FS KKR: Big discount to NAV justified in Q4; BDC remains a good income pick | Private Equity Weekly

introduce

Many may be wondering how BDCs will fare in 2024, with rates still expected to fall.I’m a big believer in the industry and think they’re more than just a high interest rate environment invest. The banking crisis about a year ago led to a tightening of lending standards, which I think will benefit the industry in the long term.

While many BDCs have provided additional income to shareholders over the past two years thanks to their predominantly floating-rate portfolios, some have faced headwinds along the way. The most recent one is the fourth largest BDC, FS KKR Capital (NYSE code: FSK). In this article, we’ll discuss why BDCs have been selling off recently, but why they’re still a good investment for income-focused investors.

Previous

The last time I covered FS KKR Capital was in December: Is the NAV discount justified, or is the BDC a good deal? I rated the stock a Buy, but the stock has since fallen nearly 6% as of this writing. In it, I discuss how the company has impressively expanded its product portfolio through acquisitions.

Additionally, I discussed BDC’s strong balance sheet, which is approaching maturities, but which are well structured and covered by its strong liquidity position. They also outperformed popular peers, Ares Capital (ARCC) and Main Street Capital (MAIN) in terms of total returns over three quarters, which I think is pretty impressive considering those two companies are more popular with investors profound. So why is BDC selling off while both ARCC and MAIN are in the black?

brief overview

Before we get into why BDC has been selling off recently, let’s talk about the company. FSK is an externally managed BDC, similar to peers ARCC and Blackstone Secured Lending (BXSL), and is managed by FS/KKR Advisor.

They are the fourth largest BDC with 204 portfolio companies with a total fair value of $14.6 billion. They invest primarily in senior secured investments, accounting for 66.4% and 58% of first-lien loans in 24 industries. Like many of its peers, they also have a large portion of their portfolio invested in software and services, accounting for 16.9%.

So why is there a sell-off?

Since my last article, FSK reported fourth-quarter earnings at the end of February, and BDC was disappointed with an increase in non-accruals during the quarter. While BDCs enjoy additional income from portfolio companies, they also face downward pressure from rising interest rates.

In the first three quarters, the company actually managed to reduce non-accrual expenses, with non-accrual expenses in the first nine months declining quarter by quarter. But in the fourth quarter, these assets accounted for 5.1% at cost and 2.6% at fair value, up from 2.4% in the third quarter.

Non-accrual charges have been plaguing many BDCs, but higher quality BDCs such as ARCC and BXSL have carefully managed these issues over the past year. BXSL actually managed to reduce non-accruals to 0.1% of total investments from 0.14% in the first quarter. ARCC’s non-accrual expenses also fell from 1.7% on a cost basis to 1.3% at year-end.

This, coupled with the decline in NII, also caused FSK’s NAV share price to decline compared to the previous quarter. They also faced some challenges setting credits on two other companies, Miami Beach Medical Group and Reliant Rehab, as non-accruals. A total of 5 companies were in non-accrual status in the fourth quarter.

Another portfolio company also saw a material deterioration in its forward EPS forecast. NII fell to $0.75 from $0.84 in the third quarter, while total investment income fell 3.9% to $447 million during the same period. So, it wasn’t a great quarter for BDC, to say the least.

As interest rates remain elevated for an extended period of time, non-accrual charges will continue to be a headwind for BDC. Although the Fed is still expected to cut interest rates in the near future, this may have a lagged effect and still put downward pressure on BDC borrowers. This will also result in higher net expenses, thus affecting their NII. Therefore, investors in this industry should be aware of this when looking to invest. I’ll be keeping an eye on what FSK management does with its portfolio companies in the near future.

Despite the challenges, FSK managed to invest $680 million in new investments during the quarter, resulting in portfolio growth of approximately $162 million. 58% of this amount was additional investment in existing companies. But its forecasts are deteriorating, both in terms of non-accrual and additional (company) numbers, and FSK investors should be very careful going forward.

Dividend safety

As a BDC investor, what you are most concerned about is the safety of dividends. During the fourth quarter, NII paid a dividend payment of $0.75. The benefit is that BDCs that pay surcharges and/or special rates can easily cut these fees at any time. The regular dividend of $0.64 gives FSK a dividend coverage ratio of 117%, which is safe. For the first quarter, BDC announced an additional total payout of $0.75 in April.

This compares to my favorite current holding, BSXL, which had a dividend coverage of 125% in Q4. For the full year FS, KKR Capital paid a distribution of $2.95 and generated a total of $3.18 in net investment income. So for those concerned about dividend safety, that’s covered for now. Going forward, if borrower credit quality continues to decline, BDC may reduce the top-up amount but still pay a decent regular dividend.

Liquidity Profile

While it does have $900 million of debt coming due this year, FSK’s balance sheet remains in good shape, with total liquidity of $3.9 billion and a net debt-to-equity ratio of 1.13x, compared with 1.10x at the end of the third quarter. That compares with 1.02 times for BDC Ares Capital, the largest by market capitalization.

However, they may have to refinance their upcoming debt issuances at higher interest rates, as the weighted average interest rates on these debts are 4.625% and 1.650%, respectively. But as noted, their liquidity positions remain strong. They also have investment-grade ratings from Fitch and Moody’s.

Underrated for a reason

As can be seen from the issue of borrower credit quality, FSK’s current P/E ratio is approximately 0.78 times. In comparison, many of its peers are currently trading at a premium to NAV as their yields and distributions are attractive due to higher interest rates.

In addition, the current discount of nearly 28% is higher than the previous discount. 3-year average 20.94%. So, for those strictly looking for income, now might be a good time to grab FSK, as valuations are attractive at the moment. However, with the credit issues they mentioned leading to lower NAV and higher non-accrual charges, I don’t see the share price appreciating significantly from here until those issues are resolved. Its price target leaves little room for upside compared to the current price of about $19. But again, for investors looking for higher yields, huge income comes into play.

bottom line

Although the credit quality of FS KKR Capital’s borrowers has declined quarter-on-quarter, the double-digit dividend yield remains attractive, with a dividend coverage ratio of over 100%. Additionally, their balance sheets remain healthy, with manageable debt maturities over the coming months and ample liquidity.

With P/E ratio below the 3-year average and currently below 1.0x, BDC may be a tough pass for those looking for higher yields. Especially considering interest rates are expected to fall in the near future. Although I downgraded BDC to Hold due to current borrower credit issues, I still think they remain a good income option.