FS Credit Opportunities Corp.

Good morning, and thank you all for joining us for FS Credit Opportunity Court's four-quarter and full-year 2023 Earnings Conference Call. Please note that FS Credit Opportunity Court 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 January 30, 2024. 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 December 31, 2023. A link to today's webcast and the presentation is available on the company's webpage at www.fsinvestments.com under the FS Credit Opportunities Court tab. 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 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 FSTO'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. FSTO 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 FSTO or information about the market as indicative of FSTO's future results. Speaking on today's call will be Andrew Beckman, Head of FS Global Credit and Portfolio Manager for FSTO, Nick Helvet, Director of Research of FS Global Credit and Portfolio Manager for FSTO, Also joining us on the phone is James Beach, Chief Operating Officer of the Fund. Following our prepared remarks, the team will take questions from the audience. If you'd like to ask a question, there is a chat function on the right side of your screen. We will try to address each of your questions after our prepared remarks. I will now turn the call over to Andrew.

Thank you, Robert, and good morning, everyone. Looking back on 2023, we are proud of the results we delivered for our shareholders across several key fronts. First, we delivered strong returns in 2023 as the fund returned 20.1% on a net basis, outperforming the high yield bond and senior secured loan indices by 667 basis points and 707 basis points respectively. This performance was strong on an absolute and relative basis as FSTO outperformed many of the larger credit-focused peers in the closed-end fund space. Net investment income fully covered distributions of $0.64 per share, and the fund's net asset value increased by $0.59 per share, or 9.3% year-over-year. We believe our performance reflects the dynamic nature of our strategy, investing across public and private credit with a focus on generating return premiums driven by the complexity of a company's balance sheet, the illiquidity of an asset, unconventional ownership, or corporate events. We increased the fund's annualized distribution by 15% in July, driven by rising market yields and the continued strong performance of our investment portfolio. This was the second increase in the annualized distribution since the fund's common shares listed on the New York Stock Exchange in November of 22. Finally, we completed all phases of FSTO's listing on May 15, 2023, and marked the one-year anniversary of the listing on the NYSE in November of last year. The discount at which the fund's common shares traded relative to its net asset value narrowed significantly during the year. We believe the improvement reflects the fund's strong performance, broader market strength, and reduced selling pressure on the stock after all the phases of the listing were completed. While we are pleased that FSTO shareholders earned a total return of nearly 35% for the year, We believe the current discount at which the stock is trading compared to NAV does not reflect the health of the portfolio or the high quality of our investment program. During the fourth quarter, funds paid monthly distributions totaling 17 cents per share, which were fully funded through net investment income, as has been the case since the FS Global Credit Team assumed management of FSEO in January of 2018. As of February 28, 2024, the fund annualized distribution yield was 9.8% based on NAV and approximately 12.17% based on the stock price. In terms of portfolio performance, contributors far outpaced detractors as positive performance was broad-based across the portfolio in 2023. The largest contributor performance during the fourth quarter and year resulted from unrealized appreciation in New Giving Inc., one of the fund's largest holdings, a directly originated investment in a healthcare services firm. The company produced strong revenue and earnings growth as operational measures implemented in 2022 continued to positively impact the business throughout 2023. This investment highlights our ability to source differentiated opportunities and creatively structure the investments. FSTO received common equity and warrants as part of our debt investment, which provides for the potential for meaningful additional capital appreciation, yet preserving the downside protection we like to see in our investments. Opportunistic equity hedges detracted from the fund's return during the year amid the strong environment for equities. I will now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the fourth quarter. Thanks, Andrew. Risk assets rallied during Treasury yields plunged during the quarter with two-year and 10-year yields falling approximately 80 basis points and 70 basis points respectively as investors firm their expectations for Fed rate cuts in the first half of 2024. Amid falling yields, the Bloomberg U.S. Aggregate Index returned 6.82% in the fourth quarter, a generally strong environment for longer-duration fixed-income assets. Positive investor sentiment and a supportive technical backdrop through high-yield bond spreads to their lowest point since January 2022, while loan spreads reached their lowest point since May 2022. High-yield bonds returned 7.1% during the quarter, outperforming senior secured loans, which returned 2.9%. Returns by credit rating were generally mixed during the quarter, with lower-rated credit, bad performance, The CCC bonds returned 20.4%, outpacing WB bonds by 892 basis points. CCC rated loans returned 17.5% compared to 10.2% for WB loans. Although the technical environment supported credit prices driven by strong investor demand and reduced supply, fundamental backdrop deteriorated modestly during the year as evidenced by uptick in default and lower recovery rates. The high-yield default rate, including distressed exchanges, increased to 2.88% as of December 31, 2023, while loan defaults in distressed exchanges rose to 3.08%. This compares to default rates of 1.65% for high-yield bonds and 1.59% for loans as of December 31, 2022. Meanwhile, recovery rates took a new board of the decline, hitting 38% for loans, a record low, and 33% for bonds, which was not a record low, but falls far below high-yield bonds' long-term average recovery rate of 40%. Turning to investment activity, the fund remained fully invested throughout the fourth quarter, driven by a healthy pipeline of new investments and relatively low levels of repayments. Excluding portfolio exits, and repayments of $173 million. Demand for high-yield bonds and senior secured loans burned amid improved investor sentiment while new issuance was limited by sluggish M&A environment. In today's competitive markets, we continue to leverage the insights and deal flow across FS Investments' $28 billion credit franchise while using our deep relationships with company management teams, financial sponsors, non-bank intermediaries, and other private credit managers to drive a steady pipeline of investments in public and private credit. Approximately 63% of new investment activity was in privately originated investments during the quarter, comprised entirely of first-line senior secured loans. Public credit investments, which represented 37% of purchases during the quarter, were comprised also in almost entirely by first lien loans, as well as high yield bonds. As of December 31st, 2023, approximately 81% of the portfolio consisted of secured debt, up from 77% the previous quarter. The funds allocation to subordinated debt was 5%, down from 7% in the previous quarter. Asset-based finance represented 4% of the portfolio, unchanged from the previous quarter. while equity and other investments represented 10% compared to 12% as of Q3 2020. Public credit represented approximately 53% of the portfolio, while private credit comprised approximately 47% as of the end of the year. Excluding asset-based finance investments, the largest sector ratings at quarter end were consumer services, followed by healthcare equipment and 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 43% of drawn leverage comprised of preferred debt financings that provide favorable regulatory treatment versus traditional term loans or revolving debt facilities. Approximately 43% of drawn leverage is multi-year fixed rate preferred debt and provides flexibility in the types of assets we can borrow against. As of December 31st, 2023, the fund's cash balance was approximately $106 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 analysis. Thanks, Nick. 2024 opened with optimism that an economic hard landing has been avoided. However, falling yet persistent inflation, tighter credit conditions, and an election cycle, and continued geopolitical conflicts are things to monitor for investors. Against this macro backdrop, we remain cautious about the economic outlook and continue to see potential for future periods of volatility. We believe the solid index level returns last year matched strong underlying cross-currents in the credit markets. Performance differences across ratings and asset classes and industries could become more pronounced in 2024 if economic growth slows. Recognizing potential for volatility in 2024, we've constructed the portfolio based on several key attributes. First, we believe active management combined with sound fundamental credit underwriting will remain critical to driving returns and avoiding excess risk in the year ahead. We're focused on businesses with strong cash flow, modest leverage profiles, and management teams with deep operational experience managing through market cycles. We are invested in credits with appropriate loan-to-values to ensure ultimate repayment of the obligations, even in a more pronounced economic slowdown. Our sector allocations are informed by our bottoms-up fundamental research, and we tend to avoid highly cyclical areas of the economy unless loan to values are particularly low. We have been more cautious about making new investments than we would be in an environment with a less controversial outlook. Therefore, we believe maintaining buying power is prudent, not only to minimize potential drawdowns, but also take advantage of attractive investment opportunities arising from periods of volatility. We continue to focus on senior debt investments with strong terms at attractive yields or expected total returns. We generally avoid debt in private equity-owned companies where we think there could be material risk of asset leakage or disputes between lenders. We are also cautious on credits where there are significant EBITDA airbags that may never materialize and instead focus on true free cash flow. We seek to identify situations where return premiums exist to the complexity of a company's balance sheet, the illiquidity of an asset, unconventional ownership, or as a result of corporate events. We are avoiding situations that are high return because of high loan values and low credit quality. Third, we will continue to leverage size and scale to drive differentiated outcomes for our investors. FSTO is one of the largest credit-focused closed-end funds in the market, with $2.1 billion in assets as of December 31, 2023. Size and scale matter in credit investing, especially when it comes to maximizing deal flow, mitigating risks, and achieving economies of scale. The portfolio management team also levers the full resources, infrastructure, and expertise of FS Investments, a $76 billion alternative asset manager. As Nick discussed, we believe our leverage structure provides FSEA with a unique advantage as a large percentage of our drawn leverage is multi-year fixed rate preferred debt and provides flexibility in the types of assets we can borrow against. Finally, our ability to invest across the public and private markets differentiates us from traditional credit funds and allows us to adjust our allocations based on where we believe the best risk-adjusted returns exist. 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 relative to a more confined strategy. Importantly, we are not constrained by a specific asset class mandate. We can invest across loans, bonds, and structured credit, and occasionally highly structured equity investments, as well as across fixed and floating rate assets. 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. In summary, we believe FSTO is a compelling long-term investment opportunity based on our well-positioned portfolio, low average duration, healthy distribution, diversified capital structure, and the flexibility of our strategy. We believe we have a fund and platform built to drive strong risk-adjusted returns through a diverse range of economic and financial market conditions. Since the current investment team assumed all portfolio management responsibilities in January of 2018, the fund on a net basis has outperformed the gross returns of ideal bonds by 260 basis points and the gross returns of levered loans by 171 basis points. The team has invested more than $7 billion over the last six years in non-traditional areas of the credit markets, including opportunistic and event-driven credit, dislocated special situations, and private structured capital solutions. Once again, I'd like to thank you all for joining us today. And with that, we'll take a brief pause to review the queue for answering your questions.

Again, if you'd like to ask a question, please use the chat function under Q&A on the right side of your screen to type in your question. And the first question, can you talk about the current market environment today as far as pricing on new opportunities, structure of deals, and how has that changed over the last few quarters?