FSK

FS KKR Capital Corp (FS Investment Corporation) 10-Q Summary

Business Context and Reporting Period

Company: FS Investment Corporation (FS KKR Capital Corp)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2012
Business Overview: An externally managed, non-diversified, closed-end management investment company regulated as a Business Development Company (BDC). The company invests primarily in senior secured loans, second lien secured loans, and subordinated debt of private U.S. companies. In May 2012, the company closed its continuous public offering.

Key Financial Metrics

Note: All figures in thousands except per share data.

Material Changes vs. Prior Period

• Portfolio Growth: Total investments increased from $1.84 billion (Dec 31, 2011) to $3.90 billion (Sep 30, 2012), driven by the closing of the continuous public offering in May 2012 and subsequent capital deployment.
• Financing Expansion: Total borrowings increased significantly from $554 million to $1.51 billion. This includes the termination of a Total Return Swap (TRS) on August 29, 2012, and its replacement with a new $550 million Arch Street credit facility with Citibank.
• Operating Expenses: Total operating expenses for the nine months ended Sep 30, 2012, were $111.4 million, compared to $27.6 million in the prior year period. This increase is primarily due to higher management fees ($46.6M vs $18.2M) and interest expense ($18.3M vs $7.4M) resulting from the larger asset base and increased leverage.
• Capital Gains Incentive Fee: The company accrued $33.9 million in capital gains incentive fees for the nine months ended Sep 30, 2012, compared to a reversal of $4.1 million in the prior year period. This accrual includes fees based on unrealized gains.
• Unrealized Appreciation: The portfolio recorded a net change in unrealized appreciation of $126.1 million for the nine months ended Sep 30, 2012, contrasting with a depreciation of $64.7 million in the prior year period, attributed to strengthening credit markets.

Guidance, Outlook, and Risks

• Outlook: Management expects operating expenses related to ongoing operations to level off as the asset base stabilizes following the closing of the public offering. The company intends to maintain its qualification as a Regulated Investment Company (RIC) by distributing at least 90% of investment company taxable income.
• Distributions: The company declared a regular monthly cash distribution of $0.0675 per share for October and November 2012. For the nine months ended Sep 30, 2012, 88% of distributions were funded by net investment income and 12% by capital gains proceeds.
• Key Risks:
  • Debt Securitization Risk: The company utilizes a complex debt securitization facility (JPM Facility) involving subsidiaries Locust Street and Race Street. Risks include subordination of equity interests, potential margin calls requiring additional funding, and misalignment of interests with the note holder (JPM).
  • Interest Rate Risk: Approximately 75% of the portfolio pays variable interest rates. While rising rates increase income, they also increase interest expense on floating-rate debt facilities.
  • Valuation Risk: The majority of investments are Level 3 assets (unobservable inputs), requiring significant management judgment and third-party valuation services.

Investor Verification Checklist

• Debt Structure: Verify the terms and covenants of the new Arch Street credit facility and the JPM debt securitization facility, specifically regarding margin thresholds and potential capital calls.
• Incentive Fee Accruals: Confirm the portion of the $33.9 million capital gains incentive fee that is based on unrealized gains versus realized gains, as unrealized fees are not payable until gains are realized.
• Portfolio Quality: Review the investment rating distribution (81% rated "2" or better) and monitor any migration to lower ratings (4 or 5) which could indicate credit deterioration.
• Liquidity Position: Assess the adequacy of the $191 million cash balance against unfunded loan commitments ($13.7 million) and potential margin posting requirements.
• Expense Reimbursement: Note that while an expense reimbursement agreement exists with the sponsor (Franklin Square Holdings), no reimbursements were required in the current period; verify if this support remains available if net investment income declines.