FS Credit Opportunities Corp. (FSCO) Q2 2026 Earnings Call Transcript

Hello, and thank you for joining us for FSCredit Opportunity Corps' second quarter 2026 earnings conference call. Please note that FSCredit Opportunity Corps may be referred to as FSCO, the fund, or the company throughout the call. Today's conference call is being recorded, and an audio replay of the call will be available for 30 days. Replay information is included in a press release that FSCO issued on August 5, 2026. In addition, FSCO has posted on its website a presentation containing supplemental financial information with respect to its portfolio and financial performance for the quarter ended June 30, 2026, which is available at www.fsco.futurestandard.com under Events and News. A link to the recording of today's webcast will also be posted to the website. 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 that are not historical facts including, without limitation, statements with regard to future events or FSCO's future performance or financial condition, statements regarding distribution levels and frequency, and the financial position, business strategy, and plans and objectives of management for FSCO's future operations words such as anticipate believe expect intend project and future or similar expressions indicate a forward-looking statement although not all forward-looking statements include these words these forward-looking statements are not guarantees of performance or events and are subject to risks uncertainties and other factors such some of which are beyond our control and difficult to predict and can cause fsco's actual results or future events to differ materially materially from those expressed or forecasted in these forward-looking statements for any reason. We ask that you refer to FSEO's most recent filing with the SEC for important factors and risks that could cause actual results or future events to differ materially from these statements. The forward-looking statements included on this call are based on information available to FSEO today and current expectations, forecasts, and assumptions, and involve a number of judgments, risks, and uncertainties. Except as required by the federal security laws, FSCO undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. 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 FSCO or information about the market as indicative of FSCO SEO's future results. In addition, this call will include certain non-GAAP financial measures that have not been prepared in accordance with U.S. generally accepted accounting principles. These non-GAAP financial measures are not in accordance with or an alternative to measures prepared in accordance with GAAP and may be different from non-GAAP financial measures used by other companies. In addition, these non-GAAP financial measures are not based on any comprehensive set of accounting rules or principles. These measures should not only be used to evaluate FSCO's results of operations in conjunction with their corresponding gap measures. To obtain copies of FSCO's latest SEC filing, please visit FSCO's website. Speaking on today's call will be Andrew Beckman, Head of FS Global Credit and Portfolio Manager for FSCO, and Nick Halbutt, Director of Research of FS Global Credit and Portfolio Manager for FSCO. Following our prepared remarks, we will conduct a Q&A session. I will now turn the call over to Andrew.

Thank you, Josh, and thank you all for joining. We're pleased with the results delivered for our shareholders during the second quarter of 2026 across several key fronts. First, FSCO delivered a net return of 3.9% based on the fund's net asset value during the quarter and 8.84% over the last year, outperforming the Morningstar LSTA U.S. Levered Loan Index by 448 basis points and the ICE Bank of America U.S. High Yield Index by 310 basis points. It's worth noting that the portfolio remained highly weighted to senior secured debt throughout the year, representing approximately 88% of the portfolio's fair value as of June 30, 2026. The fund paid distributions of approximately $0.18 per share during the quarter, compared to net investment income of approximately $0.16 per share. Net realized and unrealized appreciation totaled approximately $0.11 per share, resulting in the fund's net asset value increasing approximately $0.09 per share during the quarter to $7.13 per share. Performance was broad-based across the portfolio, with contributors significantly exceeding detractors during the quarter. The largest contributors were our investments in Church's Texas Chicken and New Giving Acquisition, Inc. We believe both investments demonstrate our ability to leverage our diverse sourcing network to identify opportunities involving borrowers with unconventional credit profiles and differentiated ownership and then structure investments with strong downside protection and the potential for equity upside. Church's Texas Chicken is a QSR restaurant brand with more than 1,500 locations globally. The fund initially participated in a first lien facility in 2021, following a disrupted sales process, and as part of our investment, received warrants that were subsequently converted to common equity. In July, the company completed a strategic growth equity investment that provided substantial capital to support its next phase of expansion, while also generating proceeds for existing shareholders. the transaction contributed to a meaningful increase in the fund's common equity position. New Giving Acquisition, Inc. is a healthcare company that provides chronic care management and home health services across the Mountain West and Southwest U.S. The fund initially invested in the company's second lien term loan in 2022 to support EQ Health's acquisition and received common equity and warrants as part of the transaction. Over the subsequent years, FSCO continued to support the company's growth, and the warrants were ultimately converted into common equity. Since our initial investment, the company has continued to grow earnings, and the unrealized appreciation recognized during the quarter reflects the business's continued operational and financial progress. The largest detractor was the fund's investment in a gaming and entertainment company, which continues to execute a restructuring plan. Second, the fund continued to deliver an attractive monthly distribution. As of September 8, 2026, the annualized distribution yield was 10% based on NAV and 13.53% based on market price. The fund declared and paid monthly distributions totaling approximately $0.18 per share during the quarter. Following quarter end, the August monthly distribution increased slightly from the July monthly distribution of approximately $0.5.8 per share to approximately $0.5.9 per share to maintain an annualized distribution rate of approximately 10% based on FSCO's NAV as of July 31st, 2026. Finally, the fund deployed $194 million in the quarter, excluding portfolio hedges, treasury bills, and unfunded commitments. We continue to benefit from our robust deal sourcing engine, which includes our team and firm-wide origination network and our private sourcing partnerships with several commercial and investment banks, Given continued headwinds in the software sector, we thought it would be helpful to provide context on FSCO's portfolio and our perspective on recent market movements. FSCO's software and services exposure was approximately 8% of the portfolio's fair value as of June 30, 2026, and was well diversified by position size, with no single investment in the sector included in the fund's top 10 holdings at quarter end. Our approach remains focused on mature cash flow generative businesses with defensive business models. While software appears to have been treated as a single category amid the sell-off, we believe outcomes will diverge meaningfully over time. In our view, the key distinction is not software exposure itself, but whether a company's value is supported by durable earnings power or relies heavily on future growth assumptions. We believe that the most at-risk segments are businesses with limited differentiation and low switching costs, including lightweight workflow tools, collaboration applications, commoditized dashboards, and seat-based productivity overlays. Conversely, we believe the most defensible segments include deeply embedded systems of record, security and control layers, and vertical software platforms with extensive integrations, proprietary data, and compliance-driven switching costs. As a result, we expect investors to place an increasing premium on businesses where competitive of advantages, customer attention, and cash flow resilience are difficult to replicate. 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. Conditions across the leveraged credit markets improved during the second quarter despite continued uncertain surrounding inflation, geopolitics, and the potential impact of artificial intelligence on portions of the software sector. Capital markets remained active and spread stabilized following the volatility experienced earlier in the year, supporting healthy refinancing and issuance activity. However, investor appetite became increasingly selective, resulting in a more bifurcated market where higher quality borrowers maintained favorable access to capital, while lower-rated issuers faced wider spreads and more challenging financing conditions. The broadly syndicated loan market demonstrated resilience throughout the quarter. According to PitchBook, overall leveraged loan activity totaled approximately $224 billion, only modestly below first quarter levels and above historical averages, despite a sharp slowdown in private equity-sponsored activity. Sector and credit selection remained important drivers of performance. Concerns surrounding AI-related disruption continued to weigh on software issuers, which significantly underperformed the broader loan market and represented the smallest share of new loan issuance in more than a decade. Based on data from KBRA, private credit market remained subdued in the second quarter of 2026, with volume declining modestly from Q1 and remaining well below the elevated levels reached at the end of 2025. While the following figures reflect sponsor-based transactions only, they provide a useful gauge of broader market conditions. U.S. sponsor lending totaled $52.2 billion in Q2, down 7% quarter-over-quarter, and 42% from the fourth quarter of 2025, though activity improved towards the end of the quarter as June volume was nearly triple that of May. Pricing dynamics continued to shift modestly in favor of lenders. Following several quarters of spread compression, spreads widened across most segments of the market in the second quarter. Through the first half of 2026, Covenant Lite deals represented 18% of all private credit transactions, but approximately 41% of upper middle market and large cap deals. In contrast, covenant light structures remained negligible in the lower and core middle markets, reinforcing the relative structural strength and lender protections available in those segments, despite softer overall deal activity. Turning to our investment activity during the quarter, transactions were generally evenly split between private and public investments. Public credit investments were primarily opportunistic first lien investments. The fund originated five new private credit investments in the lower and core middle markets, totaling $127 million in commitments. These businesses are typically of meaningful scale and domestically focused, yet often overlooked by larger credit managers due to their size and balance sheet profile. Because these companies often fall outside the standardized criteria of traditional bank lenders, we can aim to negotiate favorable terms and structure investments in ways that mitigate downside risk. Approximately 90% of new private credit originations by fund during the second quarter were in senior secured debt. The weighted average spread of new private credit originations during the quarter was SOFR plus 574 basis points. Each investment included one or more maintenance covenants. By contrast, approximately 86% of loan issuance in the syndicated market during the first half of 2026 was covenant light, meaning loans that typically lack maintenance covenants. When considering the excess spread we earn over those markets, plus the covenants and other negotiated protections we've discussed, we believe these investments are well positioned to deliver strong risk-adjusted returns for the fund. Originations were sourced through our robust sourcing network. This includes direct sponsor coverage with over 300 leading middle market private equity firms, non-bank intermediaries, incumbent borrowers, bespoke non-sponsored deal flow, and our strategic sourcing partnerships with large commercial and investment banks, including a joint venture with J.P. Morgan. Approximately 72% of new originations by the fund during the quarter were in sponsor-backed businesses. Within sponsored lending, we generally do not compete against the large direct lending funds and instead lend to smaller or emerging sponsors where there's typically less competition and greater potential to capture a yield premium. Over the last 12 months, approximately 81% and 19% of our private credit originations for the fund based on deal count were in sponsored and non-sponsored deals respectively. Non-sponsored lending opportunities comprise a wide range of borrowers that in most cases have never accepted outside capital. This includes multi-generational family-owned businesses, sole proprietors, or other tightly held businesses. We favor these types of investments because there's often a strong ability to control deal terms and create highly structured investments to protect our downside. Sales, exits, and repayments totaled $157 million for the fund during the second quarter. Among the investments exited during the quarter were Oscar Larson, Rydell Incorporated, and Pioneer Midco, which reduced the portfolio's total exposure to PIC assets. As a result, PIC income represented 15% of total investment income in the second quarter, compared to $18.6 in the first and $29.9 in the fourth quarter of 2025. In most cases, the fund's PIC investments are highly structured at issuance and typically include both a cash pay component and a PIC component. In these cases, the balance between cash and PIC is driven by the underwriting thesis and our expectation for long-term growth or operational improvements at the underlying company. In certain cases, we also negotiate equity participation or other forms of upside that are incorporated into the overall underwriting. It's also worth noting that the range of FSCOs' PIC income has varied over time, but is within its historical range since 2022. As of June 30, 2026, private investments represented approximately 68% of the portfolio based on fair value. Approximately 88% of the portfolio consisted of senior secured debt. First lien loans represented 82% of the portfolio, while second lien loans and secured bonds each represented 3%. Asset-based finance investments represented 3% of the portfolio, while equity and other investments represented 9% of the portfolio. All metrics are quoted on a fair value basis. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge with approximately 57% of drawn leverage as of June 30th, comprised of preferred equity, which provides favorable regulatory treatment for leverage and asset coverage purposes versus traditional term and revolving debt facilities, and flexibility in the types of assets we can borrow against. I'll now turn it back to Andrew to discuss our forward outlook.

Thanks, Nick. We believe our portfolio is built for long-term durability. We believe active management combined with disciplined fundamental credit underwriting remains essential for generating returns while managing risk. We believe FSEO offers a differentiated value proposition that seeks to deliver attractive risk-adjusted returns across diverse market and environments, supported by several factors. First, we target businesses with strong cash flows, modest leverage, and seasoned management teams with deep operational experience navigating market cycles. We invest in credits with appropriate loan-to-value ratios, seeking to mitigate the risk of loss, even in a more pronounced economic slowdown, although there can be no assurances that repayments will be fully achieved always. Our sector allocations are guided by our bottom-up fundamental research, and we generally avoid highly cyclical segments of the economy. Second, we remain focused on senior debt investments that offer strong structural protections and attractive yields or expected total returns. We generally avoid lending to private equity-owned companies that contain heightened risk of asset leakage or potential lender disputes. We're also cautious of credits with aggressive EBITDA adbacks that may not materialize and instead view free cash flow as a more reliable indicator of credit quality. Third, we compete primarily in the lower and core middle market, where we believe the risk return profile is most attractive, typically offering higher spreads, lower leverage, and stronger documentation than large cap transactions unlike many smaller managers in this space we bring the resources infrastructure and discipline of a large platform which in our view allows us to originate underwrite and manage investments with greater scale and rigor by focusing our private allocations in this segment we seek to capitalize on inefficiencies and deliver attractive risk-adjusted returns. 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 see the most compelling risk-adjusted return opportunities. Our goal is to dynamically allocate capital, the most attractive opportunities across the credit and business cycle, and we believe this approach may enhance stockholder returns relative to a more confined strategy. Importantly, we are not constrained by a specific asset class mandate. In summary, we believe FSCO, supported by the resources and insights of the broader FS credit platform, is well positioned to seek to deliver attractive risk-adjusted returns across a wide range of economic and financial market conditions. Once again, thank you all for joining us today. With that, we'll take a brief pause before answering questions.

Thanks, Andrew. First question is, FSEO's NAV has held up relatively well, yet the stock continues to trade at a significant discount. Why do you think the market remains unconvinced?

We believe the discount reflects broader sentiment towards publicly traded private credit vehicles rather than any specific concern about FSCO's portfolio. Valuations are influenced by a variety of factors, but one thing going on right now is funds with significant private asset exposure have been trading at lower valuations than comparable vehicles with more liquid portfolios. So we think we're sort of being dinged for being in that bucket. And, you know, I think you've seen some private credit funds underperform, and that's where that negativity comes from. But since the beginning of 2025, FSCO has produced positive NAV returns while maintaining what we believe is a conservative portfolio profile. So we think our fund is doing well, but just getting thrown in that bucket of negativity around publicly traded private credit funds. We recognize shareholders are frustrated with the discount, and we spend a considerable amount of time with investors communicating the portfolio's fundamentals and thinking about ways to close the discount. Ultimately, we believe consistent NAV performance, stable income generation, and continued execution over time will narrow the discount.

Thanks for that. Next question is, several competitors have experienced rising non-recurals and credit stress this year. What are you seeing within the FSCO portfolio?

Based on current information, meaning just the monthly reporting that we get on our portfolio, overall credit performance remains relatively stable, generally actually kind of improving on a year-over-year basis. Our portfolio is also concentrated in senior secured debt, so we're top of the cap structure. And, you know, we're continuing to see sound performance across most borrowers with leverage ticking down on a quarter-over-quarter basis. We actively monitor borrowers for signs of deterioration, and we stress test positions under a range of economic scenarios. And we like where the portfolio stands. We believe the lower and core middle market remain an attractive area for lending. In our experience, it's a bit different than the upper part of the private credit market. We generally see lower LTVs, better covenant protections, more lender control, and that helps kind of protect downside. So obviously, there can be some idiosyncratic issues from time to time, but we don't really see any evidence of broad-based deterioration across the portfolio. Yeah.

And PIC income has declined from nearly 30 percent of investment income at the end of 2025 to approximately 15 percent this quarter. Should investors view that as a positive development?

The decrease primarily reflects exits and repayments from several PIC investments, you know, rather than any change in our investment philosophy. And, you know, a number of those investments that, you know, contributed to kind of the downtick in PIC income, you know, were good investments. So obviously, I think investors like cash, you know, better than PIC. But those PIC positions were not problem positions. They were attractive positions. We've always viewed PIC as a tool rather than strategy. And in our portfolio, many times PIC does not reflect troubled positions like it does in other private credit funds. Because in some cases, our PIC investments are highly structured at issuance. And many times PIC is only a component of the coupon. on. And when we do enter a PIC investment, the investments are typically supported by strong asset coverage, good structural protections, and in some case, equity participation or other forms are upside. So PIC has come down. We're cognizant that the market doesn't like PIC you know, as we look at new investments. And, you know, we view the current, you know, PIC portfolio as, you know, kind of relatively healthy and, you know, don't really have a view right now on that level of PIC ticking back up.

And you discussed concerns surrounding AI and software evaluations. Has recent volatility created attractive opportunities or are you becoming more cautious towards the sector?

The answer is really both. Periods of volatility can create attractive entry points, but also periods of volatility can, you know, signal problems that are on the come. So, you know, we're, you know, highly, you know, selective and, you know, looking at, you know, every, you know, situation individually. Our focus continues to be on software businesses with durable cash flows, essential functionality, and strong competitive positions, high barriers to entry, you know, that we think, you know, can't be eroded by AI. We're less interested in companies, you know, know, where the value depends primarily on future growth assumptions, where the world is, you know, frankly, you know, less predictable, or companies where we think kind of switching costs are lower, and, you know, kind of the barriers with respect to kind of moving to an AI based product are lower. So we think they're going to, there is going to be some real dispersion between winners and losers, you know, in the software space. And, you know, one just really needs to be, you know, very cautious if investing in the sector. You know, our software exposure, we think, is very low for a private credit fund. And, you know, we're not, you know, really looking to increase it right now.

Thanks, Andrew. And this next one is for Nick. The fund originated only five new private credit investments during the quarter, despite highlighting attractive market conditions. Why wasn't deployment higher?

We remain disciplined and opportunity-driven more so than volume-driven. You know, we'd rather originate a smaller number of attractive investments than stretch on structural pricing simply to increase deployment. You know, we do feel that even in a slow M&A environment, our sourcing network continues to give us relatively steady deal flow. So we're still seeing a lot of stuff. But, you know, this market favors people who are going to be patient and not chase deals. And, you know, we need to maintain our underwriting discipline.

If private credit market activity remains subdued and sponsor-backed deal flow stays below historical levels, how does FSEO continue growing earnings from here?

So we do not believe that earnings growth is dependent on recovery and sponsor activity alone. A big portion of our opportunity set comes from non-sponsored borrowers and other incumbent relationships, you know, that we have, as well as, you know, our proprietary channels. In some cases, you know, slower transaction activity can actually improve lending economics by reducing competition. So I'd say just broadly, we've continued to see attractive opportunities, you know, across a wide range of markets and have no real reason to expect that that will not be the case going forward.

Total return on NAV was nearly 4% during the quarter, despite distribution coverage below 100%. How should investors think about the relationship between NII generation and overall shareholder returns?

I mean, certainly this is a credit strategy, you know, first and foremost, and so net investment income is a very important component of returns, but it is only one component of returns, and we do have a total return, you know, mentality. You know, during the quarter, performance clearly benefited both from income generation and capital appreciation and, you know, certain portfolio holdings. So, you know, we're looking to achieve an attractive level of current income, but to supplement that through active portfolio management and making investments that have the opportunity, if not the expectation, for capital appreciation, you know, as well. You know, obviously, investments like like Church's Texas Chicken and New Giving demonstrate how structured credit investments can create value in excess of contractual coupon income.

All right. The quarter benefited from meaningful, unrealized appreciation in a handful of investments. How should investors think about the sustainability of those gains and the reliability of the fund's valuation process?

So the valuation process is overseen by the Funds Board, which has designated the advisor as the fund's valuation designee to implement the process on a day-to-day basis, subject to oversight by the board and the board's audit committee. Investments for which market quotations are readily available are valued at market value. Where they're not readily available, they're fair valued in good faith by the advisor are under oversight of the board, you know, in accordance with the valuation policy, considering observable market inputs, you know, if they're available, as well as the underlying fundamentals of the borrowers, the operating performance, comparable transactions, and, you know, other relevant factors. So, you know, specific to the quarter, the appreciation recognized was driven by very specific events that occurred as well as improved business performance as opposed to a change in market multiples. We are not focused on managing short-term investment gains through changes in valuation of illiquid investments. We take an approach of doing a deep dive underwrite, and the valuation reflects the work of third parties as well as the performance of the companies we invest in over time and events that create or, in some cases, don't create value for our constituents.

All right, this concludes today's call. Thank you, Andrew. Thank you, Nick. If you have any follow-up questions, please feel free to reach out. Thank you for joining us, and we look forward to speaking with you next quarter.