FS Credit Opportunities Corp.

Good morning, and thank you all for joining us for FS Credit Opportunity Corp's fourth quarter and full year 2024 earnings conference call. Please note that FS Credit Opportunities Corp may be referred to as FSCO, 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 the press release that FSEO issued on February 6, 2025. 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 and year ended December 31, 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 FSEO. Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today's conference call includes forward-looking statements with regards to future events, performance, or operations of FSEO. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements. We ask that you refer to FSEO's most recent filings with the SEC for important factors and risks that could cause actual results or outcomes to differ materially from these statements. FSEO does not undertake to update its forward-looking statements unless required to do so by law. Additionally, information related to past performance, while helpful as an 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 of FS Global Credit and Portfolio Manager for FSCO, and Nick Heilbeck, Director of Research of FS Global Credit and Portfolio Manager for FSCO. Also joining us on the phone is James Beach, Chief Operating Officer of FSCO. Following our prepared remarks, we will take questions from the audience. If you'd like to submit your questions, please use the Q&A chat 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 on 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. We're pleased with the results we delivered for our shareholders during the fourth quarter and full year in 2024 across several key funds. First, FSTO delivered a net return of 14.25% in 2024 based on the fund's net asset value, outperforming high-yield bonds by approximately 603 basis points and loans by approximately 530 basis points. This performance was strong on an absolute and relative basis as FSBO 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, investing across public and private credit with a focus on generating return premiums driven by lower competition, asset mispricings of less understood businesses, or corporate events in complex situations. Next. The fund paid distributions of 71 cents per share in 2024. As has been the case since our team assumed management at the FSTO in January of 2018, net investment income fully covered distributions paid during the quarter and full year. We increased the fund's monthly distribution amount by approximately 5% in March 2024, driven by rising market yields and the continued strong performance of our investment portfolio. This was the third distribution increase since the fund's common shares were listed on the New York Stock Exchange in November 2022. Following year end, we increased the fund's monthly distribution amount by 7.5% in January 2025, representing an increase of approximately 52% over the fund's distribution rate at the time of listing. As of February 27, 2025, fund's annualized distribution yield was 10.7% based on NAV and 11.2% based on market price. We deployed $884 million across private and public credit assets in 2024. In our view, private credit offered greater value relative to public credit. Approximately $618 million, or 70% of our investment activity during the year, was in private credit assets with an average yield of 12.1%. While M&A activity was generally slow throughout the year, the fund benefited from our robust deal sourcing engine, which includes our team and firm-wide origination network, as well as our private sourcing partnership with J.P. Morgan. finance directly originated investments. Finally, we made substantial progress in reducing the discount at which the fund shares trade relative to its net asset value. The discount narrowed to approximately 5% as of December 31st, 2024, compared to 18% a year earlier. We're encouraged by the progress and believe this significant improvement reflects the fund's continued strong performance multiple increases in monthly distribution rates since its listing, and a broader strength in credit markets. FSBO shareholders earned a total return of 10.3% in the fourth quarter and 34.9% in 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. The U.S. economy remained on sound footing in 2024, with strong contributions from household spending, business investment, and government spending. Inflationary pressures moderated considerably, yet remained above the Federal Reserve's preferred 2% target. Falling, yet sticky inflation enabled the Fed to cut interest rates by 100 basis points during the year. Against a backdrop of falling rates and solid economic growth, the 2.10 Treasury yield curve un-inverted for the first time in more than two years as the policy-sensitive two-year Treasury yield was flat nearly a year or more while the longer end of the curve rose with the 10-year Treasury yield rising 69 basis points. Public credit markets delivered strong returns in 2024 supported by a favorable macro backdrop, elevated yields, and a resilient but moderate fundamental environment. Senior secured loans and high-yield bonds returned 9% and 8.2% respectively. High-yield bond and loan spreads tightened throughout the year and ended in the 92nd and 88th percentiles respectively compared to historical averages. In addition, lender protections in the public market materially weakened amid a highly competitive lending environment. Private credit was not fully immune to the risks presented in public credit markets, yet offered materially higher spreads over short-term rates throughout 2024. Spreads for traditional sponsor direct lending strategies and non-sponsored transactions sat at 523 basis points and 684 basis points respectively as of December 31st, 2024. Private credit investors were also able to inject greater discipline into deal terms and structures. Covenant Lite issuance represented just 28% of core middle market private equity. Private credit insurance issuance through December compared with 90% of the public loan market. Private credit yields remained attractive, resulting in an income-based total return of 12% for the 12 months ending December 31st. and private credit deal volume totaled $295 billion in the year, doubling 2023 volumes. Sentiment among middle market companies finished the year on a notably strong note. According to a survey of U.S. middle market business leaders, 78% reported they were optimistic about the state of the national economy, while 85% were upbeat about their local economy. The data supports such optimism, with revenue growth of 12.9% and employment growth 10% among domestic middle market firms, far outpacing those of their large-cap peers. Turning to our investment activity, the portfolio remained fully invested during the fourth quarter as it was throughout 2024, driven by a healthy pipeline of private and public investments that we believe offer attractive yields and strong covenants. During the fourth quarter, sales, exits, and repayments of million when excluding portfolio hedges. For the annual period, purchases excluding portfolio hedges totaled $884 million compared to sales, exits, and repayments of $849 million. As Andrew mentioned, we believe private credit offers greater relative value compared to public markets. In 2024, approximately 70% of new investment activity was in privately originated investments. 91% of which were in personally and senior secured loans. We lend to lower and core middle market companies with average earnings of $25 to $75 million, which we believe is a competitive sweet spot. These are generally robust businesses that are often too small for large credit managers to take interest in, while their balance sheets may not fit the standardized criteria for conditional lenders like banks. As a result, there is typically a greater ability to control deal terms, and create highly structured investments to protect against downside risk. We invest in both sponsored and non-sponsored back transactions. Within sponsored lending, we do not compete against the large direct lending funds and instead lend to small or emerging sponsors where there's typically less competition and greater potential to capture a yield premium. Non-sponsored lending opportunities comprise a wide range of borrowers that in many cases have never taken outside capital. This includes multi-generational, family-owned businesses, sole providers, or other tightly-held businesses. We like these types of investments because there's often a strong ability to control deal terms and create highly structured investments to protect our downside. More broadly, we view private credit as the core foundation of FFCO's portfolio and will opportunistically invest in public markets over time. We focus on high-quality performing companies in less traffic corners of public markets and these periods of market dislocation to acquire quality assets at discounted prices. We also focus on event-driven opportunities that arise from corporate actions, such as mergers and acquisitions, upcoming debt maturities, or misunderstood growth opportunities. As of the end of the year, private accredited investments represented approximately 65% of the portfolio compared to 47% a year ago. Approximately 84% of the portfolio consisted of senior secured debt compared to 82% the previous quarter. Funds allocation to unsecured debt declined to just 5% as of the end of the year compared to 6% at the end of the previous quarter. Asset-based finance represented 3% of the portfolio, which was flat the previous quarter. And equity and other investments represented 8% of the portfolio versus 9% at the end of the previous quarter. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge. 47% of drawn leverage at the end of the year comprised of preferred shares that provide favorably regulatory treatment versus traditional term or revolving debt facilities and flexibility in the types of assets we can borrow. I'll now turn it back to Andrew to discuss our forward outlook. Thanks, Nick. While many strategists forecast a benign environment for 2025, we're starting to see volatility driven by trade policy and political uncertainty. It is possible this continues where we see additional bouts this year as U.S. policy evolves and we see the outcome of the various geopolitical conflicts and economic data. While short-term volatility can affect the mark-to-market of our portfolio, our portfolio is constructed to be durable over the long term. We believe active management combined with sound fundamental credit underwriting will remain critical to driving returns and avoiding excess risk. We believe FSEO offers a differentiated value proposition built to drive strong risk-adjusted returns through a diverse range of economic and financial market conditions driven by several factors. First, 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, 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. Second, we continue to focus on senior debt investments with strong terms and attractive yields for 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 with lenders. We're also cautious on credit where there are significant EBITDA add-backs that may never materialize and instead focus on free cash flow. Third. We will continue to leverage size and scale to drive differentiated FBO as one of the largest credit-focused closed-end funds in the market, with $2.3 billion in assets as of December 31, 2024. Size and scale matter in credit investing, especially when it comes to maximizing deal flow, mitigating risks, 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 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 private and public markets differentiates us from traditional credit 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 in the most attractive opportunities across the credit and business cycle, and we think that 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, structured credit, and highly structured equity investments, and across fixed and floating rate assets. In summary, 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, as the fund's performance during 2024 again highlighted, and we look forward to the opportunities of the coming year. Once again, thank you all for joining us today. With that, we'll take a brief pause to review the queue before answering your questions. All right, thank you, Andrew. First question, with the election behind us, what are your expectations for M&A and deal flow relative to what we saw last year? Well, you know, we're starting to see signals of the M&A market improving. I think there were a lot of people that were waiting just for kind of the election to be behind them to just understand what administration they're dealing with. And, you know, I think the new administration and the FCC are generally viewed as business friendly. And we think that should spur activity. We did start to see a pickup at the end of last year. So, you know, there was strong deal volume in Q4, but particularly in December. More specifically, you know, for our fund, we closed nine direct originations, you know, in Q4, which was, you know, significantly higher than kind of the pace earlier in the year. Great. Our next question, are there any political concerns you're keeping an eye on with the new administration, most notably tariffs or other potential challenges? Yes, I mean, absolutely. While we do invest primarily in U.S.-based companies, I mean, tariffs are certainly a concern. When you think about the supply chain, a lot of U.S. businesses do source things, parts of their supply chain from overseas. Additionally, tariffs can create inflationary pressures, and potentially choke consumer demand. So it's possible that the effects of tariffs manifest itself in a slowdown on the economic side. Also, immigration constraints are likely to put upward pressure on labor costs, which can hit that consumer as well. I think we're very concerned about tariffs. We're doing our best to try to avoid investments that will be overly affected by them and stick with investments that are as insulated as possible. But obviously, the broad economic effects are a little bit more difficult to manage. And so that's where, you know, we just have to be kind of prudent, you know, from a loan-to-value perspective and, you know, invest in credits, you know, that have a margin of safety, you know, to, you know, potentially a slowdown. Great. Our next question. In January, you raised the monthly dividend by about 7.5%. Any insights into what forward-looking dividend policy may look like in light of current rate expectations? Well, we continue to review our distribution policy on an ongoing basis by analyzing the fund's national earning profile. the trajectory of forward-looking base rates, which have, you know, been moving around, you know, by quite a bit, you know, if you kind of go back to, you know, last summer, you know, and fast forward to today, there's been a lot of up and downs, including, you know, Q1, you know, of this year. So we're constantly monitoring that. And, you know, also the yields of our credit, you know, base peers are I think one of the things we're fortunate to have is a significant amount of spillback dollars. So those were earnings that weren't necessarily kind of fully distributed in prior years, which we can use and intend to use in our distribution. And it could provide some cushion if there's more, you know, if there's a decline in interest rates or kind of yields tighten. The other thing I've mentioned is a portion of our earnings are typically generated from fee-based income, which is not directly tied to the direction of interest rates. Great. Our next question says, it looks like the portfolio is now 65% private. This compares to 47% a year earlier. Do you believe that this is the higher ends of the range? And do you expect the allocation to continue to grow? I think we are sort of approaching the higher end of the range. But, you know, we also believe private credit is a key differentiator between us and our peers, drives the return profile that's a little bit more VTC-like. And in addition, you know, we've had the opportunity to continue investing back in our team, so our business has grown, and with that, the origination capabilities in private credit have expanded. So today we see a much higher level of high-quality yield flow than we did, you know, two or three or four years ago in the private credit markets, you know, which on average means the opportunity set that we see in private credit is more attractive than it has been historically. So I think that helps explain, you know, the shift in our business and portfolio mix. And it's a trend that, you know, at the margin we expect to continue. Great. Our next question, how do the deals that you've recently closed compared to spreads in the broader market when looking at the broader private credit market? So, I think today, if you look at the private credit market, you know, the average transaction is sort of probably printing around S500 for sponsor deals. There are certainly deals that are printing south of that. For very large transactions, you see spreads as tight as, you know, S450, you know, from time to time. Looking at the fourth quarter, you know, the ninth quarter, new private originations, you know, for us, had an average gap yield of 11.3%, which is pretty close to a spread of 700. So I think there's a fairly material difference between the portfolio that, you know, we're originating and managing in this fund and the broader private credit market. Great. Next question. It looks like leverage picked up at the end of the year at 0.6 debt to equity. Do you plan on maintaining that level going forward? So our leverage level was a bit elevated close to year-end large as a function of timing, given we were funding several investments at quarter end. I think leverage is generally expected to remain in line where it has trended historically. And, you know, whether it's a little bit towards the higher end of the range where it might have ended Q4 or, you know, slightly lower end of the range where it began, you know, early in the year, last year, it's just really largely a function of kind of market opportunities that are available at the time. The other thing I'd mention is NAV has grown significantly over the last few quarters. which effectively reduces the effect of leverage on NAV. So meaning, you know, kind of the dollars are a little bit less meaningful and, you know, you have to focus on the ratios. Our next question, and staying on the topic of leverage, it says, I noticed that you have a couple of preferred maturities maturing in November of this year. How do you plan on addressing those maturities and will that materially increase the cost of leverage? We've had exploratory conversations with banks and plan to engage, you know, a bank at some point in the near future to, you know, start to kind of address those maturities. So it's something we do plan to kind of like refinance. I will say the pricing for new preferreds appears to be quite attractive. And, you know, the spread level will be, you know, inside of kind of the spreads of, you know, our existing preferred. The total rate is likely to also be, you know, inside the weighted average cost of our leveraged. You know, that said, you know, the preferreds that come due in 2025 were basically put on during a zero-rate environment. So, you know, we're likely to see, you know, a total cost that's above those two tranches. Great. And one final question. Are there any updates on investments in the portfolio that are non-accrual? Okay. Non-accruals is a percentage of fair market value, approximately 2.5%. And, you know, we're very comfortable with this level. There were no new non-accruals for the quarter. So I think that that level is a good level to kind of think of. Great. This concludes today's call. Thank you, Andrew, and thank you, Nick. If you have any follow-up questions or if we didn't address one of your questions, please feel free to reach out to myself, Joe Montalian. Thank you.