FS KKR Capital Corp (FSK) 2020 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the FS KKR Capital Corp.'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 thank you.

Good morning, and welcome to FS KKR Capital Corp.'s Second Quarter 2020 Earnings Conference Call. Please note that FS KKR Capital Corp. may be referred to as FSK, the fund, or the company throughout the call.

Today's conference call is being recorded, and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSK issued on August 10, 2020. 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 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 FSK. 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 FSK's most recent filings with the SEC for important factors 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 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 FSK's website.

Speaking on today's call will be Michael Forman, Chairman and Chief Executive Officer; Dan Pietrzak Chief Investment Officer and Co-President; Brian Gerson, Co-President; and Steven Lilly, Chief Financial Officer. Also joining us on the phone are Co-Chief Operating Officers, Drew O'Toole and Ryan Wilson.

I will now turn the call over to Michael.

Thank you, Robert, and welcome, everyone, to FS KKR Capital Corp.'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 these unprecedented time.

Like other companies, the second quarter was our first full quarter operating in a COVID world. I'm pleased with how the FS KKR team has adapted its operational activities to a fully virtual work environment. Also, as I start, I'd like to remind everyone that as previously announced, during June, we had effectuated a 4-for-1 Reverse Stock Split for FSK. 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 reopenings 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 role. 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 that credit markets are more accurately pricing risk than the equity markets as the equity markets have almost entirely look 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. During the first quarter, we estimated that approximately 70% of our portfolio depreciation was related to COVID or spread widening. Most other BDCs provided these estimates as well with a range of approximately 50% in the low end and 90% on the high end. Perhaps not surprisingly, our estimates fell somewhat in the middle of the industry, owing on the one hand to the high-quality nature of our more recent investment vintages, which have been led by KKR, offset to an extent by legacy assets we have discussed on prior earnings calls.

In terms of NAV, during the second quarter, our valuation process yielded the fine results. First, we experienced depreciation within the majority of the portion of our portfolio which previously was impacted by COVID-related spread widening 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 of a portion of the portfolio that continues to be impacted by the effects of COVID.

While Brian will discuss our portfolio evaluation in detail during his portion of the call, in summary, the net results was that our total investment portfolio declined in value by approximately 1.9% during the second quarter which resulted in a 4.1% decline in our NAV on a per share basis.

Shifting to our quarterly operating results. Our net investment income was $0.62 per share during the quarter, which was $0.02 above our second quarter dividend of $0.60 per share.

From a liquidity perspective, we ended the quarter with approximately $1.3 billion of liquidity with no meaningful near-term debt maturities. From a forward-looking perspective, consistent with the dividend strategy we outlined during our last earnings call, we currently expect our third quarter net investment income per share to approximate $0.60 per share. As such, our Board has declared a distribution of $0.60 per share in the third quarter, which equates to an annualized yield of 10.3% on our NAV per share of $0.2337 (sic) [$23.37] as of June 30, 2020.

In terms of strategic BDC industry updates, we are extremely pleased to see the SEC's recent proposed modifications to the 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've also maintained a significant presence with both elected and appointed officials over the years. It is gratifying to see tangible results emerge from our and others' efforts.

Before I turn the call over to Dan, I'd like to take a minute to recognize the entire FS KKR team. Some of these people, such as the leadership team represented on this call, you know, but many of them, you have not met. They're an exceptional group of individuals who are over 150 strong who work in their own unique and individual capacities. They are focused, hard-working and dedicated through 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 of the work of these individuals.

And with that, I'll turn the call over to Dan and the team.

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 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 fiscal 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 leveraged 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, high-yield activity also has established a record issuance level of $224 billion.

However, the details of this headline number contains some interesting specifics. Almost 1/3 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 leveraged loan market. The leverage loan market, which was quite hot in January and early February, saw 0 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 2 key items: significantly reduced M&A activity and a continued focus on liquidity. Across our origination effort, we see many financial sponsors tackling the current market landscape with the following approach: number one, solidifying liquidity positions at existing portfolio companies; two, assessing future market dynamics for portfolio companies, which could involve acquiring or merging with competing businesses; and three, establishing a view on valuation multiples for existing portfolio companies and for potential new transactions.

Our view is most sponsors are generally between Steps 1 and 2 of the 3 Steps I just outlined. This drives our expectation that M&A volumes during the balance of 2020 are likely to remain depressed until at least the fourth quarter. That said, we are seeing our pipeline pick up over the last month or so. As a platform, we are focused on principal protection with our new investments, which involves financing good companies, understanding the macro picture and having structures that protect our investments.

It does not involve stretching on risk for some additional yield. Despite the rally in the public markets, we note that within the leveraged loan market at the end of June, only 12 basis points of issuers were trading at or above par as compared to historical level of approximately 30% of issuers according to S&P. The combination of the overall market and COVID focus by all underpin the reasons we originated a very modest $253 million in new investments during the quarter, most of which were follow-ons to existing names.

Our $253 million of total investments, combined with $344 million of net sales and repayments, when factoring in sales to our joint venture equated to net portfolio reduction of approximately $91 million during the second quarter. Despite our strong liquidity position, we continue to remain extremely selective in our origination and underwriting process, especially given the added complexities associated with making new commitments today. Even the concept of doing due diligence takes on special meaning during this time, given the issues associated with travel, meeting management teams face-to-face and reviewing business operations.

One data point that I would like to share with the market relates to understanding asset performance. Now that we have passed the 2-year mark since the establishment of the FS/KKR Advisor, we wanted to provide some context on our investment performance in FSK to date. Our track record is as follows: since the FS/KKR Advisor was formed, through December 31, 2019, we made approximately $3.2 billion in new investments and experienced 42 basis points of cumulative appreciation.

And from the same starting point through June 30, 2020, we have originated approximately $4.1 billion of new investments and have experienced a 3.58% of cumulative depreciation, which includes the effects of COVID. We believe these data points illustrate the manner in which we are turning the investment portfolio toward what we believe to be more conservative investment structures and companies with more defensible operating positions. While we will not be perfect, I do believe we are taking the steps commensurate with our goal of becoming an industry leader from an investment management standpoint.

Finally, I should note that in our quarterly earnings and investor presentation, this information is detailed on Slide 12. In terms of portfolio rotation, given our modest origination volume during the second quarter, still approximately 50% of our investment portfolio is comprised of assets originated by the FS/KKR Advisor. And approximately 81% of total assets in the portfolio have been originated by the KKR Credit platform.

In terms of portfolio activity, as of today, approximately 12% of our portfolio companies have asked for some sort of relief relating to COVID. Of these requests, we have granted approximately 7%. And while we expect certain portfolio companies may request additional capital or waivers through the balance of the year, we have also seen several of our portfolio companies that access revolvers in the first quarter and early second quarter, repay these revolvers as operations have stabilized. In addition, we have seen additional equity capital injections into several names.

While we remain actively engaged with all of our portfolio companies and sponsors and are receiving updates on a real-time basis across our portfolio. From a forward-looking perspective, we believe the KKR Credit franchise will emerge stronger from a relationship and transactional standpoint in a post-COVID world. The elements of industry knowledge, operational expertise and scale that the KKR Credit platform offers will be even more relevant to sponsors as they move towards Steps 2 and 3 that I outlined earlier. That is establishing a view on exit multiples for existing portfolio companies, and purchase price multiples for new assets and seeking to transact within these value ranges for both existing and new companies. Times like these in the market, where capital is scarce and relationships hind more on trust, are times where we believe we are well positioned to do quite well.

And with that, I'll turn the call over to Brian to discuss some investment portfolio specifics.

Thanks, Dan. As of June 30, our investment portfolio had a fair value of $6.6 billion consisting of 173 portfolio companies. This compares to a fair value of $6.9 billion and 184 portfolio companies as of March 31, 2020. At the end of the second quarter, our top 10 largest portfolio companies represented 22% 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 52% of first-lien loans and 67% 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 9% at March 31, 2020. The decline in our weighted average portfolio yield 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 9.9% of our portfolio on a cost basis and 3.8% of our portfolio on a fair value basis. During the quarter, we placed 5 investments on nonaccrual with a combined cost and fair value of $187 million and $89 million, respectively.

Our largest nonaccruals during the quarter were 2 legacy investments, DEI Sales and FourPoint Energy. DEI is the largest designer and marketer of premium audio systems in North America, and its sales have been meaningfully reduced due to COVID's impact on its brick-and-mortar distribution. 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 $0.04 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 exposure. Traditional mall-based retail, 0.9%; consumer durables and apparel, 4.2%; commercial aviation leasing, 1.6%; and energy 1.6%. Collectively, these industries account for 8.3% of our total investment portfolio. The largest sectors of exposure in our portfolio include capital goods, 13.5%; software and services, 12%; health care equipment and services, 8.9%; real estate, 8.3%; commercial and professional services, 7.8%; and diversified financials, 6.3%.

As Michael mentioned, from a valuation perspective, our investment portfolio declined 1.9% or $132 million during the second quarter. The details associated with our quarterly valuation results are as follows: the appreciation we experienced across the portfolio of $120 million was primarily driven by a combination of positive operating results and improved valuation inputs during the quarter where certain investments initially impacted by spread widening and general market conditions during the first quarter.

As the economy continues to stabilize, we believe this portion of our investment portfolio will continue to increase in value as these names move back toward their cost basis. Our portfolio appreciation was offset by the following: first, depreciation of approximately $191 million in certain legacy and previously credit-challenged investments, all of which were consummated prior to the FS/KKR Advisor, including energy investments and certain investments that were fully restructured; second, by certain credits, whose valuations in total declined by $61 million during the quarter as a result of the continuing effects of COVID.

Of the $191 million valuation decline associated with our legacy and previously credit-challenged investments, approximately 80% of the decline was driven by 5 specific investments and our energy exposure.

The 5 investments are DEI Sales, Mood Media, Borden Dairy, Hilding Anders and Amtek Global. As many of you know, from prior calls, these companies were in challenged positions prior to the onset of COVID and therefore, had been disproportionately impacted by the pandemic. However, we believe we have the resources, including a dedicated workout team and the ability to leverage the full KKR platform to maximize the recovery for these investments. Specific updates on Borden Dairy and Mood Media are as follows: On Borden Dairy, we partnered with Capitol Peak Partners, a private equity firm founded by the former CEO of Dean Foods, Gregg Engles, to purchase the company out of bankruptcy.

FSK held $70 million of $175 million term loan to Borden, which was used to credit bid for the assets. FSK received its pro rata share of a $19 million Term Loan A and 20% of the fully diluted common equity of the company. In addition, FSK invested its pro rata share of a $42 million Term loan B, which was used to recapitalize the company.

Mood Media filed for bankruptcy on July 30, 2020. And within 24 hours, confirmed its prepackaged plan of reorganization pursuant to a comprehensive RSA that was supported by 100% of the first-lien lenders and 100% of the second-lien lenders who submitted ballots. Mood Media's business has, like many others around the world that upended in the wake of COVID and falls into a category of businesses that face immediate and severe impacts caused by the pandemic. Approximately 70% of the company's customers operate in or adjacent to the travel, retail, restaurant, resort, automotive and/or aviation industries. After substantial business diligence, we concluded that investing additional equity into the company, especially under the current conditions will be an imprudent decision. However, we are hopeful that in a more stabilized environment and with a healthier balance sheet, a series of warrants that we received in connection with the plan for up to 60% of the equity of the company will value and help support a recovery.

DEI Sales, Mood Media, Borden Dairy, Hilding Anders, and Amtek global, combined with our energy exposure, have a combined cost basis of $753 million and an aggregate fair value of $237 million, representing a blended mark of 31%.

As a result, what has been difficult working through these legacy names, we are beginning to believe that the worst is behind us from a depreciation standpoint.

Turning back to the remaining credit whose valuation declined by $61 million during the quarter as a result of the continued effects of COVID on operations, the majority of the companies are operating well within tolerance from a credit perspective and are not in jeopardy violating covenants. Certain companies within this portion of the portfolio also have received support from their private equity sponsors as they have injected capital junior to our investments.

2 examples of this type of activity includes Savers and Entertainment Benefits Group. We own $91 million base value of a $540 million first-lien term loan to Savers, the largest for-profit thrift retailer in North America. Like many retailers, Savers has been adversely impacted by COVID-19 as its stores were shut in during the spring in response to the pandemic. In conjunction with an equity infusion from the company's financial sponsors provide additional operating liquidity, we reset covenants and received incremental pricing and call protection in our investment.

Entertainment Benefits Group is an e-commerce platform specializing in live entertainment and travel programs. The company partners with entertainment brands, hotels and other consumer leisure vendors to provide product offerings to corporate employers who then we offer the product to their corporate employees as an employment benefit. We own $35 million of the company's $235 million first-lien credit facility. In light of the COVID outbreak and the expected impact on financial performance, we recently reset covenants in exchange for an equity infusion from the sponsor, along with enhanced pricing and improved reporting rights.

And with that, I'll turn the call over to Steven to discuss our financial results in more detail.

Thanks, Brian. During my first quarter comments, we began introducing a different method of communicating from a financial standpoint. As we continue with that theme, my comments will be less focused on reporting financial metrics already contained in our earnings press release and 10-Q, but rather focused more on the color behind our results. Hopefully linking them in a more transparent and informative way to the broader comments on which Michael, Dan and Brian have touched. To that end, the $29 million decline in our investment income this quarter, which related to the following: first, the reduction in LIBOR reduced our quarterly interest income by $8 million. Additionally, we sold certain assets during the quarter and previous quarter, which reduced our interest income, both cash and PIK by approximately $7 million.

As a reminder, 98% of our floating rate debt investments have floors, which averaged 88 basis points. Nonaccrual assets reduced our interest income by $5 million. Finally, our fee income declined by $6 million as we made significantly fewer commitments of capital during the quarter, and our dividend income declined by $3 million, owing to a reduction in dividends from certain portfolio companies as they focused on maintaining healthy liquidity positions during the height of the pandemic.

Our interest expense declined by $4 million during the quarter as we benefited from the reduction in LIBOR as approximately 54% 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 and our NAV per share on a quarter-over-quarter basis is as follows: our starting 2Q 2020 NAV per share of $24.36 was increased by NII per share of $0.62, and repurchases per share totaling $0.07.

Our NAV per share was reduced by our $0.60 per share dividend and the decline in our portfolio value about which Brian spoke, which totaled at $1.08 per share. The sum of these activities results in our June 30 NAV per share of $23.37.

From a forward-looking perspective, the bridge from our second quarter NII per share of $0.62 to our third quarter NII per share guidance of $0.60 is as follows: our recurring interest income is expected to be approximately $13 million [lower] (added by company after the call) due to lower LIBOR rates and the overall lower weighted average yield of our investment portfolio. We expect fee and dividend income to approximate $31 million during the third quarter, which represents an increase of approximately $8 million from the second quarter but which is still slightly lower than our normalized level given the lower amount of origination activity, about which Dan spoke earlier, coupled with portfolio companies still maintaining a more conservative liquidity profile. From an expense standpoint, we expect our interest expense will decline by approximately $2 million during the third quarter as we benefit from the reduction in LIBOR.

A combination of these activities results in our expectation of NII per share of approximately $0.60 during the third quarter, which equals our declared dividend. As a reminder, over the long term, we expect our dividends per share will equate to a minimum of a 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 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 terms of the right side of our balance sheet, our gross and net debt-to-equity levels of 136% and 129%, respectively, or in line with our leverage levels as of the end of Q1 2020. Our available liquidity of $1.3 billion equates to approximately 20% of the value of our investment portfolio, which is a very comfortable percentage.

We continue to be pleased with our liability structure, which is 36% unsecured and 64% secured, with an overall average cost of debt of 3.9%. In terms of debt maturities, we have no maturities during the balance of this year or in 2021. During the middle of 2022, we have 3 tranches of debt totaling $1.1 billion, which mature representing approximately 21% of our full capital structure. Our largest year of maturities is 2024 and approximately 50% of our capital structure will roll forward.

Finally, from an unfunded commitments perspective, as of June 30, 2020, we had approximately $330 million of unfunded debt commitments, of which $38 million represented revolver facilities, and $261 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 $50 million under these collective commitments with approximately $7 million of that amount being repaid during the quarter. As we said during our first quarter earnings call, 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 on 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 remarks before we open the call for questions.

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 Instructions)

Our first question comes from Casey Alexander with Compass Point.

I have 3 quick questions for you. One, is I think the obvious question, sort of the elephant in the room is, when do you think you can pull the pin on merging the 2 BDCs because it looks like the sort of shareholder outflow at FSKR has been staunched and that's been stabilized in the marketplace. And frankly, if you're not going to do it for shareholders and for yourselves, do it for me because I'm tired of writing 2 reports. So when do you think that you can move forward on that?

Thanks, Casey. This is Michael, and I'll take that question. And it's certainly -- we hear the course. We've received that feedback from you, from the analyst community, from investors and we understand the positioning. I would say right now, we're still focused on the portfolios. We think we've made a lot of progress this past quarter, and we're going to continue to try to evolve the portfolios, but we're certainly considering all strategic alternatives and anything that will drive shareholder value we're open to.

So at this point, we feel like we have a lot on our plate, but we hear what you say and the market says as well.

Okay. Great. Secondly, Dan, as it relates to the JV, the JV is now up to around 9% of the total portfolio. Have you pretty much maximized how far you're willing to go in terms of dropping assets into the JV?

Yes, Casey, good question. You're right about being 9% today. I think we've talked about a target of 10%, maybe a little bit more. So I think we've got some more room to go, but it's getting to the point from a portfolio construction probably where we want it to be.

Okay. And then my last question, and then I'll get out of the way, is there's a substantial amount of nonincome earning assets in the portfolio. What's the company's strategy for getting that down and getting that rotated into some income-earning assets? And I'll step out after that question.

Yes. No, and that's a very good question, Casey. I think that's the biggest focus of this management team right now. I mean, you're right, that number is too big, both in terms of nonaccruals and equity numbers. I think the good news is when we are able to rotate out, that will mean a pretty decent amount of NII that we can create. So that's why it is a big focus. I think it's very bottoms-up and it's very tactical, right? I mean there's a couple of positions that we have moved on from. There's a couple of positions we're in negotiations right now. Some of them, we don't control the outcome, we might be a minority sort of owner, but it will be position by position, line item by line item and quite frankly, something that we're going to be reviewing in that level of detail on a very frequent basis because it is important over the coming quarters and the coming years to make sure that number goes down.

Our next question comes from Rick Shane with JPMorgan.

Stephen, I appreciate the efforts to provide some transparency on the forward look, it's very, very helpful. I want to clarify one comment, though, which is that I believe that what you said is that the target return on NAV is about 9%. If we look at the expectations for the third quarter, it's about 10%. And I'm just trying to reconcile those 2 data points with sort of the commentary it being a challenging environment, which certainly we acknowledge.

Sure, Rick. Thanks for your question. Yes, I think it's a combination of things in terms of this quarter. First, I would say that our target of a 9% yield on NAV over a sustained period of time is a minimum, which we have said. So that, I think, is the first input. The second input is -- and there were maybe some indirect comments on this in the script as well.

There -- in this COVID period, there is heightened volatility with not just our BDC franchise, but also other folks. And NAVs are moving more than is typically expected in this industry, especially with a group that would have Level 3 assets like we do. So I think one way to look at that is, as we were talking about the portfolio, we have experienced some appreciation of some names in the first quarter, we talked about -- were more COVID related in terms of spread widening and market technicals. And I think a conclusion there is we would hope over time, those would continue to move back in their normal directions. So we think the -- we could be at 10%, 1 quarter. We could actually -- we said in the script, we could go below 9% in a specific quarter as well. But over the long haul, we think that a 9% target is a very good first step in terms of total return to shareholders.

Got it. Okay. And then, look, there's a dynamic here, which is that you're trading at one of the highest yields in the space. And that's probably not particularly efficient for you guys, especially in light of the huge discount to NAV and the implications in terms of growth and opportunity for you. I am curious you have a history of repurchasing shares.

I'm curious if there are ways to increase the efficiency of distribution. What do you estimate to be your minimum distribution in order to maintain your RIC BDC status? And does it make sense in light of that to balance the dividend distribution with perhaps a more aggressive repurchase.

Yes, Rick, this is Dan. I'll start, and Steven can sort of add to this. I think you're right. I mean, we have been, I think, pretty focused on the stock buybacks historically. We obviously completed the $200 million program this quarter. If you look at the supplement, we bought back almost $500 million of shares between FSK and CCT.

I think that is always something that sort of in our mind. I do think we're trying to balance that with our balance sheet position as well. I think we're not that far away from our target leverage number, but still slightly above where we want to be. So I think that will clearly play into it as well. But Steven, feel free to add to the points around the RIC status or anything else that Rick had asked there.

Well, not -- I think you covered it well, Dan. But the only thing I would, Rick, maybe just add to is we do have, like many BDCs, we have some spillback or some people say spillover income, but it's at a very manageable level for us in terms of the number of quarters.

So I don't think we're in -- we're exactly where we'd want to be, I guess, I'd say, in the positive way, in the middle of the fairway there. So I think from a distribution standpoint, the guidance we give for the -- I just gave for the third quarter of $0.60 and $0.60, $0.60 of NII and $0.60 for the dividend is in keeping with that.

Our next question comes from Ryan Carr with Jefferies.

First question, you just mentioned spillover income. Can you just give us a sense for what level you have retained in terms of spillover?

Sure. It's a little north of $200 million total.

Okay. Great. And then next question related to the yield. I guess you saw a 30 basis point decline quarter-to-quarter and it was mostly given the LIBOR decline. Can you give us a sense for what percentage of the portfolio has LIBOR floors in place and within that, to what level they've been enacted?

Yes. And this is Dan. I'm happy to take that. I mean, you -- the 30 points is correct. I mean that is really all driven off of LIBOR. We quoted specific numbers in the script, but we're, in my mind, doing deals, specifically in the U.S. that only have LIBOR floors. And I think the market for that is 1% still today and will remain that. We have done some transactions out of Europe, which might have a floor, but that floor is at 0 which is just the market sort of standard there.

But I think the number we quoted in the script, I just can't sort of find it right now, was about north of 90%, if not 98% have a LIBOR floor, and you should expect that to continue.

That was very helpful. And then last question. In terms of the deal environment, I mean, how are you viewing the outlook for origination opportunities through the balance of the year. And that leverage is pretty consistent this quarter, but I'm just curious to hear your thoughts on the current deal environment and your leverage and how you might be thinking opportunistically moving forward?

Yes. No, a fair question with all going on in the world. I think we've clearly seen more activity in pipeline in the last month than we did in the months prior. I think everyone was very sort of inward-focused in April and even sort of most of May. So I think overall, we're -- we still would expect it to be more muted in Q3 and Q4 than in the past. But starting to see a bit of signs of life. Obviously, the current work from home, I think, environment and lack of travel does make things kind of harder. That said, deals can get done. And as I did make the comment in my prepared remarks, we are seeing -- we'll call it a decent amount of activity from existing portfolio companies looking to expand operations maybe acquire a competitor.

So we are pretty focused on supporting those incumbent lender positions, which we think are pretty value-added.

And our next question comes from Ryan Lynch with KBW.

The first one has to do with -- you guys gave some good commentary outlining some specific credits. Some were legacy investments from the previous the adviser relationship and some were just legacy trouble to credits that drove a significant portion of the decline this quarter, and I think that was helpful commentary.

When I look at some of the investments that have struggled recently or over the previous several quarters. These are not just investments that have been originated kind of under the previous adviser relationship. Some of these were legacy investments originated under the KKR platform, Hilding Anders, Belk are just a couple of the large ones that come to mind. So while you gave good commentary on where some of these troubled credits are marked today and how you guys are trying to work through them and get past those and move forward, how do investors get comfortable that the underwriting of new investments that are put in the ground today are going to be better than the ones that have historically been put into the ground, even under the previous kind of adviser relationship?

Yes. And Ryan, it's Dan. Good question. And I think we want to be transparent in these prepared remarks and in these calls about where we are seeing sort of challenges in the portfolio.

And I think as we've mentioned to you in the past, while there definitely some -- there definitely been certain assets from the prior sort of adviser relationship, we are sort of all hands on deck to maximize value and recovery kind of across the Board there. So I think that's number one. So just to point out. Two, you're not wrong. There's definitely a handful of names, and we called 2 of them out in the script with Hilding and Amtek that have underperformed that were historic KKR sort of assets. I think we tried to provide some color in the script roughly 50-odd percent originated by the new adviser, about 81% by KKR itself.

I would just say 2 things. Number one, this platform on the KKR side has come a very long way over the last 5 years, both in terms of human capital, both in terms of size and scale, in terms of footprint, it is a very different business. I think when I sit here today versus 5 years ago. And I think that's important. And I think we really built out the team on every facet from origination to structuring and execution, to hiring, legal resources to be part of the investment team. I think, really taking the business to where it needs to be from a market positioning perspective. And I think you would point to Hilding. In some ways, it's probably more rescue like and something that wasn't necessarily BDC appropriate in the context of a public entity, but when it was private, it was a bit different. So I think that, that's point 1, Ryan; two, we did try to give some color on Slide 12 about how we have performed since the start of the new adviser. This is a new slide for the purposes of this presentation. I think we need to be honest with ourselves. This is only 9 quarters of information, but it is 9 quarters. That includes the global pandemic. And that $4.05 billion versus the $145 million. I think it's a number that we're satisfied with. I think we will not be -- without mistakes, we will not sort of be perfect. But I think the origination machine and the underwriting machine is looking to put on high-quality, low, we'll call it, principal risk type investments. And I think, hopefully, you can see that in the $145 million versus the $4.05 billion.

So okay. I understood. Those fair points and you guys did give some really good color on your script over the portfolio and some of the movements. So that was definitely helpful. Just one more question for me. You guys recently did an unsecured bond offering at a fairly high cost to kind of improve the liquidity and just solidify the right-hand side of the balance sheet. Obviously, there have been additional credit issues that occurred this quarter, but you guys also had some net repayments, which helped out. I'm just wondering, as we sit here today, how comfortable are you in your current liability structure as it's composed today? Or would you guys be looking or pursuing any other unsecured notes in the near term?

Yes. It's a fair question. I mean so if you look at Page 9 of the investor supplement, maybe a couple of points. I think, one, we do, I think, like our liability structure, right? I think we've got a best-in-class revolver. I think we've been in the market meaningfully on the unsecured side. We've been able to tap the CLO market. As Steven mentioned, we have no near-term maturities. I think we feel pretty good with where we sit today. You did mention the deal that we did in April. Maybe just a couple of points on that. I think we were in a different environment, sort of then, obviously, that bond does not feel like the right price today. That said, that was not something that we had to do or something that we did want to do. We were sitting in the middle of April in the midst of tremendous amount of market volatility and the fact that we had good investor interest on the unsecured side, we view it as a very proactive and the right thing to do for the balance sheet. It moved our cost of liabilities less than 30 basis points. So hindsight, it's the wrong price. But I think at that time in place, the right thing to do. And I think our strong statement that people were willing to provide unsecured at that time. But I just want to make those comments on that note.

Our next question comes from Finian O'Shea with Wells Fargo.

I hope everyone is doing well. A lot's been asked and answered here. I'll just ask a couple of portfolio questions. Dan, can you remind us on Global Jet. Is there a senior debt in the form of securitization ahead of you there. I know you described your investment as the Mezz notes. And overall, how is that business holding up as most parts of air travel have meaningfully slowed?

I think just to level set on Global Jet, they -- there is sort of senior debt in front of us that can either be in the form of a bank warehouse facility or they have tapped the capital markets in terms of securitizations on numerous occasions, and I think their investor base is actually pretty deep, and those bonds have traded quite well post-COVID. I would just say this that the business performance has been quite strong. It is a different beast than commercial aviation. It is a diversified group of obligors from large corporates to high net worth to others who are leasing or taking loans out on assets. So the credit makeup of that portfolio is very different than a commercial leasing portfolio. And I think the nature of the pandemic that we are seeing, people are valuing access to private aircraft. So portfolio performance is very good right now. And if you go look at some of the bond prices that are out there, you would see they traded down post-COVID but have actually recovered nicely in trading above par, I believe.

Okay. That's helpful. And then on I think you have some exposures generally tied to residential housing. I think the 5 Arch income went into nonaccrual this quarter. There's also Toorak, Opendoor Labs, I don't recall how different these businesses are, but maybe can you kind of delineate what -- how this shutdown, recession, et cetera, hit Arch harder than the others?

Yes. No, it's a really good question. And maybe, to be honest, something we should have addressed more in the prepared remarks. The 5 Arch going on nonaccrual is a little bit different than sort of normal, right? I mean this is a portfolio of residential mortgage bridge loans not that to somewhat to Toorak that are, let's call it, 75% LTV. This is a transaction, though that's gone into amortization or essentially runoff. So we're getting back closer to the end of the portfolio. COVID has driven, I think, across all financing sort of activities, mortgage or consumer to a higher level of delinquencies.

I think the 5 Arch investment overall will still be a very good one. We just didn't think it was appropriate to continue to accrue the interest income. We'd rather just delever the debt as we're in the stub period of the runoff, which is different than Toorak, which is very much operating. I

think the environment is pretty attractive to them right now. But again, remember, both for 5 Arch and for Toorak, these are roughly 75% LTV loans that are upper single digits kind of unlevered. So I think the risk reward for that remains very interesting. But it really 5 Arch is not a performance matter more where it is in its life as a deal and just the prudent thing to do.

Sure. That's helpful. And then just a final higher-level question. Tying a couple of things together. You all outlined sort of a beginning of the end or worst behind us type narrative to the legacy book, which is appreciated. One of the comments stuck out to me, too, on Casey's question about pulling the pin that you're waiting for more portfolio stability to ultimately go forward in proposing commercial vehicles. Can you just tie those things together, what do you want to see in your portfolio or both the portfolios, but I guess we're on the FSK call now. Before you move forward.

Yes. And, Fin, let me sort of touch on that and tie it back to Michael's comments, too. I think the comments more we are -- we've been laser-focused on the portfolio. And I think we're happy that we've got some outcomes here. Getting the Board and restructure done was a lot. I think we're working with a lot of other names to move those forward. Even some of the COVID-impacted names, the 12% and the 7% I mentioned have required some real work to get those amendments done.

Obviously, when we're doing amendments if it's material, we want some equity dollars to come in sort of below this. So I think we've just been very focused on trying to get to the portfolio to the right spot. Like if you look at Brian's comments, where we end up being marked on those 5 names and on the energy, we think is a good number. We are happy, as I said, with kind of the restructuring work that gets done. We are positive on the forward we still -- we know we've still got some work to do, but I think we made a lot of progress this quarter on the portfolio. And then as we move forward and I think we have heard Casey's comment from a bunch of folks, and that's something that will be on our mind as we consider the strategic options going forward.

Our next question comes from Robert Dodd with Raymond James.

My first question kind of ties Casey and Rick together. I mean, obviously, your minimum NAV ROE that you're talking about, Steven, with 9%. It's going to be more than that next quarter, and that's with a large portion of portfolio of capital being in nonincome-producing assets right now. So as that evolves into income-producing, I'd expect the ROE to go higher than we're seeing even potentially next quarter, but that would be well in excess potentially of your target. So when you came up with the minimum 9%, can you give us any color of what you built into that in terms of -- was that based on the portfolio all sitting historically tight spreads compared to what we're seeing in the market and what we're going to see in incremental investments going forward? I mean can you give us any color on that?

Yes. Maybe I can start, and Steven, you can add to it. I think we we're obviously going bottoms-up, thinking about where we want portfolio construction to be, where we think sort of market pricing is. And as Steven said, we think that is what I would call a fair sort of long-term number. And one that I think is a good and sort of rational rate of return for the BDC market. But I don't want to make the statement, it sort of bottoms up. Steven sort of add to that, please.

Yes, I would agree with what Dan said, Robert. It is bottoms up. And it's -- we obviously struck it in the current environment to be appropriate in the environment that we and investors are all living in and experiencing.

Obviously, as we do things like what Dan talked about in terms -- earlier in the call in terms of transitioning some nonincome-producing assets to income producing assets, et cetera, as the portfolio grows over time. Then to the extent that, that we're overachieving that, obviously, that's a good thing for all involved. And I think you have to acknowledge that at some point in the future, too, the incentive fee will appropriately come back. Obviously, it's being waived now. And so there's an allowance for that as well in the operational model. But yes, so it's -- I wouldn't say the expectation is we'll get meaningfully, meaningfully above especially given the market environment right now in terms of how tight things are. So -- but those were the things we tried to balance.

Got it. Got it. I appreciate that. And another couple, if I can. On the origination side, there's activity starting to happen again. But I mean, if we look at your portfolio, there's more capital goods, those kind of things rather than I can imagine a BDC -- excuse me, that where the -- if they're more tech-focused, you can due diligence on some of those things more remotely than you can for capital goods. I mean, to put a name on it, could, in this environment, something like the AM General deal, heavy manufacturing be originated given the constraints on due diligence today?

Yes. Fair question. And don't worry, my dog like to interrupt at obvious moments as well. The -- I mean, it's -- there's definitely challenges to deals like that, right? I mean AM General was probably -- when we underwrote that originally in 2016, we spent a lot of time probably more on the macro and what the U.S. government was doing and using the resources of the firm like General Petraeus. So maybe that one actually could have been because it was a very low levered deal, and it was much more focused on government spending and where that was going. But the bar is high for new deals right now. We're probably more excited generally about add-ons to existing exposures, to your point, Robert, because it's easier to kind of get your arms around it, right?

And that will be a hindrance to sort of deals. Now that said, if there's a sector we like, if there's risk we want to take, I suspect we will find a way with additional resources, advisers maybe more local folks that would travel to the sites, et cetera. But I think that is one thing that will slow down M&A volume.

Got it. I appreciate it. And then if I could kind of take that question and apply it again but to workouts. I mean obviously, workouts can be very hands on. I mean financial restructuring is one thing. But the actual workout boots on the ground, that, again, adds those different complications. So is this environment going to delay the operational improvements from a workout group perspective, not just economically, obviously, to the existing stressed assets.

Yes. No, fair. And I think as we've talked about in the past, I mean, we hired a dedicated team to focus on this, really, the fourth quarter of 2017, really done at a time, obviously, not thinking about COVID, but thinking about a U.S. economy that felt like it had to take a downturn. That downturn unarguably didn't happen. But we were getting ready for that. So I think we're fortunate to have highly qualified dedicated people who've, quite frankly, worked tremendously hard over the last 5 or 6 months. So I think we all owe them a bit of gratitude for that on the team side.

It obviously doesn't make things easier, right? If you want to be blunt. I think that said, we've been able to get advisers, consultants on the ground, we've been able to leverage our own sort of resources inside of Capstone. Management teams are very important, which is why we mentioned the partner that we had on board. So I think we're starting to see that, we'll call it, recovery sort of playthrough. I think the bigger question is what's the economy going to look like Q3, Q4? And how will that sort of impact things. Will schools open?

There's obviously different things going on in different states right now. So I think it just requires an extra level of focus. But our intention is to not slow it up.

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back over to Dan Pietrzak for any further remarks.

Well, great. Well, thank you all for your time today and the very good questions. We're always available for follow-up questions at any time. Just let us know. We do hope that you remain safe and healthy during this period and enjoy the rest of the summer. Thank you.

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