FSCO - NYSE

Good morning and thank you all for joining us for FS Credit Opportunity Corp's First Quarter 2025 Earnings Conference Call. Please note that, FS Credit Opportunities Corp. may be referred to as FSCO, 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 the press release that FSCO issued on April 28th, 2025. 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 March 31st, 2025. 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 includes forward-looking statement 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; and Nick Heilbut, Director of Research of FS Global Credit and Portfolio Manager for FSCO. Also joining us on the call 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 and we'll strive to answer as many questions as possible. In addition, I'd like to point out the resources 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.

Thank you, Josh, and good morning, everyone. We're pleased with the results we delivered for our shareholders during the first quarter of 2025 across several key fronts. First, FSCO delivered a net return of 3.53% based on the Fund's net asset value, outperforming high yield bonds by 259 basis points and loans by 305 basis points. We believe our performance reflects the dynamic nature of our strategy investing across private and public credit with the focus on capturing return premiums in the lower and core middle market as well as opportunistic public credit investments. Next, the Fund paid distributions of $0.19 per share in the first quarter. As has been the case since our team assumed management of FSCO in January of 2018, distributions paid during the quarter were fully funded through net investment income on a tax basis. We increased the Fund's monthly distribution amount by approximately 7.5% in January, representing an increase of approximately 52% over the Fund's distribution rate at the time the Fund listed its common shares on the New York Stock Exchange in November of 2022. This was the fourth distribution increase since the listing. As of May 16th, 2025, the Fund's annualized distribution yield was 10.5% based on NAV and 10.8% based on market price. We deployed $163 million across private and public credit assets in the first quarter. While M&A activity slowed throughout the quarter, 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 JPMorgan to finance directly originated investments. Finally, we made significant progress narrowing the discount at which the Fund shares trade relative to its net asset value. We're encouraged by the progress and believe the significant improvement reflects the Fund's continued strong performance, the multiple increases in the monthly distribution rate since its listing and the flexibility of our strategy. FSCO shareholders earned a total return of 6.26% in the first quarter, driven by high current income and NAV appreciation. 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. Economic data were resilient during the first quarter of 2025, driven by strong consumer spending and steady employment growth. However, risk markets came under mounting pressure as sentiment weakened amid escalating trade tensions, rising inflation and signs slowing. Treasury yields declined as markets priced in as many as three Fed rate cuts for 2025. Following a strong start to the year in January, loan performance weakened in February and March as sentiment soured due to tariff concerns, capital markets volatility and weakening consumer confidence. Rising uncertainty combined with the sharp equity market selloff dampened loan demand and pushed spreads higher. Loan returns were negative in March, declining 31 basis points, marking the worst monthly performance in September '22. Despite the March pullback, loans delivered a positive return of 48 basis points for the quarter. High yield bond spreads widened materially during quarter end driven by lingering uncertainty around tariffs and their impact on business and consumer sentiment. High yield bonds declined 1.07% in the first quarter, but remained positive year-to-date returning 94 basis points as of March. Private assets were generally insulated, but not entirely immune from the volatility experienced in the public markets in the first quarter. Private credit volume totaled $64 billion in the first quarter, down 7% from the prior quarter, but up 12% year-over-year. As of March 31st, the average spread on private core middle market loans with SOFR plus 525, a 162 basis points above B-rated syndicated loans and 182 basis points above high yield bonds. Additionally, just 10% of syndicated loans issued in the first quarter included a financial covenant compared to 76% of upper middle market private deals and 96% of lower middle market private deals. Turning to our investment activity. As discussed on our call last quarter, we maintained a cautious view entering the year given the potential for volatility stemming from geopolitical conflicts, fiscal and trade policy, among other factors. Even as many market strategies forecast the benign market environment for 2025, we conducted a thorough position by position evaluation of the portfolio to assess the potential near and medium impact of tariffs and the uncertain path of economic rate and have been in close contact with sponsors and management teams. As a result, we believe we have a solid understanding of the portfolio's first order exposure to tariffs. However, we remain cautious as second and third order effects are still uncertain and may take time to materialize depending on how the tariff situation evolves. Despite the sluggish M&A environment, we saw strong origination activity supported by an expansive sourcing network. Our broad base of incumbent borrowers across our platform also remains a consistent source of repeat opportunities. As Andrew mentioned, we believe private credit offers greater relative value compared to the public markets. Approximately 96% of new investment activity was in privately originating investments, a 100% of which were first lien senior secured loans. The average GAAP yield of new portfolio credit investments was 11.9%. We went to lower and core middle market companies with average earnings of approximately $25 million to $75 million of EBITDA, which we believe is a competitive sweet spot. They are generally diversified businesses that are often overlooked by large credit managers due to their size while their balance sheets may not meet the standardized criteria for traditional lenders like banks. As a result, we typically have greater ability to negotiate favorable terms and structure investments that help mitigate downside risks. These businesses are typically more domestically focused compared to larger upper middle market firms, making them less vulnerable to global supply chain disruptions and shifts in trade policy. We invest in both sponsored and non-sponsored VAT transactions. Within sponsored leading we do not compete against the large direct lending funds and instead lend to small or emerging sponsors where there is typically less competition and greater potential to capture a yield premium. Non-sponsored lending opportunities comprise a wide range of borrowers that in most cases have never accepted outside capital. This includes multigenerational, family owned businesses, sole proprietors or other tightly held businesses and the like. We favor these types of investments because there is often a strong ability to control deal terms and create highly structured investments to protect our downside. Sales, exits and repayments of $288 million exceeding purchases of $163 million in the quarter when excluding portfolio hedges. We selectively exited in public credit positions where we identified elevated risk given the geopolitical backdrop. As of March 31st, private credit investments represented 72% of the portfolio compared to 65% as of the end of last year. Approximately 84% of the portfolio consists of senior secured debt as of March 31st, unchanged from the previous quarter. The Fund's allocation to unsecured debt declined to just 3% as of the end of the quarter compared to 5% as of the end of last year. Asset-based finance represents 3% of the portfolio as of the end of the quarter, unchanged from the previous quarter, while equity and other investments represented 10% compared to 8% as of the end of last year. Turning to the liability side of our balance sheet, we believe our cost structure gives us a competitive edge with 58% of drawn leverage as of March 31st, comprised of preferred shares, which provide favorable regulatory treatment versus traditional term or 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. The public market selloff accelerated after quarter end following the April 2nd announcement of broad-based tariffs and subsequent retaliatory measures by select trading partners. Loan and high yield spreads have since retraced much of April's widening, supported by the Trump administration's announced 90-day pause on reciprocal tariffs and growing expectations for progress towards de-escalating trade tensions. However loan and high yield spreads remain approximately 20 basis points, 60 basis points wide of their 2025 lows. We continue to believe that investors are not adequately compensated for the risks in public credit where lender protections are materially weaker than in private credit. Unless the dynamic changes, we view private credit as the core foundation of FSCO's portfolio and will opportunistically invest in public markets when opportunities present themselves over time. Our portfolio is built for long-term durability. We believe active management combined with disciplined fundamental credit underwriting remains essential to generating returns while managing risk. As we originate new investments, we carefully evaluate each opportunity for potential risks related to tariffs or broader geopolitical and economic uncertainty. We believe FSCO offers a differentiated value proposition designed to deliver strong risk adjusted returns across diverse market and economic environments, supported by several factors. First, we target businesses with strong cash flows, modest leverage and senior management teams with deep operational experience navigating market cycles. We invest in credits with appropriate loan to value ratios to help ensure repayment even at a more pronounced economic slowdown. Our sector allocations are guided by our bottoms up fundamental research and we generally avoid highly cyclical segments to the economy. Second, we remain focused on senior debt investments that offer strong structural protections and attractive yield 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 add backs that may not materialize and instead view free cash flow as a more reliable indicator of credit quality. Third, we will continue to leverage our size and scale to drive differentiated outcomes for our investors. We utilize large firm resources to compete in the core middle market. This allows us to have best-in-class sourcing and underwriting compared to our middle market peers leading to differentiated portfolios. Our investment team also benefits from the full resources, infrastructure and expertise of FS Investments. As Nick noted, we also believe our leverage structure is a key advantage as a large percentage of our drawn leverage is multiyear fixed rate preferred debt providing flexibility in the types of assets we can finance. Finally, our ability to invest across private and public markets differentiates us from traditional credit funds and allows us to adjust our 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 take this lead in enhanced stockholder returns relative to a more confined strategy. Importantly, we are not constrained by 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 FSCO supported by the resources and insights of our broader credit platform is well positioned to deliver strong risk adjusted returns across a wide range of economic and financial market conditions. The Fund's performance during the first quarter reinforced that view. Once again, thank you all for joining us today.

All right. Thank you, Andrew. Our first question is what were some of the key drivers of the Fund's performance this quarter?

So investment income was strong. We had some accretive exits during Q1. And then we also had some appreciation of certain investments, including our Lifescan Global and our Correct Care Solutions investments, two names that were previously on non-accrual, but performed very well during the quarter.

With the recent volatility in the market, have you seen any dislocations or unique opportunities to deploy capital into?

While spreads have retraced a large part of the February-April widening. We were able to take advantage of some investment opportunities during the tumultuous times. We deployed capital into some secondary market purchases at attractive yields. We were particularly focused on senior secured investments during that time period and even kind of super senior investments during that time period that had sold off. We also selectively participated in some new issues that had more favorable covenants than what was coming out in the market before the dislocation and additional spread. And then lastly, there were some private transactions that we were able to get some kind of attractive terms on likely because of the market turmoil. So terms that were likely wider than where they would have been and we not had that dislocation.

Are you making any deliberate shifts in sector allocation or the capital structure due to macro risks brought on by the recent tariffs?

So we've assessed our portfolio and reviewed each investment line by line and considered the effects of the tariff. We definitely remain focused on higher quality first lien exposure. So just trying to stay top of the cap structure, lower kind of LTV to kind of deal with like uncertain times. We continue to really value covenants as well in uncertain times. And we are monitoring the geopolitical situation, tariffs, but also DOGE and other things to constantly kind of retool the types of investments kind of we're looking at and think about portfolio exposure and how to manage that.

Can you provide an update on your leverage ratio and how much capacity remains below your target?

Yes. Regulatory leverage remains conservative at 0.48 times debt to equity as of the end of the quarter. It's about half a turn of leverage, which is below our historical leverage range of 0.5 times to 0.6 times. And just given the volatility in the market, we're happy to have a little bit of extra dry powder available to us to optimize and we invested dislocations.

And how are you managing liquidity, especially in terms of undrawn commitments and cash reserves?

Yes, we think liquidity management is a strength. We don't need to sell assets to meet any obligations. At the end of the first quarter, we had $266 million available, whether including undrawn credit lines, cash reserves. So we're in a good position to act quickly on dislocations and attractive investment opportunities.

You increased the distribution in January. Are you comfortable maintaining this distribution level going forward?

We are and we remain committed to providing consistent distributions. Net investment income is in line with our expectations and we have spillover income well over $100 million at the end of the quarter. So we have that buffer. Obviously, we are monitoring performance closely, but we continue to add investments with attractive yields to the portfolio to build projected investment to kind of look at.

And how does your pipeline look heading into Q2? Are you seeing competition easing or intensifying the deal flow?

Deal flow has picked up recently. It was picking up at the end of the first quarter then right in the beginning of April and everything sort of slowed down a little bit. But our pipeline is really, really strong. I think you saw us execute on attractive investments in the first quarter. We've done some more stuff in the second quarter that's been also very attractive. We think we're well positioned competitively. Business just doing nicely at the moment and these and your competitors I think we have a lot of tools at our disposal that allow us to find things that are off market in attractive ways.

And Andrew any updates on addressing preferred shares maturing in November 2025?

We started to engage with banks to address those upcoming maturities. The pricing for new press appears to be attractive. Spreads are likely tighter than those in the preferreds that are maturing. But given base rates, the total cost is likely to be higher than the 4.25% that we have right now.

And our final question, what does spreads currently look like in the private and public markets adjusted for recent volatility in the market?

In the public markets, we're currently seeing spreads of 375 basis points to 400 basis points and that's probably 25 basis points to 50 basis points wider than the types early this year. In the private markets, we're currently seeing spreads in the 475 basis point to 550 basis point range for sponsor-based credit. And for non-sponsor based credit, we're currently seeing spreads in the 550 plus basis point range. What I will say is those are levels for kind of the broader market, but our Fund typically focuses more on the core middle market. So the large part of the private credit market might be doing deals today at the 475 level, maybe even the 450 level and we're generally not participating in that part of the market. We are generally playing in the 500 plus part of the market. Our recent product deals we have closed are currently 600 basis points plus. So we closed a first lien to a software business that provides software for planes in the S700 range. We provided a very opportunistic financing to an AI focused data center business that was in the mid-teens. And then we also closed on a loan in the packaging space to a non-sponsor at that S600 just to give you a flavor of some recent transactions.