Source Capital (SOR) Earnings Call Transcript

Hello, and welcome to today's webcast. Please note that today's webcast is being recorded. During today's call, we will not have a question and answer session. [Operator Instructions] It is now my pleasure to turn today's program over to Ryan Leggio. Ryan, the floor is yours.

Thanks so much. Good afternoon, and thank you, everyone, for joining us for our 2025 Source Capital webcast review. My name is Ryan Leggio. I'm a partner at FPA and VP of Strategy of Source Capital. You will hear from Steven Romick and Abhi Patwardhan today. Steven joined FPA in 1996 and is a managing partner of the firm. Abhi joined FPA in 2010. Both have been portfolio managers to Source Capital since December 2015. We remain excited about Source's long-term prospects and hope you share that sentiment after today's webcast. The Fund's permanent capital, coupled with other key attributes of closed-end funds and FPA's broad investment capabilities in both public and private markets should enable Source to be one of our best, if not the best, publicly available vehicles to deliver attractive risk-adjusted returns over full market cycles. As a reminder, we will not take live questions during the webcast, but we'll answer the pre-submitted questions. Still, we are more than happy to connect with any current or potential shareholders in the coming days should you have follow-up questions or comments. It is my pleasure to turn the call over to Steven Romick.

Thank you, Ryan. And thank you for taking the time to listen to this brief update on FPA Source Capital closed-end fund. This slide you have in front of you shows the Fund's trailing performance as of December 31, 2025, versus its pertinent illustrative indices. Additional details on the Fund, including its performance, holdings and commentaries can be found in the Source Capital section of FPA's website. The Fund outperformed the balance 60% global MSCI Aqua and 40% BBG Ag Blended Index in 2025 with an average equity allocation of roughly 40%. We prefer, though, to focus on more extended time frames, specifically complete market cycles and rolling 5-year returns. Source's performance sets up well over the longer term as well. A recognition of the Fund's strong risk-adjusted performance relative to its peers, Morningstar rates Source Capital as a 4-star fund. We believe this strategy is well positioned to continue, as Ryan mentioned earlier, delivering attractive risk-adjusted returns over the long term. Source Capital had an unusually opportunistic -- has not had, we still have it, thankfully, has an unusually opportunistic charter that affords tremendous flexibility. As a closed-end Fund, it allows for less liquid investments, which serve its goal of balancing capital appreciation and income while endeavoring to avoid permanent impairments of capital or losing money. Our use of private credit is an example of our commitment to finding discrete opportunities that offer different yet so attractive risk/reward profiles compared to public securities. Source's exposure to private credit, including its committed yet undrawn capital ended last year at 26.1%, up from 19.5% at the end of 2024. We plan to increase our exposure in the coming years, which should allow us to increase the sustainable distribution rate, all else equal. Source's discount net asset value, or NAV, remained narrow in 2025, averaging less than 5% and even traded at a premium to NAV on multiple days. Shareholder-friendly opportunities could open up if the Fund trades at or above NAV. We will show more about this -- when we say more about this, should that come the best. As of year-end, Source's distribution yield was at 5.5%. Last year's distribution yield was comprised entirely of ordinary income and capital gains, sidestepping any return of capital. We continue to manage distributable income to deliver a competitive risk-adjusted distributable yield. We remain committed to Source's price to trade tightly to NAV over a full market cycle. To accomplish that, we may use several levers including seeking to increase the Fund's distribution yield and in certain circumstances, engaging in share repurchases. Source's portfolio managers and partners and First Pacific Advisors hold sizable stakes in the Fund, reflecting appropriate alignment with our shareholders. We continue to take advantage of broad investment options, allocating capital to private and public credit and equity. The added flexibility of investing in public and private credit opportunities that can, at the right price, Successfully rivaled public equities in their prospective return will hopefully improve the Fund's risk-adjusted returns over time while allowing for greater sustainable distributable yield over a full market cycle. If the fixed income sector offers more attractive opportunities, the Fund's underlying risk exposure might shift more from equity to debt. We will add leverage to the portfolio when the opportunity presents itself on the fixed income side, and that will be a function of yield spread and conviction in the underlying collateral. We may have little to no leverage if such opportunities don't present themselves. We will continue to return capital to shareholders and repurchased shares at a wide NAV discount to increase investor level return. All of this should help contribute to the Fund's distributable yield, driving it hopefully higher over time. I previously mentioned Source's narrower discounts to NAV. This chart depicts that favorable trend. The average discount last year was 4.6%, which was significantly lower than the 9% average since 2023 and a 13% average since 2020 -- that was in 2020. This was the lowest average discount to NAV during the calendar year since Source initiated its discount management program in 2021. We hope that the successful execution of the strategy over time, combined with shareholder-friendly actions such as high distributions, share repurchases and proactive client relations efforts will continue to allow the Fund's discount to trade closer to NAV over full market cycles. Source Capital ended 2025 with 44% of equities, 38% in credit and about 20% in cash. The Fund's gross yield is around 4.2%, which is about 1.5 percentage points higher than the yield of the Global Balanced Index. The portfolio yield has declined slightly from the prior year-end 2024, that's partly due to good news given price appreciation in the public credit segment. We hope to continue increasing the Fund's yield as we improve the Fund's credit book yield, draw down cash and ultimately add leverage via the established credit line. This chart provides greater granularity on the private credit sleeve within Source. Private credit exposure would be 26.1%, as I mentioned earlier, if all commitments were drawn. In the current interest rate environment, we have underwritten the Fund's private credit exposure, a mix of private funds and individual loans to a targeted yield of at least 8%, which is higher than the 6.1% of the high-yield ETF. We also expect less downside in volatility in our private credit investments, increased exposure and hopefully, good performance in our private credit book will bolster the Fund's distributable yield. As an example of what we're doing in asset-based lending, let's show you a direct loan in the space. Source Capital participated in a 3-year $45 million first lien term loan to a digital media company last year. We underwrote an expected IRR of 11.6% and a much higher yield in the high yield index. The loan has collateral conservatively in the $55 million to $75 million range, placing its loan to value at 60% to 83%. As important as the value is, our ability to get to that collateral should the company encounter challenges is protected somewhat by cash sweeps, debt limitations, liquidity covenants and other protections that we have in place. We consider both quantitative and qualitative analysis as we underwrite new investments and monitor existing equity positions. It is not enough to be a great company nor is it sufficient to trade on a superficially low PE multiple to garner our interest and attention. Instead, we are looking for rare cases where both quality and value intersect even if near-term headwinds may delay the potential payoff. As a result, you will rarely find our recent purchases on the 52-week high list. We ignore the momentum factor and regularly troll the 52-week low list for potential opportunities. It is in that vein that we let value guide our focus. The investment community is currently casting its gaze away from various market constituents that offer asymmetric risk reward for those willing to look forward 3 to 5 years. We primarily speak of global securities with lower market capitalizations and up until recently, health care stocks. As you can see from this diagram, new purchases over the past 2 years are clear evidence that we are willing to back up this view with our actions and not just our words. While a few of the names you see on this slide are household names, each holds a strong competitive position in their respective industry, if not market leadership. Furthermore, we would go so far as to say we believe we purchased them at absolute values that will allow us to achieve equity-like returns over the coming years and a bargain-like valuations when compared to the S&P 500. I'm going to turn it over to Abhi to chat about high yield.

Thank you, Steve. Our comments today on public credit markets will be brief because unfortunately, the market is very expensive, which means that there's not much to do or say at the moment. This chart shows the yield and spread on the high-yield index and the BB component of the high yield index, excluding energy. We find this BB component to be a useful indicator of high-yield market pricing because it offers a somewhat more consistent data point over time. As shown in this chart on the right-hand side and in the table at the top left, high yield spreads are very low. As of the end of the year, spreads were at the second or third percentile of the available history, which means that historically, 97% to 98% of the time, spreads have been higher. This data point corroborates what we've seen when evaluating individual opportunities where we typically find that the spread available on high-yield rated investment is inadequate for the credit risk. This has been true for several quarters. Nevertheless, we try to be opportunistic and are happy to invest when we can find an attractive reward for the risk. We made 4 investments for Source in 2025. However, those investments were more than offset by a number of existing investments, which fully or partially matured or were called away from us. The net effect is that the exposure decreased, which is fine. We're happy to wait for better opportunities in the portfolio. That's the end of our prepared remarks. We'll turn it back to Ryan for Q&A.