Better Investment Grade High Yield Buy: Main Street Or FS KKR? (NYSE:FSK)

Both FS KKR (NYSE:FSK) and Main Street Capital (NYSE:MAIN) are high-yield business development companies (i.e., BDCs) with investment grade balance sheets. MAIN is internally managed and has an impressive track record that enables it to stand on its own merits as a proven long-term wealth compounding machine:

Externally managed FSK, meanwhile, has a poor long-term track record but was fairly recently acquired by alternative asset managing giant KKR (KKR) and underwent a significant merger, which has dramatically improved its underwriting and bottom-line performance. While its performance this past year has been far from stellar, as FSK’s old loans continue to roll off and its KKR-underwritten loans make up an increasingly large percentage of the investment portfolio, the BDC has managed to outperform both the broader BDC sector (BIZD) as well as the S&P 500 (SPY):

In this article, we will compare them side by side and offer our take on which one is a better buy at the moment.

Main Street Capital Vs. FS KKR – Balance Sheet

Both MAIN and FSK have some of the stronger balance sheets in the BDC sector, enjoying investment grade credit ratings and plenty of access to capital at reasonable cost.

MAIN’s leverage ratio is on the low end of the spectrum at 1.0x, which makes sense given that it has above average exposure to equities in its investment portfolio. MAIN’s balance sheet also has sufficient liquidity of $420 million (8.7% of its enterprise value).

FSK’s balance sheet is even more flexible with total liquidity of approximately $2.75 billion (19.9% of its enterprise value) and a pretty average net debt to equity ratio for the industry of 1.19x.

Overall, we put this at a draw given that MAIN has a significantly lower leverage ratio while FSK has more than twice as much relative liquidity.

Main Street Capital Vs. FS KKR – Business Models

While MAIN and FSK are both BDCs that mostly invest in a combination of middle market company debt, equity, preferred equity, and joint ventures, there are two main differences between them:

1. MAIN is internally managed and FSK is externally managed. What this means is that, generally speaking, MAIN’s management is likely a little better aligned with shareholders and also shareholders pay less in management fees than FSK shareholders do. While FSK previously had waived some of its management fees to lighten the burden on shareholders, beginning in Q1 2023 the full incentive fee to the manager will be reinstated. This is expected to result in a ~$0.21 per share – or ~0.8% of NAV – annualized headwind for shareholders, which could result in a substantial hit to the supplemental dividend.
2. The other main difference here is that MAIN has a generally more aggressive profile with greater equity investment exposure and an asset management business of its own. In contrast, FSK has more exposure to debt investments. This means that MAIN is a bit more sensitive to economic conditions than FSK is, though it does offset this to some degree with its lower leverage ratio. This also helps to explain MAIN’s massive outperformance over time given that the vast majority of its history has been during periods of economic expansion and easy money.

Both businesses have had decent underwriting performance of late. MAIN’s non-accrual rate is currently 0.8% of total portfolio fair value whereas FSK’s non-accruals totaled 2.5% on a fair value basis, down 40 basis points sequentially. On a cost basis, MAIN’s nonaccruals were at 3.7% and FSK’s were at 4.9%. Most importantly for FSK’s forward outlook is that none of its nonaccruals were due to assets originated by the FS/KKR Advisor since April 2018. This implies that its non-accrual rate should continue to decline moving forward as it underwrites new loans and its legacy loans continue to roll off of the balance sheet.

Main Street Capital Vs. FS KKR – Dividend Outlook

Both businesses are experiencing solid earnings per share growth thanks in large part to rising interest rates on their floating rate loan investments, which in turn is giving them the ability to raise their dividend payouts via a combination of growing their base dividends and increasing supplemental payouts.

Analysts expect MAIN to generate a 3.3% dividend per share CAGR supported by a 5.7% CAGR in earnings per share through 2024.

Meanwhile, with a recession looming, interest rates likely to peak next year, and FSK seeing a restoration of previously waived management fees beginning next quarter, FSK is expected to suffer cuts to its supplemental dividend over the next two years, leading to a negative 3.4% CAGR on its total dividend payout through 2024. On top of that, its normalized earnings per share are expected to be pretty flat, ultimately declining at a 0.8% CAGR over that time span.

In the meantime, however, both companies are enjoying the aforementioned strong tailwinds from rising interest rates.

For example, MAIN’s management recently said of its increased dividend and special dividend:

We are pleased to be able to deliver this significant additional value to our shareholders. We currently expect to recommend that our Board declare future supplemental dividends to the extent DNII significantly exceeds monthly dividends paid in future quarters and we maintain a stable to positive net asset value. Based upon our current expectations for continued favorable performance in the fourth quarter, we currently anticipate proposing an additional supplemental dividend in the first quarter of 2023.

On its latest earnings call, FSK’s management announced:

The recent increases in interest rates have positively impacted our net investment income. And as Brian mentioned, we are well positioned to continue to benefit from the Fed’s most recent action as 89% of our debt investments or floating rate. From a starting point of September 30, a 100-basis point move and higher and short-term rates ultimately will increase our net investment income by approximately $0.25 per share per year, which equates to approximately $0.06 per share per quarter.

MAIN has a significantly superior short-to-medium term outlook for its dividend given that its payout is much lower than FSK’s and its track record is more respected. Furthermore, it is able to continue issuing equity at a significant premium to NAV to continue growing earnings per share whereas FSK is not able to do so given its steep discount to NAV, so this gives MAIN a clear edge in driving more consistent earnings per share and dividend per share growth. That said, FSK’s current dividend yield and earnings per share yield are roughly twice that of MAIN’s, so it has a huge head start here and investors can simply reinvest surplus dividends to achieve even better dividend growth relative to MAIN.

Main Street Capital Vs. FS KKR – Valuation

Based on the numbers below, FSK is way cheaper than MAIN is. Its dividend yield is nearly double MAIN’s, its price to earnings ratio is 58% that of MAIN’s and its price to NAV ratio is less than half (49%) that of MAIN’s. As a result, investors literally get more than twice as much BDC for their money with an investment in FSK than they do with an investment in MAIN:

Valuation Metric	MAIN	FSK
Price to NTM Normalized Earnings	10.22x	5.90x
NTM Dividend Yield	7.3%	14.4%
P/NAV	1.42x	0.69x

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Investor Takeaway

As you might expect, this comes down to a comparison between quality and value. MAIN has a very impressive long-term track record, a well-aligned internalized management team that owns a meaningful percentage of the company’s common equity, and a more efficient operating model. On top of that, its dividend is paid out monthly and has a more stable growth profile than FSK offers. MAIN also has a significantly lower leverage ratio and non-accrual rate.

That said, FSK’s structuring and underwriting performance have been improving significantly in recent years thanks to its new world-class manager and recently executed merger. The company has been slowly repurchasing its heavily discounted shares while replacing underperforming legacy investments with much better newly underwritten ones. Its balance sheet is solid with plenty of liquidity and shares are deeply undervalued. Overall, we actually believe that FSK offers the most attractive risk-reward for investors with a more aggressive profile given its incredibly cheap valuation despite its solid constitution and performance.

We rate MAIN a Hold and FSK a Strong Buy at the moment and hold it as our largest single BDC among several in our Core Portfolio: