FS Credit Opportunities Corp.

Good morning, and thank you all for joining us for FS Credit Opportunity Corp's third quarter 2024 earnings call. Please note that FS Credit Opportunities Corp may be referred to as FSEO, the fund, or the company throughout this 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 23, 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 second quarter ended September 30, 2024. A link to today's webcast and the presentation is available on the company's webpage at fsinvestments.com under the Investor Relations tab. Please note that this call is the property of FSCO. Any unauthorized broadcast 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 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 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 of FS Global Credit and Portfolio Manager for FSCO, and Nick Heilbutt, Director of Research of FS Credit Opportunities and Portfolio Manager for FSCO. 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 questions, please use the Q&A function on the right side of your screen, and we'll strive to answer as many questions as possible. In addition, I'd like to point to the resources that we have listed in 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, Joe, and good morning, everyone. Proud of the results we delivered for our shareholders during the third quarter of 2024 across several key fronts. First, the fund delivered a net return of 3.35% based on NAV. While portfolio performance was broad-based during the quarter, the top 10 contributors based on issuer accounted for 49% of the total realized and unrealized appreciation during the quarter. Year-to-date, as of September 30, 2024, the fund generated a net return of 12.31% based on NAV, outperforming high-yield bonds by approximately 430 basis points and loans by 580 basis points. This performance was strong on an absolute and relative basis as FSEO outperformed many of the larger credit-focused peers in the closed-end fund space. We believe our performance reflects the dynamic nature of our strategy and the ability to source differentiated investments. Our strategy includes 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 for corporate events. We have a very robust sourcing engine as a combination of business-led and firm-wide sourcing. Next, the firm paid distributions of 18 cents per share in the third quarter. As has been the case since FS Global Credit Team assumed management of FSCO in January of 2018, net investment income fully covered distributions paid during the quarter. As of November 22nd, 2024, the fund's annualized distribution yield was 10.3% based on NAB and 11.1% 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 continued in 2024. We believe the improvement reflects the fund's continued strong performance, the increase in the annualized distribution, and the broader strength in the credit markets. We're pleased that FSTO shareholders earned a total return of 2.6% in the third quarter of 2024, and 27.4% year-to-date as of November 22, 2024. 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. Over the past two years, higher interest rates have dampened transaction volumes and overall sentiment in private markets. Private credit performance has remained strong, The U.S. economy has grown 5.5% in real terms since the Fed began raising interest rates in the first quarter of 2022, or 2.4% on a annualized basis. Middle market companies have been both drivers and beneficiaries of this economic strength. The average revenue growth for middle market companies was nearly 13% as of June 2024. Privately originated senior loans returned 12.5% over the past year, marking the highest on record outside of late 2020 and early 2021 amid the COVID recovery period. Following 75 basis points of Fed rate cuts thus far this year, it's clear that the Fed is set to reduce short-term rates further, but the pace of timing and future cuts is less clear. Lower rates in the absence of a recession would likely spur rebounded M&A activity and create greater opportunities for growth. In addition, lower rates may provide some relief to borrowers, especially those with constrained balance sheets. Public credit markets benefited from the support of macro backdrop, coupled with a constructive, if softening, fundamental picture. In the defining rate environment, high-yield bonds returned 5.28% and now conform senior secured loans by 320 gold basis points. Lower-rated credit, Choke high yield returns as CCC bonds returned 11.5% during the quarter, outpacing WB bonds by 727. Despite the decline in rates, loan prices have been supported by strong CLO demand. Loan performance was mixed as single B loans outperformed double B loans and CCC. starting yields are compelling, the quality of the broader loan market is low, as composition has shifted towards lower-rated credits with comparatively higher leverage than lower interest coverage. Credit risk continues to diverge as high-yield bond default rates fell to a 26-month low, while loan defaults have risen to a 44-month high as of the end of October. While default rates, including distressed exchanges, ended a quarter below their 25-year average for both We expect the false will likely increase modestly throughout the next year with a composition skewed towards loans due to weaker credit fundamentals and a higher pace of distressed transactions across the market. We can do that through management. Combining the sound fundamental credit underwriting will be critical to driving returns and avoiding excess risk in the year ahead. Turning to investment activity, the fund remains fully invested throughout the third quarter. Purchases including portfolio pitches, totaled approximately $270 million compared to sales, exits, and payments of $233 million. Credit markets remained competitive during the war. Especially in these times, we continue to leverage the insight and deal flow to process investments, $82 billion asset management platform, and use our deep relationships with commercial and investment banks Non-bank intermediaries, sponsors, industry specialists, and other like-minded investment firms drive a steady pipeline of investments in public and private credit. Approximately 59% of new investment activity was in privately originated investments, 100% of which were in first-name loans. Public credit investments represented 41% of new investment activity during the quarter, of which approximately 65% were in first-name. As of September, public credit comprised 42% of the portfolio, with private credit comprising 58%. By asset type, approximately 82% of the portfolio consisted of senior secured debt, while subordinated debt was 6%. Asset-based finance is 3% of the portfolio, and equity and other investments represents 9%. Excluding asset-based finance investments, The largest sector ratings were in consumer services, 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 broader economic slowdown. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge with 53% of drawn leverage as of September 2021. comprised of deferred debt financings. We provide favorable regulatory treatment versus traditional term or revolving debt facility and flexibility in the types of assets we can work against. I'll now turn it back to Andrew to discuss our forward outlook. Thanks, Nick. Economic data and credit returns were both solid during the quarter of 2024. While many strategists are forecasting a benign market environment for the remainder of the year and into 2025, it's possible to see periods of volatility driven by geopolitical conflicts, the path of U.S. rates, and new policies following the leadership changes in the White House and Congress following the November elections. While we are not necessarily positioning for expected volatility, our portfolio is constructed to be durable over the long term. Key attributes include, first, we're focused on businesses with strong cash flows, modest leverage profiles, and management teams with deep operational experience managing through cycles. We're 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. Credit spreads are tight, and covenants in the broadly syndicated loan markets are weak. This, coupled with uncertainty over inflation rates and the durability of the economy, are causing us to be a bit more cautious about making new investments than we would be in other environments. Therefore, we believe maintaining extra bonding power is prudent, not only to minimize potential drawdowns, but also take advantage of attractive investment opportunities arising from periods of volatility. Step We continue to focus on senior debt investments with strong terms and attractive yields where expected total returns. We generally avoid debt and private equity-owned companies where we think there could be material risk of asset leakage or disputes between lenders. We're also cautious on credits where there are significant EBITDA netbacks that may never materialize and instead focus 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'll continue to leverage the 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 $2.2 billion in assets as of September 30, 2024. 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 leverages the full resources, infrastructure, and expertise of FS Investments. As Nick discussed, We believe our leverage structure provides FSTO with the unique advantage as a large percentage of our drawdown 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 funds and allows us to adjust allocations based on where we believe the best risk-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 a specific asset class mandate. We can invest across loans, bonds, and structured credit, as well as highly structured equity, and across fixed and floating rate assets. Our private investment portfolio includes highly bespoke investments originated through our team firm-wide sourcing network. Our intensive due diligence process benefits from the sharing of collective insights on the markets and individual credits. We believe our origination capabilities within private markets 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 by investing in non-traditional areas of the credit market, including opportunistic and event-driven credit, special situations, investment team assumed all portfolio management responsibilities in January of 2018, the fund net returns have outperformed the gross returns of high yield bonds by 294 basis points and by loans by 230 basis points per year. Once again, thank you all for joining us today. With that, we'll take a brief pause and review the queue before answering your questions. All right. First question. In November, you declared the ninth straight monthly dividend at the $0.06 per share rate. Any insights into what forward-looking dividend policy may look like, particularly in light of current rate expectations? So we'll continue to review our distribution policy on an ongoing basis. We'll look at the fund's natural earnings profile, the trajectory of forward-looking base rates, where credit spreads are, and, you know, where our fund is and where the peers are so it's not a static policy. You know, in addition to looking at those attributes, you know, the fund does generate a decent amount of fee-based income, so that's not directly tied to kind of interest rates and bears monitoring. And lastly, we are fortunate to have significant spillback dollars, which should keep our distribution rates higher than where it might otherwise be if base rates fall. Great. For our next question, private credit continues to tighten relative to public credit. Do you believe that the relative value still exists in private credit today after accounting for the liquidity premium? So in the deals that we see, I would say both asset classes are tightening. So the like-for-like transaction in private credit versus public credit, I believe, has tightened in a commensurate way. Public credit is really tight. I would tell you the average B3 that we see for a new issue buyout is probably coming at around 350, maybe 325 over SOFR. The average new private credit transaction with a similar credit profile is probably coming right around, you know, S500. So it's still coming at 150 to 175 basis point premium. We don't think that's changed. The other thing to think about is the structural premium in terms of what you're getting in private credit docs versus public credit docs. And we think the structural premium still exists with private credit docs, you know, generally being a lot tighter than public credit docs, which creates downside protection. Great. Next question. In your prepared remarks, you mentioned seeing a lot of weak covenants in the market. How is this affecting deal volumes? The average new issue, broadly syndicated loan, has very weak covenants. Some of those weaker covenants are spilling into the top part of the private credit market, private credit for large blue chip sponsors. And some of the smaller sponsors are trying to get some of the terms that the protections. We're keeping our bar up. So, within private credit, we're passing on those transactions that generally mimic the public credit market. It's causing us to need to increase head, you know, look at more deals because with a higher bar, you have a lower hit rate. But that said, we believe our deal flow is sufficient, you know, to implement that strategy, and we've been very active in good transactions. Next question. You mentioned that the portfolio was approximately 58% private in Q3 compared to 52% in Q2. Do you expect this allocation increase to continue – over time. And can you talk about the opportunity, why the opportunity is attractive today? What spreads you are deploying at in both public and private investments? We believe the opportunity is attractive because there is a nice spread premium for private credit in general, which I mentioned, as well as like a structural premium where we think you get better downside protection. in a default scenario and thus like higher recoveries. The other thing I would mention is dispersion in private credit is much more significant than it is in public credit, so it creates the opportunity for significantly more alpha. If you look at the new issue B3, broadly syndicated term loan, you know, there's very, very little dispersion, maybe 25 basis points of dispersion in terms of where something might come. You know, so if the average deal is coming at 350, you know, maybe, you know, a really strong deal comes at 325 and a weak deal comes at, you know, 375, so 25 basis points of dispersion. The thing we like about Private credit is we can see a significant amount of dispersion depending on like the deal dynamics. You know, it's possible to get 200 basis points, you know, plus of dispersion. So if you look at, you know, our originations, you know, we had five new originations in the quarter, $162 million on the originated gap yield of 11.5% and a spread of 700 So if you look at, like, the generic private credit deal that I mentioned that, you know, 500 over, you know, we were able to find, you know, 200 basis points or so worth of dispersion, which you can't find in the public markets. So right now we continue to be positive on private credit. But that said, you know, we'll continue to, you know, monitor the markets and go where the opportunity is best, you know, if things change. Next question. Are there any subsectors in credit which, in your view, currently present more of a relative value versus the broader market? Yeah. So, you know, healthcare is an industry that always requires, you know, deep fundamental knowledge and expertise, you know, as well as a network of relationships and experience to to invest in and that can create the opportunity for excess returns. So, you know, we found some nice opportunities there as we often do. And then maybe, you know, media and entertainment stands out as an area where, you know, there's ongoing technological and distribution-related changes in the landscape. And then over the last several years, there have been some specific labor challenges in Hollywood and Hollywood-adjacent industries as well that have created some disruption and an opportunity to find excess return in crafting deals to well-positioned businesses. Great. Next question. What is your latest view on the macro environment in light of recent rate moves in the presidential election? How do you expect recent developments to affect the portfolio? Certainly the recent rate moves and the Trump presidency suggest that base rates will probably remain a little higher than people were thinking six months ago, and so think we're nearer to a trough in rates and indeed may actually see an uptick in inflation in 2025. We're generally agnostic on rates when it comes to investing and allocating the portfolio. 63% of the portfolio is floating rate today, so that higher kind of base So for short end, you know, can be good for portfolio yield for us. You know, obviously we'll be mindful of the shape of the yield curve and, you know, there have been some changes there. We'll continue to monitor that and look for opportunities. But I think we're set up in a way right now which, you know, should be pretty strong if base rates, you know, sort of stay where they are. or tick up, honestly. Other than that, we'll look to take advantage of dislocations in sectors that may fall out of favor. I mean, we don't know what will happen with tariffs. I think we have a reasonable base case regarding corporate taxes, but there could be other changes in the regulatory landscape. favor certain industries, you know, or, you know, negative for, you know, for others, and, you know, that can create opportunity. So, we'll have more to say about that as things progress next year. Next question. Are there any updates on investments in the portfolio that are on the monocle? Yeah, so right now non-pools are just under 3% of fair market value in the portfolio, which is a level that we're comfortable with and sort of broadly in line with historical levels in the portfolio. There was one new non-pool this quarter, which was an investment we had in a company called Lasership, which is a distribution business that sort of run into some macro-driven, largely macro-driven sort of revenue shortfalls, and it was over a lever coming out of COVID. But, you know, we had a path forward there that's about $11 million of fair market value portfolio. Next question. Can you discuss your fee structure relative to your peers in the closed-end fund space? Yes, this is a question we get a lot because we have an incentive fee and we also have a management fee that can optically be viewed as being a tad higher relative to kind of closed-end fund peers. I think the thing that's important is we view our peers as not just closed-end funds, but a mixture of closed-end funds as well as BDCs. If you remember from my remarks, 58% of our fund is invested in private credit. So not only is that BDC-like, if you look at our average private investment, it is a more tailored, more structured, and more intensive private investment than the average investment the BDC makes. But, like, if you wanted to simplify things and say 58% of our fund, you know, is like a BDC and 42% of our fund is like a closed-end fund and blended the fees, you would see something that, you know, really, you know, justifies our fees and maybe even makes our fees look a bit low. Great. Next question. The revolver and term loan are due to mature in December. Has there been any progress in refinancing the capital structure? Yes. So we successfully refinanced our leverage facility with Barclays in September. We were able to take advantage of historically tight levels in the market and refinance the terminal and revolver at SOFR plus 215, which was down from SOFR plus 265. We were also able to reduce our fee on undrawn capital to 35 basis points per from 55 basis points. Just to refresh, the facility still consists of a $285 million return loan and a $65 million revolver, so that sizing has been unchanged. The other thing worth mentioning is, in addition to pricing improvements, we were able to improve some of the composition requirements, which allow for increased borrowing capacity Great. 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, Joe Monteleone. Thank you.