FS Credit Opportunities Corp.

Good morning, and welcome to FS Credit Opportunity Corp's third quarter 2023 earnings conference call. Please note that FS Credit Opportunities Corp may be referred to as FSCO, 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 FSEO issued on October 24th, 2023. In addition, FSEO 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, 2023. A link to today's webcast and the presentation is available on the company's webpage at www.fsinvestments.com. Please note that this call is the property of FSTO. 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 FSTO. 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 FFCO'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. FFCO 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 evaluative tool, is not necessarily indicative of future results, the achievement of which cannot be assured. Investors should not view the past performance of FSEO or information about the market as indicative of FSEO's future results. Speaking on today's call will be Andrew Beckman, Head Portfolio Manager for FSEO, and Nick Helvet, Director of Research and Portfolio Manager for FSEO. Also joining us on the phone is James Beach, Chief Operating Officer of the Fund. Before turning it over to Andrew, I'd like to note that we will not be taking live Q&A during today's webinar. However, you can submit your questions using the Q&A function on the left side of your screen, and we will strive to answer as many questions as possible throughout the webinar and at the Q&A session at the end. In addition, I'd like to point out the resources that we have listed at the bottom of the screen, which you can access through the webinar. I will now turn the call over to Andrew.

Thank you, Robert, and thank you all for joining us today. We are pleased to report solid results for the third quarter as the fund returns 7.1%. driven by strong earnings as net investment income fully covered distributions of 17 cents per share, and NAV increased 30 cents per share quarter over quarter. We announced a 15 percent increase in the annualized distribution, effective with the July monthly payment, bringing the annualized distribution rate to approximately 9.9 percent today. This marks the second increase since the fund's common shares were listed on the New York Stock Exchange in November of last year. The largest contributor to performance during the quarter was appreciation in the fund's directly originated investment in New Giving, Inc., a healthcare and pharmaceuticals company. The company's revenue and EBITDA have grown significantly, driven by growing patient census and increased financial performance, as operational measures implemented last year continue to positively impact the business. In addition, the fund's directly originated investment in a midstream energy company operating in the Permian Basin was a meaningful contributor to performance during the quarter 2020. as the company generated strong earnings growth. These investments are good examples of our ability to identify situations where return premiums exist due to complexity of a company's balance sheet, the illiquidity of an asset, unconventional ownership, or as a result of corporate events. In both investments, this fund received equity ups as part of our debt investment. providing for the potential for meaningful capital appreciation. Beyond the largest contributors, positive performance was broad-based across the portfolio during the quarter, as contributors far outpaced detractors. We're pleased with the fund's NAV return of 18.3% year-to-date as of September 30, 2023, which outperformed high yield bonds by 839 basis points and loans by 1,233 basis points. As many participants are aware, we implemented a phased approach to listing FSTO's common shares through which one-third of common shares were available for trading in November of last year. An additional one-third of shares were made available for trading 90 days after the listing on February 13th, and the final one-third of shares were made available for trading on May 15th. The discount at which the stock has traded compared to the net asset value narrowed significantly during the quarter. We believe this is reflective of the fund's recent positive performance, broader market stability, and the reduced selling pressure on the stock now that all phases of the listing are complete. While the price to NAV discount has narrowed, we believe the current discount at which the stock is trading compared to the net asset value is still too large and not indicative of the health of the portfolio or the forward return potential of our investments. We believe FFCO offers a differentiated value proposition in the market for several key reasons. First, FFCO 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, mitigating risks, 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. As of September 30th, 2023, the split between public and private investments was 57% and 43% respectively. We tend to have a differentiated focus than traditional credit funds. We're not constrained by a specific asset class mandate. We can invest across loans, bonds, structured credit, or highly structured equity, and across fixed and floating rate assets. As previously noted, 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, a lack of publicly available information, and the niche-y nature of the potential asset or company. Our private investment portfolio includes highly bespoke investments originated through our firm-wide sourcing network, Our intensive due diligence process benefits from the sharing of collective insights on markets and individual credits. We believe our origination capabilities within the private market and focus on providing specialized financing solutions differentiates us from our closed-end fund peer group. The fund offers a highly attractive annualized distribution yield of approximately 9.9% based on NAV and approximately 12% based on stock price, which we believe is attractive on an absolute and relative basis compared to our peers. The distribution has been fully covered through net investment income since I joined FS, and the current investment team assumed management of the fund in January of 2018. Over that time, net investment income has represented an average of 117% of distributions paid to shareholders. The portfolio is weighted to senior secured debt with a focus on first lien debt, which has helped preserve capital over time. Senior secured debt represented 77% of the portfolio's fair value as of September 30th, 2023. Loading rate assets comprise approximately 54% of the portfolio as of September 30th. We're seeing the benefit of higher base rates pass through to shareholders as evidenced by our ability to increase the annualized distribution by a total of 34% through two distribution increases since December of last year. Finally, the fund uses a modest 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. I'll now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the quarter. Thanks, Andrew. Rising real yield negatively impacted core fixed income returns and other rate-sensitive assets during the third quarter of 2023. amid strong economic data and a clear Fed pivot toward a higher-for-longer rate environment. The U.S. Treasury curve steepened during the quarter, with two-year Treasury yields rising 17 basis points, while the 10-year yield spiked 75 basis points and ended the quarter at 4.59%, its highest level since August 2007. Demand for high yield bonds and senior secured loans continued to handily outpace new supply year to date. Senior secured loans returned 3.4% during the third quarter, benefiting from significant institutional demand from collateralized loan obligation managers, while high yield bonds returned 0.5% amid elevated rate and equity volatility and rising net outflows in September. Lower-rated securities outperformed, driven by a combination of improved economic sentiment and their lower duration profiles. While the technical backdrop supported high-yield bond and leveraged loan prices amid strong investor demand and limited supply, fundamentals deteriorated modestly, as evidenced by the uptick in defaults. The high-yield default rate, including distressed exchanges, increased to 2.6 percent at the end of October, while loan defaults and distressed exchanges increased to 3.08 percent as of the same period. This compares to default rates of 1.65 percent for each high-yield bonds and loans as of December 31st, 2022. We believe the current environment requires a deep, bottoms-up understanding of fundamental credit risks. In our experience, inflection points in a market cycle or periods of volatility often present attractive investment opportunities. As Andrew will discuss further, we are focused on businesses with strong cash flows, moderate leverage profiles, and management teams with deep operational experience managing through market cycles. Turning to investment activity during the third quarter, purchases totaled $203 million, compared to sales, exits, and repayments, approximately $172 million. Amid heightened market volatility, new investment activity focused on higher quality, first lien, senior secured debt across private and public credit, while sales and repayments were concentrated in select second lien and other junior debt and equity. Approximately 41% of new investment activity was in privately originated investments during the quarter and comprised entirely of first lien senior secured loans. Public credit investments, which represented approximately 43% of purchases during the quarter, were comprised of first lien loans and high yield bonds. increase in rates throughout the quarter provided opportunities to selectively invest in high-yield bonds, trading at meaningful discounts to par value, providing the fund with attractive current yields and the potential for upside appreciation. The remainder of the purchases during the quarter were comprised by opportunistic portfolio hedges. As of September 30, 2023, Approximately 77% of the portfolio consisted of senior secured debt unchanged from the previous quarter. The fund's allocation to subordinate debt was 7%, also unchanged from the previous quarter. Asset-backed finance represented 4% of the portfolio compared to 6% as of June 30, 2023, while equity and other investments accounted for 12% compared to 10%. as of the end of the second quarter. Public credit represented approximately 57% of the portfolio, while private credit comprised approximately 43% of the portfolio. The largest sector weightings at quarter end were healthcare equipment services, followed by consumer services and commercial and professional services. We believe these investments offer the potential to drive strong risk-adjusted returns and operate in areas of the economy that may be more insulated in the event of a broader economic slowdown. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge with 46% of drawn leverage comprised of preferred debt financings. which provide favorable regulatory treatment versus traditional term or revolving debt facilities. Approximately 46% of drawn leverage is multi-year, fixed-rate preferred debt and provides flexibility in the types of assets we can borrow against. On August 1st, the fund paid down $100 million of preferred debt maturing during the month. As a result, all of the fund's preferred debt matures in 2024 or beyond. At quarter end, the fund's cash balance was approximately $76 million. Despite a modest cash balance, we have ample availability in our credit facilities should a liquidity need arise. I'll now turn it back to Andrew to discuss our forward outlook. Thanks, Nick. Financial markets continue to wrestle with the forward path of the economy and geopolitical conflicts. A steady stream of strong growth data and the Fed's purposeful messaging away from rate cuts combined to fuel a bond market sell-off in September that gained speed in October. But that has since reversed itself. Despite the recent run in equity markets, we remain cautious about the economic outlook and see potential for future volatility. and therefore have been more cautious about making new investments than we would be in a more benign environment. We think being a bit extra cautious is prudent, not only to minimize potential drawdowns, but because such volatility often creates dislocations that can create attractive investment opportunities for the fund. We believe the strong index level returns this year mask strong underlying cross-currents in the public and private credit markets. Performance differences across ratings and asset classes could become more pronounced as economic conditions change. We believe active management combined with sound fundamental credit underwriting will be critical to driving returns and avoiding excess risk. We continue to focus on senior debt investments with strong terms at attractive yields or expected total returns and are generally avoiding debt in private equity-owned companies where we think there could be material risk on asset leakage or lender-on-lender violence. We're also cautious on credits where there are significant EBITDA add-backs that may never materialize and instead are focusing on companies with true free cash flow. We are invested in credit instruments with appropriate loan-to-values to ensure ultimate repayment of the obligations, even if the environment deteriorates or equity multiples compress. Our sector allocations are informed by bottoms-up fundamental research, and we tend to avoid highly cyclical areas of the economy unless the loan-to-value in those types of investments is particularly low. We've constructed the portfolio around these attributes and are confident in the position of the portfolio as well as the opportunity set. In our experience, the opportunities in private and public credit tend to ebb and flow and relative attractiveness can shift around meaningfully. Our goal is to dynamically allocate capital of the most attractive opportunities across the credit and business cycle, and we think this leads to enhanced stockholder returns relative to a more confined strategy. We believe the flexibility of our strategy and the expertise of our team have helped drive strong outperformance versus the loan and high-yield bond indices. From January 2018, through September 30, 2023, FFCO outperformed high-yield bonds by approximately 361 basis points per year and loans by 195 basis points per year. I should mention that those are gross returns for high-yield bonds and loans, and if one were to invest in those underlying instruments, they'd have to do so through some vehicle that would have some fees and further reduce those returns. We're proud of our performance on an absolute and risk-adjusted basis. 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 asset managers. Once again, thank you all for joining us today. And with that, we'll take a brief pause to review the queue before answering your questions.

Thanks, Andrew. Just as a reminder, you can submit your questions using the Q&A function on the left side of your screen. We'll just pause here. Okay, our first question is market-related. Can you talk about the current market environment today as far as pricing spreads on new opportunities, structure of deals, and how this has changed from the beginning of the year?

Sure. So if you were to focus on the public markets and just looked at kind of the loan market, you'll see spreads have come in a bit. So loan spreads are in about 65 basis points today. year to date and then on the flip side you know rates have kind of moved out so SOFR you know has moved out about 86 basis points so net net you know total yields are up a little bit you know a lot of that's driven by kind of risk free rates that's the public market the average kind of broadly syndicated loan On the private side, we have not seen spreads move to the same extent. I think spreads are more or less kind of unchanged on a year-to-date basis, and yields are higher because of the base rates. And I think what you're seeing on the private market is a pullback from financing counterparties in the middle market space, you know, predominantly banks, regional banks. So particularly for non-sponsored businesses, there's been a real pullback in regional banks providing capital and that's why the private market opportunity has stayed wide to the public opportunity.

Next question on opportunities for next year. What are your expectations for new deal flow and new opportunities heading into 2024?

We're optimistic about 2024. We continue to see a very strong pipeline on the private side, driven by what I mentioned before about regional banks really pulling out of the market and de-risking their balance sheets. And then on the public side, we've seen a little bit of a pickup in opportunity. as private equity firms can start to kind of underwrite, you know, the economic outlook a bit more with the Fed language kind of indicating, you know, a potential pause. So we're seeing M&A activity pick up a little bit, and that usually kind of feeds through to kind of public market volume. So overall, you know, we're excited about next year and have a very strong pipeline.

And the next question, what type of risks are you seeing the best and most attractive opportunities in terms of public versus private, specific sectors or industries? Any color would be helpful there.

So right now, the best opportunities that we're seeing on average are in privates. There are a few attributes that make privates kind of more attractive. You know, one, we think the market's a little bit more disciplined. This spread, as I mentioned earlier, you haven't seen the same spread compression that you've seen kind of in the public markets. Two, leverage levels and kind of loan-to-values, you know, we think are more conservative in the private stuff that we're looking at. three deal documents and kind of structure is a lot better. The private deals that we do just tend to really lock down the capital structure. Syndicated loans and bonds really still have quite a bit of kind of loopholes for borrowers to kind of take advantage of lenders. They've not been stamped out of kind of that market yet. So for all those reasons, spread downside protection through loan-to-values and structural protections, we find privates to be more attractive than publics right now. In terms of specific sectors or industries, we're focused on companies and sectors where you've seen a pullback of lending by commercial banks. We're also focused on defensive sectors where we can kind of underwrite kind of credits, even if we were to see a slowing of the economy or potentially even a recession.

Great. And you've talked a lot about your private investments and the attractive opportunities there. The allocation has increased over the past few quarters. Do you have a specific target allocation for private versus public investments?

So as mentioned right now, our private exposure is approximately 43% of the portfolio. We do not have a set target, but we do believe that there is room for kind of both, you know, privates and publics kind of in the portfolio. So, you know, you won't, you know, see either one of those buckets, you know, go away. We like to go where the opportunity set is. Right now, we view privates as more attractive. That was not the case in the back half of last year, where we saw publics more attractive. But right now, we view the private pipeline and the average private investment as kind of being more attractive than what we're seeing in the public market. So we could see that kind of increase in the near term or medium term.

Next question is a macro question. What future economic conditions would be the most concerning regarding the future performance of the fund?

You know, we run a balanced portfolio, which is deliberately positioned for potential margin degradation, which could arise from either inflation or a demand slowdown. You know, in addition, high rates are not a significant problem for the book. portfolios performed well this year despite the rising rate environment. You know, we achieved this by keeping our investments low loan to value and maintaining a relatively short duration portfolio. So we see ourselves as being defensively positioned for the obvious economic risks that may come to pass in 2024. Great.

Next question on net asset value. Can you provide some more color on the NAV move in the quarter? It seemed like a strong move higher this quarter.

Sure. So if you look at the top five contributors to NAV and those contributors represented roughly 40%, of the move in NAV. You have three private positions, two of which were mentioned in my comments, New Giving, as well as kind of the midstream energy business in the Permian. And then outside of that, we had an investment in a consumer products company, a private investment in a consumer products company that also had equity ups that performed strongly in the quarter. And then there were two investments in publicly traded instruments, one in a company called Aptum and another in a company called OneCall that were the other two strong movers in the quarter. Outside of that, it was really kind of broad-based uplift throughout the portfolio.

Next question. The stock has had a nice move higher in the past few months, but it continues to trade at a discount to its net asset value. Why do you think that is, and what are the plans to close the gap here?

So the stock has performed well over the last few months, and the discount has closed meaningfully, particularly if you look at the lows this year on a price to kind of NAV basis. We've moved quite a bit. What do we do from here? We're focused on the performance of the fund, investing in high-quality instruments, and continuing to perform well. And I believe, you know, showing the street that we have a high-quality portfolio that performs well and performing well compared to our peers will help us continue to shrink the discounts. Outside of performance, we're focused on our IR efforts and talking to analysts and investors to pitch the fund and make investors aware of the high-quality nature of the portfolio. And we're hopeful that our efforts all around will close the discount. We think our stock should trade much more in line with book value as well as the peer group.

Great. And then any plans for a share repurchase plan to help narrow the discount?

We continuously discuss everything with the board, all potential options, including repurchase programs. At this time, we do not have one in place, but it's something that we will continue to talk about as we monitor the fund's liquidity and investment options that exist.

Next question on the dividend. Can you just remind us of the dividend policy and the plan going forward?

Sure. So, you know, as I mentioned, we've increased the dividend two times since going public. The second increase happened in July. It was a 15% increase. And the So on one hand, we want to continue to kind of push that dividend up when we can. On the other hand, we are focused on distributing income and not overreaching, so having a fund that's kind of balanced and works well. So we continue to monitor the income of the portfolio, and as it increases, we'll push it through to investors. We're also watching rates, though, and the rate curve. Obviously, that's been a big benefit for funds like ours. But if you look to 2024, the rate curve starts to kind of move the other way. So we're evaluating everything.

Next question is on the right side of the balance sheet. Can you just talk about leverage and targets on the capital structure?

So in August of this year, we repaid $100 million of preferred that was coming due. We repaid it because we had excess liquidity. it is likely something that we will look to replace when market conditions are there and we think we could price something attractively. So I think, or I would point investors to our Q2 capital structure before that repayment, and I would say that that is a good benchmark for target leverage levels.

Great. Next question. While rising rates aren't an issue for your portfolio today, will sustained higher rates have an issue 12 months out from now, or do you believe companies will be able to sustain the higher rate environment?

So we stress every investment in our portfolio for a wide range. potential environments, including an environment with higher interest rates in the future. This portfolio has been deliberately high graded throughout the year. And for the most part, good businesses can raise prices in inflationary environments, you know, which can end up being a net benefit to the P&L if rates go up. So we think from a fundamental perspective, the book is very well positioned should interest rates rise over the next 12 months and don't see that as a material risk to the book.

Great. Looks like we've answered all the questions in the Q&A chat function here. And if we didn't answer your questions, you can feel free to reach out to the investor relations team. With that, this concludes today's call. Hope everyone has a great Thanksgiving and a happy holiday season, and we'll talk to you next quarter. Thanks.