To be read in conjunction with the BDC Summary Results Table for the IQ 2024.

FS-KKR Capital’s (FSK) IQ 2024 financial performance exceeded expectations and resulted in a 4 rating on our 5-point scale.

PERFORMANCE

Frankly, our expectations for FS-KKR Capital (FSK) – one of the largest public BDCs – are muted after several years of mediocre credit performance and shrinking Net Asset Value Per Share (NAVPS) – down (23%) in the past 5 years. (By contrast – Ares Capital -ARCC – a direct competitor has recorded a 13% net increase in NAVPS over that same time period). We were very interested to see – as must FSK’s shareholders – if the BDC had made any progress in the IQ 2024.

Profiting

On paper, Net Investment Income Per Share (NIIPS) increased nicely in the IQ 2024 versus the IVQ 2023: going from $0.71 to $0.76. However, there’s more to the story. Total income dropped in the IQ 2024 from $447mn to $434mn as the portfolio shrunk slightly in size; the yield on income producing investments decreased and from the impact of non-accruals. Expenses were slightly lower in the IQ 2024. More importantly, though, there were no excise taxes charged in the beginning of 2024 but ($23mn) incurred in the prior quarter. This caused Net Investment Income to jump from $200mn to $212mn.

Different Strokes

If we calculated Net Investment Income Per Share on an “adjusted” basis (ANIIPS) – defined as excluding “(i) the accrual for the capital gains incentive fee for realized and unrealized gains; (ii) excise taxes;(iii) the impact of accretion resulting from merger accounting; and (iv) certain non-recurring operating expenses that are one-time in nature and are not representative of ongoing operating expenses incurred during FSK’s normal course of business” – profitability was slightly lower: falling to $0.73 from $0.75 in the IVQ 2023.

Falling Behind

Maybe most off-putting of all, whether you use NIIPS or ANIIPS, is that FSK in the IQ 2024 has fallen well off its recurring earnings of a year ago – or even 6 months ago – despite the high interest rate environment.

No Help

Also disappointing for shareholders is that the external manager continues to charge high incentive fees even as the BDC racks up substantial realized losses. As this table below shows, FSK has written off ($569mn) in the last 5 quarters while paying the manager (KKR and FS Investments) $244mn.

Lesser

Nonetheless – as we said – our earnings expectations for 2024 are low: BDC Best Ideas is projecting NIIPS of $2.79 this year and the analysts $2.80. That’s about (10%) lower than the full 2023 performance. The IQ 2024 actual results annualize out at $3.04 per share, slightly ahead of expectations.

Book Value

When both realized and unrealized gains and losses are added together, FSK didn’t fare so badly in the IQ 2024 – down ($39mn), not much for a BDC of this size. However, we can’t ignore the fact that net realized losses amounted to ($246mn) this quarter – one of the worst results in the BDC’s recent history. and – far and away – the highest number of any BDC by this metric in the IQ 2024. That also exceeds all the NII FSK booked in the first 3 months of the year: $211mn. Unfortunately, this was not a one-off occurrence. In the last 3 calendar years (2021-2023) net realized losses have amounted to ($295mn). Add the IQ 2024 net loss and FSK has permanently lost over half a billion dollars in capital. Even for a huge BDC like FSK these are substantial losses.

Eroding

Unlike many other BDCs, FSK – in an attempt to keep shareholders happy with high distributions – is not generating much in the way of income over its distribution level. As this “Net Asset Value Bridge” chart shows, the BDC’s NAVPS dropped in the quarter from $24.46 to $24.32 – a (0.6%) drop.

However, BDC Best Ideas – maybe a little bleakly – is projecting a (20%) decrease in FSK’s NAVPS between 2023 and 2028, so this quarter’s result was no great surprise and was within expectations.

Credit

We’ve touched on FSK’s realized losses this quarter already but these typically relate to companies that have been troubled for some time – i.e. old news. There has been some progress elsewhere in the portfolio this quarter. Most notably, 3 companies were removed from non-accrual status thanks to restructurings.

First there was Wittur:

We placed our second lien loan on non-accrual during the first quarter of 2023 as [Wittur] was facing persistent inflation headwinds as well as a slowdown in construction in China. The restructuring resulted in our second lien loan being fully equitized and KKR taking control of the business. The first lien debt of the company was significantly reduced at the operating company, and FSK’s existing first lien loan was converted into a EUR 52.2 million senior secured debt position. FSK and other funds managed by KKR provided new capital to the company to fund operations. This recapitalization resulted in $122.5 million of cost and $31 million of fair value being removed from non-accrual status.

FSK – IQ 2024 Conference Call

Then there was Kellermeyer Bergensons Services, or KBS:

KBS completed its full consensual restructuring during the quarter, which resulted in equitization of a portion of the non-accruing second out loans and FSK and other lenders taking control of the company. FSK received $190.5 million of a new first lien loan, $82.8 million of a new second out first lien loan, $48.3 million of preferred equity and KKR managed funds now own 46% of the company. This restructuring resulted in $197.6 million of cost and $135.3 million of fair value being removed from non-accrual status.

FSK – IQ 2024 Conference Call

Finally, there is Sweeping Corp of America:

Our first lien position in Sweeping Corp of America, was restructured during the first quarter, and the company received a $50 million cash injection from the equity sponsor. The first lien debt facility was restructured into a $15.7 million first-lien first-out cash paid term loan, a $28.1 million first-lien first-out PIK tranche, a $8.3 million second lien first out and a $24 million second lien second-out term loan. This restructuring resulted in $75.3 million of cost and $57.2 million of fair value being removed from non-accrual status.

FSK – IQ 2024 Conference Call

On Their Toes

FSK is not letting the grass grow under their feet and are keen to tackle the many trouble spots in the portfolio with all the tools available to lead lenders in leveraged loans: debt-for-equity and debt-for-debt swaps foremost amongst them. On their conference call, FSK’s Co-President made the point forcefully:

Metrics

These initiatives are reflected in some of the credit metrics we follow. The percentage of FSK’s non-accrual assets dropped between the IVQ 2023 and the IQ 2024 going from a (high) 8.9% of the portfolio at cost to a (still too high but better) 6.5% of our portfolio on a cost basis. On a FMV basis, FSK went from 5.5% to 4.2%.

Better

Looking at FSK’s own investment ratings, the value of assets in the bottom two categories on their 4 point scale have decreased from $1.055bn to $856mn – a near 20% improvement. This should be considered against the fact that category 2 investments – “no concern about repayment of both interest and our cost basis but company’s recent performance or trends in the industry require closer monitoring” – have increased and category 1 have decreased.

Second Opinion

The BDC Credit Reporter had a look at FSK’s portfolio and identified 11 “Important Underperformers” – companies rated 4 or 5 on our 5 point scale and with a BDC-wide FMV greater than $5mn. The total cost of those assets comes to $1.4bn – about 10% of the total. The FMV involved is just north of $1.0bn. That’s a smaller list than in the past and may suggest FSK is making real progress in shrinking its credit problems – albeit mostly by losing hundreds of millions of capital and reducing their earnings power.

Guesstimate

One of the key features of what the BDC Credit Reporter seeks to do is quantify what further losses might come from these Important Underperformers down the road. This quarter, we estimate there are ($302mn) of losses yet to be booked – using the high end of our loss ranges. That’s (4.4%) of the BDC’s remaining net assets, or a ($1.08) per share. That’s on the high side – ARCC’s equivalent percentage is (0.7%) for example – but close to the high end of a “normal” level.

Net-net, we’d say that FSK – which only added 1 new non-accrual this quarter – saw its overall credit performance improve in the IQ 2024, albeit at a heavy price for its shareholders. There is still some way to go before FSK can match its peers.

Full Pay Out

As we’ve noted, FSK is keeping its dividends high versus its earnings – at variance with most of its peers who are planning for lower profits ahead. In the IQ 2024, 5 different distributions were paid : a $0.64 regular; a $0.06 supplemental and three $0.05 specials. (Why payouts have to be so complex is a question without an answer). For the IIQ 2024 and already past their ex-date as we write this – the total came to $0.75, bringing the YTD to $1.60 per share, as this table shows.

Better?

In 2023, FSK paid out a record $2.95 per share. In 2024, BDC Best Ideas is projecting a near-record $2.90 per share. At the moment, if we just annualize the mid-year numbers FSK might do better than we expect and than last year’s record. However, those ever dropping earnings may keep that from happening.

CONCLUSION

Reasoning

Because of our lower expectations for FSK than most of its peers, we’re giving an “above expectations” 4 out of 5 rating nod to the BDC in the IQ 2024. Those realized losses – while unfortunate – reflect prior quarters credit mistakes crystallized. Otherwise, earnings and the net book value were in-line, while credit and the distributions are running ahead.

Maybe

FSK argues – quarterly – that the bulk of its above-average level of credit problems date back to loans booked years ago by the former manager. KKR makes a point like this one on every conference call:

We believe it will also be helpful to provide the market with information based on the assets originated by KKR Credit. As of the end of the first quarter, non-accruals relating to the 88% of our total portfolio, which has been originated by KKR Credit and the FS/KKR Advisor were 2.3% on a cost basis and 1% on a fair value basis.

Hopeful Note

If those sort of averages hold up till all the troubled deals booked by the former manager get cleaned up one way or another, FSK should perform more in line with its peers. [ARCC’s non-accrual assets represent 0.7% of their portfolio, Blue Owl’s (OBDC) 1.5%]. However much damage to the net asset value of the BDC – and its earnings power – has already occurred and more is likely on the way. Can FSK really ever “catch up” after booking losses equal to (28%) of its equity at par? Management may hope that – one day – some of the debt to equity swaps they’ve engaged in will pay out in an outsized way. Till then – and despite an above average IQ 2024 – FSK has a long way to go.

PRICE PERFORMANCE

Here’s a lifetime chart for FSK that dates back to 2014 when the BDC was co-managed by GSO Blackstone. For the first 3 years, the stock price held up well but began to sink in 2017. KKR Credit came on the scene – replacing GSO Blackstone in April 2018 – following an announcement in December of the prior year. As you can see, the change in management did not long arrest the BDC’s stock price decline over the following 6 years.

Right Now

At the open on June 20, 2024, FSK traded at $19.40 a share, (55%) below its 2017 highest price. Over 5 years, the stock is down (18%) and off (3.2%) YTD. The current price is (7%) off its 52 week high. In March-June of this year, the BDC saw its price shoot up 12% as investors bet on a revival of its fortunes but has slumped back halfway in recent weeks.

Valuations

The BDC trades at a (20%) discount to its ever-lower NAVPS and at a price-to-expected 2024 earnings of just under 7x, well below the BDC average. The likely yield in 2024 – going by the BDC Best Ideas projection – is 14.9%, versus a sector average – as calculated also by BDC Best Ideas – of 11.2%.

Not Sold

These metrics suggest investors are far from convinced FSK can match the performance of other mega-BDCs that serve the upper middle market. If FSK was in line with ARCC’s price to book, it would trade at $25.54 – 32% higher than today and a PE of 9.1x. Even the large – and growing payout – from FSK has not helped all that much to boost its stock price.

Mitigate

Nonetheless – and it bears noting – that the dividends received have gone a long way to ensure buy-and-hold FSK investors have not fared so badly on a “total return” basis. If you’d bought the stock 10 years ago, your annual total return would average 8.1%, over 5 years 16.2% and 3 years 11.6%. (We draw this data from Seeking Alpha which does not explain their methodology, so please use salt).