FSK

Business Context and Reporting Period

Company: FS KKR Capital Corp. (NYSE: FSK)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2020
Business Overview: FS KKR Capital Corp. is an externally managed, non-diversified, closed-end management investment company regulated as a Business Development Company (BDC) and taxed as a Regulated Investment Company (RIC). The Company focuses on generating current income and long-term capital appreciation primarily through debt investments (senior secured and second lien loans) in private U.S. middle-market companies. It is managed by FS/KKR Advisor, LLC, a partnership between FS Investments and KKR Credit.

Key Financial Metrics

Material Changes vs. Prior Period

• Portfolio Valuation Decline: The Company reported a net decrease in net assets of $405 million for 2020, compared to an increase of $246 million in 2019. This was primarily driven by a net change in unrealized depreciation of $221 million and net realized losses of $496 million, attributed to mark-to-market declines across the portfolio due to the COVID-19 pandemic and economic uncertainty.
• Revenue Decrease: Total investment income decreased to $639 million in 2020 from $779 million in 2019. This decline was due to the repayment of higher-yielding assets replaced by lower-yielding assets, the impact of declining LIBOR on floating-rate investments, and an increase in investments in the Strategic Credit Opportunities Partners, LLC joint venture.
• Expense Reduction: Total operating expenses decreased to $298 million in 2020 from $362 million in 2019, largely due to the absence of subordinated income incentive fees in 2020 (compared to $57 million in 2019) and lower management fees.
• Reverse Stock Split: Effective June 15, 2020, the Company completed a 4-for-1 reverse stock split. All share and per-share data in the filing have been retroactively adjusted to reflect this split.

Guidance, Outlook, Risks, and Unusual Items

• Pending Merger: On November 23, 2020, the Company entered into a merger agreement with FS KKR Capital Corp II (FSKR). The transaction is expected to close in the second or third quarter of 2021. Upon closing, the Company plans to reduce its income incentive fee rate from 20% to 17.5% and remove the total return lookback provision.
• COVID-19 Impact: Management expects the pandemic to continue negatively impacting portfolio company operations and investment income. The Company anticipates potential restructuring of investments and further impairments.
• Liquidity and Capital Resources: As of December 31, 2020, the Company held $191 million in cash and foreign currency and had $1.04 billion available under financing arrangements. The Company maintains sufficient liquidity to fund unfunded commitments of approximately $437 million.
• Key Risks:
  • Interest Rate Risk: 63.5% of the portfolio consists of variable-rate debt. While rising rates could increase income, they also increase borrowing costs and could lead to higher defaults among portfolio companies.
  • Leverage: The Company utilizes leverage to enhance returns, which magnifies the potential for loss. The maximum debt-to-equity ratio is 2.0x under current regulations.
  • Valuation Uncertainty: A significant portion of the portfolio (Level 3 assets) is valued using unobservable inputs, introducing subjectivity and potential volatility in reported NAV.
  • RIC Status: The Company must distribute at least 90% of its investment company taxable income to maintain RIC tax status. Non-cash income (e.g., PIK interest) may require cash distributions or asset sales to meet this requirement.

Important Facts for Investor Verification

• Merger Completion: Verify the status and expected closing date of the merger with FS KKR Capital Corp II, including the final exchange ratio and the implementation of the reduced incentive fee structure.
• Portfolio Quality: Review the specific composition of the 5% of the portfolio rated as "Underperforming" (Rating 4) and the 2.5% on non-accrual status to assess credit risk exposure.
• Distribution Sustainability: Confirm whether the Company can maintain its quarterly distribution rate of $0.64 per share (annualized $2.56) given the decline in net investment income and the potential for distributions to include a return of capital.
• Debt Maturities: Monitor the repayment schedule of the $4.0 billion debt portfolio, particularly the $695 million in notes maturing in 2022, to ensure refinancing capabilities in a volatile market.
• LIBOR Transition: Assess the Company's progress in transitioning its variable-rate investments and borrowings from LIBOR to alternative reference rates (e.g., SOFR) and the potential impact on yields and costs.