FS and KKR BDC partnership: Portfolio churn fears and discounts

The new arrangement is all but complete, with the shareholders of all requisite BDCs signing off on the marriage. An upside in their stock price, however, has been outweighed by other factors.

FS Investments and KKR have won shareholder approval for a plan that would create a partnership between their various business development companies, making them one of the largest BDC managers, with around $18 billion in assets under management across six vehicles.

As the marriage becomes finalised, Blackstone credit arm GSO Capital Partners is set to launch its own direct lending business, with the dissolution of the advisor-subadvisor relationship with FSIC effective 9 April. So far, the partnership has not shown any enhancement to FSIC’s stock price, and while CCT’s shares have rebounded from a sub-$15-a-share low, market watchers attribute the discount to factors other than the partnership.

“People and investors naturally don’t like change and uncertainty, and this presents a lot of change and uncertainty,” said KBW analyst Ryan Lynch, who covers FSIC.

“The biggest point is, ‘How does this transition occur?’ There is likely going to be value left on the table. Any time one credit manager takes over another book, they’re just naturally not going to be as knee-deep in those credits [as the lender that originated those loans].”

Sourcing, relationships and churn

As the sub-advisor, GSO’s core responsibility was originating the deals, according to a source familiar with the division of labour.

“It was regularly known that GSO [Capital Partners] was doing the heavy lifting on the investment side,” Lynch said.

Because GSO sourced many of the deals, some say its relationship with borrowers may be stronger than with the BDC as a whole. As part of the breakup, GSO is subject to a “lock-out” provision, in which it cannot refinance the current FSIC portfolio companies for 18 months.

“One has to assume that there are going to be heavy prepayments in FSIC portfolio,” a market observer said. “These weren’t KKR’s origination relationships. In the environment of [high] prepayment activities, it’s hard to hold onto assets.”

“Across the industry last year, prepayments across the BDC market were just under 40 percent,” said Rich Byrne, president of Benefit Street Partners and chief executive Business Development Corporation of America.

For its part, FS had the final say on the investments. On FSIC’s second-quarter earnings call in August, Wells Fargo analyst Jonathan Bock asked Michael Forman, FSIC chief executive, if there was a statistic in the deals FS from GSO “turn[ed] down” any point in the origination process.

“I often get pinched by investors that ask for numbers,” Bock said, who was inquiring about the statistic as part of a routine Securities and Exchange Commission process that evaluates investment advisory agreements.

“We try not to keep score that way,” Forman responded, saying he himself has been involved in “every deal since inception”.

Winning hearts, minds and corporate pocketbooks

The management for both FSIC and CCT say they have been very proactive working to mitigate portfolio churn, as an external source familiar with the matter told Private Debt Investor in Febrary.

“We’ve been very engaged with KKR for a long time now,” Brian Gerson, FS’s head of private credit, told PDI. “This started during the diligence process, several months before the announcement of the partnership. While there is going to be natural portfolio turnover, we are working to maintain our incumbency position with our borrowers.”

Gerson explained the FS and KKR teams interact daily and have regular portfolio review sessions, in addition to multiple strategic meetings where the team goes through the portfolio “on a name-by-name basis”.

FSIC’s portfolio consists of 100 companies, with 64 percent of its investments being first lien senior secured loans; 5 percent second lien senior secured loans; 4 percent senior secured bonds; 13 percent subordinated debt; 1 percent collateralised securities; and 13 percent equity.

For its part, CCT has 113 portfolio companies, with 42 percent of its book in first lien senior secured loans; 24 percent in second lien senior secured loans; 4 percent in other senior secured loans; 10 percent in subordinated debt; 9 percent in asset-based finance; 8 percent in its Strategic Credit Opportunities Partners joint venture with Conway; and 5 percent in equity investments.

“Number one, [FS] has a history and relationship with these borrowers,” KKR member and CCT chief investment officer Daniel Pietrzak said. “A good handful of the names we knew because we looked to lend to them. I think everybody is motivated to hit the ground running.”

FSIC’s ‘struggling’ ROE

“We believe that [return on equity] is the key driver of where a BDC trades,” said Mitchel Penn, an analyst at Janney Montgomery Scott who covers FSIC. “That includes realised and unrealised gains and losses. A lot of folks look at [net investment income], but we don’t believe that’s an accurate portrayal of what they’ve been returning.

FSIC reported a net asset value per share of $9.30 as of 31 December. On Thursday, its stock price closed at $7.10.

FSIC posted a 7.9 percent ROE for 2017 and has posted a 6.99 percent ROE since it went public in April 2014, he said. FSIC should generate at least 9.5 percent, which would cover their cost of capital, Penn said. He projects an 8.2 percent 2018 return.

“If you look at FSIC, they’ve been struggling from an ROE standpoint,” Penn explained. “You’re paying these firms to underwrite credit, and if they can’t get the ROE to the point where it covers their cost of capital, they’ll trade below book.”

Uncertainty in the portfolio has affected returns lately, one source said, noting FSIC’s 11.84 percent return since inception.

A notable boost to performance was the 33 percent FSIC generated in 2009, purchasing loans at a discount during the global financial crisis, according to a Montgomery Scott research note. The ROE since 2009 has been 9.4 percent.

Chris Condelles, FS’s head of capital markets, said the BDC is taking steps to shore up its ROE, which he says is in line with the BDC’s peers.

In addition to the announced share buyback, FSIC also has additional levers it can pull, he said, including delivering cost savings from the partnership, taking advantage of a wider deal funnel and continuing to focus on reducing the fund’s equity exposure, which is currently 13 percent of its book.

FSIC is trading at its lowest levels since it went public in April 2014. The stock was initially hit by the market volatility in early 2016, a point at which FSIC had heavier energy exposure than they do now.

The stock later rallied the rest of the year before falling throughout 2017, which KBW’s Lynch said was initially due to dividend coverage concerns and then later due to GSO leaving. Lynch has a market perform rating on the stock, noting it is relatively cheap when compared to the other publicly traded large BDCs.

CCT’s ‘scratch-and-dent discount’

CCT has seen its stock price rebound from its low of $14.63 per share in February, traded around $17 since then. Several analysts consider CCT’s discount “largely due to technical pressures”, posited a Wells Fargo CCT research note entitled “Discount is Overdone, Reiterate Outperform”.

The company reported a net asset value per share of $19.55 as of 31 December. On Thursday, the stock closed at $17 a share. For CCT’s part, its ROE stood at 7.7 percent last year. In 2015 and 2016, years the BDC was private, those numbers were 7.3 percent and 7.89 percent.

“CCT was trading at what I’d call a ‘scratch-and-dent’ discount,” said Doug Mewhirter, an analyst at SunTrust Robinson Humphrey covering CCT.

“I think the CCT reaction was related less to the specific factors of the deal,” he continued. “The discount is more for technical reasons than anything. The sell-off post-[NYSE] listing was more of the timing of the listing. There was a lot of retail selling and not a lot of institutional buying [post-NYSE listing].”

CCT also announced a $50 million buyback programme and noted in its quarterly earnings call the BDC’s management team would begin buying stocks after the restriction period stemming from the company’s public listing in November ended.

“We listed a name that had north of 70,000 shareholders,” KKR member and CCT CIO Pietrzak said, noting the tender it conducted upon its public listing was oversubscribed. “We’re working hard to meet with investors to ensure they understand the KKR/CCT story.”

Building on new ground

The reconfigured landscape provides another wildcard: GSO’s to-be-built standalone direct lending business. One of the world’s largest credit managers, GSO, which declined to comment, likely will not have trouble raising capital – for proof, look to the latest mezzanine and rescue financing funds, which both ended north of $6 billion.

In the December statement announcing the plans for the internal direct lending operations, GSO said it anticipates to beginning generating revenue from the new platform this year and that it will “fully replace, and ultimately exceed”, those the FSIC BDCs provided to GSO.

A FS-KKR partnership will have large implications for the private credit space, but the biggest question will be for shareholders, institutional and retail. If FS and KKR management’s campaign has been successful, shareholders could realise some real value.

For FSIC, that upside would be ROE: “We’re not saying that the new partnership can’t achieve [an ROE above 9.5 percent]. We think they probably can,” Montgomery’s Penn said.

For CCT, it would be the ability to write larger cheques and take down larger hold sizes: “The optimism [for CCT] of [the partnership] is getting a better strategy [on moving up-market],” SunTrust’s Merwhirter said. “The opposite side of the tension is, KKR has to deal what’s in the portfolio and from GSO and it looked like FSIC had been taking credit losses.”