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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, ladies and gentlemen. Welcome to FS Investment Corporation's First Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded. At this time, Marc Yaklofsky, Senior Vice President of FS Investments, will proceed with the introduction. Mr. Yaklofsky, you may begin.
Good morning, and welcome to FS Investment Corporation's First Quarter 2018 Earnings Conference Call. Please note that FS Investment Corporation may be referred to as FSIC, the fund or the company throughout the call.
Today's conference call is being recorded, and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSIC issued on May 10, 2018.
In addition, FSIC has posted on its website, a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended March 31, 2018. A link to today's webcast and the presentation is available on the Investor Relations section of the company's website at www.fsinvestmentcorp.com under Presentations and Reports.
Please note that this call is the property of FSIC. Any unauthorized rebroadcast of this call in any form is strictly prohibited.
I would also like to call your attention to the customary disclosure in FSIC's filings with the SEC regarding forward-looking statements. Today's conference call includes forward-looking statements, and we ask that you refer to FSIC's most recent filings with the SEC for important factors that could cause actual results or outcomes to differ materially from these statements. FSIC does not undertake to update its forward-looking statements unless required to do so by law.
In addition, this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures can be found in FSIC's first quarter earnings release that was filed with the SEC on May 10, 2018. Non-GAAP information should be considered supplemental in nature and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly named measures reported by other companies. To obtain copies of the company's latest SEC filings, please visit FSIC's website.
Speaking on today's call will be Michael Forman, Chairman and Chief Executive Officer of FSIC; Dan Pietrzak, Cohead of Private Credit at KKR and Chief Investment Officer of FSIC; and Mike Kelly, President and Chief Investment Officer of FS Investments. We're also joined by Brian Gerson, Head of Private Credit of FS Investments; and Chris Condelles, Head of Capital Markets of FS Investments. I will now turn the call over to Michael.
Thank you, Marc, and welcome everyone to FS Investment Corporation's First Quarter 2018 Earnings Conference Call. On today's call, I will provide an update on the progress we've made on several key fronts, since announcing the formation of our strategic partnership with KKR in December. Following my remarks, Dan Pietrzak will provide perspective on the current lending environment and discuss our investment activity for the quarter. Mike Kelly will then discuss our financial results for the quarter.
Before turning to FSIC's first quarter results, I want to provide an update on FS Investment's new partnership with KKR. Since December, our collective teams have focused on 3 primary areas: one, working with our borrowers and their sponsor partners to efficiently manage the transaction -- the transition; two, providing support to our existing portfolio companies as evidenced by several add-on financings closed during the first quarter; and three, further building the pipeline of new investment opportunities. In April, we closed on the FS/KKR joint investment adviser. It now advises 6 BDCs, FSIC, FSIC II, III and IV, CCT and CCT II, which has $18 billion in combined assets under management, 150 sponsor relationships and 325 portfolio companies.
To complete the transactions, we sought shareholder approval for all of those BDCs. Of those stockholders who voted, the overwhelming majority voted to approve the joint adviser. And we received all necessary approvals across the platform, well ahead of the closing of the proxy window.
All the while, we've been focused on deriving the full benefits of the combined FS Investments and KKR platforms. Under exemptive relief granted by the SEC, FSIC is able to co-invest across the KKR Credit platform providing FSIC with greater access to international sponsor-backed deals, nonsponsor deals and global asset-based finance opportunities.
We recently closed our first 2 transactions under the joint adviser and the pipeline is robust. A more diverse set of origination channels will help enhance deal flow, further optimize FSIC's portfolio and position us to generate better risk-adjusted returns for our stockholders.
As part of the effort to create value for our investors, we continue to consider potential mergers of the 6 BDCs that comprise the FS and CCT franchises. We believe that merging these entities will provide business and operational synergies that will expand long-term stockholder value, specifically, through reductions in administrative costs, further expansion and diversification of the investment portfolio, and the optimization of our capital structure with lower borrowing costs. Any mergers will, among other things, be subject to market conditions and review and approval from the respective Board of Directors. Additionally, in March, the FSIC board-authorized repurchase of up to $50 million in aggregate of outstanding common stock in the open market over the next 12 months. While we have discretion over the timing and pace of share repurchases, we have already purchased -- repurchased $25 million in shares, and it is our intention to utilize the full repurchase authorization.
Before I turn the call over to Dan, I'd like to make a few comments about the Small Business Credit Availability Act that passed in March. We believe the legislation represents the most significant advancements for BDC investors in decades, and creates more opportunities to provide much-needed capital to the middle market, which is the lifeblood of the U.S. economy. At its most basic level, we believe adding incremental leverage will afford us the ability to expand the universe of senior secured first-lien loans, while positioning us to deliver attractive risk-adjusted returns for investors. We sought and received board approval for the incremental increase purely as a means to initiate the 1-year waiting period, as we continue to engage with key stakeholders, including stockholders, bondholders, rating agencies and credit facility providers on the full impact of the legislation.
Subsequent to publicly announcing the board's action, Standard and Poor's placed the ratings of certain BDCs, including FSIC, on credit watch with negative implications. S&P did not telegraph its position on the legislation, and it was not something we or other BDC managers anticipated. We were surprised by S&P's action, and since we're very protective of our investment-grade credit-rating, we ask the board to revoke the approval, we initially sought.
Like the rest of the industry, we are carefully evaluating the full business implications of incremental leverage, and we will remain actively engaged with our key stakeholders throughout the evaluation process. Should we ultimately decide to move forward, we would certainly seek stockholder approval prior to advancing any effort. I will now turn the call over to Dan to discuss [Audio Gap]
activity during the quarter. Dan?
Thank you, Michael. I act on your comments on the recent transition period. Our teams have had very good dialogue with our borrower and their sponsor partners. And the feedback we've received, thus far, has been quite positive. FSIC completed 7 add-on financings during the first quarter with nominal portfolio turnover, which is a testament to the value proposition the partnership can deliver going forward.
Making this partnership a success for our stockholders has been and will be our primary focus. And has the full commitment of our total combined resources. We believe the totality of our combined BDC platform places us in the company of a select number of middle market lenders who are able to provide the certainty and flexibility of capital at scale that our borrowers demand. Over the past several quarters, we have commented on the generally tight conditions that continue to prevail in today's market. New CLO formation remains strong during the first quarter of 2018. And flows into the bank loan mutual funds turned positive after 2 straight quarters of outflows.
In markets like these, careful credit selection and discipline is critical as is being focused on structural protections within transactions. With the portfolio fully invested, we will remain patient and only selectively deploy capital as opportunities arise, maintaining high underwriting standards in the face of continued competition and a loose lending environment. Total purchases during the quarter were $116 million, 85% of which were first lien senior secured loans. Exits of $216 million during the quarter were driven by repayment of certain directly originated investments, largely spending from sales and takeouts by the syndicated markets. As said prior, we remain focused on working on additional financing opportunities with our existing portfolio companies.
Refinancing and add-on activity represented 86% or -- I'm sorry, $86 million or 88% of total purchases during the quarter. We maintained our focus on investing in senior secured and floating-rate debts, which at the end of the first quarter represented approximately 73% and 69%, respectively, of the portfolio based on fair value. These measures are both unchanged from the prior quarter.
In terms of return profile, the gross portfolio yield prior to leverage and excluding nonincome-producing assets was 10.9%, up from 10.5% for the prior quarter and 10.3% for the quarter ended September 30, 2017. The increase in FSIC's gross yields -- gross portfolio yield was primarily attributable to movements in LIBOR.
As of March 31, 2018, we had 2 companies on nonaccrual, which, in aggregate, represented a de minimis portion of the portfolio based upon fair value and amortized cost. During the first quarter, our investment in H.M. Dunn was put on nonaccrual, making it the only new nonaccrual asset for the quarter. The position totals approximately $500,000 based on fair value and $1.07 million based on amortized costs. Additionally, [ Global A&T ] was removed from nonaccrual status due to a restructuring that took place in January.
Equity compromised approximately 13% of the portfolio as of March 31, based on fair value, unchanged from the prior quarter.
During the quarter, we exited our entire equity positions in AP Exhaust and SandRidge Energy. And we intend to be very focused on rotating our equity positions into income-producing investments on an opportunistic basis over the coming quarters.
Before I turn it over to Mike Kelly, I did want to make some comments about deal volumes we're seeing and the Q2 pipeline. KKR has been investing into its private credit platform over the last several years and that effort has shown real traction on the origination and sourcing side, which will be further enhanced with the FS partnership. To provide some numbers to this, during Q1, KKR reviewed 324 private credit deals, up meaningfully quarter-on-quarter. And I said -- and as I said before, in this market we think it's important to be selective, and we believe this amount of origination volume will allow for that, for FSIC.
In terms of FSIC specifically for the month of April, FSIC is closed or formally committed to roughly $180 million of transactions. And we remain positive about our current pipeline. Please note that there is no certainty these transactions will close, but we feel they are quite high probability.
I'll now turn the call over to Mike Kelly to discuss our financial results during the quarter.
Thanks, Dan. During the first quarter, we outearned the distribution of $0.19 per share through net investment income. Net investment income was $0.21 per share compared to $0.22 per share for the fourth quarter of 2017 and $0.22 per share for the quarter ended March 31, 2017.
Adjusted net investment income for the quarter was $0.21 per share compared to $0.24 per share for the fourth quarter of 2017 and $0.22 per share for the quarter ended March 31, 2017.
It is important to note that, as we announced last year, the board intends to make a special distribution in the fourth quarter of 2018 to the extent net investment income earned from the fourth quarter of 2017 through the end of third quarter of 2018 exceeds the current annualized distribution amount of $0.76 per share. In other words, our stockholders will receive the benefits of any outperformance over the current annualized distribution rate. Fee and dividend income during the first quarter was higher from the previous quarter, primarily driven by a dividend received from one directly originated investment during the quarter. Fee and dividend income totaled $9.8 million in the first quarter of 2018 compared to $8.7 million in the fourth quarter of 2017.
The funds NAV declined from $9.30 per share as of December 31, 2017 to $9.16 per share as of March 31, 2018, driven primarily by unrealized losses attributed to certain equity positions, and one loan position, which, we believe, we will ultimately realize the full value of our investment. Equity investments are not a core part of our senior debt-focused origination strategy, and we will be actively working to reduce this exposure as attractive exit opportunities materialize. Finally, as Michael mentioned, last quarter we implemented a share buyback plan, which is a reflection of our confidence in FSIC's current portfolio. At a discount -- at a 15% discount to NAV, we believe the current stock price is not reflective of the strength in our current portfolio and the potential earnings power from rotating out of our equity position and better utilizing our nonqualified bucket.
I will now turn the call back over to Michael.
Thank you, Mike. We appreciate everyone's time this morning. We are excited about both the opportunities and benefits we believe this partnership will create for our investors, and we remain relentlessly focused on delivering the industry's premier BDC platform.
With that, we will now open the call for questions. Operator?
[Operator Instructions] The first question comes from the line of [ Mr. Greg Mason ].
Michael, I just wanted to see if you could kind of give us an outline of what combining the BDCs might look like. I completely agree managing 6 BDCs is not an efficient way to run the business. But given that you've got 2 publics and 4 privates, how might that conceptually work? Do the stocks have to get back above book value? Or can do you a NAV for NAV merger? What -- just if you could give us any kind of guidance that would be helpful.
Sure. We did provide some guidance in the script and it's something we and KKR and our boards are evaluating across all of our BDCs. The good news is there they're fairly straightforward simple mechanism in the '40 Act, where you can combine BDCs on an NAV to NAV basis. So in any acquisition or consolidation of BDC, that's the base case. So that's probably the other way all folks look at the consolidation of BDCs. We are in active discussions with KKR about the strategy going forward. We agree that consolidation makes sense, and we would expect to have more information about our exact strategy in the coming weeks and months.
The next question comes from the line of Mr. Jonathan Bock.
Turning first to the originations this quarter. I noticed that there were several follow-ons. And so would you be able to perhaps comment? These follow-on investments kind of indicate now you've moved from one external partner and managing this portfolio to another. Can you talk about the net benefit of incumbency, and how this is percolating and should we expect to see additional follow-on transactions in the future as the relationships between DSO and KKR, while "similar," right, every private equity sponsor has a different relationship with one or the other. So just curious and trying to translate follow-on investments today with existing portfolio companies and how you see that changing in the future, if at all.
Yes, Jonathan. Let me start, and I'm going to turn it over to Brian. And thank you for the question. It's certainly, a very, very important issue for us, and as we talked about in our last call, a key component of our transaction with GSO on the -- on their exit was anti-poaching protection, to make sure that we could maintain the portfolio. All of us were happy to see now looking back that we did not see a lot of activity with respect to the portfolio. We did not see a lot of competition. As we said, we've done a number of refinancing with the existing portfolio. That's always the easiest place to go for transaction capital. And I'll turn it over to Brian to provide a bit more detail.
Thanks, Michael. Yes, I mean, in the transition period, our big focus was on maintaining our incumbency position and our existing borrowers. And myself -- and I've been visited by a majority of our borrowers and sponsors. And I think, where you saw that bear fruit was in these add-on transactions that we saw over the quarter. So clearly, maintaining those incumbency positions is a focus of ours. And we clearly like to make loans to existing borrowers and credits that we feel comfortable with, and we expect that to continue.
So then, that's also a question. What was the timing of some of those follow-on investments in the quarter? Was it before April or was it after April? Can you give us a sense of when those effectively were transacted?
They happened throughout the first quarter in January, February and March.
Well, the only reason we ask that question is GSO was still the external manager of this portfolio during that timeframe, right? So investors would want to understand was this transaction done in partnership with GSO before it moved or not?
Yes, while done in the first quarter, Jon, we and KKR were the ones that were actively engaged in managing the portfolio, as you recall. KKR was paying a consulting fee during that period. Brian, Dan and others were very active with the sponsors. So we look at that as definitely being hosted by this joint adviser, while done during the first quarter. I would say, and I think we said in the script, we like the activity we're seeing going into the second quarter. The origination pipeline is strong. And we feel really good about the current credits and sponsors with whom we've done business with over the last several years.
Just add to that, because I think our focus during this transition period was really, as sort of Brian said, to get out there, to be in front of these folks to explain the new partnership, to explain the transition, to communicate to them how this was going to sort of work for them going forward. Because we really want to make sure that come that sort of April 9 day, we really did hit the ground running. So I think specifically to your question, those 7 that I mentioned in my script were all Q1 activity. Before that sort of formal flip of the -- the $180 million that I mentioned was actual sort of deal flows that rather than close, they're sort of committed post April 1.
Got it. And then, one question on -- because it's a common theme throughout the space this quarter. So, Michael, we understand that the board quite quickly chose to approve 2:1 leverage only to then also, quite quickly retract that. And so can you walk us through that process? Some folks are extremely deliberative on how this is working, with no decisions made. And so institutional investors are just going to have a question, what was going through your and the board's mind -- you chair the board, in making that decision. And walk-through us the need for an investment grade rating, if one could also outline that investor economics can be improved at an improved regulatory profile.
Yes. And as you know, Jonathan, we were quite involved in the process, the legislative process. And I think we all believe it's very important to the industry. We think it will take a little bit of time to sort itself out. We moved as a board to get the 1-year clock rolling. None of us in the space had any indication from S&P that they would move as they did. When we saw that move as they did, we thought the best action was to revoke that action. As you said, be deliberative. As I said in the script, it was always our intention to have our -- all the stakeholders involved and to submit this to a shareholder vote and to the extent we decide to go forward that's what we'll do. And we're still evaluating kind of the timing and the strategy around that.
Appreciate that. And then, if you were thinking about, on a go-forward basis, how this effectively works, my -- this is a question of -- more of a personal view for you, and no way shape or form should be expected as corporate direction. But to the event -- to the extent that you find 2:1 viable, that magically, the rating agencies or others kind of present alternatives you find acceptable to work this through. Do you find that there is a greater opportunity to focus on lower-yielding assets? And if that's the case, do you believe there needs to be some form of net win-win for the shareholders beyond just improved risk economics to the shareholder and an actual growth in ROE for both the external manager, as well as the shareholder?
I think the simple answer is yes, Jon. I mean, we've always looked to do what's in our shareholders' best interest. We do believe that the 2:1 leverage provides all of us, all of the BDCs, an opportunity to deliver better risk-adjusted returns to our investors. And in addition to that, the benefit should be shared. So something we're evaluating, we recognize it. And I would point back to the share repurchase plan, Jon, something we have been laser-focused on. We went back and did the research, and you can do the research. Not a lot of folks have announced share repurchase plans and filled those plans. As I said, we filled half and tend to continue moving forward until we fill the whole thing. So we've always tried to do what's in the shareholders' best interest. And I think, you and we and KKR are aligned in our thinking with respect to the leverage.
Your next question comes from the line of Rick Shane.
I appreciate how much you guys are doing and certainly, the strategy makes a great deal of sense. I'd like to sort of delve in a little bit to what types of efficiencies can be garnered by combining all of these entities. When I look at the numbers, my back of the envelope is roughly 90-plus percent of the expenses excluding interest or management fee and incentives. So presumably, the leverage is in that remaining 10%. I'm curious when you sort of walk through that, what type of savings, what type of operating leverage can you get on that remaining 10%? And how do you think that translates into ROE accretion?
Thank you, Rick, and I'm going to take a shot at that and have Dan also talk to that. I think first of all, the scale that we have combining CCT and FSIC, we think is a differentiator. The ability to do larger deals. We do believe there is a better risk-adjusted return in the upper middle market, a little bit less competition at times in the upper middle market, so we think that's one key differentiator. Another key differentiator is exemptive relief. As we look to a new partner, one that had exemptive relief, so that the good deals could go to the BDCs as well. And we love the way that KKR approaches the market so we can invest across the credit spectrum and not just be a one-trick pony. We thought that was really, really significant in our view. We've always had low administrative service expenses. We think we can continue to drive those down relentlessly. In these kind of vehicles every couple of basis points matter. We think the partnership between KKR and FS is highly accretive. We are each good at what we do, and we think combining them together is kind of a 1 plus 1 equals 3 result. So we think there is lots of value here. Let me -- let Dan talk to kind of the portfolio dynamics.
Yes. I think one other thing, Rick, that's kind of on our mind. And -- because I think Michael is right. I mean basis points in these vehicles do matter. It's the liability side of the balance sheet. And I think, one synergy, which we'll definitely spend time on is looking to sort of optimize that. And I think an entity with a potentially larger capital base will have access to more different forms of capital, potentially even simplifying some of the facilities that are out there. So I think it's a multipronged approach as we think about that. But I think as Michael said, we're somewhat in the early days of our thoughts but it's something we're going to spend some real time on going forward.
That makes sense. And look again, maybe it's interesting. I think in some ways I probably oversimplified just in terms of that one expense number, but there are potentially a lot of other -- and I know this moves into sort of bankers term, synergies other than just expense reductions.
Yes. I mean, I think, there's lots of obvious ones, I think, Rick. Dan really hit the liability side to be -- that's one of the reasons we're focused on the investment-grade rating. To be able to go to the public market is significant, to be able to have the kind of scale we have. We think it's a differentiator. And to be able to speak to very large deals, another thing we thought would add great value -- and we were in an interesting position at FS as we evaluated partners. We think the capital markets business that KKR has built the platform is a true differentiator. We can see bigger, bigger deals and speak for sizes of deals that not many folks, if any in the -- certainly in the BDC space can speak to.
Great. I think, we've answered all the questions. Thank you again for your time this morning. We look forward to keeping in touch, and we look forward to our next call with you all.
This concludes today's conference call. You may now disconnect.