FS Credit Opportunities Corp.

Good morning and thank you all for joining us for FS Credit Opportunity Corp's first quarter 2024 earnings 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 April 22nd, 2024. 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 March 31st, 2024. 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 FSCO. 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 FSCO. 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 FSEO or information about the market as indicative of FSEO's future results. Speaking on today's call is Andrew Beckman, head of FS Global Credit and portfolio manager for FSEO, and Nick Helbit, Director of Research of FS Global Credit and Portfolio Manager for FSBO. Also joining us on the phone is James Beach, Chief Operating Officer of the Fund. Following our prepared remarks, we will take questions from the audience. If you'd like to submit your question, please use the Q&A function on the right side of your screen, and we will strive to answer as many questions as possible. In addition, I'd like to point out the resources that we have listed at the bottom of the screen, which you can access throughout the call, including a link to the earnings presentation. I will now turn the call over to Andrew.

Thank you, Robert, and good morning, everyone. We are proud of the results we delivered for our shareholders during the first quarter of 2024 across several key fronts. First, the fund delivered a net return of 5.8% based on NAV and outperformed the high yield bond and senior secured loan indices by 429 basis points and 338 basis points respectively during the quarter. This performance was strong on an absolute and relative basis as FFCO outperformed many of the larger credit focused peers in the closed end fund space. As has been the case since the FS Global Credit team assumed management of FSEO in January of 2018, net investment income fully covered distributions paid during the quarter. 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. Next, we are pleased to continue to reward shareholders by increasing the fund's monthly distribution to $0.06 per share in connection with the March distribution, which represented a 5% increase over the February distribution. The increase was driven by the continued strong performance of our investment portfolio. This was the third increase in the distribution since the fund's common shares listed on the New York Stock Exchange in November of 2022. The fund paid a total of 17 cents per share of distributions in the first quarter. As of May 16, 2024, the fund's annualized distribution yield was 10.12% based on NAV, and approximately 11.71 percent based on the stock price. Finally, the discount at which the fund's common shares traded relative to its net asset value narrowed significantly in 2023, and that trend has continued into the start of 2024. We believe the improvement reflects the fund's continued strong performance, the increase in the annualized distribution in March, and the broader strength in the credit markets. While we are pleased that FSEO shareholders earned a total return of 7.8% in the first quarter of 2024, we believe the current discount at which the stock is trading compared to the NAV still does not reflect the health of the portfolio or the high quality of our investment program. Turning to the fund's performance, The fund's net asset value increased by 22 cents per share. Portfolio performance was broad-based during the quarter. The largest individual contributor was New Giving, a directly originated investment in a healthcare company. This investment highlights our ability to source off-the-run opportunities and creatively structure investments. FFCO received common equity and warrants as part of our debt investment, which provides the potential for meaningful additional capital appreciation. This was a non-sponsor transaction that we sourced through our proprietary network. I'll now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the first quarter. Thanks, Andrew. The start of 2024 has seen a continuation of the positive investor sentiment that ended 2023. Resilient corporate earnings, a positive growth outlook, and a healthy labor market have underpinned valuations, even as markets have needed to absorb a higher resting heart rate for interest rates and inflation. Treasury yields rose during the quarter as the 10-year yield increased 33 basis points to 4.2%. While the policy-sensitive two-year yield increased 37 basis points to 4.62% as investors reduced their expectations for the number of rate cuts the Federal Reserve would enact in 2024. Spreads on high-yield bonds and senior secured loans tightened to their lowest levels since April 2022. Senior secured loans returned 2.38% during the quarter, benefiting from the elevated rate environment as investors delayed their expectations for Fed rate cuts, while high-yield bonds returned 1.47%. Lower-rated securities again led returns during the first quarter, in line with the performance trend throughout 2023. CCC loans returned 5.17%, outpacing BB loans by 317 basis points. while CCC-rated bonds outpaced BB bonds by 211 basis points. Following two consecutive years of leveraged credit market shrinking, high-yield bond and loan issuance surged in the first quarter compared to recent quarters. As of March 31st, year-to-date loan issuance represents 86% of the total volumes in 2023, while high-yield issuance stands at 65%. Notably, repricings comprised 48% of gross loan issuance, a post-GFC high. Fundamentals remain generally firm in the high-yield market, where strong economic growth has supported revenue and EBITDA, the latter of which grew 4.6% year-over-year as of the end of 2023. Leverage remains low and coverage strong versus long-term averages. Default rates are in line with the 25-year averages for high-yielding loans. While we don't expect these levels to rise materially through year-end, the high-yield default rate may be more subdued given healthier fundamentals. Double Bs comprise 46% of the index and triple Cs just 13% compared to long-term averages of 40 and 18, respectively. Conversely, approximately 29% of the loan market is rated B- or lower. an all-time high that we believe deserves attention in an environment where recovery rates have persistently declined. Turning to investment activity, the fund remained fully invested throughout the first quarter. Purchases, excluding portfolio hedges, totaled approximately $155 million, compared to sales, exits, and repayments of $122 million. Credit markets remained competitive during the quarter. Especially in these times, we continue to leverage the insights and deal flow across F Investments' $79 billion asset management program platform and use our deep relationships with commercial and investment banks, non-bank intermediaries, sponsors, industry specialists, and other like-minded investment firms to drive a steady pipeline of investments in public and private credit. Approximately 75% of new investment activity was in privately originated investments, and nearly all purchases were in first lien secured loans. Public credit investments across first lien and senior unsecured bonds represented approximately 25% purchases throughout the quarter. As of March 31st, approximately 81% of the portfolio consisted of senior secured debt, unchanged from the previous quarter. Funds allocation to subordinated debt was 5%, also unchanged. Asset-based finance represented 4%, while equity and other investments represented 10%. Public credit represented approximately 43% of the portfolio, while private credit comprised approximately 47%. Excluding asset-based finance investments, the largest sector weightings 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 broad economic slowdown. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge, with 42% of drawn leverage comprised of preferred debt financings provide favorable regulatory treatment versus traditional term or revolving debt facilities and flexibility in the types of assets we can borrow against. Approximately 42% of drawn leverage was multi-year fixed rate preferred debt as of March 31st. On May 16th, the fund issued $100 million of term preferred shares due in May 2029 at 205 basis points over Treasury's. Preferred financing provides the fund with additional purchasing power at favorable pricing. As of March 31st, the fund's cash balance was approximately $92 million, and we have ample availability in our credit facilities. I'll now turn it back to Andrew to discuss our forward outlook. Thanks, Nick. The momentum carrying the economy through the most aggressive rate hike cycle in decades continued in the first quarter, supporting the performance of risk assets. Against this backdrop, however, challenges linger. Inflation is persistently above the Fed's 2% target. Regional conflicts continue and geopolitical risks remain elevated. Recognizing the uncertainty, 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 losses in the year ahead. We're focused on businesses with strong cash flows, modest leverage profiles, and management teams with deep operational experience managing through market cycles. We're invested in credits with appropriate loan-to-values to ensure ultimate repayment of the obligations to the extent we were to see an 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 LTVs are particularly low. Credit spreads are tight, and covenants in the broadly syndicated loan market are weak. This coupled with uncertainty over inflation, rates, and the durability of the economy are causing us to be a bit more cautious now about making new investments than we would be in other environments. Therefore, we are maintaining some extra buying power to minimize potential drawdowns but also take advantage of investment opportunities should a period of volatility arise. We continue to focus on senior debt investments with strong terms and attractive yields or expected total returns. We generally avoid debt in private equity-owned companies where we think there could be a material risk of leakage due to covenants or disputes with lenders. We are also cautious on credits where there are significant EBITDA add-backs that may never materialize and instead are focusing on free cash flow. We seek to identify situations where return premiums exist due to the complexity of a company's balance sheet, the illiquidity of an asset, unconventional ownership, or as a result of corporate events. Third, we will continue to leverage size and scale to drive differentiated outcomes for our investors. FFCO is one of the largest credit-focused end funds in the market, with $2.15 billion in assets as of March 31, 2024. Size and scale matter in credit investing, especially when it comes to maximizing deal flow. The portfolio management team also leverages the full resources, infrastructure, and expertise of FS Investments, $76 billion alternative asset manager. As Nick discussed, we believe our leverage structure provides FSEO 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 public and private markets differentiates us from traditional credit closed-end funds and allows us to adjust allocations based on where we believe the best risk-adjusted return opportunities lie. 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 specific asset class mandate. We can invest across loans, bonds, structured credit, and highly structured equity investments, and across fixed and floating rate assets. Our private investment portfolio includes highly bespoke investments originated through our team and 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 return for a diverse range of economic and financial markets. Since the investment team assumed portfolio management responsibilities in January of 2018, the fund on a net basis has outperformed the gross returns of high-yield bonds by 319 basis points and loans by 212 basis points. The team has invested more than $7 billion over the last six years in non-traditional areas of the credit market, including opportunistic and adventurous credit, dislocated special situations, and private structured capital solutions. 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.

Just as a reminder, if you'd like to submit a question, please use the Q&A chat function on the right side of your screen. Okay, our first question, I believe you mentioned spread tightening in your prepared remarks. Can you please provide some more color on what you're seeing in the market today as far as pricing and spread levels and how that compares to six months to a year ago?

Sure. So if you just look at levered loans, you know, broadly syndicated levered loans, I'd say spreads are in, depending on the indices, you look at about 110 basis points over the past year and over the past six months, probably 50 to 60 basis points. If you look at private credit, I would say, you know, over the past, you know, six plus months, Private credit spreads, generic leveraged buyout, backed private credit spreads are in 75 to 100 basis points as well. But, you know, one thing I will say is, you know, that's why our off-the-run focus is, you know, kind of more important and probably highlighted as an advantage in today's environment. A lot of the private credit transactions that we're looking at today have similar spreads to kind of what we would have looked at a year ago because we're dealing with non-sponsored transactions and, you know, complicated credits that don't necessarily have access to traditional, you know, private credit financing or broadly syndicated markets.

Great. Next question. With around 25% of your portfolio allocated to consumer sections, can you talk about the opportunities you're seeing there and how those companies are exposed to lower-income consumers? Sure.

So we are cautious on the lower-income consumer and the consumer in general, just given the rate hiking cycle and some of the data that we're seeing. So our consumer exposure is not reflective of, you know, our desire, you know, to belong to the consumer. Our consumer exposure is very idiosyncratic and, you know, has a range of different types of companies that we believe are either kind of positioned well in this economic environment, you know, or really insulated from what's going on. We have, you know, our second largest investment is an investment in a growth consumer brand, a company that's growing very rapidly in a new category. And, you know, while, you know, somewhat beholden on the consumer, you know, it's really tied to, you know, the category growth of a new product. You know, we've got exposure here. through a restaurant, a franchise, Zor, that actually is a QSR business that benefits from consumers trading down. We're actually seeing, you know, foot traffic and sales in that business benefit from the trading down from, you know, higher-end, you know, dine-out options. And then, you know, the exposure, you know, falls off, you know, pretty rapidly to like a super low LTV loan to a luggage business and some other things. So again, very idiosyncratic, either super low leverage benefits from kind of the trade down, you know, or something very specific, you know, with a growth opportunity in a category. But we are cautious on the lower end consumer. And, you know, if you look at data, you're definitely seeing you know, the lower end consumer gets squeezed and pulled back. And, you know, it's something that's in our minds as we evaluate new opportunities.

Next question. Where do the best risk-adjusted returns sit within your portfolio today? Is it predominantly first lien, senior secured risk, or are you looking to go down for opportunities to go down the capital structure?

I would say definitely, you know, first thing, senior secured risk. We are a little bit cautious about going down the capital structure today. You know, valuations, you know, definitely seem, you know, a bit stretched. And, you know, we're worried, you know, that a reversion to mean on the valuations could kind of push up LTV. So that's causing us to be, you know, more careful from a loan to value perspective. It favors kind of dollar one risk. In addition, I would say the private markets. As I mentioned, the public market spreads have compressed pretty significantly. And actually, within the private markets, the more kind of non-sponsor or complicated stuff, because within the private markets, the on-the-run sponsor lending spreads have also compressed pretty significantly. And those terms are starting to look more and more like broadly syndicated terms and one of the reasons we're attracted to the private credit market is to avoid, you know, kind of the lack of covenants. I think that discipline still exists in the, you know, more solution-oriented, you know, private transactions. So that's a big focus for us.

Yeah, but a follow-up to the private portfolio, I believe you said 75% of new investments during the quarter were in privately-originated investments. Can you just talk about why this opportunity is attractive today?

So it dovetails with, you know, what I just mentioned. I think you've got to look at what's going on in the other markets to kind of understand why we think, you know, our private strategy is attractive today. The broadly syndicated credit markets spreads have compressed pretty significantly, as mentioned. Terms, structural terms are also quite weak. So, you know, the deals are Covey Light, lots of EBITDA kind of add-backs in defining kind of leverage in those transactions. And those cub-like deals lend themselves to one of two risks, you know, either sponsors, you know, kind of leaking out kind of assets or money, you know, around the debt to benefit the equity, or lender-on-lender, you know, violent situations, which you're seeing, you know, in the news. And then, you know, when you, you know, flip it to private credit, you know, private credit is definitely more disciplined, you know, from a doc perspective, and spreads are still higher in private credit. But the top part of the private credit market competes with the broadly syndicated loan market as sponsors are usually weighing, you know, what route to go down. So as spreads have tightened and broadly syndicated credit and structural terms have loosened, traditional private credit, you know, has had to follow to some extent. You're also seeing a lot of new entrants in traditional private credit, whether it's kind of banks get into that market, you know, or, you know, different firms just raise lots of assets. So for us, you know, we're trying to focus where others aren't, where that capital's kind of not flowing, and thus, you know, terms are more disciplined and, you know, are, you know, non-traditional areas of the private credit markets that we focus on, you know, don't really kind of price off the broadly syndicated market, don't structure off of that, and don't really compete with those capital flows into private credit that I mentioned. So we're still able to, you know, price and structure what we think are, you know, just attractive deals, not just on a relative basis, but, you know, on absolute terms that haven't really changed all that much.

Great. And then another follow-up to the private portfolio. Can you talk about how the team sources these private deals? Maybe you can talk about the origination and due diligence process there. Sure.

So our philosophy is to cast a very wide net, and we have a broad range of lending capabilities as well as other kinds of structuring capabilities across our business. Right now, We have a 21-person investment and sourcing team working directly on the strategy, and we also liaise with the broader FS organization that has many relationships that accrue to the benefit of our team and this fund as well. We talk to a lot of businesses that are owned by financial sponsors as well as businesses that are non-sponsor-owned. Those conversations are sometimes generated directly through, you know, relationships we have, and sometimes they're sourced through intermediaries that can include more traditional private channels as well as specialty relationships focused on specific geographies or industries and smaller lower middle market businesses. Another important part of our strategy is leaning into our peer network, which we've developed over the course of our careers. Others on our team also have deep relationships across the business. And then lastly, we manage a large portfolio. In that portfolio, there are current companies as well as prior companies who continue to have new financing needs and So we try to maintain an active dialogue with them to see if there are ways to partner up.

Great. And then the next question focuses on performance. Net asset value was up around 3% this quarter compared to year end. Can you talk about the drivers of the valuation moves during the quarter?

Yeah, so performance was broadly strong across both the public and private investments in the portfolio. You know, on the upper end of drivers, we did have a couple of private debt and equity positions in the healthcare, education, and logistics industries that had some company-specific events. which led to, I'd say, modest increases in the valuation, slight increases at the position level. On the negative side, there was one position which ended up costing us about 30 basis points in the quarter, which has subsequently shown some signs of improvement. But overall, pretty broad, strong performance across the board.

out great in the next question following up on those marks can you provide some color on your valuation process you use a third-party valuation firm any color on the valuation process and how often it takes place would be helpful

So I think as investors know, roughly half of our portfolio is made up of private securities and half of our portfolio is made up of public securities. The public securities are marked using third-party valuation services every day. So loans and bonds are marked daily. by a third party every quarter. So we use a third party that does detailed evaluation of all of our private positions, and those marks are done every quarter by that firm. Intra-quarter, we rely on internal marks. So we review those positions for, you know, key news, trends, financial updates. to determine if the mark warrants change. And, you know, if there is news or event that does warrant change, we run that through our internal process. But everything is done externally on a quarterly basis on Friday.

Next question. Can you talk about the thought process on raising the dividend again in March? Was it interest rate driven, higher for longer rates, and the impact on the portfolio? Just any color on the dividend strategy would be helpful. Sure.

So we were continuing to out-earn our dividend, if you looked at our portfolio. We came into the year a little bit more cautious on rates, just looking kind of at the forward curve and how quickly rates were dropping. I think, as everyone probably knows, Fed funds' expectations changed a little bit. So less rate cuts became priced into the market. We were continuing to out-earn our dividend, and we thought it was prudent to kind of pass on those excess earnings to investors. So that's what we did.

Next question. Assuming the fund still owns Monotronics, can you discuss the progress you're expecting with that company? Sure. Sure.

It's a private company, and so there's a little bit of a limitation on what we can discuss. We do still own it. We are both optimistic about the options to create value from the current position, as well as encouraged by the actions management state and the trends that we've seen in the business, which have been somewhat positive. The majority of our monotronic exposure is in a first-wing loan that is, in our estimate, a very attractive, low LTV piece of paper. And we also see a significant amount of potential upside for our equity investment there as well. So we like what we're seeing and hope that things continue to progress nicely.

Okay, the next question. The stock performed well last year and early this year, and the discount to net asset value has closed. Any color on how you think about the stock's valuation and where it's trading compared to your NAV and to some of your peers?

Yeah, so we're pleased with the improvement in the trading performance that we've seen this year, but we still believe the stock is trading below where it should trade, you know, based on the quality of the portfolio, the track record, and, you know, the overall opportunity set. So we think we're trading at too big of a discount. And, you know, we continue to focus on opportunities to close that discount.

And next question, just how have your, you talked a little bit about macro views, but how have they changed over the last few months and quarters? Seems like the tone and view on rates and inflation has changed pretty meaningfully from earlier this year. Just curious as to your views on the macro environment today, expectations for the year, and any macro thoughts that your investment team considers when making investments would be helpful.

Yeah, so, you know, first, we obviously pay very close attention to what's going on in our portfolio companies, and generally we see companies that are in good shape. So that pleases us. There is some evidence of slight slowing in manufacturing and consumer spending or consumer savings or consumer sentiment, depending upon if you're focused on the higher-end consumer or the lower-end consumer, there are slightly different trends in terms of earnings power or savings or credit performance. Nothing strikes us as being particularly abnormal or unexpected, I think, the behavior that we see is pretty easy to sort of understand. But we're mindful of what is likely going to happen over the next year or two or beyond in terms of normalization of interest rates and normalization of credit spreads. and normalization of unemployment levels and things of that nature. So where that puts us essentially is we see a strong economy right now with healthy performance in the portfolio, but because interest rates are high and we expect them to stay relatively high for a while and there is a sort of slow uptick in in manufacturing spending and the consumer, we think we'll see a little bit of a slowdown and a little bit of spread widening, and we're sort of keeping that in mind as we build and manage our books.

Next question is, what percentage of loans or investments in the portfolio would you characterize as a non-accrual?

So today, non-accruals represent approximately 3% of the portfolio. What I would caution investors on is focusing too much on that number. Remember, our strategy is a strategy that focuses on event-driven and complicated situations. So sometimes we are buying positions that we sort of expect will be on or will go on to non-accrual because our focus is really on recovery values and P&L. So if we were to buy a piece of debt at $0.50, our non-accrual rate could tick up. But if we're buying something at $0.50 because we think intrinsic value is $0.70, that could be a great opportunity.

Great. And this concludes today's call. Thank you, Andrew. Thank you, Nick. If you have any follow-up questions or if we didn't address any of your questions, please feel free to reach out to myself, Robert Pond. Thank you.