FS Credit Opportunities Corp. Q4 FY2023 earnings call

Key Points

• 2023 Results: Fund returned 20.1% net, outperformed bond and senior secured loan indices. Net investment income covered distributions of $0.64 per share. NAV increased by $0.59 per share (9.3% YOY). Distribution increased 15% in July 2023. Listing on NYSE completed in May 2023, discount narrowed.
• Market Trends (Nick Heilbut): Risk assets rallied in Q4 2023, Treasury yields fell, Bloomberg US Aggregate Index up 6.82% in Q4. High yield bonds outperformed loans. Default rates increased, recovery rates low.
• Investment Activity: Fully invested in Q4, purchases ($184M) exceeded sales/exits/repayments ($173M). 63% privately originated investments (first lien senior secured loans), 37% public credit (first lien loans/high-yield bonds). 81% secured debt, 5% subordinated debt, 4% asset-based finance, 10% equity/other. Leverage structure: 43% preferred debt.

No specific product segments discussed; portfolio performance in 2023 included strong net return of 20.1%, outperforming indices, NAV increase of $0.59 per share, and distribution coverage by net investment income. Fourth quarter distributions were $0.17 per share, fully funded by net investment income. Annualized distribution yield as of Feb 28, 2024, was 9.8% based on NAV and ~12.17% based on stock price. Positive portfolio performance with New Giving, Inc. as a large contributor, while opportunistic equity hedges detracted from returns.

Forward-Looking Statements

• Cautious on 2024 economic outlook due to inflation, credit conditions, election cycle, geopolitics. Focus on active management, sound credit underwriting, senior debt with strong terms. Leverage size/scale and invest across public/private markets. Believes FSCO is a compelling long-term investment with well-positioned portfolio, low duration, healthy distribution, diversified structure.

Risks

• Factors like falling yet persistent inflation, tighter credit conditions, election cycle, geopolitical conflicts. Potential for market volatility. Increased default rates and low recovery rates in credit markets.

Q: Can you talk about the current market environment today as far as everything on new opportunities, structure of deals, and how has that changed over the last few quarters?

A: Sure. Credit markets were strong in 2023 with spreads compressing. Tighter pricing in public markets led to focus on off-the-run opportunities in private markets. Private credit spreads remained consistent. Deal flow revving up.

Q: You said 63% of new investments during the quarter were in privately originated investments. Can you talk about why this opportunity is attractive today?

A: Niche private transactions offer significant return premiums vs public markets. Better spreads, structural terms, and protections. Public market credit docs often weak.

Q: How does the team source these private deals?

A: Combination of team-led and firm-wide sourcing. 21 investment professionals with industry relationships. Firm-wide sourcing funnel leveraging FS Investments' 76B assets.

Q: Where in the capital structure are you seeing opportunities today?

A: Generally prefer top of capital structure, but look for attractive upside in senior securities. Moved up in quality, more secured debt.

Q: 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?

A: Yes, looking at opportunities. Collaborate with FS real estate business. Not a huge portion, but an opportunity to explore.

Q: Can you provide color on your valuation process?

A: Public investments marked daily by third-party pricing service. Private investments use third-party valuation firm, monthly marks with internal marks intermonth. Moving to quarterly private valuations in 2024.

Q: Your views of the macro environment today and expectations for the year, where do you see rates headed at the end of the year?

A: See rates in current range, no meaningful rate cuts in 2024. Sensitize investments to rate environments. Focus on individual company performance and top-down outlook.

Q: Your dividend strategy. Can you talk about the strategy?

A: Focus on total returns for shareholders. Dividend policy aims to pay projected net income, considering market conditions. Current dividend covered by net income, but reevaluate due to downward sloping yield curve. Near-term cushion for maintaining/increasing dividend.

Q: Given the discount at which the stock trades compared to its net asset value, would you consider a share repurchase program?

A: Board constantly looks at capital allocation, continuous discussion on best use of capital.

Q: Can you talk about leverage and targets of the capital structure?

A: Portfolio leverage depends on asset pool composition and market opportunity. Asset side high quality, moving up in secured debt. Maintain capacity to add risk in market sell-off.

Q: Discuss your fee structure relative to your peers and that closed-end funds base?

A: Dynamic investment strategy with private/public allocations differentiates from typical closed-end funds. Actively managed, fee structure straddles BDC and closed-end fund space, incentive fee well below average BDC.

Q: What was the percentage of non-accrual assets for the portfolio at the end of the year?

A: On fair value basis ~1.3%, on cost basis ~3%. Down from June 30 figures.