FS KKR Capital Corp

Moat: 1.5/5

Understandability: 3/5

Balance Sheet Health: 3/5

FS KKR Capital Corp. is a business development company that provides financing solutions to private middle-market companies, focusing on providing senior secured loans, but is highly dependent on the macro-economic environment and management skills.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

FS KKR Capital Corp (FSK) operates as a Business Development Company (BDC), which means it’s a closed-end investment company that invests in debt and equity instruments of private companies. FSK focuses on directly originated senior secured loans and, to a lesser extent, junior loans and equity investments in mid-market companies. These are typically smaller, less liquid companies that may not have access to traditional capital markets.

  • Revenue Distribution: FSK generates income primarily through interest payments on loans and, to a lesser extent, from capital gains on its equity investments and dividends. The majority of their portfolio (~80% currently) consists of first lien senior secured loans, which are generally considered less risky, but may have lower returns compared to other forms of credit. A smaller percentage of their investments are structured as second lien loans (riskier with higher returns) and equity positions (riskiest with the highest potential returns).
  • Industry Trends: The BDC industry has been growing as companies that do not have the scale for public debt markets often rely on these forms of financing. Recent trends in the industry are highlighting the importance of credit quality and risk management. BDCs are particularly vulnerable to changes in the overall macro-economic environment because their borrowers tend to be smaller businesses that are more impacted by economic downturns and interest rate increases.
  • Recent rate hikes by the Fed, combined with the lingering impact of high inflation and a possible economic downturn, will lead to increased scrutiny for BDCs. It is important for management to appropriately manage risk, maintain adequate diversification, and keep a close eye on the credit quality of its borrowers.
    • There’s a risk of rising interest rates leading to a downturn, which may cause an increase in defaults among mid-market companies, potentially harming FSK’s financials.
  • Margins: Because FSK derives its revenues primarily from interest income, their margins are dependent on the net interest income (NII). NII has historically been good for FSK, but it is closely tied to the interest rate environment and to the amount of defaults in their loan book. FSK also experiences additional expenses such as management fees, operating costs, and incentive fees, that eat away from the interest income.
  • FSK’s management has been trying to increase their revenue from their joint venture, but it is too early to determine if this will be a positive contributor.
  • Competitive Landscape: The BDC market is becoming increasingly competitive as more players enter the market to take advantage of opportunities in the private credit market. FSK competes with other publicly traded and privately owned BDCs, private credit funds, banks, and insurance companies, which increases pressure on margins and deal terms. This also makes finding good investment opportunities with high returns more difficult.
  • Since many of their competitors are privately owned, these firms are willing to push for higher bids than FSK is to find an investment, making it harder for FSK to get good deals.
  • What makes the company different?: FSK is a partnership between two powerful financial firms, FS Investments, and KKR, who both have established a solid reputation and history of expertise in financial management. The combination of FSK, FS Investments, and KKR is meant to provide superior access and capabilities to source and analyze investments in middle-market companies.
  • The new structure of the advisor, which combined KKR Credit and FS Investments into the new FS KKR Advisor, was meant to better align the financial resources and investment strategies of both firms. Although it is too early to conclude how successful this will be, there are several risks associated with this merger, which may hamper the success of the advisor.
  • Other relevant aspects: FSK aims to create a diversified and balanced investment portfolio by focusing on a variety of businesses in diverse industries. This minimizes risks related to having a large concentration in one sector. FSK’s investment approach also includes proactive monitoring and engagement with their portfolio companies to improve value creation and to mitigate risks.

Financial Analysis

  • Assets: FSK’s major asset base is their investment portfolio, which totaled $11.7 billion at December 31, 2022. As already mentioned most of it is senior secured loans, but it also has some amount in junior loans, and equity investments. FSK’s asset base is fairly stable over recent periods, indicating the stability of their investments.
  • Liabilities: FSK finances its operations through debt, which provides leverage in its operations and enhances returns when managed well. As of December 31, 2022, FSK’s total liabilities were $7.5 billion, a substantial amount which creates risks for FSK, due to interest payments, and the increased likelihood of default and bankruptcy during an economic downturn. FSK’s liabilities are made up of credit facilities, notes payable, and other financing options.
  • Equity: FSK’s equity as of December 31, 2022, stood at around $4.4 billion, which comprises retained earnings, and capital contributed by shareholders. A higher level of equity can cushion the impact of losses from poor investments, and provides financial stability to the BDC.
  • Overall, the company’s financial health seems adequate, but it is vulnerable to an economic downturn, because they are a leveraged entity with substantial amount of debt.
  • FSK’s management is focused on maintaining the portfolio’s credit quality and financial health. However, external variables such as interest rates are almost impossible to predict.
  • FSK’s management has talked about their intention of reducing reliance on debt to finance their operations in the near future. Although that may boost FSK’s resilience during adverse market conditions, It is too early to determine if this strategic objective can be realized.

Moat Analysis

FSK’s moat is considered narrow, rated 1.5 out of 5, because it lacks strong barriers to entry and depends on intangible assets and cost efficiency, which can be difficult to maintain over the long term.

  • Intangible Assets: The company’s brand reputation and relationships may attract some clients to their fund but is likely not durable and defensible. The combination of FS Investments and KKR has a good reputation, but in this market, these firms’ reputation may not hold a lot of water because the expertise is readily available from other firms as well.
  • Switching Costs: Although most BDC debt providers have limited switching costs, some of FSK’s larger relationships may be able to provide stability. However, as many firms have established relationships with multiple debt providers, this is unlikely to be a consistent, long-term moat.
  • Network Effect: As FSK does not deal in products that have a network effect, it does not benefit from a network effect moat.
  • Cost Advantage: FSK’s cost advantage is weak because there are many other firms that have similar access to credit. FSK has highlighted that they are a low cost provider, but such claims have not been validated with enough public information. As such we can’t put a lot of faith on such claims.

Risks to the Moat and Resilience

  • Credit risk: Due to the nature of its business, FSK is particularly vulnerable to credit risk—the chance of borrowers defaulting on their payments. BDCs tend to provide funding to smaller companies, which often come with higher risk of failure. A severe downturn in the economy could cause many of FSK’s borrowers to struggle, leading to increased defaults, and eroding the NII.
    • As the Fed continues to raise rates, a greater number of small companies will have a harder time paying down their debts. If FSK’s management is unable to find the right deals at this time, it can severely impact the company’s performance.
  • Interest rate risk: FSK relies on leverage to improve returns, but is very vulnerable to changes in interest rates, since debt is a major part of its business. As rates climb, their debt payments go up as well, affecting the NII and its profitability. Because most of their holdings have a floating rate of interest, this effect may not be as noticeable initially. However, if the rates remain elevated, their borrowers may default on their debts and this will affect FSK in the long run.
  • Competitive pressures: The market is becoming more and more competitive as other established and new firms take advantage of opportunities in the private debt market. This increased competition can lead to lower returns on capital and reduced investment opportunities.
  • Management skills: FSK is reliant on the expertise of its investment advisors at FS KKR Advisor. The management of these firms can have a substantial impact on the quality of investment decisions and profitability of the company. FSK’s decision to change its advisor in mid-2021 is a sign that management might not have all the power that they need to succeed in their investment ventures. This adds an element of uncertainty to the stability of the business.
  • Although FSK’s management is aiming to invest in high-growth industries and companies that provide good economic moats, given that their track record and historical performance, their current ability to do so is still questionable.
  • Regulatory changes: Regulatory changes can make it more difficult or more expensive for BDCs to raise capital or invest in certain types of assets, all of which could impact FSK’s profitability and its ability to create value for shareholders. A change in tax policy can also have negative effects on the business.

Understandability: 3 / 5

FSK is a moderately complicated company to analyze, because of the intricacies of its business. While the basic concept of investing in smaller companies is straightforward, the nuances of their investment strategies, risk management, and financial statements can be hard to comprehend for an investor that lacks experience and basic knowledge of accounting and finance. However, through detailed analysis and diligent research it is possible to arrive at a reasonably clear picture of the company and its moat.

Balance Sheet Health: 3 / 5

FSK’s balance sheet health is adequate, but not excellent. While they have a large portfolio of assets and a sizable amount of equity, they rely heavily on debt to fund operations which can amplify the effects of an economic downturn. * FSK’s management has indicated that they aim to deleverage in the future, which may benefit them if they are able to follow through with that plan, improving their resilience.

The combination of leverage, the need for constant risk management, and the ever present fear of a macro-economic downturn places the company’s health at 3/5.