.

And I'd like to echo that. I think that those kind of metrics would certainly be a hallmark of a broken relationship. And this has been a relationship for 9 years that's worked well. If you look at the performance over that period of time, it's been very good. We've had a little bit of a challenging period here. We hope and expect to recover from that. We believe, we've done the right thing by investors, in terms of waiving the 25 basis points of management fee. And we'll continue to work hard to deliver performance for the investors.

(Operator Instructions) Your next question comes from Ryan Lynch with KBW.

First one, the newly reduced dividend of $0.19 per share that exactly matches the $0.19 per share of earnings this quarter. So obviously, when the fee waivers kick in that will help dividend coverage over those next 4 quarters. But how should we think about dividend coverage going forward? And what levers can you pull to drive, further expand dividend covers, given that, that earnings today were $0.19, which were exactly in line with your newly reduced dividend?

Yes. Ryan, it's Jerry. We've talked about, historically, when we set our dividend policy, we want to set it at a level that we think is sustainable, given the market condition that we're in and that we foresee over the coming quarters. And historically, we've always set it at a level, where we've outearned that distribution, and we had, I think, it's 11 special distributions and a number of distribution rate increases over the life of the fund. So unfortunately, we now find ourselves in a challenging environment. Where based on what we see as the expected the run rate of the portfolio that -- the $0.22 per share is not sustainable in today's environment. We do think that $0.19 is a sustainable level. And to the extent that conditions improve, or to the extent, as Michael and Brad touched on, that we're able to rotate out of those equity positions and redeploy that into income-producing assets. If we foresee that we can outearn that $0.19 per share then we and the board will revisit the regular distribution rate and set it, again, at what we think is a long-term appropriate level, given the portfolio and the market as we see it.

Yes. Ryan, what I'd add to that is, during the quarter yield expanded, and we went further up the capital structure, and we're seeing a fairly active third quarter. So I think that would -- all signs are very positive for the near term.

Okay. And then a follow-up. We definitely appreciate you guys voluntarily waiving fees at the BDC, I mean, anytime a manager chooses to voluntarily waive fees is certainly welcome and definitely appreciated by shareholders. But with this fee waiver, it is just temporary. It's just over 4 quarters. And sometimes temporary fee waiver, investors can sometimes overlook that and look at what are earnings going to be once that fee waiver stops. What is the sustainable amount of earnings without any sort of waivers, when there’s just a temporary fee waiver in place. So why not set a more -- why not set a permanent fee waiver and give investors more clarity about future earnings further down beyond 2018?

Yes, thanks Ryan. I think, that's similar to the question that Rick asked earlier, and what we're doing is we're setting it for a year out, so giving you a year worth of visibility. And over the course of that 12-month period, market conditions change, the portfolio can certainly change, as we exit some of those equity investments and redeploy that capital. We've got to then evaluate at that point in time, what do we think the long-term sustainable dividend level is? And at that point, we will evaluate that and evaluate the fees and make a determination as to whether or not that fee waiver is maintained or made permanent, or whether or not if we’re in an environment where our distribution is back above the today's level. Then we can make that assessment at that point in time.

Right. And I would add to that. We're not going to put ourselves in the position where we're not able to earn the distribution through investment income. And I think, that's the reason for the shift, and we're not going to go back to the enhanced 175 when we're at the current level. So we want to give ourselves a chance to see how the portfolio develops, but unless there is a material change in the portfolio, we don't see us being in a position to reinstate that $0.25 -- 25 basis points.

At this time, I would like to refer back to management for any closing remarks.

Well, thank you all for your attendance today on the call. We appreciate the questions and look forward to the next quarterly call.

This does conclude today's presentation. You may now disconnect, and have a wonderful day.