Earnings Call Transcript - FSCO Q2 2024

Operator, Operator

Good morning and thank you all for joining us for Credit Opportunity Corp's Second Quarter 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 our press release that FSCO issued on August 5, 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 June 30, 2024. A link to today's webcast and the presentation is available on the Company's webpage at www.fsinvestments.com under the Investor Relations 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 will include forward-looking statements regarding future events, performance, and operations of FSCO. These forward-looking statements are subject to inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projections. 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 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; and 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, 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. We will strive to answer as many questions as possible. In addition, I would like to point out the resource that we have listed at the bottom of the screen which you can access throughout the call including a link to the earnings presentation. I will now turn the call over to Andrew.

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Thank you, Joe, and good morning, everyone. We are proud of the results we delivered for our shareholders during the second quarter of 2024 across several key fronts. First, the Fund delivered a net return of 2.75% based on NAV. While portfolio performance was broad-based during the first quarter, the top 10 contributors based on issuer accounted for over 40% of the total realized and unrealized appreciation. Year-to-date, as of June 30, 2024, the Fund generated a net return of 8.67% based on NAV, outperforming high yield bonds by 609 basis points and loans by 432 points. This performance was strong on both an absolute and relative basis as FSCO 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 our 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, and unconventional ownership for corporate events. We have a very robust sourcing engine that combines business-led and firm-wide sourcing investments. Next, the Fund paid distributions of $0.18 per share in the second quarter. As has been the case since our team assumed management of FSCO in January of 2018, net investment income fully covered distributions paid during the quarter. As of August 30, 2024, the Fund's annualized distribution yield was 10% based on NAV and 11.5% based on the stock price. On May 16, 2024, the Fund issued $100 million of term preferred shares due in May of 2029 at 205 basis points over treasuries. The preferred financing provides the Fund with additional purchasing power at favorable pricing. As of June 30, 2024, the Fund's cash balance was approximately $104 million, and we have ample availability on our credit facilities. Finally, the discount at which the Fund's common shares traded relative to its net asset value narrowed significantly in 2023 and that trend has continued in 2024. We believe the improvement reflects the Fund's continued strong performance, the increase in the annualized distribution in March, and the broader strength in credit markets. We're pleased that FSCO shareholders earned a total return of 10.6% in the second quarter of 2024, and we believe the current average discount at which the stock is trading compared to NAV still does not reflect the health of the portfolio or the high quality of our increase program. I'll now turn the call over to Nick to provide our perspective on the markets and discuss our investment activity during the first quarter.

Nick Heilbut, Director of Research and Portfolio Manager

Thanks, Andrew. U.S. economic growth was solid during the second quarter of 2024, bolstered by the strength of attrition. Despite some signs of cooling, the generally strong labor market provided a tailwind for consumer spending. Treasury yields rose modestly during the quarter as the 10-year yield increased 14 basis points to 4.34%, while the policy-sensitive two-year yield increased 10 basis points to 4.72%. Credit markets benefited from the supportive macro backdrop and carry-driven returns, while investors reduced and delayed their expectations for Fed rate cuts throughout the quarter. Senior secured loans returned 1.85% during the quarter, while high yield bonds returned 1.05%. Higher-rated bonds led returns as CC bonds returned 1.29% compared to 0.13% for CCC-rated bonds. Loan performance was mixed as B rated loans outperformed both higher and lower rated peers. Against a generally solid economic backdrop, defaults remain largely in check. The second quarter produced the lowest volume of defaults since the fourth quarter of 2022. While default rates, including distressed exchanges, ended the quarter below the 25-year average for both high yield bonds and loans. We expect defaults will likely increase through next year with the composition skewed toward loans due to weaker credit fundamentals and a higher pace of distressed transactions across the market. The volume of distressed loan transactions through July is already the largest annual total on record. We also expect the divergence in recovery rates between high yield bonds and loans to continue. Recovery rates for high yield bonds over the last 12 months are 40%, which is directly in line with the longer-term average while loan recoveries are 43% today and well below the historical average of approximately 64%. We believe active management combined with sound fundamental credit underwriting will remain critical to driving returns and avoiding excess risk in the year ahead. Turning to the investment activity, the Fund remained fully invested throughout the first quarter. Purchases, excluding portfolio hedges, totaled approximately $233 million, compared to sales, exits, and repayments of $234 million. Credit markets remained competitive during the quarter. Especially in these times, we continue to leverage the insight and deal flow across FS 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 to drive steady portfolio investments in public and private credit. Approximately 67% of new investment activity was in privately originated investments and purchases were weighted to first lien senior secured loans and, to a lesser extent, subordinated debt. Public credit investments represented a third of the investment activity during the quarter with 91% of purchases being first lien loans. As of June 30, approximately 83% of the portfolio consisted of senior secured debt, unchanged from the previous quarter. The fund's allocation to subordinated debt was 4% compared to 5% in March. Asset-based finance represented 4% of the portfolio while equities under investments represented 9%. Public credit comprised 48% of the portfolio as of the end of June, while private credit comprised 52%. Excluding asset-based finance investments, the largest sector ratings at quarter end were consumer services, followed by commercial and professional services, and healthcare equipment and 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.

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Thanks, Nick. Economic data and credit returns were both solid during the second quarter of 2024, yet markets were impacted by significant volatility following the quarter end, driven by a mix of lackluster economic data that put the economic soft-landing narrative into question and shifted Fed rate expectations. While markets recovered, it is certainly possible that we see further volatility through the remainder of the year as investors continue to monitor geopolitical conflicts and wrestle with the forward path of U.S. rates, the U.S. economy, and the presidential election in November. Recognizing the potential for volatility in 2024, we've constructed the portfolio based on several key attributes. First, we are focused on businesses with strong cash flows, modest leverage profiles, and management teams with deep operational experience managing through market cycles. We're investing 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 those investments are particularly low leverage. Credit spreads were tight and covenants in broadly syndicated loan markets are weaker-than-usual. This, coupled with uncertainty over inflation rates and the durability of the economy, leads us to have a higher bar for evaluating new investments. We also believe that maintaining some extra buying power is prudent, not only to minimize potential drawdowns by not being overly leveraged, but also to take advantage of attractive investment opportunities arising in 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 risks of asset leakage or disputes between lenders. We're 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, as opposed to poor 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 end funds in the market with $2.1 billion in assets as of June 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 FSCO with a unique advantage as a large percentage of our drawn leverage is multiyear 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-adjusted return opportunities lie. Our goal is to dynamically allocate capital to the most attractive opportunities across the credit and business cycle, and we think this leads to enhanced stockholder returns relative to a more confined strategy. Importantly, we are not constrained by 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. Our private investment portfolio includes highly bespoke investments originated through our team and 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 our focus on providing specialized financing solutions differentiate 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 flexible management. 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 less traditional areas of the credit market including opportunistic and event-driven credit, special situations, and private structured capital solutions. Since the current investment team assumed all portfolio management responsibilities in January of 2018, the Fund's net returns have outperformed the gross returns of high yield bonds by 334 basis points and loans by 217 basis points per year. Once again, thank you all for joining us today. And with that, we'll take a brief pause to review the queue before answering your questions.

Operator, Operator

Okay. Our first question, what is the target LTV for portfolio companies we invest in?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Sure. So, we take a bottom-up approach and look at where the value is coming from and the stability of that asset value or enterprise value. So, it really depends, but I would say on average our typical investments are going to be somewhere between 50% and 60% loan to value based on FS' view of value, not necessarily the owner of the business' view of value. Often LTV is lower based on where businesses may transact and kind of what owners will be their businesses.

Operator, Operator

Great. Our next question. Are there any considerations for buying back equity to take advantage of the discounts you've had?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So, we and the Board are constantly evaluating the best use of capital for the fund. We are weighing the option of buying back shares within our distribution policy, alongside our investment opportunities in the market at any given time, and it's a constant discussion with the Board on how to allocate capital to those three opportunities.

Operator, Operator

Our next question. Does the expected decline in rates affect the Fund's ability to pay the $0.06 per share monthly dividend? Do you anticipate cutting your dividends when interest rates do fall?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So right now, we believe our dividend is very well protected. We've modeled out the base case, or I would say, kind of what the market is projecting from a rate perspective and the dividend looks nicely covered, certainly for a period of time. Depending on what happens with rates and how low they go, the whole sector is likely to face some earnings pressure in the downward rate environment. I think the way to look at our fund is really on a spread basis, so a spread basis over the SOFR rate, and our goal is to generate an attractive spread to whatever the risk-free rate is. Our portfolio is 62% floating, so we cannot totally insulate ourselves from the rate environment. But I would note that a significant portion of our earnings is generated from fee-based income, and that is not directly tied to the direction of rates. So, I think, in summary, we have to see where rates are. I think we are as insulated, if not better insulated than most, but can't fully diverge from the macro.

Operator, Operator

Next question. It's great to see that the stock performs very well so far this year, but FSCO still trades at a 10% to 12% discounting bid. Can you provide a bit of color as to how the stock is valued relative to peers?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So, closing the discount is a big focus of ours. We continue to focus on strong investment management to deliver returns that are best-in-class. We think that will ultimately drive the stock price. If you look at our stock, we're mostly in line from a dividend perspective today. Our policy with respect to our dividend is to be prudent and offer a dividend that is well covered. If you look at many of the peers in the closed-end space, they are over-distributing to achieve a higher yield. So, we sort of trade in line from a dividend perspective, but that discount is there because our absolute dividend yield on an NAV basis might be a tad lower than some of those peers that are over-distributing.

Unidentified Company Representative, Representative

Our next question. The Fund's generated a significant portion of net earnings from dividends and fee-based income in the first half. Can you talk a bit about how these revenues are generated?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So, one-time fee income is usually tied to originations, so private deal originations as well as exit fees. So, if you think about our typical deal, we usually get a fee upon the closing of the deal that goes to the Fund. It could be anywhere from 1 to 3.5 points. And then some of our deals have back-end fees, which could be either hardwired exit fees where there is a fee payable upon repayment of the loan. Other times, they could be more contingent-type fees that are tied to early repayment like call payments and whatnot. Those fees should generally be pretty steady regardless of the interest rate environment. Obviously, those fees are more tied to deal activity, both new transactions originated as well as exits. On the dividend side, occasionally the fund will invest in equity. Usually, it's equity that we get for a minimal cost upon investing in a private transaction. So, think about warrants for the ability to buy some really inexpensive equity upon our primarily debt-based deal, and then occasionally we'll get dividends associated with those equity stakes. That was the case with the investments that led to the large dividend earlier this year.

Operator, Operator

Next question. You mentioned spread tightening in your prepared remarks. Can you provide a bit more color on what you're seeing in the market today as far as pricing and spread levels and how that compares to six months ago?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So, we've seen general spread tightening both in the private and public markets. The private markets, the statistics are not as good, but when we look at one stack that's out there, it shows average private credit spreads of 630 basis points as of the end of 2023 and spreads today at around 530 basis points. So that one statistic shows about 100 basis points of credit spread tightening. We feel that's around what we're seeing. So private credit markets are about 100 basis points higher than they were. If you look at the on-the-run private credit, I would say the average sponsor loan, so the direct loan to sponsor that bypasses banks and goes through one of the big private direct lenders is probably coming at around 475 basis points over SOFR today. We're generally not playing in that market. We're usually playing in the part of the market where they're either smaller sponsors, more story credits, or non-sponsors, and we're usually paying a premium for that, but it gives you a direction. If you look at the on-the-run public credit markets, the average new issued B3, which is sort of comparable to the average new sponsor private loan, our feel is that B3 is probably coming around 350 basis points, so 100 to 125 basis points tighter than private credit.

Operator, Operator

Our next question. How have your macro views changed over the last few months? What is your perspective on the current balance between being in a borrower's versus a lender's market? Specifically, are you seeing an increase in borrowers leveraging into your pricings and are you seeing tighter or looser common structures overall?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

It's a great question. So, the market I think is definitely transitioning to a borrower's market. You can see it in the big uptick in re-pricings. Q2 re-pricings were the highest on record. You've had increased competition in private credit, lots of money being raised for private credit, and that's putting more pressure on the space and more competition for deals, which gives borrowers a little bit more leverage in their negotiations. All of that is leading to that spread tightening we've seen, as well as more favorable non-economic terms for lenders. So, fewer covenants, wider covenants, etc. That said, it doesn't mean credit is unattractive. It's just tighter than it was. We still think credit streams relatively attractive compared to equities and other asset classes based on valuations and projected returns. Additionally, we still see some really nice opportunities in more off-the-run areas of the credit market. A lot of the dynamics that I mentioned are dynamic in the on-the-run areas. Ever since the financial crisis, we've seen mandates that are more constrained and our whole strategy is to focus on areas of the market that those mandates don't. We see some really nice opportunities there. Our private originations in the quarter came in at an average yield of 12.6%. So, if you think about like that 475 basis points that's on the run, we've couple of 100 basis point premium to that. And then, in the public markets, we're picking our spots, but our average investment in Q2 has spread to SOFR of 600 basis points. Again, that compares to that like 350 basis points or 75 basis points on the fee rate. So, we're seeing plenty of opportunity.

Operator, Operator

Our next question. The portfolio is approximately 52% private dividend compared to 46% one year ago. As you mentioned, 67% of new investment this quarter was private. Can you talk about why this opportunity is attractive today and what spreads are you deploying after both public and private investments?

Nick Heilbut, Director of Research and Portfolio Manager

Sure. We continue to see good opportunities to act as a very efficient solutions provider to forward state in the private market. I think a lot of the reason for that is the design of our business and the relationships that we have and capabilities on our team. Andrew touched on some of the spreads in his prior answer, a little bit higher in the private market, but we're also seeing attractive things in the public market. So, we continue to put much more at the 600 spread or greater. Just some examples of opportunities in the private market in the last quarter included an investment that we've led in Core Health and Fitness, an investment in a company called ECI in the pharma business, a follow-on investment to support a portfolio company called Nephron, a restructured investment in another healthcare company, something in the gaming space, and something in the sports equipment space. So, we have broad regions in the market and strong capabilities to create idiosyncratic opportunities in the private space.

Operator, Operator

Our next question. Do you think the economy will slow down in coming quarters? If so, how do you shift your fund's focus to best preserve NAV?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Yes. So, we see some signs of modest slowing in the economy. I think we still have the view that the chance of a recession in the U.S. is below 50% over the next 12 months. But we're always underwriting downside scenarios for these investments. I think first and foremost, we want to hold to our standards when we underwrite deals through all points in the cycle, achieving appropriate creditor protections as well as investing in good businesses. It's always the best way to limit downside. So far, we've been able to continue identifying good opportunities with superior risk-adjusted returns. I think the cadence of investing and the style of investing that we've been doing is consistent and mindful of protecting downside should things deteriorate. I'd also mention that our fund has the flexibility to take advantage of market dislocations as well as broad sector expertise, which allows us to focus on sectors that fall out of favor just for slowdowns and how they're positioned in the market.

Operator, Operator

Our next question. Where do the best risk-adjusted returns sit within your portfolio today? Are these predominantly first lien senior secured risk or are you willing to go down in the capital structure?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

So, what we've seen repeatedly in credit is that there are huge advantages to being secured. Our experience has continued to illustrate that being secured is normally the best place to be in the capital structure. And so, generally speaking, that's where we like to focus—very downside oriented. Obviously, we understand that spreads can widen, the economy can slow down, and there could be various challenges that businesses face. But if we do a good job structuring and underwriting our investments, we should get our money back plus our coupon and maybe some fees and such along the way, and that informs the core go-to-market strategy, which is to protect principal and avoid losses.

Operator, Operator

Our next question. Could you discuss your fee structure relative to peers in the closed-end fund space?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

We view our peers as a mixture of closed-end funds and BDCs. Half of our portfolio is BDC-like, so private investments represent 52% of the portfolio. I'd actually go a step further and say that half is actually more intensive than the average credit, given the special nature of many of our private deals and their non-sponsor status. So, they're heavily negotiated, heavily diligence, and highly monitored transactions. Two-thirds of our investments in this quarter were in direct origination, so the trend is up. That said, the remainder of our portfolio are in public investments. Again, those public investments are not on-the-run type investments, but more intensive investments that are also underwritten and monitored. If you just look at the public-private nature of our business, it's sort of half-closed-end fund life, half-BDC life. If you look at our fee structure, it sits in between the closed-end funds and BDC fee structures.

Operator, Operator

Our next question. Can you provide an update on non-accrual investments in the portfolio?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

Yes. So non-accruals are about 2.7% of fair market value, again, predominantly first lien. Just because something is non-accrual doesn't necessarily mean we're going to lose money on that investment. We're comfortable with the level of non-accruals in the portfolio. There were two new non-accruals in the quarter, one investment of $5.3 million fair market value and one with a fair market value of $23 million.

Operator, Operator

Our next question. Can you talk about leverage and targets on the capital structure?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

At quarter-end, the revolver was fully paid down. Leverage on a gross basis was 0.48x, which is the lower end of the range for FSCO. Is this reduction in leverage intentional? So, our views on leverage haven't changed in terms of target leverage levels. I think two things. One, with respect to this particular reduction, it was really a function of two different things. The biggest was NAV growing over the last few quarters and debt levels not changing that much, just ticking down a little bit, but that leads to a lower ratio. So, that was the biggest driver. The second thing just to think about is, given our focus on private investments, you can’t always perfectly find them. They haven't flowed in terms of when a repayment may be coming. We don't get a lot of notice when repayments come, and originations have their own timelines that can move around. So, any particular day, week, or quarter-end, it's possible you're hitting the repayment with the new origination coming not exactly at the same time, and that probably speaks for the slight reduction in debt that we had quarter-over-quarter.

Operator, Operator

Our last question. Given that the revolver and term loan mature this December, do you intend on refinancing and/or raising additional leverage and also closing your target liquidity level?

Andrew Beckman, Head of FS Global Credit and Portfolio Manager

We have plans to address the 2024 maturities. We're in active discussions right now about the most cost-effective and flexible way to do that. From a target perspective, our view is nothing has changed. We’re focused on maintaining our current leverage target and we're also focused on ensuring we have the right mix of leverage in terms of debt versus preferred.

Operator, Operator

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, Joseph Montelione. Thank you.