Item 1. Business
Item 1.
Business.
Summary
FS KKR Capital Corp. (NYSE: FSK),
or the Company, which may also be referred to as we, us or our, was incorporated under the general corporation laws of the State of Maryland on December 21, 2007 and formally commenced investment operations
on January 2, 2009. We are an externally managed, non-diversified, closed-end management investment company that has elected to be regulated as a business
development company, or BDC, under the Investment Company Act of 1940, as amended, or the 1940 Act. As such, we are required to comply with certain regulatory requirements. In addition, we have elected to be treated for U.S. federal income tax
purposes, and intend to qualify annually, as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code of 1986, as amended, or the Code. As of December 31, 2021, we had total assets of approximately
$17.2 billion.
We are managed by FS/KKR Advisor, LLC, or the Advisor, a registered investment adviser under the Investment Advisers
Act of 1940, as amended, or the Advisers Act, which oversees the management of our operations and is responsible for making investment decisions with respect to our portfolio. Our investment objectives are to generate current income and, to a lesser
extent, long-term capital appreciation. We seek to meet our investment objectives by:
utilizing the experience and expertise of the management team of the Advisor;
employing a defensive investment approach focused on long-term credit performance and principal protection;
focusing primarily on debt investments in a broad array of private U.S. companies, including middle-market
companies, which we define as companies with annual earnings before interest, taxes, depreciation and amortization, or EBITDA, of $25 million to $100 million at the time of investment;
investing primarily in established, stable enterprises with positive cash flows; and
maintaining rigorous portfolio monitoring in an attempt to anticipate and
pre-empt negative credit events within our portfolio, such as an event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company.
Our portfolio is comprised primarily of investments in senior secured loans and second lien secured loans of private middle market U.S.
companies and, to a lesser extent, subordinated loans and certain asset-based financing loans of private U.S. companies. Although we do not expect a significant portion of our portfolio to be comprised of subordinated loans, there is no limit on the
amount of such loans in which we may invest. We may purchase interests in loans or make other debt investments, including investments in senior secured bonds, through secondary market transactions in the over-the-counter, or OTC, market or directly from our target companies as primary market or directly originated investments. In connection with our debt investments, we may on occasion receive
equity interests such as warrants or options as additional consideration. We may also purchase or otherwise acquire interests in the form of common or preferred equity or equity-related securities, such as rights and warrants that may be converted
into or exchanged for common stock or other equity or the cash value of common stock or other equity, including through a co-investment with a financial sponsor or possibly the restructuring of an investment.
In addition, a portion of our portfolio may be comprised of corporate bonds, structured products, other debt securities and derivatives, including total return swaps and credit default swaps. The Advisor will seek to tailor our investment focus as
market conditions evolve. Depending on market conditions, we may increase or decrease our exposure to less senior portions of the capital structures of our portfolio companies or otherwise make opportunistic investments, such as where the market
price of loans, bonds or other securities reflects a lower value than deemed warranted by the Advisors fundamental analysis. Such investment opportunities may occur due to general dislocations in the markets, a misunderstanding by the market
of a particular company or an industry being out of favor with the broader investment community and may include event driven investments, anchor orders and structured products.
The senior secured loans, second lien secured loans and senior secured bonds in which we invest generally have stated terms of three to seven
years and subordinated debt investments that we make generally have stated terms of up to ten years, but the expected average life of such securities is generally three to four years. However, we may invest in loans and securities with any maturity
or duration. Our debt investments may be rated by a nationally recognized statistical rating organization, or NRSRO, and, in such case, generally will carry a rating below investment grade (rated lower than Baa3 by Moodys Investors
Service, Inc., or Moodys, or lower than BBB- by Standard & Poors Ratings Services, or S&P). We may invest without limit in debt or other securities of any rating, as well
as debt or other securities that have not been rated by a NRSRO.
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To seek to enhance our returns, we employ leverage as market conditions permit and at the
discretion of the Advisor, but in no event will leverage employed exceed the maximum amount permitted by the 1940 Act. Prior to June 14, 2019, in accordance with the 1940 Act, we were allowed to borrow amounts such that our asset coverage,
calculated pursuant to the 1940 Act, was at least 200% after such borrowing. Effective June 15, 2019, following approval by our stockholders, our asset coverage requirement was reduced from 200% to 150%.
As a BDC, we are subject to certain regulatory restrictions in making our investments. For example, BDCs generally are not permitted to co-invest with certain affiliated entities in transactions originated by the BDC or its affiliates in the absence of an exemptive order from the U.S. Securities and Exchange Commission, or the SEC. However, BDCs are
permitted to, and may, simultaneously co-invest in transactions where price is the only negotiated term. In an order dated January 5, 2021, the SEC granted exemptive relief permitting us, subject to the
satisfaction of certain conditions, to co-invest in certain privately negotiated investment transactions, including investments originated and directly negotiated by the Advisor or KKR Credit
Advisors (US) LLC, or KKR Credit, with our co-investment affiliates. We believe this relief enhances our ability to further our investment objectives and strategy. We believe this relief may also increase
favorable investment opportunities for us in part by allowing us to participate in larger investments, together with our co-investment affiliates, than would be available to us if such relief had not
been obtained.
Reverse Stock Split
On June 15, 2020, we filed Articles of Amendment to our Articles of Incorporation, or the Reverse Stock Split Amendment, with the State
Department of Assessments and Taxation of the State of Maryland to effect a 4 to 1 reverse split of our shares of common stock, or the Reverse Stock Split. The Reverse Stock Split became effective in accordance with the terms of the Reverse Stock
Split Amendment on June 15, 2020. As a result of the Reverse Stock Split, every four shares of our common stock issued and outstanding were automatically combined into one share of our common stock, and the number of outstanding shares of our
common stock was reduced from approximately 495.0 million to approximately 123.8 million as of June 15, 2020. The Reverse Stock Split did not modify the rights or preferences of our common stock. We also filed a separate Articles of
Amendment to its Articles of Incorporation with the State Department of Assessments and Taxation of the State of Maryland to provide that there would be no change in the par value of $0.001 per share as a result of the Reverse Stock Split.
FS KKR Capital Corp. II Acquisition
On June 16, 2021, we completed our acquisition of FS KKR Capital Corp. II, or FSKR, pursuant to that certain Agreement and Plan of Merger,
or the 2020 Merger Agreement, dated as of November 23, 2020, by and among the Company, FSKR, Rocky Merger Sub, Inc., a former wholly-owned subsidiary of the Company, or Merger Sub, and the Advisor. Pursuant to the 2020 Merger Agreement, Merger
Sub merged with and into FSKR, with FSKR continuing as the surviving company and as a wholly-owned subsidiary of the Company, or the First Merger, and, immediately thereafter, FSKR merged with and into the Company, with the Company continuing as the
surviving company, or together with the First Merger, the 2021 Merger. In accordance with the terms of the 2020 Merger Agreement, each outstanding share of FSKR common stock was converted into the right to receive 0.9498 shares of our common stock.
As a result, we issued an aggregate of approximately 161,374,028 shares of its common stock to former FSKR stockholders. Following the consummation of the 2021 Merger, we entered into a new investment advisory agreement with the Advisor, dated as of
June 16, 2021, or the investment advisory agreement.
About the Advisor
The Advisor is a Delaware limited liability company, located at 201 Rouse Boulevard, Philadelphia, PA 19112, registered as an investment
adviser with the SEC under the Advisers Act. The Advisor is a partnership between an affiliate of Franklin Square Holdings, L.P. (which does business as FS Investments), or FS Investments, and KKR Credit. Our chairman and chief executive officer,
Michael C. Forman, serves as the Advisors chairman and chief executive officer.
The Advisor has significant experience in private
lending and private equity investing, and has developed an expertise in using all levels of a firms capital structure to produce income-generating investments, while focusing on risk management. The Advisor also has extensive knowledge of the
managerial, operational and regulatory requirements of publicly registered alternative asset entities, such as BDCs. We believe that the active and ongoing participation by the Advisor, FS Investments, KKR Credit and their respective affiliates in
the credit markets, and the depth of experience and disciplined investment approach of the Advisor, will allow the Advisor to successfully execute our investment strategies.
Our board of directors, which is comprised of a majority of independent directors, oversees and monitors our investment performance, and
beginning with the second anniversary of the effective date of the investment advisory agreement, will review the investment advisory agreement to determine, among other things, whether the fees payable under such agreement are reasonable in light
of the services provided.
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About FS Investments
FS Investments is a leading asset manager dedicated to helping individuals, financial professionals and institutions design better portfolios.
The firm provides access to alternative sources of income and growth, and focuses on setting industry standards for investor protection, education and transparency. FS Investments is headquartered in Philadelphia, PA, with offices in New York, NY,
Orlando, FL, and Leawood, KS. The firm had approximately $32 billion in assets under management as of December 31, 2021.
About KKR Credit
KKR Credit is a Delaware limited liability company, located at 555 California Street, 50th Floor, San Francisco, CA 94104, registered as
an investment adviser with the SEC under the Advisers Act. It had approximately $187 billion of assets under management as of December 31, 2021 across investment funds, structured finance vehicles, specialty finance companies and
separately managed accounts that invest capital in both liquid and illiquid credit strategies on behalf of some of the largest public and private pension plans, global financial institutions, university endowments and other institutional and public
market investors. Its investment professionals utilize an industry and thematic approach to investing and benefit from access, where appropriate, to the broader resources and intellectual capital of KKR & Co. Inc., or KKR & Co.
KKR Credit is a subsidiary of KKR & Co., a leading global investment firm with approximately $471 billion in assets under
management as of December 31, 2021, that manages investments across multiple asset classes, including private equity, energy, infrastructure, real estate and credit, with strategic manager partnerships that manage hedge funds. KKR &
Co. aims to generate attractive investment returns for its fund investors by following a patient and disciplined investment approach, employing world-class people, and driving growth and value creation with KKR & Co. portfolio companies.
KKR & Co. invests its own capital alongside the capital it manages for fund investors and provides financing solutions and investment opportunities through its capital markets business.
Potential Market Opportunity
We believe
significant investment opportunities will continue to present themselves in the senior secured and second lien secured loan asset class, as well as investments in debt securities of middle market companies.
Attractive Opportunities in Senior Secured and Second Lien Secured Loans
The variable rate structure of most senior secured and second lien secured loans present significant opportunities across the asset class,
particularly within a rising interest rate environment. Additionally, the strong defensive characteristics inherent to many securities across the asset class make them compelling to many investors, especially as financial conditions tighten. Because
senior secured debt has priority in payment among an issuers security holders (i.e., holders are due to receive payment before junior creditors and equity holders), they carry the least potential risk within the issuers capital
structure. Further, senior secured debt investments are secured by the issuers assets, which may be seized in the event of a default. Senior secured loans generally also carry restrictive covenants aimed at ensuring repayment before junior
creditors, including unsecured bondholders and other security holders, preserving collateral to protect against credit deterioration.
Opportunity in Middle Market Private Companies
In addition to investing in senior secured and second lien secured loans, we believe that the market for lending to private companies,
particularly middle market private companies within the United States, presents a compelling investment opportunity. The following characteristics support our belief:
Large Target Market. Middle market U.S. companies have historically represented a significant portion of
the growth segment of the U.S. economy. These companies also often require substantial capital investment to grow their businesses. Historically, significant private equity capital has been available for investment in middle market companies and we
expect that private equity firms will continue to leverage their investments in middle market companies with senior secured and second lien secured loans.
Limited Investment Competition. Despite the size of the market, regulatory changes and other factors have diminished the role of
traditional financial institutions in providing financing to middle market companies in favor of lending to large corporate clients and leading syndication efforts for capital markets transactions. Further, we believe a limited number of lenders are
willing to hold large amounts of middle market loans. As a result, we believe our ability to eliminate syndication risk by holding middle market loans is a competitive advantage.
Lending and originating new loans to middle market companies, which are often private, generally requires a
greater dedication of a lenders time and resources compared to lending to larger companies as it is often more difficult to
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make investments in, and acquire information, about smaller companies. Many investment firms lack the breadth and scale necessary to identify investment opportunities, particularly directly
originated investments in middle market companies, which may result in their overlooking many attractive investment opportunities. Middle market companies also may require more active monitoring and participation on the lenders part. We
believe that many large financial organizations, which often have relatively high-cost structures, are not suited to deal with these factors and instead emphasize services and transactions to larger corporate clients, resulting in a reduction in the
availability of financing to middle market companies.
Attractive Market Segment. The underserved nature of such a large segment of the market can at times
create significant investment opportunities. In many environments, lending to middle market companies may offer more attractive economics than lending to larger corporations in terms of transaction pricing,
up-front and ongoing fees, prepayment penalties, stricter covenants and quality collateral. In addition, middle market companies often have simpler capital structures and carry less leverage than larger
companies, thus aiding the structuring and negotiation process and allowing us greater flexibility in structuring favorable transactions.
Potential Competitive Strengths
We
believe that we offer investors the following potential competitive strengths:
Large, scalable, global platform with seasoned
investment professionals
We believe that the breadth and depth of the experience of the Advisor and its affiliates, which are
dedicated to sourcing, structuring, executing, monitoring and harvesting a broad range of private investments, provide us with a significant competitive advantage in sourcing and analyzing attractive investment opportunities. Our investment platform
is supported by approximately 160 dedicated investment professionals at KKR Credit located in nine global cities. We also benefit from the expertise, network and resources of KKR & Co., which has over 400 investment professionals located in
21 global cities. The individual members of these teams have diverse investment backgrounds, with prior experience at investment banks, commercial banks, other asset managers and operating companies. We believe this diverse experience provides an in-depth understanding of the strategic, financial and operational challenges and opportunities of middle-market companies.
Utilization of long-standing relationships and international capital market capabilities to source investments
The Advisor and its affiliates have worked diligently over many years to build strategic relationships with private equity firms, banks and
trading desks globally. Our and our affiliates long history of serving as a reliable financing partner to middle-market sponsors, even during periods of significant market dislocation, has enhanced our reputation. We believe that our network
of relationships will continue to produce attractive investment opportunities.
The Advisor also leverages the intellectual capital,
industry experience and global network of KKR & Co.s Capital Markets franchise to support the origination of new private credit investment opportunities. Through KKR & Co.s Capital Markets franchise, the Advisor
benefits from expanded sources of deal flow, real-time market intelligence on pricing trends and continuous dialogue with issuers and sponsors to provide holistic financing solutions to current and prospective portfolio companies. In addition,
KKR & Co.s Capital Markets franchise gives us the ability to access and originate larger transactions and enhances the Advisors ability to manage risk.
Focus on larger middle market companies and customized one-stop credit solutions
We are focused on providing customized credit solutions to private upper middle market companies, which we generally define as companies with
annual EBITDA of at least $50 million at the time of our investment. Based on its size and scale, the KKR Credit platform is able to originate, commit to and hold positions in excess of $1 billion in a given transaction. This size allows
us to serve in the lead financing role for certain larger middle market companies with more than $100 million in EBITDA. We believe our ability to underwrite an entire transaction provides financial sponsors and companies with a greater degree
of financing certainty and further enhances our competitive position. The KKR Credit platform also offers a variety of financing structures and has the flexibility to structure investments to meet the needs of companies. Finally, we believe that the
upper end of the middle market is less competitive as fewer lenders have the requisite size and scale to provide holistic solutions for these companies.
Long-term investment horizon
Our long-term investment horizon gives us great flexibility, which we believe allows us to maximize returns on our investments. Unlike most
private equity and venture capital funds, as well as many private debt funds, we are not required to
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return capital to our stockholders once we exit a portfolio investment. We believe that freedom from such capital return requirements, which allows us to invest using a longer-term focus,
provides us with the opportunity to increase total returns on invested capital, compared to other private company investment vehicles.
Disciplined, income-oriented investment philosophy
The Advisor employs a defensive investment approach focused on long-term credit performance and principal protection. This investment approach
involves a multi-stage selection process for each investment opportunity, as well as ongoing monitoring of each investment made, with particular emphasis on early detection of deteriorating credit conditions at portfolio companies which would result
in adverse portfolio developments. This strategy is designed to maximize current income and minimize the risk of capital loss while maintaining the potential for long-term capital appreciation.
Investment expertise across all levels of the corporate capital structure
The Advisor believes that its broad expertise and experience investing at all levels of a companys capital structure enable us to manage
risk while affording us the opportunity for significant returns on our investments. We attempt to capitalize on this expertise in an effort to produce and maintain an investment portfolio that will perform in a broad range of economic conditions.
Ability to create bespoke financing solutions through asset-based opportunities
The Advisor believes that there is an expansive and growing opportunity to create customized solutions in underserved asset classes, including
across the aircraft, consumer finance and auto and equipment finance sectors. The Advisor will seek to identify investments with strong collateral protection, a low correlation to the broader markets and equity-like upside potential.
Maintenance of portfolio diversification
In addition to focusing our investments in middle-market companies, we seek to invest across various industries. The Advisor monitors our
investment portfolio to ensure we have acceptable industry balance, using industry and market metrics as key indicators. By monitoring our investment portfolio for industry balance, we seek to reduce the effects of economic downturns associated with
any particular industry or market sector. Notwithstanding our intent to invest across a variety of industries, we may from time to time hold securities of a single portfolio company that comprise more than 5.0% of our total assets and/or more than
10.0% of the outstanding voting securities of the portfolio company. For that reason, we are classified as a non-diversified management investment company under the 1940 Act.
Investment Strategy
Our principal focus
is to invest in senior secured and second lien secured loans of private middle market U.S. companies, and to a lesser extent, subordinated loans and certain asset-based financing loans of private U.S. companies. Although we do not expect a
significant portion of our portfolio to be comprised of subordinated loans, there is no limit on the amount of such loans in which we may invest. We may purchase interests in loans or make other debt investments, including investments in senior
secured bonds, through secondary market transactions in the OTC market or directly from our target companies as primary market or directly originated investments. In connection with our debt investments, we may on occasion receive equity interests
such as warrants or options as additional consideration. We may also purchase or otherwise acquire interests in the form of common or preferred equity or equity-related securities, such as rights and warrants that may be converted into or exchanged
for common stock or other equity or the cash value of common stock or other equity, including through a co-investment with a financial sponsor or possibly the restructuring of an investment. In addition, a
portion of our portfolio may be comprised of bonds, structured products, other debt securities and derivatives. The Advisor will seek to tailor our investment focus as market conditions evolve. Depending on market conditions, we may increase or
decrease our exposure to less senior portions of the capital structures of our portfolio companies or otherwise make opportunistic investments, such as where the market price of loans, bonds or other securities reflects a lower value than deemed
warranted by the Advisors fundamental analysis. Such investment opportunities may occur due to general dislocations in the markets, a misunderstanding by the market of a particular company or an industry being out of favor with the broader
investment community and may include event driven investments, anchor orders and structured products.
When identifying prospective
portfolio companies, we focus primarily on the attributes set forth below, which we believe will help us generate higher total returns with an acceptable level of risk. While these criteria provide general guidelines for our investment decisions, if
we believe the benefits of investing are sufficiently strong, not all of these criteria necessarily will be met by each portfolio company in which we choose to invest. These attributes are:
Leading, defensible market positions. We seek to invest in companies that have developed strong
competitive positions within their respective markets and exhibit the potential to maintain sufficient cash flows and profitability to service our
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debt in a range of economic environments. We seek companies that can protect their competitive advantages through scale, scope, customer loyalty, product pricing or product quality versus their
competitors, thereby minimizing business risk and protecting profitability.
Investing in stable companies with positive cash flow. We seek to invest in established, stable companies
with strong profitability and cash flows. Such companies, we believe, are well-positioned to maintain consistent cash flow to service and repay our loans and maintain growth in their businesses or market share. We do not intend to invest to any
significant degree in start-up companies, turnaround situations or companies with speculative business plans.
Proven management teams. We focus on companies that have experienced management teams with an established
track record of success. We typically prefer our portfolio companies to have proper incentives in place, which may include non-cash and performance-based compensation, to align managements goals with
ours.
Private equity sponsorship. Often we seek to participate in transactions sponsored by what we believe to
be sophisticated and seasoned private equity firms. The Advisor believes that a private equity sponsors willingness to invest significant sums of equity capital into a company is an endorsement of the quality of the investment opportunity.
Further, by co-investing with such experienced private equity firms which commit significant sums of equity capital ranking junior in priority of payment to our debt investments, we may benefit from the due
diligence review performed by the private equity firm, in addition to our own due diligence review. Further, strong private equity sponsors with significant investments at risk may have both the ability and incentive to contribute additional capital
in difficult economic times should operational or financial issues arise, which could provide additional protections for our investments.
Allocation among various issuers and industries. We seek to allocate our portfolio broadly among issuers
and industries, thereby attempting to reduce the risk of a downturn in any one company or industry having a disproportionate adverse impact on the value of our portfolio.
Viable exit strategy. While we attempt to invest in securities that may be sold in a privately negotiated
OTC market, providing us a means by which we may exit our positions, we expect that a large portion of our portfolio may not be sold on this secondary market. For any investments that are not able to be sold within this market, we focus primarily on
investing in companies whose business models and growth prospects offer attractive exit possibilities, including repayment of our investments, an initial public offering of equity securities, a merger, a sale or a recapitalization, in each case with
the potential for capital gains.
Joint Venture
We also co-invest with South Carolina Retirement Systems Group Trust, or SCRS, through Credit
Opportunities Partners JV, LLC (formerly konwn as Strategic Credit Opportunities Partners, LLC), or COPJV, a joint venture with SCRS. COPJV invests its capital in a range of investments, including senior secured loans (both first lien and second
lien) to middle market companies, broadly syndicated loans, equity, warrants and other investments. We and SCRS each have 50% voting control of COPJV and together are required to agree on all investment decisions as well as certain other significant
actions for COPJV. As of December 31, 2021, COPJV had total capital commitments of $2 billion, $1.75 billion of which was from us and the remaining $250 million of which was from SCRS. As of December 31, 2021, we had funded
approximately $1.4 billion of our commitment. Additionally, as of December 31, 2021, COPJV had $477.9 million of borrowing capacity. As of December 31, 2021, our investment in COPJV was approximately $1.4 billion at fair
value. We do not consolidate COPJV in our consolidated financial statements.
Investment Types
We primarily focus on the following investment types:
Senior Secured Loans
Senior secured loans are situated at the top of a companys capital structure. Because these loans generally have priority in payment,
they carry the least risk among all investments in a firm. Generally, our senior secured loans are expected to have maturities of three to seven years, offer some form of amortization, and have first priority security interests in the assets of the
borrower. Generally, we expect that the interest rate on our senior secured loans typically will have variable rates over a standard benchmark, such as the prime rate or the London Interbank Offered Rate, or LIBOR.
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Second Lien Secured Loans
Second lien secured loans are immediately junior to senior secured loans and have substantially the same maturities, collateral and covenant
structures as senior secured loans. Second lien secured loans, however, are granted a second priority security interest in the assets of the borrower, which means that any realization of collateral will generally be applied to pay senior secured
loans in full before second lien secured loans are paid and the value of the collateral may not be sufficient to repay in full both senior secured loans and second lien secured loans. In return for this junior ranking, second lien secured loans
generally offer higher returns compared to senior secured debt. These higher returns come in the form of higher interest and in some cases the potential for equity participation through warrants, though to a lesser extent than with subordinated
loans. Generally, we expect these loans to carry a fixed rate, or a floating current yield over a standard benchmark. In addition, we may receive additional returns from any warrants we may receive in connection with these investments.
Senior Secured Bonds
Senior secured bonds are generally secured by collateral on a senior, pari passu or junior basis with other debt instruments in an
issuers capital structure and have similar maturities and covenant structures as senior secured loans. Generally, we expect these investments to carry a fixed rate.
Subordinated Debt
In addition to senior secured loans, second lien secured loans and senior secured bonds, we may invest a portion of our assets in subordinated
debt. Subordinated debt investments usually rank junior in priority of payment to senior debt and are often unsecured, but are situated above preferred equity and common equity in the capital structure. In return for their junior status compared to
senior debt, subordinated debt investments typically offer higher returns through both higher interest rates and possible equity ownership in the form of warrants, enabling the lender to participate in the capital appreciation of the borrower. These
warrants typically require only a nominal cost to exercise. We generally target subordinated debt with interest-only payments throughout the life of the security, with the principal due at maturity. Typically, subordinated debt investments have
maturities of five to ten years. Generally, we expect these securities to carry a fixed rate, or a floating current yield over a standard benchmark. In addition, we may receive additional returns from any warrants we may receive in connection with
these investments. In some cases, a portion of the total interest may accrue or be paid-in-kind, or PIK.
Equity and Equity-Related Securities
While we intend to maintain our focus on investments in debt securities, from time to time, when we see the potential for extraordinary gain,
or in connection with securing particularly favorable terms in a debt investment, we may enter into investments in preferred or common equity, typically in conjunction with a private equity sponsor we believe to be sophisticated and seasoned. In
addition, we may receive the right to make equity investments in a portfolio company whose debt securities we hold in connection with the next equity financing round for that company. This right may provide us with the opportunity to further enhance
our returns over time through equity investments in our portfolio companies. In addition, we may hold equity-related securities, such as rights and warrants that may be converted into or exchanged for common stock or other equity or the cash value
of common stock or other equity, generally obtained in conjunction with one of our debt investments or through a co-investment with a financial sponsor, such as an institutional investor or private equity
firm. In the future, we may achieve liquidity through a merger or acquisition of a portfolio company, a public offering of a portfolio companys stock or by exercising our right, if any, to require a portfolio company to repurchase the
equity-related securities we hold.
Convertible Securities
We may invest in convertible securities, such as bonds, debentures, notes, preferred stocks or other securities that may be converted into, or
exchanged for, a specified amount of common stock of the same or different issuer within a particular period of time at a specified price or formula.
Non-U.S. Securities
We may invest in non-U.S. securities, which may include securities denominated in U.S. dollars or in non-U.S. currencies and securities of companies in emerging markets, to the extent permitted by the 1940 Act.
Investments in Asset-Based Opportunities
We may invest in asset-based opportunities through joint ventures, investment platforms, private investment funds or other business
entities that provide one or more of the following services: origination or sourcing of potential investment opportunities, due diligence and negotiation of potential investment opportunities and/or servicing, development and management
(including
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turnaround) and disposition of investments. Such investments may be in or alongside existing or newly formed operators, consultants and/or managers that pursue such opportunities and may or may
not include capital and/or assets contributed by third party investors. Such investments may include opportunities to direct-finance physical assets, such as airplanes and ships, and/or operating assets, such as financial service entities, as
opposed to investment securities, or to invest in origination and/or servicing platforms directly. These asset-based opportunities are expected to offer mezzanine-like structural downside protection as well as asset collateral, and equity-like
upside that can be achieved through appreciation at the asset-level or, in the case of platforms, through growth of the enterprise value. Key areas of focus include, without limitation, aircraft, real estate and consumer finance.
Structured Products
We may invest in structured products, which may include collateralized debt obligations, collateralized bond obligations, collateralized loan
obligations, structured notes and credit-linked notes. The issuers of such investment products may be structured as trusts or other types of pooled investment vehicles. Such products may also involve the deposit with or purchase by an entity of the
underlying investments and the issuance by that entity of one or more classes of securities backed by, or representing interests in, the underlying investments or referencing an indicator related to such investments.
Derivatives
We may
also invest from time to time in derivatives, including total return swaps, interest rate swaps, credit default swaps and foreign currency forward contracts. We anticipate that any use of derivatives would primarily be as a substitute for investing
in conventional securities or to hedge potential risk that is identified by the Advisor.
Investments with Third-Parties
We may co-invest with third parties through partnerships, joint ventures or other entities,
thereby acquiring jointly-controlled or non-controlling interests in certain investments in conjunction with participation by one or more third parties in such investment. Such joint venture partners
or third party managers may include former personnel of the Advisor or its affiliates or associated persons.
Cash and Cash
Equivalents
We may maintain a certain level of cash or equivalent instruments, including money market funds, to make follow-on investments, if necessary, in existing portfolio companies or to take advantage of new opportunities.
Comparison of Targeted Debt Investments to Corporate Bonds
Loans to private companies are debt instruments that can be compared to corporate bonds to aid an investors understanding. As with
corporate bonds, loans to private companies can range in credit quality depending on security-specific factors, including total leverage, amount of leverage senior to the security in question, variability in the issuers cash flows, the quality
of assets securing debt and the degree to which such assets cover the subject companys debt obligations. As is the case in the corporate bond market, we will require greater returns for securities that we perceive to carry increased risk. The
companies in which we invest may be leveraged, often as a result of leveraged buyouts or other recapitalization transactions, and, in many cases, will not be rated by national rating agencies. When our targeted debt investments do carry ratings from
a NRSRO, we believe that such ratings generally will be below investment grade (rated lower than Baa3 by Moodys or lower than BBB- by S&P). To the extent we make unrated
investments, we believe that such investments would likely receive similar ratings if they were to be examined by a NRSRO. Compared to below- investment grade corporate bonds that are typically available to the public, our targeted senior secured
and second lien secured loan investments are higher in the capital structure, have priority in receiving payment, are secured by the issuers assets, allow the lender to seize collateral if necessary, and generally exhibit higher rates of
recovery in the event of default. Corporate bonds, on the other hand, are often unsecured obligations of the issuer.
The market for loans
to private companies possesses several key differences compared to the corporate bond market. For instance, due to a possible lack of debt ratings for certain middle market firms, and also due to the reduced availability of information for private
companies, investors must conduct extensive due diligence investigations before committing to an investment. This intensive due diligence process gives the investor significant access to management, which is often not possible in the case of
corporate bondholders, who rely on underwriters, debt rating agencies and publicly available information for due diligence reviews and monitoring of corporate issuers. While holding these investments, private debt investors often receive monthly or
quarterly updates on the portfolio companys financial performance, along with possible representation on the companys board of directors, which allows the investor to take remedial action quickly if conditions happen to deteriorate. Due
to reduced liquidity, the relative scarcity of capital and extensive due diligence and expertise required on the part of the investor, we believe that private debt securities typically offer higher returns than corporate bonds of equivalent credit
quality.
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Investment Process
The investment professionals employed by the Advisor or its affiliates have spent their careers developing the resources necessary to invest in
private companies. Our current transaction process is highlighted below.
Our Transaction Process
Sourcing
The relationships of the Advisor and its affiliates provide us with access to a robust and established pipeline of investment opportunities
sourced from a variety of different investment channels, including private equity sponsors, non-sponsored corporates, financial advisors, banks, brokers and family offices.
Evaluation
Screening. Once a potential investment has been identified, the Advisor screens the opportunity and makes a preliminary
determination concerning whether to proceed with a more comprehensive deal-level due diligence review.
Pipeline/Risk
Update. Upon review of the full deal pipeline, the Advisor raises key risks and issues to determine whether or not an investment meets our basic investment criteria and offers an acceptable probability of attractive returns with
identifiable downside risk. The objective is for the Advisor to identify a suitable and attractive opportunity for a more comprehensive due diligence review based on the facts and circumstances surrounding the investment.
Deal-level Q&A: After an investment has been identified and preliminary due diligence has been completed, screening
memos and a credit research analysis is prepared. These reports are reviewed by the Advisors investment committee, or the Investment Committee, to discuss key diligence and structuring issues. Following the Advisors review, the
Investment Committee will complete any incremental due diligence prior to formal Investment Committee approval. Though each transaction may involve a somewhat different approach, the Advisors diligence of each opportunity could include:
a full operational analysis to identify the key risks and opportunities of the targets business, including
a detailed review of historical and projected financial results;
a detailed analysis of industry dynamics, competitive position, regulatory, tax and legal matters;
on-site visits, if deemed necessary;
background checks to further evaluate management and other key personnel;
a review by legal and accounting professionals, environmental or other industry consultants, if necessary;
financial sponsor due diligence, including portfolio company and lender reference checks, if necessary; and
a review of managements experience and track record.
Execution
Following any incremental due diligence, the Investment Committee is presented with a formal recommendation for approval. Once the Investment
Committee has determined that the portfolio company is suitable for investment, the Advisor works with the management team of the prospective company to finalize the structure and terms of the investment. We believe that structuring transactions
appropriately is a key factor to producing strong investment results. Accordingly, we will actively consider transaction structures and seek to process and negotiate terms that provide the best opportunities for superior risk-adjusted returns.
Post-Investment Monitoring
Portfolio Monitoring. The Advisor monitors our portfolio with a focus toward anticipating negative credit events. To maintain portfolio
company performance and help to ensure a successful exit, the Advisor works closely with, as applicable, the
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lead equity sponsor, loan syndicator, portfolio company management, consultants, advisers and other security holders to discuss financial position, compliance with covenants, financial
requirements and execution of the companys business plan. In addition, depending on the size, nature and performance of the transaction, we may occupy a seat or serve as an observer on a portfolio companys board of directors or similar
governing body.
Typically, the Advisor receives financial reports detailing operating performance, sales volumes, cost of goods sold,
operating expenses, operating margins, cash flows, financial position and other key operating metrics on a quarterly basis from our portfolio companies. The Advisor uses this data, combined with due diligence gained through contact with the
companys customers, suppliers, competitors, market research and other methods, to conduct an ongoing, rigorous assessment of the companys operating performance and prospects.
In addition to various risk management and monitoring tools, the Advisor uses an investment rating system to characterize and monitor the
expected level of returns on each investment in our portfolio. The Advisor uses an investment rating scale of 1 to 4. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of
OperationsPortfolio Asset Quality for a description of the conditions associated with each investment rating.
Valuation
Process. We determine the net asset value of our investment portfolio each quarter. Securities are valued at fair value as determined in good faith by our board of directors. In connection with that determination, the Advisor provides our board
of directors with portfolio company valuations which are based on relevant inputs, including, but not limited to, indicative dealer quotes, values of like securities, recent portfolio company financial statements and forecasts, and valuations
prepared by independent third-party valuation services.
Accounting Standards Codification Topic 820, Fair Value Measurements and
Disclosure , or ASC Topic 820, issued by the Financial Accounting Standards Board, or FASB, clarifies the definition of fair value and requires companies to expand their disclosure about the use of fair value to measure assets and liabilities in
interim and annual periods subsequent to initial recognition. ASC Topic 820 defines fair value as the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date. ASC Topic 820 also establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets;
Level 2, which includes inputs such as quoted prices for similar securities in active markets and quoted prices for identical securities where there is little or no activity in the market; and Level 3, defined as unobservable inputs for
which little or no market data exists, therefore requiring an entity to develop its own assumptions.
With respect to investments for which
market quotations are not readily available, we undertake a multi-step valuation process each quarter, as described below:
our quarterly fair valuation process begins by the Advisor providing financial and operating information with
respect to each portfolio company or investment to our independent third-party valuation service providers;
our independent third-party valuation service providers review this information, along with other public and
private information, and provide the Advisor with a valuation range for each portfolio company or investment;
the Advisor then discusses the independent third-party valuation service providers valuation ranges and
provides the valuation committee of the board of directors, or the valuation committee, with a valuation recommendation for each investment, along with supporting materials;
preliminary valuations are then discussed with the valuation committee;
our valuation committee reviews the preliminary valuations and the Advisor, together with our independent
third-party valuation service providers and, if applicable, supplements the preliminary valuations to reflect any comments provided by the valuation committee;
following the completion of its review, our valuation committee recommends that our board of directors approves
the fair valuations determined by the valuation committee; and
our board of directors discusses the valuations and determines the fair value of each such investment in our
portfolio in good faith based on various statistical and other factors, including the input and recommendation of the Advisor, the valuation committee and our independent third-party valuation service providers.
Determination of fair value involves subjective judgments and estimates. Accordingly, the notes to our consolidated financial statements refer
to the uncertainty with respect to the possible effect of such valuations and any change in such
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valuations on our consolidated financial statements. In making its determination of fair value, our board of directors may use any approved independent third-party pricing or valuation services.
However, our board of directors is not required to determine fair value in accordance with the valuation provided by any single source, and may use any relevant data, including information obtained from the Advisor or any approved independent
third-party valuation or pricing service that our board of directors deems to be reliable in determining fair value under the circumstances. Below is a description of factors that the Advisor, any approved independent third-party valuation services
and our board of directors may consider when determining the fair value of our investments.
Valuation of fixed income investments, such as
loans and debt securities, depends upon a number of factors, including prevailing interest rates for like securities, expected volatility in future interest rates, call features, put features and other relevant terms of the debt. For investments
without readily available market prices, we may incorporate these factors into discounted cash flow models to arrive at fair value. Other factors that may be considered include the borrowers ability to adequately service its debt, the fair
market value of the borrower in relation to the face amount of its outstanding debt and the quality of collateral securing our debt investments.
For convertible debt securities, fair value generally approximates the fair value of the debt plus the fair value of an option to purchase the
underlying security (i.e., the security into which the debt may convert) at the conversion price. To value such an option, a standard option pricing model may be used.
Our equity interests in portfolio companies for which there is no liquid public market are valued at fair value. Our board of directors, in its
determination of fair value, may consider various factors, such as multiples of EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. All of these factors may be subject to adjustments based upon the
particular circumstances of a portfolio company or our actual investment position. For example, adjustments to EBITDA may take into account compensation to previous owners or acquisition, recapitalization, restructuring or other related items.
The Advisor, any approved independent third-party valuation services and our board of directors may also consider private merger and
acquisition statistics, public trading multiples discounted for illiquidity and other factors, valuations implied by third-party investments in the portfolio companies or industry practices in determining fair value. The Advisor, any approved
independent third-party valuation services and our board of directors may also consider the size and scope of a portfolio company and its specific strengths and weaknesses, and may apply discounts or premiums, where and as appropriate, due to the
higher (or lower) financial risk and/or the smaller size of portfolio companies relative to comparable firms, as well as such other factors as our board of directors, in consultation with the Advisor and any approved independent third-party
valuation services, if applicable, may consider relevant in assessing fair value. Generally, the value of our equity interests in public companies for which market quotations are readily available is based upon the most recent closing public market
price. Portfolio securities that carry certain restrictions on sale are typically valued at a discount from the public market value of the security.
When we receive warrants or other equity securities at nominal or no additional cost in connection with an investment in a debt security, the
cost basis in the investment will be allocated between the debt securities and any such warrants or other equity securities received at the time of origination. Our board of directors subsequently values these warrants or other equity securities
received at their fair value.
The fair values of our investments are determined in good faith by our board of directors. Our board of
directors is responsible for the valuation of our portfolio investments at fair value as determined in good faith pursuant to our valuation policy and consistently applied valuation process. Our board of directors has
delegated day-to-day responsibility for implementing our valuation policy to the Advisor, and has authorized the Advisor to utilize independent third-party
valuation and pricing services that have been approved by our board of directors. The valuation committee is responsible for overseeing the Advisors implementation of the valuation process.
Managerial Assistance. As a BDC, we must offer, and provide upon request, managerial assistance to certain of our portfolio companies.
This assistance could involve, among other things, monitoring the operations of our portfolio companies, participating in board and management meetings, consulting with and advising officers of portfolio companies and providing other organizational
and financial guidance. Depending on the nature of the assistance required, the Advisor will provide such managerial assistance on our behalf to portfolio companies that request this assistance. To the extent fees are paid for these services, we,
rather than the Advisor, will retain any fees paid for such assistance.
Exit
While we attempt to invest in securities that may be sold in a privately negotiated OTC market, providing us a means by which we may exit our
positions, we expect that a large portion of our portfolio may not be sold on this secondary market. For
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any investments that are not able to be sold within this market, we focus primarily on investing in companies whose business models and growth prospects offer attractive exit possibilities,
including repayment of our investments, an initial public offering of equity securities, a merger, a sale or a recapitalization, in each case with the potential for capital gains to the extent we maintain an equity interest in the underlying
portfolio company.
Risk Management
We seek to limit the downside potential of our investment portfolio by, among other things:
applying our investment strategy guidelines for portfolio investments;
requiring a total return on investments (including both interest and potential appreciation) that adequately
compensates us for credit risk;
allocating our portfolio among various issuers and industries, size permitting, with an adequate number of
companies, across different industries, with different types of collateral; and
negotiating or seeking debt investments with covenants or features that protect us while affording portfolio
companies flexibility in managing their businesses consistent with preservation of capital, which may include affirmative and negative covenants, default penalties, lien protection, change of control provisions and board rights.
We may also enter into interest rate hedging transactions at the sole discretion of the Advisor. Such transactions will
enable us to selectively modify interest rate exposure as market conditions dictate.
Affirmative Covenants
Affirmative covenants require borrowers to take actions that are meant to ensure the solvency of the company, facilitate the lenders
monitoring of the borrower, and ensure payment of interest and loan principal due to lenders. Examples of affirmative covenants include covenants requiring the borrower to maintain adequate insurance, accounting and tax records, and to produce
frequent financial reports for the benefit of the lender.
Negative Covenants
Negative covenants impose restrictions on the borrower and are meant to protect lenders from actions that the borrower may take that could harm
the credit quality of the lenders investments. Examples of negative covenants include restrictions on the payment of dividends and restrictions on the issuance of additional debt without the lenders approval. In addition, certain
covenants restrict a borrowers activities by requiring it to meet certain earnings interest coverage ratio and leverage ratio requirements. These covenants are also referred to as financial or maintenance covenants.
Operating and Regulatory Structure
Our
investment activities are managed by the Advisor and supervised by our board of directors, a majority of whom are independent. Under the investment advisory agreement, we have agreed to pay the Advisor an annual base management fee based on the
average weekly value of our gross assets (excluding cash and cash equivalents) and an incentive fee based on our performance. See Notes 2 and 4 to our consolidated financial statements included in this annual report on
Form 10-K for a description of the fees we pay to the Advisor.
From time to time, the Advisor
may enter into sub-advisory relationships with registered investment advisers that possess skills or attributes that the Advisor believes will aid it in achieving our investment objectives. The Advisor
oversees our day-to-day operations, including the provision of general ledger accounting, fund accounting, legal services, investor relations, certain government and
regulatory affairs activities, and other administrative services. The Advisor also performs, or oversees the performance of, our corporate operations and required administrative services, which includes being responsible for the financial records
that we are required to maintain and preparing reports for our stockholders and reports filed with the SEC. In addition, the Advisor assists us in calculating our net asset value, overseeing the preparation and filing of tax returns and the printing
and dissemination of reports to our stockholders, and generally overseeing the payment of our expenses and the performance of administrative and professional services rendered to us by others.
Pursuant to our administration agreement, dated April 9, 2018, or the administration agreement, we reimburse the Advisor for expenses
necessary to perform services related to our administration and operations, including the Advisors allocable portion of the compensation and related expenses of certain personnel of FS Investments and KKR Credit providing administrative
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services to us on behalf of the Advisor. We reimburse the Advisor no less than quarterly for all costs and expenses incurred by the Advisor in performing its obligations and providing personnel
and facilities under the administration agreement. The Advisor allocates the cost of such services to us based on factors such as total assets, revenues, time allocations and/or other reasonable metrics. Our board of directors reviews the
methodology employed in determining how the expenses are allocated to us and the proposed allocation of administrative expenses among us and certain affiliates of the Advisor. Our board of directors then assesses the reasonableness of such
reimbursements for expenses allocated to us based on the breadth, depth and quality of such services as compared to the estimated cost to us of obtaining similar services from third-party service providers known to be available. In addition, our
board of directors considers whether any single third-party service provider would be capable of providing all such services at comparable cost and quality. Finally, our board of directors compares the total amount paid to the Advisor for such
services as a percentage of our net assets to the same ratio as reported by other comparable BDCs.
We have contracted with State Street
Bank and Trust Company to provide various accounting and administrative services, including, but not limited to, preparing preliminary financial information for review by the Advisor, preparing and monitoring expense budgets, maintaining accounting
and corporate books and records, processing trade information provided by us and performing testing with respect to RIC compliance.
As a
BDC, we are required to comply with certain regulatory requirements. Also, while we are permitted to finance investments using debt, our ability to use debt will be limited in certain significant respects pursuant to the 1940 Act. Within the limits
of existing regulation, we will adjust our use of debt, according to market conditions, to the level we believe will allow us to generate maximum risk-adjusted returns. See Regulation. We have elected to be treated for U.S. federal
income tax purposes, and intend to qualify annually, as a RIC under the Code.
Regulation
We have elected to be regulated as a BDC under the 1940 Act and as a RIC under the Code. The 1940 Act contains prohibitions and restrictions
relating to transactions between BDCs and their affiliates, principal underwriters and affiliates of those affiliates or underwriters, as described below. The 1940 Act also requires that a majority of our directors be persons other than
interested persons, as that term is defined in the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a BDC unless approved by a majority
of our outstanding voting securities. The 1940 Act defines a majority of the outstanding voting securities as the lesser of (i) 67% or more of the voting securities present at a meeting if the holders of more than 50% of our
outstanding voting securities are present or represented by proxy or (ii) 50% of our outstanding voting securities.
We will generally
not be able to issue and sell our common stock at a price per share, after deducting underwriting commissions and discounts, that is below our net asset value per share. We may, however, sell our common stock, or warrants, options or rights to
acquire our common stock, at a price below the then-current net asset value of our common stock if our board of directors determines that such sale is in our best interests and the best interests of our stockholders, and our stockholders approve
such sale. At the 2021 annual stockholders meeting, our stockholders approved the sale of shares of our common stock at a price below the then-current net asset value per share, subject to certain conditions, during the period beginning on
December 10, 2021 and expiring on December 10, 2022. We currently do not intend to utilize this authority to sell shares of our common stock at a price below the then-current net asset value per share. In addition, we may generally issue
new shares of our common stock at a price below net asset value per share in rights offerings to existing stockholders, in payment of dividends and in certain other limited circumstances.
As a BDC, we are subject to certain regulatory restrictions in making our investments. For example, BDCs generally are not permitted to co-invest with certain affiliated entities in transactions originated by the BDC or its affiliates in the absence of an exemptive order from the SEC. However, BDCs are permitted to, and may, simultaneously co-invest in transactions where price is the only negotiated term. In an order dated January 5, 2021, the SEC granted exemptive relief permitting us, subject to the satisfaction of certain conditions, to co-invest in certain privately negotiated investment transactions, including investments originated and directly negotiated by the Advisor or KKR Credit, with our
co-investment affiliates. Under the terms of this relief, a required majority (as defined in Section 57(o) of the 1940 Act) of our independent directors must make certain conclusions in
connection with a co-investment transaction, including that (1) the terms of the proposed transaction, including the consideration to be paid, are reasonable and fair to us and our stockholders and do not
involve overreaching of us or our stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of our stockholders and is consistent with our investment objectives and strategy and any criteria
established by our board of directors.
Under the 1940 Act, we may only invest up to 30% of our portfolio in entities that are not
considered eligible portfolio companies under the 1940 Act, including companies located outside of the United States, entities that are operating pursuant to
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certain exceptions under the 1940 Act and publicly traded entities whose public equity market capitalization exceeds the levels provided for under the 1940 Act.
We may invest up to 100% of our assets in securities acquired directly from issuers in privately negotiated transactions. Our intention is to
not write (sell) or buy put or call options to manage risks associated with the publicly traded securities of our portfolio companies. We may enter into hedging transactions to manage the risks associated with interest rate and currency
fluctuations. We may purchase or otherwise receive warrants or options to purchase the common stock of our portfolio companies in connection with acquisition financings or other investments. In connection with such an acquisition, we may acquire
rights to require the issuers of acquired securities or their affiliates to repurchase them under certain circumstances.
We also do not
intend to acquire securities issued by any investment company that exceed the limits imposed by the 1940 Act. Under these limits, we generally cannot acquire more than 3% of the voting stock of any investment company (as defined in the 1940 Act),
invest more than 5% of the value of our total assets in the securities of one investment company or invest more than 10% of the value of our total assets in the securities of investment companies in the aggregate. With regard to that portion of our
portfolio invested in securities issued by investment companies, it should be noted that such investments might subject our stockholders to additional expenses.
On June 14, 2019, our stockholders approved the application of the modified asset coverage requirement set forth in Section 61(a)(2)
of the 1940 Act, as amended by the Small Business Credit Availability Act. As a result, we are permitted, under specified conditions, to issue multiple classes of debt and one class of stock senior to our common stock if our asset coverage, as
defined in the 1940 Act, is at least equal to 150% immediately after each such issuance, such that the Companys maximum debt to equity ratio increased from a prior maximum of 1.0x (equivalent of $1 of debt outstanding for each $1 equity) to a
maximum of 2.0x (equivalent to $2 of debt outstanding for each $1 of equity). In addition, while any senior securities remain outstanding, we must make provisions to prohibit any distribution to our stockholders or the repurchase of such securities
or shares unless we meet the applicable asset coverage ratios at the time of the distribution or repurchase. We may also borrow amounts up to 5% of the value of our total assets for temporary purposes without regard to asset coverage.
During 2021, compliance with material governmental regulations applicable to us did not have a material effect on our capital expenditures,
earnings, or competitive position.
Securities Exchange Act and Sarbanes-Oxley Act Compliance
We are subject to the reporting and disclosure requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, including
the filing of quarterly, annual and current reports, proxy statements and other required items. In addition, we are subject to the Sarbanes-Oxley Act, which imposes a wide variety of regulatory requirements on publicly-held companies and their
insiders. Many of these requirements affect us. For example:
pursuant to Rule 13a-14 promulgated under the Exchange Act, our chief
executive officer and chief financial officer are required to certify the accuracy of the financial statements contained in our periodic reports;
pursuant to Item 307 of Regulation S-K, our periodic reports are
required to disclose our conclusions about the effectiveness of our disclosure controls and procedures;
pursuant to Rule 13a-15 promulgated under the Exchange Act, our
management is required to prepare a report regarding its assessment of our internal control over financial reporting; and
pursuant to Item 308 of Regulation S-K, our auditors must attest to,
and report on, our managements assessment of our internal control over financial reporting.
The Sarbanes-Oxley Act
requires us to review our current policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. We monitor our compliance with all regulations that are adopted under the Sarbanes-Oxley
Act and take actions necessary to ensure that we are in compliance therewith.
The New York Stock Exchange Corporate Governance Regulations
The New York Stock Exchange, or NYSE, has adopted corporate governance regulations with which listed companies must comply. We believe we
currently are in compliance with such corporate governance listing standards. We intend to monitor our compliance with all future listing standards and to take reasonably necessary actions to ensure that we stay in compliance.
Taxation as a RIC
We have elected to be
subject to tax as a RIC under Subchapter M of the Code. As a RIC, we generally will not have to pay corporate-level U.S. federal income taxes on any ordinary income or capital gains that we timely distribute each tax year as
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distributions to our stockholders. To qualify for and maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as described below). In addition, in order to maintain RIC tax treatment, we must distribute to our stockholders, for each tax year, distributions
generally of an amount at least equal to 90% of our investment company taxable income, which is generally the sum of our net ordinary income plus the excess, if any, of realized net short-term capital gains over realized net long-term
capital losses, determined without regard to any deduction for distributions paid, or the Annual Distribution Requirement.
If we:
qualify as a RIC; and
satisfy the Annual Distribution Requirement,
then we will not be subject to U.S. federal income tax on the portion of our income or capital gains we distribute (or are deemed to
distribute) as distributions to our stockholders. We will be subject to U.S. federal income tax at the regular corporate rates on any income or capital gains not distributed (or deemed distributed) as distributions to our stockholders.
As a RIC, we will be subject to a 4% nondeductible federal excise tax on certain undistributed income unless we distribute distributions in a
timely manner to our stockholders generally of an amount at least equal to the sum of (1) 98% of our net ordinary income (taking into account certain deferrals and elections) for the calendar year, (2) 98.2% of our capital gain net income,
which is the excess of capital gains in excess of capital losses, or capital gain net income (as adjusted for certain ordinary losses), for the one-year period ending October 31 of that
calendar year and (3) any net ordinary income and capital gain net income for the preceding years that were not distributed during such years and on which we paid no U.S. federal income tax, or the Excise Tax Avoidance Requirement. Any
distribution declared by us during October, November or December of any calendar year, payable to stockholders of record on a specified date in such a month and actually paid during January of the following calendar year, will be treated as if it
had been paid by us, as well as received by our U.S. stockholders, on December 31 of the calendar year in which the distribution was declared.
We have previously incurred, and may incur in the future, such excise tax on a portion of our income and capital gains. While we intend to
distribute income and capital gains to minimize exposure to the 4% excise tax, we may not be able to, or may choose not to, distribute amounts sufficient to avoid the imposition of the tax entirely. In that event, we generally will be liable for the
excise tax only on the amount by which we do not meet the excise tax avoidance requirement.
In order to qualify as a RIC for U.S. federal
income tax purposes, we must, among other things:
continue to qualify as a BDC under the 1940 Act at all times during each tax year;
derive in each tax year at least 90% of our gross income from dividends, interest, payments with respect to
certain securities, loans, gains from the sale of stock or other securities, net income from certain qualified publicly-traded partnerships, or other income derived with respect to our business of investing in such stock or other
securities, or the 90% Income Test; and
diversify our holdings so that at the end of each quarter of the tax year:
at least 50% of the value of our assets consists of cash, cash equivalents, U.S. government securities,
securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of such issuer; and
no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities
or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain qualified
publicly-traded partnerships, or the Diversification Tests.
A RIC is limited in its ability to deduct expenses in
excess of its investment company taxable income. If our expenses in a given tax year exceed our investment company taxable income, we may experience a net operating loss for that tax year. However, a RIC is not permitted to carry forward net
operating losses to subsequent tax years and such net operating losses do not pass through to its stockholders. In addition, deductible expenses can be used only to offset investment company taxable income, not net capital gain. A RIC may not use
any net capital losses (that is, the excess of realized capital losses over realized capital gains) to offset its investment company taxable income, but may carry forward such net capital losses, and use them to offset future capital gains,
indefinitely. Due to these limits on deductibility of expenses and net capital losses, we may for tax purposes have aggregate taxable income for several years that we are required to distribute and that is taxable to our stockholders even if such
taxable income is greater than the net income we actually earn during those years.
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For U.S. federal income tax purposes, we may be required to recognize taxable income in
circumstances in which we do not receive a corresponding payment in cash. For example, if we hold debt instruments that are treated under applicable tax rules as having original issue discount (such as debt instruments with PIK interest or, in
certain cases, increasing interest rates or debt instruments that were issued with warrants), we must include in income each tax year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash
representing such income is received by us in the same tax year. We may also have to include in income other amounts that we have not yet received in cash, such as deferred loan origination fees that are paid after origination of the loan or are
paid in non-cash compensation such as warrants or stock. We anticipate that a portion of our income may constitute original issue discount or other income required to be included in taxable income prior to
receipt of cash. Further, we have elected to amortize market discount and include such amounts in our taxable income in the current tax year, instead of upon their disposition, as an election not to do so would limit our ability to deduct interest
expense for tax purposes.
We invest a portion of our net assets in below investment grade instruments. Investments in these types of
instruments may present special tax issues for us. U.S. federal income tax rules are not entirely clear about issues such as when we may cease to accrue interest, original issue discount or market discount, when and to what extent deductions may be
taken for bad debts or worthless instruments, how payments received on obligations in default should be allocated between principal and income and whether exchanges of debt instruments in a bankruptcy or workout context are taxable. We will address
these and other issues to the extent necessary in order to seek to ensure that we distribute sufficient income to avoid any material U.S. federal income or excise tax.
Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the tax year of the
accrual, we may be required to make a distribution to our stockholders in order to satisfy the Annual Distribution Requirement, even though we will not have received any corresponding cash amount. As a result, we may have difficulty meeting the
Annual Distribution Requirement necessary to maintain RIC tax treatment under Subchapter M of the Code. We may have to sell or otherwise dispose of some of our investments at times and/or at prices we would not consider advantageous, raise
additional debt or equity capital or forgo new investment opportunities for this purpose. If we are not able to obtain cash from other sources, we may fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax.
Although we do not presently expect to do so, we are authorized to borrow funds and to sell or otherwise dispose of assets in order to satisfy
distribution requirements. However, under the 1940 Act, we are not permitted to make distributions to our stockholders while our debt obligations and other senior securities are outstanding unless certain asset coverage tests are met.
See RegulationSenior Securities. Moreover, our ability to sell or otherwise dispose of assets to meet the Annual Distribution Requirement may be limited by (1) the illiquid nature of our portfolio and/or (2) other
requirements relating to our status as a RIC, including the Diversification Tests. If we sell or otherwise dispose of assets in order to meet the Annual Distribution Requirement or the Excise Tax Avoidance Requirement, we may make such dispositions
at times that, from an investment standpoint, are not advantageous.
A portfolio company in which we invest may face financial difficulties
that require us to work-out, modify or otherwise restructure our investment in the portfolio company. Any such transaction could, depending upon the specific terms of the transaction, result in unusable
capital losses and future non-cash income. Any such transaction could also result in our receiving assets that give rise to non-qualifying income for purposes of the 90%
Income Test or otherwise would not count toward satisfying the Diversification Tests.
Some of the income that we might otherwise earn,
such as fees for providing managerial assistance, certain fees earned with respect to our investments, income recognized in a work-out or restructuring of a portfolio investment, or income recognized from an
equity investment in an operating partnership, may not satisfy the 90% Income Test. To manage the risk that such income might disqualify us as a RIC for failure to satisfy the 90% Income Test, one or more subsidiary entities treated as U.S.
corporations for entity-level income tax purposes may be employed to earn such income and (if applicable) hold the related asset. Such subsidiary entities will be required to pay U.S. federal income tax on their earnings, which ultimately will
reduce the yield to our stockholders on such fees and income.
Competition
Our primary competitors for investments include other BDCs and investment funds (including private equity funds, mezzanine funds and CLO
funds). In addition, alternative investment vehicles, such as hedge funds, have begun to invest in areas in which they have not traditionally invested, including making investments in middle market private U.S. companies. We also compete with
traditional financial services companies such as commercial banks. We believe we will be able to compete with these entities for financing opportunities on the basis of, among other things, the experience of the Advisor and its affiliates.
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Some of our competitors are substantially larger and have considerably greater financial,
technical and marketing resources than we do. For example, some competitors may have a lower cost of capital and access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or
different risk assessments than we have and may not be subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC or the restrictions that the Code imposes on us as a RIC. These characteristics could allow our competitors to
consider a wider variety of investments, establish more relationships and offer better pricing and more flexible structuring than us.
Employees
We do not currently have any employees. Each of our executive officers is a principal, officer or employee of the Advisor or its
affiliates, which manages and oversees our investment operations. In the future, the Advisor may directly retain personnel based upon its needs.
Available Information
We file with or
submit to the SEC annual, quarterly and current periodic reports, proxy statements and other information meeting the informational requirements of the Exchange Act. This information is available free of charge by calling us collect at (215) 495-1150 or on our website at www.fskkradvisor.com . Information contained on our website is not incorporated into this annual report on Form 10-K
and you should not consider such information to be part of this annual report on Form 10-K. Such information is also available from the EDGAR database on the SECs web site at www.sec.gov .
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.