FS Credit Opportunities Corp. Q2 FY2023 earnings call

Management Statement and Operational Highlights:

• The Fund returned 7.5% in Q2, with NAV increasing by $0.33 per share.
• Announced a 15% increase in the annualized distribution, bringing the rate to ~9.9% based on NAV.
• Phased listing of common shares completed, with all shares available for trading by May 15th.
• Portfolio sales and repayments of $216 million outpaced purchases of $144 million in Q2, with majority of purchases to existing portfolio companies.
• Senior secured debt was the majority of purchases and 77% of portfolio fair value at quarter end.
• Private investments valued monthly by third-party, with intra-month valuations done internally.
• 58% of drawn leverage is preferred debt, with $100 million of preferred debt paid down on August 1st, leaving remaining preferred debt maturing in 2024 or beyond.

The Fund returned 7.5% in the second quarter, driven by strong earnings with net income covering distributions of $0.15 per share and NAV appreciation of $0.33 per share. As of June 30, 2023, the split between public and private investments was 55% and 45% respectively. Senior secured debt represented 77% of the portfolio's fair value, and floating rate assets comprised approximately 58% of the portfolio. Net income has covered distributions since January 2018, with net investment income representing 116% of distributions paid to shareholders.

Guidance:

• Cautious outlook due to economic uncertainty, with focus on active management and sound fundamental credit underwriting.
• Running less levered than long-term targets to minimize drawdowns and position for potential volatility.
• Focus on senior debt investments with strong terms and attractive yields.
• Private credit seen as more attractive currently, with focus on non-sponsored transactions; public credit focused on idiosyncratic event-driven situations.
• Aim to dynamically allocate capital to most attractive opportunities across credit and business cycle.

Risks:

• Default rates rising across bonds and loan markets, sitting at two-year highs.
• Rapid rise in interest rates pressuring coverage ratios, margins, and liquidity of many companies.
• Need for deep bottoms-up understanding of fundamental credit risks to navigate market cycles and volatility.

Q: What is your leverage at the end of the quarter?

A: On a debt-to-asset basis, leverage was 34% as of June 30th, including both debt and preferred stock; debt-to-equity was 52%, with debt mix ~40% debt and 60% preferred.

Q: Can you provide some more color on the net asset value move in the quarter?

A: NAV increased to $6.68 a share at June 30th from $6.35 per share prior quarter, a ~5.2% increase.

Q: Can you talk about your valuation process, specifically on the private investments?

A: Private investments are valued by a third-party on monthly basis, with intra-month valuations done internally.

Q: Can you discuss your current fee structure and how it compares to your peers?

A: FSCO has a dynamic investment strategy with allocation to privately sourced/structured and liquid investments, putting it between closed-end fund and BDC; management fee is in between, incentive fee on income with 6% hurdle, no capital gains incentive fee.

Q: What's target allocation for private versus public investments in the Fund today?

A: No specific target, but long-term average of ~50/50 is reasonable.

Q: Where are you seeing the best investment opportunities from a private versus public standpoint?

A: Private credit more attractive currently, focusing on non-sponsored transactions; public credit on idiosyncratic event-driven situations.

Q: What industries are you seeing the best opportunities?

A: Focus on businesses with steady operating margins, with opportunities in healthcare and financial services with low LTVs and margins of safety.

Q: What are your views on the economic outlook, specifically interest rates, potential challenges such as inflationary pressures and its impact on the portfolio?

A: Likely higher for longer interest rates, which bodes well for portfolio income; portfolio is short duration, positioned to withstand economic slowdown.

Q: What are your plans to close the gap between stock price and net asset value?

A: Focus on Fund performance, making good investments, and constant contact with research community, current investors, and prospective buyers.

Q: Can you comment on your approach to share buybacks and any plans to initiate a share repurchase program?

A: Assess all capital allocation options, including share repurchases, mindful of leverage and liquidity.

Q: Can you remind us of the dividend policy and the plan going forward here?

A: Dividend policy is to pay out net income, with 15% increase in July, and will continue to assess dividend based on net income trends.

Q: Can you talk about how you utilize leverage at the Fund?

A: Utilize leverage to produce differentiated returns and protect downside, with debt-to-assets ~34% at quarter end (adjusted for cash, sub-30%).

Q: What is the non-accrual rate as of June 30th?

A: Non-accrual rate is approximately 2%, including investments purposely bought while non-accruing.

Q: Equity exposure increased to 10% of the portfolio at the end of June. What drove that increase?

A: Increase driven by appreciation of instruments in the equity bucket, primarily warrants from loans or debt-to-equity conversions.