FSCO - NYSE

Hello, and thank you all for joining us for FS Credit Opportunity Corp.'s Fourth Quarter 2025 Earnings Conference Call. Please note that FS Credit Opportunities Corp. 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 the press release that FSCO issued on February 6, 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 December 31, 2025. A link to today's webcast and the presentation is available on the company's web page at www.futuresstandard.com under Investor Relations. 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 outcome 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 evaluated 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 for 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 we delivered for our shareholders during the fourth quarter of 2025 across several key fronts. First, FSCO delivered a net return of 1.69% based on the Fund's net asset value, bringing the net total return for 2025 to 10.89%, outperforming senior secured loans by 499 basis points and high yield by 239 basis points. It is worth noting that the portfolio remained highly weighted to first lien senior secured loans throughout the year, representing approximately 83% of the portfolio's fair value as of December 31, 2025. The Fund paid distributions of approximately $0.20 per share during the quarter compared to net investment income of $0.12 per share, including NAV depreciation of $0.08 per share. While contributors significantly outweighed detractors during the quarter, the Fund's exposure to the second lien term loan of MBS Services Holdings, a North American studio operating and production services company was the largest detractor during the quarter. The company has experienced weakness in its operations amid the broader slowdown in film and television production. Second, the Fund continued to deliver an attractive monthly distribution. As of February 20, 2026, the annualized distribution yield was approximately 11.4% based on NAV and 14.6% based on market price. Following year-end, the Fund declared and paid monthly distributions of $0.06 and $0.0678 per share for January and February. Third, the Fund deployed $182 million in the fourth quarter, bringing net investment activity to $541 million in 2025, with both figures excluding portfolio hedges and unfunded commitments. We continue to benefit from our robust deal sourcing engine, which includes our team and firm-wide origination network, our sponsor coverage, our intermediary coverage and our private sourcing partnership with JPMorgan to finance directly originated investments. Finally, on October 21, 2025, the Fund completed the issuance of $200 million of fixed rate term preferred securities, consisting of $50 million due in 2028 and $150 million due in 2023. Proceeds were used to refinance preferred shares maturing in 2025 and early 2026. This represents the Fund's 6th and 7th term preferred issuance since its listing in November 2022. We believe our continued access to the capital markets and the favorable pricing reflect both the portfolio's strong credit quality and the market's confidence in our strategy and management team. Given the sharp sell-off in the software sector in recent weeks, 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 8.8% as of December 31, 2025, and was well diversified by position size with no single investment included in the Fund's top 10 holdings at year-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 most at risk segments are companies with limited differentiation and low switching costs such as lightweight workflow tools, collaboration apps, commoditized dashboards and seat-based productivity overlays. In these segments, it is certainly possible AI native competitors can replicate function quickly, increasing competitive pressure. Conversely, we believe the most defensible segments include deeply embedded systems of record, security and control layers and vertical software with extensive integrations and compliance-driven switching costs. In these categories, AI is more likely to be layered onto incumbent platforms rather than replace them outright, reinforcing the durability of established providers. 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. High-yield and leveraged loan markets delivered modest gains in the fourth quarter of 2025. The performance was increasingly defined by sector dispersion and a more cautious investor tone into the year-end. High-yield bonds returned 135 basis points in December, bringing full year gains to 8.5% with BB-rated credits leading performance and spreads tightening to 3-month lows amid a dovish Fed backdrop and resilient corporate earnings. Leveraged loans gained 5.9% for the year. The performance lagged high yield, particularly in the software sector, where spreads widened sharply and returns turned negative. Credit fundamentals remain broadly stable with default volumes subdued and concentrated in a handful of issuers. However, recovery rates declined to multiyear lows with trailing 12-month recoveries falling to 26.8% for high-yield bonds and 34.8% for loans, well below their 25-year averages, reflecting a rise in liability management exercises and distressed exchanges. Market technicals were supported by strong demand from CLOs, which helped offset outflows from traditional mutual funds and ETFs. Private credit market activity remained strong heading into year-end. While the following figures reflect sponsor-backed transactions only, they underscore broader momentum across private credit. U.S. sponsored lending rose 21% quarter-over-quarter to $105 billion, driven by a strong rebound in buyouts, add-on M&A and dividend recapitalizations as improving rate visibility and stronger public markets unlock pent-up sponsor demand. Pricing continued to compress, the relative value across segments remained intact. Large cap spreads tightened to SOFR plus 493 basis points, while core and lower middle market spreads ended the quarter at SOFR plus 503 and 513 basis points, respectively. Covenant discipline remains a key point of differentiation across the market. Covenant-light structures continue to migrate higher in 2025, but remain concentrated amongst large issuers. In the fourth quarter, covenant-like terms were still rare for borrowers below $50 million of EBITDA, while issuers above that threshold, particularly those with $100 million plus EBITDA, accounted for the majority of covenant-light issuance. Larger borrowers continue to benefit from heightened competition between private and public markets, whereas we see more robust covenant packages in the lower middle market. Turning to our investment activity during the quarter. We continue to favor private credit, where we see more compelling relative value than in public markets. Approximately 90% of new investment activity was in privately originated investments, 97% of which were in first lien senior secured loans. Originations were strong in the fourth quarter, supported by our robust sourcing network. This includes direct sponsor coverage, nonbank intermediaries, incumbent borrowers, bespoke nonsponsored deal flow and our sourcing partnership with JPMorgan. We made 5 new private credit investments in the fourth quarter weighted to lower and core middle market companies, which we believe represents a competitive sweet spot. These businesses are 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 of the standard criteria of traditional bank lenders, we can generally negotiate favorable terms and structure investments that mitigate downside risk. All new originations during the quarter were in sponsor-backed businesses. Within sponsored lending, we do not compete against the large direct lending funds and instead lend to small or emerging sponsors where there's typically less competition and greater potential to capture a yield premium. In 2025, approximately 68% and 32% of our private credit originations were in sponsor and nonsponsored deals, respectively. Non-sponsored lending opportunities comprise a wide range of borrowers that, in many cases, have never accepted outside capital. This includes multigenerational 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. In 2025, we originated 19 new private credit investments at a weighted average spread of SOFR plus 661 basis points. Approximately 95% of these investments included one or more maintenance covenants. By contrast, approximately 90% of the broadly syndicated loan issuance in 2025 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 the Fund is well positioned to deliver strong risk-adjusted returns for clients. Sales, exits and repayments totaled $253 million during the fourth quarter compared with purchases of $182 million. We've actively deployed excess liquidity from these sales and repayments into an attractive investment pipeline of private credit deals in the first quarter of 2026. As of December 31, private credit investments represented approximately 75% of the portfolio based on fair market value. Approximately 90% of the portfolio consisted of senior secured debt. First lien loans represented 83% of the portfolio, second lien loans represented 4%, while senior secured bonds represented 3%. Unsecured debt and asset-based finance investments each represented 2% of the portfolio, while equity and other investments represented 6%. 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 58% of drawn leverage as of December 31, 2025, comprised of preferred shares, which provide favorable regulatory treatment 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. As we originate new investments, we carefully evaluate each opportunity for potential risks related to tariffs, broader geopolitical and economic uncertainty as well as the newly created AI risk. We believe FSCO offers a differentiated value proposition designed to deliver strong risk-adjusted returns across diverse market and economic environments, which is 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 to help ensure repayment even in a more pronounced economic slowdown. And our sector allocations are guided by our bottom-up fundamental research. 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-on-lender disputes. We're also cautious of credits with aggressive EBITDA add-backs that do not materialize and are very focused on making sure that current free cash flow is -- covers interest expense and other obligations in a way with some significant cushion. 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 the large-cap private transactions. Unlike many smaller managers in this space, however, 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 better risk-adjusted returns. Finally, our ability to invest across private and public markets differentiates us from traditional credit funds and allows us to just allocations based on where we see the most compelling risk-adjusted returns. 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 specific asset class mandate. 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 markets. The Fund's performance during the fourth quarter reinforced that view. Once again, thank you all for joining us today. And with that, we'll take a brief pause before answering questions.

All right. Our first question today revolves around software exposure. Software has been an area of heightened scrutiny across credit markets. Can you walk us through your current exposure to software and software adjacent credits, how you're dealing -- how you're defining that bucket and whether that exposure has changed meaningfully quarter-over-quarter?

So I hit on some of this in my prepared remarks, but I'll kind of elaborate. So first of all, software is currently 8.8% of the Fund's portfolio. So it's a fairly modest allocation. The second thing I'd say is we don't have any very large individual investments in the software space. I believe our largest holdings is less than 1.5% of the gross asset value of the Fund. The other thing I would say is I talked about how not every software company is the same. Some are much more embedded in customer kind of workflows, harder to replace and more value add and others are more container like, which can kind of be easily replaced. When we've looked at our software exposure, I think we feel comfortable that generally, the businesses we've lend to are businesses with pretty high switching costs that are nicely embedded in their businesses. The other thing I would say is there's a lot of lending done to kind of software companies on the forward. So software businesses that were expected to grow rapidly that couldn't necessarily support the debt based on kind of the current free cash flow profile or earnings profile of the business. Those are called ARR loans, when you look at loan-to-value based on a multiple of recurring revenue because the cash flow is not necessarily there. We've generally avoided ARR loans and all of the loans that we made were to mature cash flow generating businesses that should produce kind of nice cash flow to kind of delever us and ultimately drive repayment.

Thanks, Andrew. And given today's interest rate backdrop, how are you positioning the portfolio to balance income generation versus downside protection? Specifically, what are you doing on duration, floating rate mix and spread selection?

So I think there's a couple of things to kind of hit on here. One, we are focused on interest rates and what they will do to kind of the economy and kind of the underlying credits that we invest in. Obviously, kind of higher rates could put stress on businesses. Lower rates could kind of be helpful in terms of improving cash flow of businesses through reduced interest expense and also kind of valuations of businesses. It also can be helpful in generating more transaction flow, more M&A activity, kind of more exits. So we're focused on kind of the path of interest rates and looking at that. But what I would say is our portfolio today is mostly like a floating rate portfolio. So interest rates are really kind of like a pass-through for us in terms of we've got floating rate debt. We've got floating rate kind of long exposure. On the levered portion of our book, the move in rates shouldn't hurt us. But on the unlevered portion of the book, sure, like a decrease in interest rates is a mild negative from a yield perspective. But I think all of our peers are similarly situated. One of the reasons we're in floating rate debt as opposed to fixed rate debt is there's just a much better kind of opportunity set. Fixed rate debt below kind of investment grade, you're more or less limited to high yield. And when we look at kind of spreads in high yield and the risk return in high yield relative to the types of things we're originating kind of in private credit, we see like a 200 basis point, if not more, spread pickup from investing in privately originated credit. So the portfolio tilts floating rate just because that's kind of where the attractive total returns are.

And on the topic of sector positioning, can you talk us through your current sector allocation and what you've been rotating towards or away from? What is the investment team most constructive on today?

We believe we're late cycle. We don't know how late cycle we are, and it's tough to kind of make a macro call. We're not economists and most economists are often more wrong than right anyway. But we do think we're late cycle. And as a result of kind of being late cycle, our portfolio is really defensively positioned. If you look at the types of things we're invested in, our largest exposure right now is consumer services at about 15%. But when you double-click on what that means, they're not like discretionary purchases within consumer services. They tend to kind of be more staple-driven type businesses. Our next largest exposure is commercial and professional services. And when you double-click on that, it tends to be kind of really kind of like recurring services that businesses use as opposed to, again, like larger cap purchases. And then our next exposure after that is 12% to kind of health care, which is defensive in nature. So you look at our top 4 exposures, they're all kind of defensive in terms of kind of industry positioning. And then when you start to kind of look at the types of instruments we're investing, they tend to be pretty downside protected instruments, senior secured instruments with like good covenants and kind of reasonable LTV. So our big focus right now is trying to kind of generate income for the investor, but making sure that income is protected to the extent we see a cycle. Obviously, now with all the focus on AI and how AI can be a disruptor, it's something we're very focused on when it comes to kind of new investments, trying to find investments that will benefit from AI as opposed to kind of being harmed by AI.

All right. And now turning to Nick. What are you seeing today in terms of new investment opportunities? Are spread structures and covenants improvement? How does that influence your pace of deployment?

The changes in the market are subtle, but we do think things are starting to improve at the margin from a quality perspective for us. That being said, we are being highly selective in our deployment. We do have a preference for allocating to the primary market as opposed to purchasing things in the secondary market where sort of we're applicable. And of course, we're maintaining our underwriting discipline as we continue to invest the portfolio.

And what do you -- how are you thinking about leverage levels in the current environment? And what flexibility do you have to adjust leverage as opportunities or risks evolve?

Yes. So despite subdued levels of index volatility, we are mindful that on an underlying basis, there has been a little bit more noise in individual sectors or individual companies from a forward outlook and valuation perspective. As such, we are maintaining our traditionally conservative approach to using leverage. I think we have approximately 20% debt to equity in the portfolio. Clearly, we always need to be mindful of balancing income generation for the portfolio and protecting the balance sheet. We do have an attractive level of yield in the book. So right now, we view it as appropriate to maintain access to liquidity and use leverage conservatively.

Okay. And I know this question is on everyone's mind. Are you seeing any early signs of stress across the portfolio or broader credit markets?

Not really. Clearly, there are some businesses which are going to be negatively impacted by changes in the economy sooner than others. And we're mindful of that. As Andrew mentioned, we don't have much software exposure in this portfolio. We don't have a lot of concentrated exposure. As you know, we've traditionally shied away from commodity-sensitive businesses and things where you can have more abrupt changes in the profitability of the firm based off of macro factors. So overall, we're pleased with the credit quality of the portfolio. Clearly, we are managing through one idiosyncratic situation, which was disclosed on this call. So we'll continue to be mindful of that. But for the most part, we're pleased with the portfolio performance and the credit quality of the portfolio as well.

And for the final question, regarding public versus private credit, where are you seeing better relative value today?

Yes. We continue to see better opportunities in the private space. Clearly, we're focused on the volatility in the public markets and are continuously looking for opportunities to take advantage of dislocations if they don't make sense. Right now, we haven't really seen that yet. So as has been the case in the recent past, we believe the better opportunity set is in private credit, but we always will reevaluate based off of what's going on in the world and in the markets.