FS Credit Opportunities Corp.

Good morning and welcome to FS Credit Opportunity Corp's first quarter 2023 earnings conference call. Please note that this conference is being recorded. If you would like to ask a question throughout today's conference, please type your question in the ask a question box and click send. At this time, Robert Pond, Heads Investor Relations, will proceed with the introduction. Mr. Pond, you may begin.

Thank you. Good morning and welcome to FS Credit Opportunities Corp's first quarter 2023 conference call. Please note that FS Credit Opportunities Corp may be referred to as FSTO, 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 FSTO issued on May 3rd, 2023. In addition, FSTO has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended March 31st, 2023. A link to today's webcast and the presentation is available on the company's webpage at www.fsinvestments.com under the investor relations tab. Please note that this call is the property of FFCO. Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today's conference call includes forward-looking statements with regard to future events, performance, or operations of FFCO. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements. We ask that you refer to FSEO's most recent filings with the SEC for important factors and risks that could cause actual results or outcomes to differ from these statements. FSEO does not undertake to update its forward-looking statements unless required to do so by law. Additionally, information related to past performance, while helpful as an evaluation tool, is not necessarily indicative of future results, the achievement of which cannot be assured. Investors should not view the past performance of FSTO or information about the market as indicative of FSTO's future results. In addition, this call will include certain financial measures that have not been prepared in accordance with generally accepted accounting principles in the U.S. or GAAP. FSEO uses these non-GAAP financial measures internally in analyzing financial results and believes that the use of these non-GAAP financial measures is useful to investors as an additional tool to evaluate ongoing results and trends and in comparing FSEO's financial results with other closed-end funds. For such non-GAAP measures, reconciliation with the most directly comparable GAAP measures can be found in FSTO's form N-CSR that was filed with the SEC on March 1, 2023. 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 measures may not be the same as similarly named measures reported by other companies. Speaking on today's call will be Andrew Beckman, Head of Liquid Credit and Special Situations at FS Investments and Portfolio Manager for FSEO, and Nick Helbit, Director of Research for the Liquid Credit and Special Situations Team and Portfolio Manager for FSEO. Also joining us on the phone is Jason Zeleznik, Chief Operating Officer of FSEO. I will now turn the call over to Andrew.

Thank you, Robert, and thank you all for joining us today. We are pleased to be with you following our first full quarter as a publicly traded company. FSTO's listing on the New York Stock Exchange last November was a significant milestone for the fund and our stockholders. Next week will mark yet another important milestone as we approach the final stage and completion of the phased listing. As many participants on the call are aware, we implemented a phased approach to listing FSTO's common shares by gradually increasing the supply of shares available for trading in the market. Under the phased approach, one-third of common shares were available for trading last November. An additional one-third of shares were made available for trading 90 days after the listing on February 13, 2023. And the final one-third of shares will be available for trading next week on May 15th. In our view, the discount at which the stock is trading compared to the net asset value is driven by near-term selling pressure following the listing and is not indicative of the health of the portfolio or the forward return potential of our diversified credit strategy. In fact, the fund's net asset value has increased by approximately 20 basis points during the quarter after accounting for distributions paid during the quarter. We believe FSTO offers a differentiated value proposition for several key reasons. First, FSTO is one of the largest credit-focused closed-end funds in the market. Size and scale matter in credit investing, especially when it comes to maximizing deal flow and achieving economies of scale. Our dynamic strategy provides the flexibility to invest across public and private credit based on what we believe are the best risk-adjusted return opportunities. The mix of public and private assets was approximately 60-40 as of quarter end. We believe our origination capabilities within the private markets and focus on providing specialized financing solutions differentiates the fund from other closed-end funds and the BDCs in the market. The fund offers an attractive annualized distribution yield of 9.2% based on NAV and a current yield of close to 14% based on stock price. It's important to note that the distribution has been fully covered through net investment income since the management of FSTO was brought in-house at FS in January of 2018. Over that time, net investment income has represented 119% of distributions paid to shareholders. The portfolio is weighted to senior secured debt with a focus on first lien debt, which has helped us preserve capital over time. Senior secured debt represented 82% of the portfolio's fair value as of March 31, 2023. Floating rate assets comprise approximately 62% of the portfolio as of March 31, 2023, which contributes to the fund's low average duration profile of just under one year. Finally, the fund uses a prudent level of leverage to help enhance shareholder returns. Our diversified capital structure provides us with flexibility to invest across asset types and maturities through a mix of revolving, term loan, and preferred financings. Since many participants joining us today are new to our company and our story, we thought it would be helpful to reintroduce the portfolio management team and reiterate our investment strategy. We will then discuss the fund's quarterly results before concluding with some perspective on FSTO's outlook. To begin, FS Credit Opportunities is an affiliate of FS Investments, a $35 billion alternative asset manager headquartered in Philadelphia, with offices throughout the U.S., including New York, which is where the FSTO investment team is located. I joined FS in late 2017 to build out the firm's liquid credit and special situations team and manage FSTO. Our team is comprised of 11 dedicated investment professionals with deep expertise in investing in syndicated and private credit, as well as structured products. There is a high degree of continuity across our team with many of us, including Nick and I, working together since our time at Goldman Sachs in the early 2000s. Scott Giordina, our head trader, has been with us since our time at Magnetar and DW Partners. With an average of 16 years experience, the team has invested across multiple credit cycles, and we draw upon this expertise to source, analyze, and structure a broad universe of investment opportunities. A large part of the investment team's DNA is investing in stressed and dislocated markets. While we have a significant amount of distressed experience, distressed investing is not a core focus for FSTO, but we believe our experience and expertise is well-suited to assess opportunities and downside risks in today's volatile market. As we think about FSTO's differentiated value proposition, The fund is one of the largest credit-focused closed-end funds in the market with over $2 billion in total assets, with access to the infrastructure, relationships, and resources of FS Investments. This allows us to streamline operations, reduce costs, and enhance deal flow and idea generation. For example, the FS Capital Markets team helps source, negotiate, and structure financing facilities across the entire FS platform, representing over $25 billion in financings. The firm's relationships span across bulge bracket and regional banks, as well as insurance companies. FS Investment's strong presence in debt and equity capital markets helps drive down borrowing costs and provides FSEO with a broad range of financing options. Our reach and scale also helps us source deal flow through these same relationships. Our team can extract significant economies of scale across the legal, finance, compliance, and operations teams supporting FSEO and the infirm's entire platform of 1940 Act funds. While we do not compete for deal flow with the FSBDC franchise, from time to time it may serve as a source of deal flow for credit profiles that do not fit the more traditional BDC private credit mandates. Most importantly, we benefit from the sharing of collective insights on markets and individual credits and idea generation that comes with managing over $24 billion of credit as a firm. We believe our investment strategy is dynamic and flexible as we tend to have a differentiated focus than traditional credit funds. We are not constrained by a specific asset class mandate. We can invest across loans, bonds, structured credit, or highly structured equity investments, and across fixed and floating rate assets. We look for situations where return premiums exist due to complexity, illiquidity, or as a result of corporate events. These opportunities often require significant expertise and resources to source and analyze due to the complexity of company balance sheets, a lack of publicly available information, or the illiquidity of an asset. In private credit, our focus is on financings to unconventional credit profiles outside the focus of banks, traditional BDCs, and other conventional lenders. Examples include transitional lending, lending to out-of-favor industries and companies, and non-sponsored lending. Within public credit, our focus is on event-driven and opportunistic performing credit, as opposed to highly liquid credits commonly found in high-yield funds and CLOs. In our experience, the opportunities in private and public credit tend to ebb and flow, and relative attractiveness can shift meaningfully. Our goal is to dynamically allocate capital to the most attractive opportunities across the credit and business cycle, and we think this leads to enhanced stockholder returns as well as better downside protection to a more confined strategy. We believe the flexibility of our strategy and ability to leverage the broader expertise and infrastructure of FS investments provides us with a competitive advantage in today's market. I'll now turn the call over to Nick to provide thoughts on the markets and discuss our results for the first quarter. Nick? Thanks, Andrew. Macro uncertainties intensified during the quarter, driven by the largest bank failure since the great financial crisis, which led to rapid repricing of Fed rate expectations. Despite intra-quarter volatility, loan spreads widened just 15 basis points quarter over quarter, while high yield spreads tightened to over 30. Lower-rated credit outperformed in the first quarter. Triple C bonds returned 4.8%, outperforming double B-rated bonds by 147 basis points. The divide in performance was more pronounced in the loan market as CCC-rated loans outperformed BB loans by 180 basis points, with CCCs returning 3.9% and BBs 2.1% during the quarter. Despite stress within the regional bank sector and a more cautious outlook among consumers and businesses, the U.S. economy remains on generally strong footing with equity markets pricing in a soft landing. Looking broadly across the bond and loan markets, leverage and interest coverage metrics are holding steady, yet margin pressure is evident and default rates have ticked up from historically low levels. These metrics are inherently backward-looking, and the creditworthiness of borrowers will be dictated by future performance, which is difficult to predict in uncertain economic environments such as today. As the economic environment evolves, swings in investor sentiment can change quickly, creating market volatility. We remain cautious about the economic outlook and see potential for future volatility and therefore are less invested than where we would be in a more benign environment. We think maintaining extra buying power is prudent, not only to minimize potential drawdowns, but such volatility often creates dislocations that can create attractive investment opportunities for the fund going forward. Turning to the portfolio, Net investment activity was nearly flat during the quarter, with sales, exits, and repayments slightly outpacing purchases. Given the volatility in the broader markets, we selectively rotated out of unsecured debt positions into senior secured debt investments with the capital structures of a few portfolio companies. First lien debt investments represented 72% of purchases during the first quarter. while 87% of all investments during the quarter were in senior secured debt. We continue to expect inflation to remain elevated and believe that higher interest rate environment will last longer than some market observers are expecting. The rapid rise in base rates over the past year has enhanced the portfolio yield, and we are seeing the benefit of elevated rates pass through to investors as we increase the distribution by approximately 16% in December of last year. Loading rate assets comprise 62% of the portfolio's fair value as of March 31st, 2023. We believe the combination of high current income and low average duration should prove to be an attractive income stream for many investors. Especially during uncertain market environments, our ability to invest across public and private markets allows us to adjust allocations as economic and credit conditions change. Private market volume has slowed alongside a decline in M&A activity as issuers and lenders adjust to an environment of higher rates and falling yet still elevated inflation. Pricing and terms in the public markets have been quicker to respond to changing investor sentiment compared to the private markets, and we believe some of the most compelling investment opportunities generally skew to the public markets today. Given the potential for additional market volatility in the coming months, we continue to prefer senior debt investments with strong documents sourced at attractive discounts and tend to avoid companies that will recent LBOs because they're often subject to lender versus lender battles for control and tend to be underwritten to aggressive terms with large EBITDA at-backs that may or may not materialize. We believe we are invested in high-quality companies with strong fundamentals. Our sector allocations are informed by our bottom-up fundamental research, and we tend to avoid highly cyclical areas of the economy. We are also invested in credit instruments with appropriate loan-to-values to ensure ultimate repayment of the obligations, even if the environment continues to deteriorate. We've constructed the portfolio around these attributes and are confident in the position of the portfolio as well as the opportunity set. We believe the flexibility of our strategy and the expertise of our team have driven strong outperformance versus the loan and high-yield bond indices. From January 2018 through March 2023, FSEO outperformed high-yield bonds by approximately 100 basis points per year and loans by 65 basis points per year. Performance has been strong on an absolute and risk-adjusted basis as demonstrated by our higher Sharpe ratio compared to the liquid credit benchmarks. Turning to FSTO's performance during the quarter, the fund generated net investment income of 18.4 cents per share, driven by the positive impact of rising interest rates and the continued strong performance of the portfolio. Consistent with our distribution policy of delivering a fully funded annualized distribution, the fund's net investment income exceeded the distribution of approximately 15 cents per share paid during the quarter. As a result, the fund's net asset value increased by approximately 20 basis points quarter over quarter after taking into consideration distributions paid. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive advantage. It's important to note that the preferred financings are multi-year with the majority of the maturities in 2025 and beyond. Although in the near term, the fund does have $100 million of preferred financings maturing in 2023, we are confident in our ability to address these maturities and optimize our capital structure. Approximately 52% of drawn leverage is fixed rate and provides us with flexibility in the type of assets that we can borrow against. Finally, the preferred financings provide favorable regulatory treatment versus traditional term or revolving debt facilities. As of March 31st, 2023, the fund had approximately $265 million in undrawn debt plus ample cash on hand, which provides us with significant dry powder to deploy in the event that spreads widen further or idiosyncratic opportunities arise driven by short-term market dislocations, asset mispricings, or other special situations. I'll now turn the call back to Andrew. Thanks, Nick. Before I begin taking questions, we have one housekeeping note. We expect to reinstate the amended and restated distribution reinvestment plan on May 16th following the listing of the third tranche of shares on the NYSE on May 15th. Once the distribution reinvestment plan is reinstated, registered shareholders who elect to receive cash prior to the listing and still hold their shares with the funds transfer agent will continue to receive cash distributions. In summary, based on our well-positioned portfolio, low average duration, healthy distribution, diversified capital structure, and the flexibility of our strategy, we believe FSEO is a compelling long-term investment opportunity. We will continue to be highly proactive in our efforts to broaden the investor base for FSEO shares in the public markets with sell-side research analysts, mutual fund managers, private wealth managers, and other private credit and closed-end fund-focused managers. Once again, thank you all for joining us today. With that, we will take a brief pause to review the queue for answering your questions.