Earnings Call Transcript - FSCO Q4 2023

Operator, Operator

Good morning, and thank you all for joining us for FS Credit Opportunities Corp’s Fourth Quarter and Full-Year 2023 Earnings Conference Call. Please note that FS Credit 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 January 30th, 2024. 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 December 31, 2023. A link to today's webcast and the presentation is available on the company's webpage at www.fsinvestments.com under the FS Credit Opportunities Corp tab. 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 FSCO'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. FSCO 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 FSCO or information about the market as indicative of FSCO's future results. Speaking on today's call will be Andrew Beckman, head of FS Global Credit and Portfolio Manager for FSCO; Nick Heilbut, 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 the Fund. Following our prepared remarks, the team will take questions from the audience. If you'd like to ask a question, there is a chat function on the right side of your screen. You will try to address each of your questions after our prepared remarks. I will now turn the call over to Andrew.

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Thank you, Robert, and good morning, everyone. Looking back on 2023, we are proud of the results we delivered for our shareholders across several key fronts. First, we delivered strong returns in 2023, as the fund returned 20.1% on a net basis, outperforming the ideal bond and senior secured loan indices by 667 basis points and 707 basis points, respectively. This performance was strong on an absolute and relative basis as FSCO outperformed many of the larger credit-focused peers in the closed-end fund space. Net investment income fully covered distributions of $0.64 per share, and the fund's net asset value increased by $0.59 per share, or 9.3% year-over-year. We believe our performance reflects the dynamic nature of our strategy, investing across public and private credit with a focus on generating return premiums driven by the complexity of a company's balance sheet, the illiquidity of an asset, unconventional ownership, or corporate events. We increased the fund's annualized distribution by 15% in July, driven by rising market yields and the continued strong performance of our investment portfolio. This was the second increase in the annualized distribution since the fund's common shares listed on the New York Stock Exchange in November of 2022. Finally, we completed all phases of FSCO's listing on May 15, 2023, and marked the one-year anniversary of the listing on the NYSE in November of last year. The discount at which the fund's common shares traded relative to its net asset value narrowed significantly during the year. We believe the improvement reflects the fund's strong performance, broader market strength, and reduced selling pressure on the stock after all the phases of the listing were completed. While we are pleased that FSCO shareholders earned a total return of nearly 35% for the year, we believe the current discount at which the stock is trading compared to NAV does not reflect the health of the portfolio or the high quality of our investment program. During the fourth quarter, the fund paid monthly distributions totaling $0.17 per share, which were fully funded through net investment income, as has been the case since the FS Global Credit Team assumed management of FSCO in January of 2018. As of February 28, 2024, the fund's annualized distribution yield was 9.8% based on NAV and approximately 12.17% based on the stock price. In terms of portfolio performance, contributors far outpaced attractors as positive performance was broad-based across the portfolio in 2023. The largest contributor performance during the fourth quarter and year resulted from unrealized appreciation in New Giving, Inc., one of the fund's largest holdings, a directly originated investment in a healthcare services firm. The company produced strong revenue and earnings growth as operational measures implemented in 2022 continue to positively impact the business throughout 2023. This investment highlights our ability to source differentiated opportunities and creatively structure the investments. FSCO received common equity and warrants as part of our debt investment, which provides for the potential for meaningful additional capital appreciation, yet preserving the downside protection we like to see in our investments. Opportunistic equity hedges detracted from the funds returned during the year amid the strong environment for equities. I will now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the fourth quarter.

Nick Heilbut, Director of Research of FS Global Credit and Portfolio Manager

Thanks, Andrew. Risk assets rallied during the fourth quarter as expectations for an economic soft landing supplanted recession fears. Treasury yields plunged during the quarter, with two-year and 10-year yields falling approximately 80 basis points and 70 basis points, respectively, as investors firm their expectations for Fed rate cuts in the first half of 2024. Amid falling yields, the Bloomberg US Aggregate Index returned 6.82% in the fourth quarter in a generally strong environment for longer duration fixed income assets. Positive investor sentiment and a supportive technical backdrop drove high yield bond spreads to their lowest point since January 2022, while loan spreads reached their lowest point since May 2022. High yield bonds returned 7.1% during the quarter, outperforming senior secured loans which returned 2.9%. Returns by credit rating were generally mixed during the quarter as lower-rated credit flat performance. The CCC bonds returned 20.4%, outpacing BB bonds by 892 basis points. CCC rated loans returned 17.5% compared to 10.2% for BB loans. Although the technical environment supported credit prices, driven by strong investor demand and reduced supply, the fundamental backdrop deteriorated modestly during the year as evidenced by a rise in defaults and lower recovery rates. The high yield default rate, including distressed exchanges, increased to 2.88% as of December 31, 2023, while loan defaults and distressed exchanges rose to 3.08%. This compares to default rates of 1.65% for high-yield bonds and 1.59% for loans as of December 31, 2022. Meanwhile, recovery rates took a notable decline, hitting 38% for loans, a record low, and 33% for bonds, which was not a record low but far below high yield bonds, long-term average recovery rate of 40%. Turning to investment activity, the fund remained fully invested throughout the fourth quarter, driven by a healthy pipeline of new investments and relatively low levels of repayments. Excluding portfolio hedges, purchases of $184 million exceeded sales, exits, and repayments of $173 million. Demand for high-yield bonds and senior secured loans rose amid improved investor sentiment, while new issuance was limited by a sluggish M&A environment. In today's competitive markets, we continue to leverage the insights and deal flow across FS Investments' $28 billion credit franchise, while using our deep relationships with company management teams, commercial investment banks, financial sponsors, non-bank intermediaries, and other private credit managers to drive a steady pipeline of investments in public and private credit. Approximately 63% of new investment activity was in privately originated investments during the quarter, comprised entirely of first lien senior secured loans. Public credit investments, which represented 37% of purchases during the quarter, were comprised also almost entirely by first lien loans as well as high-yield bonds. As of December 31, 2023, approximately 81% of the portfolio consisted of secured debt, up from 77% the previous quarter. The fund's allocation to subordinated debt was 5%, down from 7% in the previous quarter. Asset-based finance represented 4% of the portfolio, unchanged from the previous quarter, while equity and other investments represented 10% compared to 12% as of Q3 2023. Public credit represented approximately 53% of the portfolio, while private credit comprised approximately 47% as of the end of the year. Excluding asset-based finance investments, the largest sector ratings at quarter-end were consumer services, followed by healthcare equipment and services, and commercial and professional services. We believe these investments offer the potential to drive strong risk-adjusted returns and operate in areas of the economy that may be more insulated in the event of a broader economic slowdown. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge, with 43% of drawn leverage comprised of preferred debt financings that provide preferable regulatory treatment versus traditional term loans or revolving debt facilities. Approximately 43% of drawn leverage is multi-year fixed rate preferred debt and provides flexibility in the types of assets we can borrow against. As of December 31, 2023, the fund's cash balance was approximately $106 million. Despite a modest cash balance, we have ample availability in our credit facilities should a liquidity need arise.

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Thanks, Nick. 2024 opened with optimism that an economic hard landing has been avoided. However, falling yet persistent inflation, tighter credit conditions, an election cycle, and continued geopolitical conflicts are things to monitor for investors. Against this macro backdrop, we remain cautious about the economic outlook and continue to see potential for future periods of volatility. We believe the solid index level returns last year matched strong underlying cross currents in the credit markets. Performance differences across ratings, asset classes, and industries could become more pronounced in 2024 as economic growth slows. Recognizing potential for volatility in 2024, we've constructed the portfolio based on several key attributes. First, we believe active management combined with sound fundamental credit underwriting will remain critical to driving returns and avoiding excess risk in the year ahead. We're focused on businesses with strong cash flow, modest leverage profiles, and management teams with deep operational experience managing through market cycles. We are invested in credits with appropriate loan-to-values to ensure ultimate repayment of the obligations, even in a more pronounced economic slowdown. Our sector allocations are informed by our bottoms-up fundamental research, and we tend to avoid highly cyclical areas of the economy unless loans to values are particularly low. We have been more cautious about making new investments than we would be in an environment with a less controversial outlook. Therefore, we believe maintaining buying power is prudent not only to minimize potential drawdowns, but also to take advantage of attractive investment opportunities arising from periods of volatility. Second, we continue to focus on senior debt investments with strong terms at attractive yields or expected total returns. We generally avoid debt in private equity-owned companies where we think there could be material risk of asset leakage or disputes between lenders. We are also cautious on credits where there are significant EBITDA add-backs that may never materialize and instead focus on true 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. We are avoiding situations that are high return because of high loan-to-values and low credit quality. Third, we will continue to leverage size and scale to drive differentiated outcomes for our investors. FSCO is one of the largest credit-focused closed-end funds in the market with $2.1 billion in assets as of December 31, 2023. Size and scale matter in credit investing, especially when it comes to maximizing deal flow, mitigating risks, and achieving economies of scale. The portfolio management team also leverages the full resources infrastructure and expertise of FS Investments, a $76 billion alternative asset manager. As Nick discussed, we believe our leverage structure provides FSCO with a unique advantage as a large percentage of our drawn leverage is multi-year fixed-rate preferred debt and provides flexibility in the types of assets we can borrow against. Finally, our ability to invest across the public and private markets differentiates us from traditional credit funds and allows us to adjust our allocations based on where we believe the best risk-adjusted returns exist. Our goal is to dynamically allocate capital to the most attractive opportunities across the credit and business cycle. And we think this leads to enhanced stockholder returns relative to a more confined strategy. Importantly, we're not constrained by a specific asset class mandate. We can invest across loans, bonds, structured credit, and occasionally highly structured equity investments, as well as across fixed and floating rate assets. Our private investment portfolio includes highly bespoke investments originating through our firm-wide sourcing network. Our intensive due diligence process benefits from the sharing of collective insights on markets and individual credits. We believe our origination capabilities within the private market and focus on providing specialized financing solutions differentiates us from our closed-end fund peer group. In summary, we believe FSCO 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 funded platform built to drive strong risk-adjusted returns through a diverse range of economic and financial market conditions. Since the current investment team assumed all portfolio management responsibilities in January of 2018, the fund on a net basis has outperformed the growth returns of high yield bonds by 260 basis points and the gross returns of levered loans by 171 basis points. The team has invested more than $7 billion over the last six years in nontraditional areas of the credit markets, including opportunistic and event-driven credit, dislocated special situations, and private structured capital solutions. Once again, I'd like to thank you all for joining us today. And with that, we'll take a brief pause to review the queue for answering your questions.

Operator, Operator

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

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Sure. So the credit markets were very strong in 2023, and we saw spreads compress throughout the year, particularly in the fourth quarter of the year. High-yield spreads compressed by 133 basis points last year, and levered loan spreads came in by 92 basis points last year. The trends continued into this year, with high-yield spreads decreasing around 25 basis points and loan spreads decreasing by 15 basis points. So generally speaking, pricing has come in. That aspect of tighter pricing is most pronounced in the public markets, where there's visible spreads and transactions. This has caused us to look more for off-the-run opportunities in private markets. Plain vanilla private credit spreads have trended with the public markets, but our focus in off-the-run private credit, the capital structure in a solution area, provides capital to less conventional companies. That opportunity set, spreads have remained more consistent. And I think that's because there's less competition there and less visibility. So tighter public markets have kept our private opportunity set more stable. There definitely has been a positive though for our opportunity set from a deal flow perspective. Last year, with an uncertain economic environment, companies, whether they were sponsor-owned, entrepreneur-owned, or family-owned, were much more cautious about expanding M&A or acquisitions. With the performance in the market last year and a more benign outlook by many, at least as the markets are pricing in, we're starting to see activity ramp up, which is good for deal flows. Our deal flow is up significantly to start this year.

Operator, Operator

Great. And the next question, I believe you said 63% of new investments during the quarter were in privately originated investments. Can you talk about why this opportunity is attractive today?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Yes, so I think that dovetails with the first question. What we're really seeing is the opportunity set in those niche private transactions. The return premiums there relative to the public markets are very significant and that spread has grown as public markets have compressed. We're seeing better spreads, but we're also seeing better structural terms and protections to mitigate downside through credit documents. When public markets weaken, the credit documentation is often weak, and that's reflected in the average transaction coming through the public markets right now.

Operator, Operator

And just to follow up there, can you talk about how the team sources these private deals? Maybe you can discuss the origination and due diligence process here.

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Our sourcing is a combination of team-led sourcing and firm-wide sourcing. Our team consists of 21 individuals focused on the strategy. Each professional has numerous relationships in the industry. We've developed a CRM where we cover various counterparties, including management teams, brokers, law firms, and advisors. We're constantly working to extract deal flow from these relationships. Many of us have over 15 years of experience and a history of successful transactions with these counterparties, leading to continued deal flow. We combine our team-led sourcing effort with a firm-wide sourcing funnel. FS is a $76 billion organization with multiple business units. Every FS business seeks to support other businesses in sourcing. When they take meetings, they communicate what we are looking for and pull in deal flow, which then gets directed to the relevant group.

Operator, Operator

Great. And next question, where in the capital structure are you seeing opportunities today? Is it predominantly first lien senior secured risk or are you willing to go down the capital structure?

Nick Heilbut, Director of Research of FS Global Credit and Portfolio Manager

Yes. As the portfolio reflects, we generally prefer being at the top of the capital structure. However, if we can create attractive upside optionality in senior securities, we can incorporate that nicely into the fund's overall return profile. As the cycle has lengthened, we've moved up in quality a bit, which has generally led to more secured debt. So I'd say, broadly speaking, that's where we see the best opportunities, though from time to time, some idiosyncratic situations will arise that fit nicely and complement the portfolio.

Operator, Operator

Great. And next question in the chat. Would you consider investments in the commercial real estate sector, considering the need for many real estate features to refinance in the next few years?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So, yes, we would. We have been looking at some opportunities in the commercial real estate space. I still think it's early in terms of the problems manifesting in that space, as well as valuations being reset. We do have a real estate business at FS, so to the extent we explore real estate opportunities, we try to collaborate with that business to gain institutional knowledge and specific asset insights. I wouldn't expect it to constitute a huge portion of the portfolio, but it is an opportunity we're examining.

Operator, Operator

Great. And then in terms of your valuation process, can you provide some color there? Do you use a third-party valuation firm? Any details on the process and its frequency would be helpful.

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Sure. As mentioned, we have public investments and private investments in the portfolio. Public investments are marked using a third-party pricing service. Those instruments are marked daily. For our private investments, we use a third-party valuation firm that provides valuations monthly. Inter-month, those positions would be internally marked if there were any material events or news affecting their valuation. In 2024, the fund is continuing its process of daily marking for public instruments but is transitioning to third-party marks for private valuations done quarterly, with internal marks applied inter-quarter. We believe this is more consistent with industry practices and will also lead to some G&A savings for the fund.

Operator, Operator

And the next question, curious about your views of the macro environment today and expectations for the year. Where do you see rates headed at the end of the year? Any macro thoughts that your investment team considers when making investments would be helpful?

Nick Heilbut, Director of Research of FS Global Credit and Portfolio Manager

Yeah, so we see rates remaining in the current range for the foreseeable future and really don't expect any meaningful rate cuts in 2024. Obviously, we analyze all of our investments across different rate environments and when we incorporate something into the portfolio, we're not making an explicit bet on a change in interest rates. It's sort of outside our purview to provide a strong call on that. Across the portfolio, performance has been strong at the individual company level, which we consistently monitor. We gather a lot of information from a top-down perspective. The outlook we anticipate is benign, though we expect some weakness in certain areas. We're certainly seeing some weakness in the low-end consumer, along with some changes in certain sectors like commercial real estate, which can create unique weaknesses that occasionally offer opportunities for outsized returns.

Operator, Operator

Next question on your dividend strategy. Can you talk about the strategy? You've raised your dividend a few times since the listing in November of 2022, and coverage is still fairly high here. Any thoughts around the strategy and if you would evaluate any changes to the dividend in the future?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

The first thing I would say is that we are focused on our total returns for shareholders, first and foremost. We're very proud of our performance. As mentioned, the fund returned greater than 20% on a net basis last year, which is based on total returns comprising both dividend and NAV changes. The stock returned a total of 37%. With respect to the dividend, our policy is generally to pay out projected net income while considering current market conditions, interest rate curves, and other market changes on the horizon. Right now, our dividend is more than covered by net income, but we face a downward sloping yield curve. So, we will continue to reevaluate whether or not the current dividend is appropriate. Generally speaking, I believe there's a cushion in the near term for either maintaining or increasing the dividend.

Operator, Operator

Okay, and then the next question. Given the discount at which the stock trades compared to its net asset value, would you consider a share repurchase program?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

The board is constantly looking at all different strategies regarding capital use, and it's a continuous discussion about how best to allocate capital.

Operator, Operator

Okay, and then next question is on the balance sheet. Can you talk about leverage and targets of the capital structure?

Nick Heilbut, Director of Research of FS Global Credit and Portfolio Manager

Portfolio leverage derives from the composition of the asset pool and our views on market opportunities. Currently, the asset side of the balance sheet is exceptionally high quality. We continue to increase the percentage of secured debt, and we are pleased with the performance of our investments. Given the high quality of the assets, we're comfortable using leverage in mind, as you would expect, the current leverage in the portfolio. However, we always want to maintain some capacity to absorb risk in the event of a market sell-off.

Operator, Operator

Great. And next question, can you discuss your fee structure relative to your peers in the closed-end funds space?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

FSCO has a dynamic investment strategy with an allocation to private and public investments, which differentiates us from typical closed-end funds, in fact almost all closed-end funds. Our fund is also managed more actively in terms of content and exposure compared to most competitive closed-end funds we observe. Our fee structure straddles the closed-end fund space and the publicly traded BDC space. As Nick mentioned, roughly half of our investments are in private credit, which demands more intensive sourcing, structuring, and diligence compared to traditional BDC credit. Hence, our fee structure reflects a blend of private credit funds and public credit funds. While the fund does incur an incentive fee, it remains well below the average for BDCs.

Operator, Operator

Great. Next question. What was the percentage of non-accrual assets for the portfolio at the end of the year?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

On a fair value basis, it was around 1.3% and on a cost basis, it was approximately 3%. Those are year-end figures and down 2% on a fair value basis as of June 30 and 4% on a cost basis as of June 30.

Operator, Operator

Okay, great. That addresses all the questions on today’s call. I’d like to thank all of you for joining the year-end call today. If you have any further questions, please feel free to reach out to myself, Robert Paun, on the investor relations team. Thanks again.