FS Credit Opportunities (FSCO) - 2024 Q2 - Earnings Call Transcript

Financial Data and Key Metrics - The Fund delivered a net return of 2.75% based on NAV in Q2 2024, with the top 10 contributors accounting for over 40% of total realized and unrealized appreciation [5] - Year-to-date net return as of June 30, 2024, was 8.67% based on NAV, outperforming high-yield bonds by 609 basis points and loans by 432 basis points [5] - The Fund paid distributions of $0.18 per share in Q2 2024, with net investment income fully covering distributions [6] - The Fund's annualized distribution yield was 10% based on NAV and 11.5% based on the stock price as of August 30, 2024 [6] - The Fund issued$ 100 million of term preferred shares in May 2024, with a cash balance of approximately $104 million as of June 30, 2024 [7] Business Line Data and Key Metrics - Approximately 67% of new investment activity in Q2 2024 was in privately originated investments, with purchases weighted towards first lien senior secured loans and subordinated debt [13] - Public credit investments represented 33% of the investment activity, with 91% of purchases in first lien loans [13] - As of June 30, 2024, 83% of the portfolio consisted of senior secured debt, unchanged from the previous quarter, while subordinated debt allocation decreased to 4% from 5% in March [13] - Asset-based finance represented 4% of the portfolio, and equities under investments represented 9% [13] - Public credit comprised 48% of the portfolio, while private credit comprised 52% [13] Market Data and Key Metrics - U.S. economic growth was solid in Q2 2024, with Treasury yields rising modestly (10-year yield increased 14 basis points to 4.34%, and 2-year yield increased 10 basis points to 4.72%) [9] - Senior secured loans returned 1.85%, while high-yield bonds returned 1.05% in Q2 2024 [9] - Default rates, including distressed exchanges, ended the quarter below the 25-year average for both high-yield bonds and loans [10] - Recovery rates for high-yield bonds over the last 12 months were 40%, in line with the long-term average, while loan recoveries were 43%, below the historical average of approximately 64% [11] Company Strategy and Industry Competition - The Fund focuses on investing across public and private credit, targeting return premiums driven by balance sheet complexity, asset illiquidity, and unconventional ownership [6] - The Fund leverages its$ 82 billion asset management platform and deep relationships with banks, sponsors, and other investment firms to drive steady portfolio investments [12] - The Fund's strategy includes maintaining a diversified portfolio with a focus on senior debt investments, avoiding highly cyclical areas of the economy, and maintaining buying power to capitalize on market volatility [15][16] - The Fund differentiates itself by investing across public and private markets, allowing dynamic allocation to the most attractive risk-adjusted return opportunities [18] Management Commentary on Operating Environment and Future Outlook - Management expects defaults to increase through next year, with a higher pace of distressed transactions, particularly in loans [10] - The Fund is positioned to navigate potential volatility in 2024, with a focus on businesses with strong cash flows, modest leverage profiles, and experienced management teams [15] - Management believes the current discount at which the Fund's shares trade relative to NAV does not reflect the health of the portfolio or the quality of its investment program [7] - The Fund aims to generate attractive spreads over the risk-free rate, with 62% of the portfolio in floating-rate assets, providing some insulation from rate changes [23] Other Important Information - The Fund's largest sector exposures at quarter-end were consumer services, commercial and professional services, and healthcare equipment and services [14] - The Fund's leverage structure includes 58% drawn leverage as of June 30, 2024, with a focus on preferred debt financings for favorable regulatory treatment and flexibility [14] - Non-accrual investments represented 2.7% of the portfolio's fair market value, predominantly in first lien positions [40] Q&A Session Summary Question: What is the target LTV for portfolio companies? - The Fund typically targets loan-to-value (LTV) ratios between 50% and 60%, based on its view of asset or enterprise value [20] Question: Are there considerations for buying back equity? - The Fund and its Board are constantly evaluating the best use of capital, balancing share buybacks, distribution policy, and investment opportunities [21] Question: How does the expected decline in rates affect the Fund's dividend? - The Fund believes its dividend is well-protected, with a significant portion of earnings generated from fee-based income, which is less tied to rate changes [22][23] Question: How does the Fund's valuation compare to peers? - The Fund trades at a discount due to its lower absolute dividend yield on a NAV basis compared to peers that over-distribute [24] Question: How are net earnings generated from dividends and fee-based income? - Fee income is tied to originations and exits, while dividends are generated from equity stakes acquired in private transactions [25][26] Question: What are the current market spreads and pricing trends? - Private credit spreads have tightened by approximately 100 basis points, with average yields on private originations at 12.6% and public investments at 600 basis points over SOFR [27][28][31] Question: How has the macro view changed, and is the market shifting to a borrower's market? - The market is transitioning to a borrower's market, with increased competition and more favorable non-economic terms for lenders [29][30] Question: Why is private credit attractive, and what spreads are being deployed? - Private credit offers higher spreads, with the Fund focusing on opportunities in less traditional areas of the market [32][33] Question: How is the Fund positioned for a potential economic slowdown? - The Fund focuses on downside protection, investing in good businesses with strong creditor protections and sector expertise to navigate slowdowns [34][35] Question: Where are the best risk-adjusted returns in the portfolio? - The Fund prioritizes secured investments, focusing on principal protection and avoiding losses [36][37] Question: How does the Fund's fee structure compare to peers? - The Fund's fee structure sits between closed-end funds and BDCs, reflecting its hybrid public-private investment approach [38][39] Question: What is the update on non-accrual investments? - Non-accruals represent 2.7% of the portfolio, with two new non-accruals in Q2 2024 [40] Question: What are the leverage targets and capital structure plans? - Leverage was 0.48x at quarter-end, with plans to address 2024 maturities and maintain current leverage targets [41][42][44]