FS KKR Capital - Q3 2024

Transcript

Operator (participant)

Good morning, ladies and gentlemen. Welcome to FS KKR Capital Corp's third quarter 2024 earnings conference call. Your lines will be in a listen-only mode during remarks by FSK's management. At the conclusion of the company's remarks, we will begin the question-and-answer session, at which time I will give you instructions on entering the queue. Please note that this conference is being recorded. At this time, Ana Kleinhenn, Head of Investor Relations, will proceed with the introduction. You may now begin.

Anna Kleinhenn (Head of Investor Relations)

Thank you. Good morning and welcome to FS KKR Capital Corp's third quarter 2024 earnings conference call. Please note that FS KKR Capital Corp may be referred to as FSK, 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 FSK issued yesterday. In addition, FSK has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended September 30th, 2024. A link to today's webcast and the presentation is available on the Investor Relations section of the company's website under Events and Presentations.

Please note that this call is the property of FSK, and the unauthorized rebroadcast of this call in any form is strictly prohibited. Today's conference call includes forward-looking statements and are subject to risks and uncertainties that could affect FSK or the economy generally. We ask that you refer to FSK's most recent filings with the SEC for important factors and risks that could cause actual results or outcomes to differ materially from these statements. FSK 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 FSK's third quarter earnings release that was filed with the SEC on November 6th, 2024.

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 FSK's website. Speaking on today's call will be Michael Forman, Chief Executive Officer and Chairman, Dan Pietrzak, Chief Investment Officer and Co-President, Brian Gerson, Co-President, and Steven Lilly, Chief Financial Officer. Also joining us on the call today are Co-Chief Operating Officers, Drew O'Toole and Ryan Wilson. I will now turn the call over to Michael.

Michael Forman (CEO and Chairman)

Thank you, Ana, and good morning, everyone. Thank you all for joining us today for FSK's third quarter 2024 earnings call. FSK's financial and operating results showed continued strength during the third quarter as we again exceeded our earnings guidance and over-earned our quarterly base and supplemental distribution. During the third quarter, FSK generated net investment income of $0.77 per share and adjusted net investment income of $0.74 per share as compared to our public guidance of approximately $0.72 and $0.70 per share, respectively. Our net asset value per share at the end of the third quarter was $2,382. On October 8th, 2024, we announced that our board declared a total fourth quarter distribution of $0.70 per share, consisting of our base distribution of $0.64 per share and a supplemental distribution of $0.06 per share.

This results in $2.90 per share of total distributions in 2024, which equates to a 12.2% yield on our September 30, 2024, net asset value of $0.2382 per share and a yield of approximately 14% based on our recent share price. As Dan will discuss in more detail during his comments, the FS/KKR Advisor continues to maintain its high bar on credit quality and disciplined underwriting process. During the third quarter, we originated approximately $1.1 billion of investments, and we ended the quarter with ample liquidity totaling approximately $4.4 billion. As we begin focusing on 2025, FS KKR is well positioned to capitalize on expected market conditions. First, given the recent reduction in interest rates and assuming some level of additional rate cuts over the next 12 months, our portfolio companies should experience improved credit metrics such as interest and fixed charge coverage ratios.

Next, based on our expectation for continued improvement in the M&A environment, there should be additional opportunities to rotate out of certain legacy portfolio companies, which have positioned themselves favorably over the last several years. Lastly, we are optimistic about the outlook for new investment opportunities and continue to believe that the KKR Credit platform is well positioned to generate differentiated deal flow across private debt and asset-based finance investments, and with that, I'll turn the call over to Dan and the team to provide additional color on the market and the quarter.

Dan Pietrzak (CIO and Co-President)

Thank you, Michael, and good morning, everyone. Despite the recent noise surrounding the presidential election, the U.S. economy continues to remain on solid footing. Since the Fed began raising rates in early 2022, the U.S. economy has experienced a 6.8% growth rate in real terms. Recent economic data released through September illustrates that the labor market has remained resilient, boosting income levels for workers, which continues to support consumer spending. At the same time, inflation has declined from 9.1% in June of 2022 to approximately 2.4% today. Both of these inputs create a favorable backdrop for a sustained economic expansion. As Michael alluded in his comments, we believe that M&A activity will increase meaningfully in 2025 as the market has seen interest rates peak and economic sentiment improve.

In line with this, we have seen greater momentum in middle market deal volumes, and our pipeline of new investment opportunities continues to grow. The bar remains high when looking for new opportunities to deploy capital. The market continues to be competitive, which has resulted in tighter credit spreads and more borrower-friendly terms. Nevertheless, we remain prudent and disciplined in our underwriting and have continued to pass on opportunities that do not meet our credit standards. We continue to see compelling opportunities in asset-based finance as banks strategically reposition their portfolios, largely due to regulatory requirements. As we have discussed previously, our ABF investments are often structured as fixed rate, which helps offset the impact of declining rates in the direct lending portion of our investment portfolio. During the third quarter, FSK originated $1.1 billion of new investments.

Approximately 57% of our new investments were focused on add-on financings to existing portfolio companies and long-term KKR relationships. Our new investments, combined with $1 billion of net sales and repayments when factoring in sales to our joint venture, equated to a net portfolio increase of $185 million. New originations consisted of approximately 84% in first lien loans and 16% in asset-based finance investments. Our new direct lending investments had a weighted average EBITDA of approximately $211 million, 6.3x leverage through our security, and a weighted average coupon of approximately SOFR plus 505 basis points. Through our ABF team and the broader KKR network, we have developed deep relationships, which allows us to access niche sectors that we find attractive within the ABF market and to structure deals that many market participants are unable to execute on due to transaction size, complexity, or platform capabilities.

One example of an asset-based finance deal that we originated during the quarter was the purchase of an approximately $10 billion pool of seasoned private student loans from Discover Financial Services. This portfolio is focused on prime borrowers or co-signers and has an average FICO score above 750. KKR Credit and another large manager jointly led and structured the multi-billion dollar deal, with FSK committing $94 million. The trend of well-performing portfolio companies proactively seeking repricings continued during the third quarter. We have also experienced instances of companies seeking overly aggressive price reductions or structural amendments, which don't align with our return or risk thresholds. In those situations, we have proactively chosen to be repaid. When we look at aggregate trends across our portfolio companies, we observed a 13% year-over-year EBITDA growth rate at portfolio companies in which we have invested in since April of 2018.

Additionally, the weighted average and median EBITDA of our portfolio companies was $237 million and $121 million, respectively, as of September 30th, 2024. As of the end of the third quarter, non-accruals represented 3.8% of our portfolio on a cost basis and 1.7% of our portfolio on a fair value basis. This compares to 4.3% of our portfolio on a cost basis and 1.8% of our portfolio on a fair value basis as of June 30th, 2024. Brian will provide further details on this during his comments. We also believe it is helpful to provide the market with information based on the FSK assets originated by KKR Credit.

Non-accruals relating to the 88% of our total portfolio, which has been originated by KKR Credit and the FS/KKR Advisor, were 2.2% on a cost basis and 50 basis points on a fair value basis as of the end of the third quarter. This compares to 2.4% on a cost basis and 60 basis points on a fair value basis as of June 30th, 2024. And with that, I'll turn the call over to Brian to discuss our portfolio in more detail.

Brian Gerson (Co-President)

Thanks, Dan. At the end of the third quarter, our investment portfolio had a fair value of $13.9 billion, consisting of 217 portfolio companies. This compares to a fair value of $14.1 billion and 208 portfolio companies as of June 30th, 2024. Our net leverage remained flat quarter-over-quarter, and the decline in our investment portfolio's fair value was primarily driven by unrealized depreciation relating to three investments: Production Resource Group, Miami Beach Medical Group, and Worldwise. PRG continues to be impacted by the lingering effects of the Writers' Strike and its corresponding impact on TV and film, as well as softness in its live performance business due to the delay of certain artists' tours. Miami Beach recently filed for Chapter 11 as part of its anticipated sale to Humana. Over the coming months, should this transaction close, we will exit our position in it.

Worldwise has experienced headwinds in its core pet bed business due to increased competition from low-cost foreign suppliers. We are actively engaged with the sponsor, Worldwise, to negotiate a potential restructuring, and we will provide additional updates as we learn more. At the end of the third quarter, our 10 largest portfolio companies represented approximately 20% of the fair value of our portfolio, which is in line with prior quarters. We continue to focus on senior secured investments as our portfolio consisted of approximately 60% first lien loans and 67% senior secured debt as of September 30th. In addition, our joint venture represented 9.9% of the fair value of our portfolio.

As a result, when investors consider our entire portfolio, looking through to the investments in our joint venture, then first lien loans total approximately 69% of our portfolio and senior secured investments total approximately 76% of our portfolio as of September 30th. The weighted average yield on accruing debt investments was 11.5% as of September 30th, a decrease of 50 basis points compared to 12% at the end of the second quarter. The decrease is primarily attributable to lower spreads on new investments, the repayment of certain higher-yielding investments during the quarter, and portfolio company repricings. As a reminder, the calculation of weighted average yield is adjusted to exclude the accretion associated with the merger with FS KKR. During the third quarter, Global Jet returned $76 million of capital to FSK, which was used to further reduce our position.

This distribution brings our total capital received to $205 million over the last two and a half years, and we continue to be pleased with the performance of the company. During the quarter, one investment was added to non-accrual status, and three investments were removed. Our subordinated delay draw position in Miami Beach Medical Group was added to non-accrual status, contributing $17 million of cost and $8 million of fair value. Five Arch Income Fund, a legacy investment which has been on non-accrual since 2020, was fully exited, removing $54 million of cost and $2 million of fair value. Lastly, a recapitalization of Belk resulted in the removal of $36 million of cost and $13 million of fair value across two investments. And with that, I'll turn the call over to Steven to go through our financial results.

Steven Lilly (CFO)

Thanks, Brian. Our total investment income increased by $2 million during the third quarter to $441 million. The primary components of our total investment income during the quarter were as follows. Total interest income was $356 million, representing an increase of $3 million quarter-over-quarter. A component of interest income, PIK interest, was $66 million, as three portfolio companies, ATX, PRG, and KBS, paid their interest in the form of PIK. Dividend and fee income totaled $85 million, a decrease of $1 million quarter-over-quarter. Our total dividend and fee income during the quarter is summarized as follows: $46 million of recurring dividend income from our joint venture, other dividends from various portfolio companies totaling approximately $18 million during the quarter, and fee income totaling approximately $21 million during the quarter.

Our interest expense totaled $118 million, an increase of $3 million quarter-over-quarter, and our weighted average cost of debt was 5.5% as of September 30th. Management fees totaled $54 million, unchanged quarter-over-quarter, and incentive fees totaled $44 million, a decrease of $1 million quarter-over-quarter. Other expenses totaled $10 million, unchanged quarter-over-quarter. The detailed bridge in our net asset value per share on a quarter-over-quarter basis is as follows. Our ending Q3 2024 net asset value per share of $23.95 was increased by GAAP net investment income of $0.77 per share and was decreased by $0.20 per share due to a decrease in the overall value of our investment portfolio. Our net asset value per share was reduced by our $0.70 per share total quarterly distribution paid during the quarter.

The sum of these activities results in our September 30, 2024, net asset value per share of $23.82. From a forward-looking guidance perspective, we expect fourth quarter 2024 GAAP net investment income to approximate $0.63 per share, and we expect our adjusted net investment income to approximate $0.68 per share. Detailed fourth quarter guidance is as follows. Our recurring interest income on a GAAP basis is expected to approximate $332 million. We expect recurring dividend income associated with our joint venture to approximate $52 million, an increase of approximately $6 million quarter-over-quarter. The expected increase is a result of the recent sale of $370 million of assets to the joint venture from FSK's balance sheet. We expect other fee and dividend income to approximate $31 million due to lower non-recurring fee income within our investment portfolio.

From an expense standpoint, we expect our management fees to approximate $53 million. We expect incentive fees to approximate $36 million. We expect our interest expense to approximate $117 million, and we expect other G&A expenses to approximate $10 million. During the fourth quarter, we expect our excise taxes will approximate $24 million. We expect the net effect of excise taxes to be partially offset by the accretion of our investments due to merger accounting. The primary drivers of the change from FSK's third quarter adjusted net investment income of $0.74 per share to our expected fourth quarter adjusted net investment income guidance of $0.68 per share are the reduction in interest rates by the Federal Reserve in September and lower fee income in the fourth quarter as compared to the third quarter.

Turning to our capital structure, our gross and net debt to equity levels were 121% and 109%, respectively, at September 30, 2024, as compared to 119% and 109% at June 30, 2024. As of the end of the third quarter, our available liquidity was $4.4 billion, and approximately 66% of our junior balance sheet and 46% of our committed balance sheet was comprised of unsecured debt. As a team, we are very focused on managing the right side of our balance sheet and optimizing our capital structure through multiple funding sources. Like certain other BDCs, which took advantage of the lower rate environment in 2019 and 2020, FSK has some lower cost debt maturing next year. In 2025, FSK has approximately $1.2 billion of unsecured notes maturing, representing approximately 10% of our total debt commitments and carrying a weighted average cost of 5.1%.

FSK has been a frequent issuer in the unsecured market with a focus on well-laddered maturities. We will continue to opportunistically assess the unsecured market, and we have over $3.5 billion of undrawn capacity under our senior secured revolving credit facility to utilize should we desire to aid with timing differences, and with that, I'll turn the call back to Michael for a few closing remarks before we open the call for questions.

Michael Forman (CEO and Chairman)

Thank you, Steven. In closing, we are pleased with FSK's third quarter performance as we have further reduced our non-accrual investments and are continuing to see significant new investment opportunities. As we look toward 2025, we believe the next several quarters could yield meaningful opportunities for FSK as the M&A market continues to improve. As we actively pursue well-structured new investments and focus on rotating legacy investments, we believe that 2025 has the potential to be a very active year for FSK. And with that, operator, we'd like to open the call for questions.

Operator (participant)

Now opening the floor for question-and-answer sessions. If you'd like to ask a question, please press star followed by number one on your telephone keypad. Your first question comes from Bryce Rowe from B. Riley Securities. Your line is now open.

Bryce Rowe (Analyst)

Thanks a lot. Good morning to everyone. Wanted to maybe start on just on yields and what you're seeing there in the market. Obviously, you called out yield compression within the portfolio in the quarter of 50 basis points. Just wanted to try to understand the impact from lower rates and spread compression within that 50 basis points. And then the guide that you're giving here for the fourth quarter of, I guess, lower interest income from rates, is that all lower rates, or is there some spread compression kind of baked into that assumption too?

Michael Forman (CEO and Chairman)

Yeah. Good morning, Bryce. I think the simple summary is it's a little bit of both, right? Clearly, there was the initial Fed move of the 50 basis points. We have seen from a new deal perspective, your regular way, direct lending deal is probably 500 basis points to 550 basis points. That's before kind of fees and OID. We have seen some repricings across the book. I think we called that out in our prepared comments. I think for names that we're comfortable with and we like the risk, we could be supportive of those. We have used a couple of those opportunities to just get repaid. It is, I think, a little bit of a harder market these days, right? The M&A volumes that everybody's been forecasting, including ourselves, have been a little bit slow to return.

I think we've been happy with our deployment numbers, but there's a bit of an imbalance in terms of available capital and kind of deal flow, which I think is driving some of that. All that being said, I think what you are earning on these loans in totality is still north of 10%. And considering, I think, the quality of the company that we are seeing, considering the LTV or the equity checks below us, that is one comforting fact in terms of total return on these deals.

Bryce Rowe (Analyst)

Yeah. Okay. All right. That's helpful, and then one more for me, and I'll jump back in queue, but when we think about kind of the guide, and obviously, we're getting to a point where most BDCs are seeing earnings compression and putting themselves into a position where you've got dividend coverage starts to fall below 100%, especially when we're thinking about the supplemental plus the base. You guys have plenty of spillover income, so I think you all have communicated in the past that that spillover income is certainly sufficient to bridge any gaps. Kind of curious where you'd like the spillover to kind of base out, so to speak. Do you want to try to reserve or keep two quarters of spillover versus what you have right now in roughly three?

Michael Forman (CEO and Chairman)

No, that's a fair question. I think your estimates there are pretty much on point. I do think the spillover income is quite beneficial in the environment that we're in. I would kind of note, I mean, our starting point from an earnings perspective is strong. I think 12.2% on NAV from a yield perspective is attractive. I think we are, as Steven talked about, forecasting lower Q income or lower fee income in Q4. I think the one thing that we're going to watch play out is we do believe increased activity in 2025 will occur. That should be beneficial to that fee income line and provide some offset. But yes, the nearly three quarters of spillover is available as it relates to the $0.70.

Bryce Rowe (Analyst)

Okay. Thank you, guys.

Michael Forman (CEO and Chairman)

Thank you.

Operator (participant)

Your next question comes from Casey Alexander from Compass Point. Your line is now.

Casey Alexander (Analyst)

Yeah. Hi. Good morning. The income generation in the quarter was, I think, better, actually, than most of us expected. But there was a meaningful, especially over the last two quarters, increase in PIK income. Can you give us some sense of how you expect that to develop next quarter and in some of the succeeding quarters?

Michael Forman (CEO and Chairman)

Yeah. Good morning, Casey. I think in terms of the PIK, I kind of frame it in one way, and then maybe Brian will talk about some of the specific deals. While it's a smaller part of our portfolio, we have been active in certain junior debt deals. athenahealth would be an example of that. So of the PIK income, roughly half of that is what I'll call regular way kind of new business. A lot of those companies end up being kind of a larger size, which we like from a risk perspective. I think when we did the athenahealth deal as an example, it was like $1 billion of EBITDA. The rest of it, as Steven called out, was related to a handful of names.

Those names, we're using that as they were reinvesting dollars into kind of growth activities, which I think we're supportive of them doing. I think in terms of the forward outlook, I think we were roughly 15% this quarter. You're probably in and around that range. My guess would be for the next couple of quarters. Brian, you might want to add to that.

Brian Gerson (Co-President)

Yeah. Look, I think when you step back as it relates to these three names, when we restructure businesses, we always tie debt capacity to the current and projected earnings part of the business. But these businesses are being restructured because they've been underperforming. They've lacked strategic guidance. They often need management upgrades. They may have been underinvested in SG&A or CapEx. And we structure these loans, this new debt, with a PIK option, which gives us and management flexibility to address these underperformance issues and gives us. But we do have sign-off on all the budgeting since we're on the board. So I do think these PIKs, they're not surprising. They were intentionally structured. And I think currently the deals that do have that option are utilizing it. That may address your question about future.

But again, there's a lot of thought that goes into how we structure these deals and really focusing on the ultimate outcome and activity.

Casey Alexander (Analyst)

Okay. Thanks. My next question is, last year around this time, you gave kind of pretty clear indications of how you sort of intended to manage the dividend for 2024, and it ended up getting broken into kind of three components. I'm curious if you have any view of how you think the board expects to handle it, especially against, A, rate compression, B, declining base rates. I mean, would it be your expectation that in 2025, investors should think more in terms of the base dividend and then see how things develop through 2025?

Michael Forman (CEO and Chairman)

Yeah, and thanks for that, Casey. I think we try to be pretty transparent the way we've thought about dividend policy. And you are correct. We broke it into kind of three pieces, right? We wanted to reward shareholders for what's called outperformance on the income side. That was the $0.05. That was the additional that I think we paid for five straight quarters. We have broken it down into the $0.64 and the $0.06 to get to the $0.70. I think when we do talk about this with the board, we do think about it over a longer term, at a longer-term horizon, right? That's why we did set the base at $0.64. I think we'll continue to evaluate that with the board. I think you had an interesting piece out yesterday as it relates to the potential impact of the presidential election.

I think our initial gut is while rates will continue to trend down, it probably will be a little bit slower than maybe we would have guessed 30 or 60 days ago, so I think we have to kind of watch that play out. I think we have to watch the deal volume sort of play out, see what that does to kind of fee income, but I would go back to Bryce's question. We're at the upper end of the range on the spillover, and that's available to support that $0.70 number we've been paying out.

Brian Gerson (Co-President)

Just to be clear and put a fine point on it, the $0.05 was the spillover that we were paying after five quarters, and the $0.06 was what reflected the higher rate environment that we've been operating in.

Casey Alexander (Analyst)

Right.

All right. All right. Great. Thank you for taking my questions.

Michael Forman (CEO and Chairman)

Thank you, Casey.

Operator (participant)

Your next question comes from John Hecht from Jefferies. Your line is now open.

John Hecht (Analyst)

Thanks very much for taking my questions. Actually, a couple just were asked. But I'm wondering, on the investment pipeline, I mean, Dan, it sounded like there's more activity, but maybe the kind of pipeline of activity growth isn't quite as much as you would have expected. I guess my question is, as you look into 2025, given the forward curve and some anticipated maybe deregulation, do you think that the M&A pipeline and the investment pipeline will grow over the course of the next few quarters, or is kind of where we are where we are?

Michael Forman (CEO and Chairman)

Yeah. Thanks, John. I think we do believe that it will grow, right? You have the continued fact out there that the holding period for a bunch of these deals that are sponsor-owned has been probably longer than intended. You do have, I think, a continued focus from LPs to get capital back out of these funds. So I think there is a certain amount of pressure to sell some of these companies. There's a lot of dry powder on the private equity side that's arguably getting kind of further down the road inside of fund life. So you have the capital there to be involved or acquire these companies. So I think that setup kind of remains. It probably has been, well, it's just called slower to start than I think we would have guessed maybe at the start of 2024.

I think we did have a view that to make the bid-ask kind of difference narrow, you needed kind of market participants to get their arms around inflation being under control, rates being, let's call it, more stable, and kind of the hard landing being removed from people's kind of minds. I think that all happened, but I think we have seen more and more people anticipating these rate reductions, so it has been kind of slower. Now, all that said, when I do look at the pipeline and I do look at activity of the deal teams, it's been the highest. It's been since the start of 2022, so I think that's positive, so I think we do expect that to play out as we get into 2025.

John Hecht (Analyst)

Okay. That's helpful context. And then maybe just from a credit outlook perspective, is there anything to talk about or maybe call out in terms of EBITDA or revenue trends within the portfolio at the company level?

Michael Forman (CEO and Chairman)

I think two things. I mean, number one, we've still seen revenue and EBITDA growth. I think that's positive. I would say that revenue and EBITDA growth has been slower than we would have seen maybe in the years prior. So I think we are kind of watching that. And I think all market participants would probably say this, but we are in an environment where rates have been such that most companies' interest coverage ratios are just tighter than we'd probably like it to be. So I think that does provide a backdrop if there is a challenge, if somebody does lose a customer, they had done a bad M&A deal or what it might be, these kind of issues bubble to the surface more because there's not a lot of room to maneuver. I think that obviously can change a little bit.

The one benefit of a falling rate environment is kind of more cash flow at these kind of companies. But I think in totality, it's generally been positive. I think some of the issues that we have seen either in the portfolio or in the market have been more idiosyncratic to the particular name than anything that's more widespread.

Brian Gerson (Co-President)

Yeah. And really, the couple of sectors that we've been seeing underperforming over the course of the year sort of continue to be anything that's sort of touching old retail, which we have very little exposure to. But consumer product companies are down because the retailers just are carrying much lower levels of inventory. People keep talking about de-stocking. I don't know how you de-stock for two years, but I think you're talking about just a lower inventory model. And then within industrial, there's certain pockets of weakness given, I think, this year there was more of a conservative outlook on capital spend in a lower rate environment. That should be positive.

John Hecht (Analyst)

Great. Thanks very much.

Michael Forman (CEO and Chairman)

Thanks, John.

Operator (participant)

Your next question comes from Mark Hughes from Truist. Your line is now open.

Mark Hughes (Analyst)

Yeah. Thanks. Good morning.

Michael Forman (CEO and Chairman)

Good morning.

Mark Hughes (Analyst)

The repricing activity you've seen portfolio companies looking for better terms. How has that trended over the last few months? Is that kind of a step function when you see the rates change, or is that just slow with day-to-day interest rates and spreads?

Michael Forman (CEO and Chairman)

I think it's probably maybe a little bit more nuanced than that, right? I mean, I think it's based upon what I would call new deal activity. So you have data points out there that someone can sort of comp to. I think companies can only really make those ask if they've had steady performance over a period of time. So the one, let's call it, positive thing of the repricings would be a high correlation to well-performing businesses. I think we would have a thesis, Mark, that as rates do fall, I think that will put a little bit of pressure on spreads to widen. I don't think that will be basis point for basis point in any scenario. But I think general kind of fixed income markets, as the benchmarks sort of change, there will be some impact on credit spreads.

Obviously, the benchmark moved almost 500 basis points, and you've seen some spread reduction since January 2022. So I think it is sort of case by case, but I think we would expect, as rates fall, a bit of movement wider on spreads.

Mark Hughes (Analyst)

Okay. And then have you seen any change in the trajectory on that activity in the recent months, or has it been reasonably steady?

Michael Forman (CEO and Chairman)

Yeah. I would say it's probably been a little bit slower, right, or at least kind of spreads have settled at a level. I think there's a level of where spreads are that on particular deals wouldn't make sense for pools of capital like this. So I think there's a little bit of a floor there. But I think you've seen, let's call it, a bit of slowdown or kind of finding kind of that sort of bottom point.

Mark Hughes (Analyst)

Yeah. And then just kind of you talked about passing on more deals based on the pricing issue. You're maintaining your discipline. When you think about kind of when you do pass credit versus competition, what's the usual dynamic there? And maybe you can't separate those because they're interrelated, but how significant is that? When you get into a little tighter market, how much harder is it to see the origination activity in your usual ratios?

Michael Forman (CEO and Chairman)

Yeah. I'll probably answer it a little bit differently, but tell me if it makes sense. I think we have, as I mentioned, been happy to see, let's call it, an uptick of activity. I think the larger lenders like us do benefit from these existing portfolios so you can maintain that incumbency position. We can pass on deals for a multitude of reasons. I mean, sometimes it's just the sector, the credit. We're not going to do it. Those deals probably don't even make it to a screening or an investment committee. It's more of a desk kill. There are deals we won't play in because of where it's priced versus where we think it should be priced. That said, I think our primary focus is on credit. And then there are structural pieces, right?

I mean, there are certain asks on certain deals that we think is a step too far for private debt or a liquid credit, and we've walked away from certain deals after having done a lot of work on it because we're just not comfortable with the structure.

Brian Gerson (Co-President)

Yeah. Look, and I think the other thing to note is that our leverage is currently in the middle of our target range. So there's no pressure to deploy. I mean, we do benefit, as Dan said, from those incumbency positions. And we meet when repricings occur with the right to credit, we maintain them.

Michael Forman (CEO and Chairman)

Yeah. And maybe one last point, Mark, because I think it is important. I think we're very focused on maintaining kind of that broad origination funnel, right? We've always talked about being active in the upper end of the middle market. We'd probably classify that as $50 million-$150 million of EBITDA. Obviously, when the syndicated loan markets were shut in 2022 and 2023, we had the opportunity to participate in some larger deals. I think those were kind of very, very good risk-reward. We are prepared to go down to a lower number than that $50 million. The floor is probably $25 million, but there's a very high bar for that. It would be an industry or a sector that we really like. We're probably lending to one of their competitors. So we've got a real view in it that it's going to grow.

But we do think it's important to have a broad kind of funnel there. We've got a very active non-sponsor business. We have people dedicated to that. We think that's helpful. We've been active in some of the ABL activity, let's call that receivables and inventory, right? We find those deals quite interesting from a risk-adjusted return perspective. And then our asset-based finance business remains active. We talked about Discover in our prepared remarks, but those deals are generally returning several hundred basis points wide of what we're seeing in direct lending. So I think that broad funnel is an advantage to us, and the ability to deploy across different companies, sponsor, non-sponsor, and things like asset-based finance is quite important.

Mark Hughes (Analyst)

Yeah. Yeah. Thanks for that perspective. Appreciate it.

Michael Forman (CEO and Chairman)

Have a good day.

Mark Hughes (Analyst)

Thank you.

Operator (participant)

Your next question comes from Kenneth Lee from RBC. Your line is now open.

Kenneth Lee (Analyst)

Hey, good morning. Thanks for taking my question. Just one follow-up on that last comment around the asset-based finance opportunities there. Wondering which benchmark rates are they typically keyed off, given that they're fixed rates, and it sounds like the spreads are pretty wide right now. Just any kind of additional color there around that? Thanks.

Michael Forman (CEO and Chairman)

Yeah. No, happy to give. It is a different, let's call it, return profile in a lot of ways than what you're seeing in direct lending. I think you could either have loan portfolios that you're buying, but the underlying loans themselves are fixed-rate. We're usually using the bank market or the capital markets to finance those loan portfolios so you can generate kind of that what I'll call fixed-rate return. Even though if it's floating-rate loans, if we are financing it, we'd be financing with floating-rate debts, you're effectively creating that more kind of stable or almost fixed-rate return profile. In that part of the market, I don't think we think about it entirely like spreads. You're acquiring these asset portfolios, thinking about making a kind of targeted return on it. That's generally in kind of the mid-teens type context.

We remain quite bullish on the market opportunity there. We think that market is approaching $7 trillion of market size. That doesn't mean everything's for us, but that does mean there's a lot of white space because there has not necessarily been a lot of scaled capital raised. We're fortunate to have 50 people dedicated to that space. There's some pretty good tailwinds there that we expect to continue to be quite active.

Kenneth Lee (Analyst)

Gotcha. Very helpful there. And just one follow-up on the comments around the PIK income and the earlier comments you made there. Just wanted to clarify, how much of the PIK income was originally underwritten as PIK versus electing? Thanks.

Michael Forman (CEO and Chairman)

Roughly half.

Kenneth Lee (Analyst)

Okay. Gotcha. That's all I had. Thanks again.

Michael Forman (CEO and Chairman)

Thank you.

Operator (participant)

Your next question comes from Melissa Wedel from JPMorgan. Your line is now open.

Melissa Wedel (Analyst)

Good morning. Thanks for taking my questions. Just to follow up on the theme of PIK, definitely take your points that those deals were structured to give some flexibility during perhaps a turnaround. I'm curious how PIK versus cash-paying income will impact sort of if it impacts and to what extent it impacts your fair value marks over time, particularly if you see in certain deals PIK persisting longer than you would have originally expected.

Michael Forman (CEO and Chairman)

Yeah. Good morning, Melissa. I would say, and Brian, you might want to add to this, it's probably going to be very much on a case-by-case basis. I think you could probably make a correlation that if a company is forced to PIK for an extended period of time, the company could be underperforming. But on the other side of that, you could have because these companies are in turnaround, kind of either the seeds being planted or some meaningful, let's call it, upside kind of on the revenue side. So I think you are independently valuing these businesses based upon what their financial performance is and all the other inputs that would go into the valuation model. So there's probably not kind of the perfect answer, but it's, and Brian, feel free to add to that.

Brian Gerson (Co-President)

Yeah. I mean, look, when you own a business, you're always making capital decisions and trying to figure out what dollars can be invested at the highest return on capital. So I mean, that sort of goes to the commentary of flexibility because we are very much focused on the long-term exit in all of these. And look, it's going to be performance-related in terms of and capital decision-making-related decisions as we go forward in terms of whether the companies continue to PIK or not.

Melissa Wedel (Analyst)

Okay. And then to your comments about rates likely to trend lower, but the initial thought is maybe they won't go as low or as quickly as we would have thought a few months ago. Does that impact how you're thinking about sort of credit trends across the industry broadly? We think if there's a slower pace of rate decline, that a natural trade-off on that would be a bit more distressed or default activity. Thanks.

Michael Forman (CEO and Chairman)

No, it's a fair question, and I think our thoughts on this are probably evolving as obviously there were some pretty big market moves in the last couple of days. I think we've always expected the Fed to be kind of disciplined as they bring down kind of rates. I think the Fed's done a nice job of getting inflation under control. I think there are certain things that could happen in this Republican administration that could be viewed as inflationary. That said, I think the big focus of the election was to make sure inflation's under control, so I think it'll be balanced there. I don't think that slower pace, though, Melissa, is kind of that long to have a real impact to kind of credit.

I just, if you were thinking that there was going to be three or four rate cuts in the next, let's call it, 12-18 months, maybe you're just kind of one slower than that or one less than that. But I think it'll be interesting to watch how that kind of plays out in the coming months and the coming quarters.

Brian Gerson (Co-President)

Yeah. Look, I'd add where it's less constructive is to the equity in these deals. Higher rates have extended the hold periods for companies as they've had less cash to pay down debt, which is how an LBO works. So to the extent rates stay higher, it could extend, but that's offset by the pressure that LPs are putting on GPs to sell assets and return capital. So there's certainly a balance there.

Melissa Wedel (Analyst)

Got it. Thank you.

Operator (participant)

That concludes our question-and-answer session. I'd now like to hand back over to Dan Pietrzak for a closing remark.

Dan Pietrzak (CIO and Co-President)

Thank you, everyone, for your time today. We're always available for any follow-up points as needed. We do wish everyone a great holiday season, and we'll talk with you next quarter. Thank you.

Operator (participant)

Thank you for attending today's call. You may now disconnect. Have a wonderful day.