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Ares Capital Corporation. (NASDAQ:ARCC)

Q3 2008 Earnings Call

November 6, 2008 10:00 am ET

Executives

Michael J. Arougheti – President

Richard S. Davis – Chief Financial Officer

Carl Drake – Senior Vice President of Finance

Scott Wims – Finance

Kipp deVeer – Partner

Mitch Goldstein – Partner

Michael L. Smith – Partner

Analysts

Vernon Plack - BB&T Capital

Troy Ward - Stifel Nicolaus

Sanjay Sakhrani – Keefe, Bruyette & Woods

Jim Ballan - J.P. Morgan

Adam Waldo - Private Investor

Jasper Birch - Fox-Pitt Kelton

John Arfstrom - RBC Capital Markets

Operator

Good morning, ladies and gentlemen and thank you for standing by. Welcome to the Ares Capital Corporation third quarter 2008 earnings conference call. (Operator Instructions) In addition to Ares Capital Corporation’s earnings release and quarterly report on Form 10-Q, the company is offering a webcast and slide presentation to accompany this call. Copies of the earnings release, Form 10-Q, and the slide presentation can be obtained from the company’s website at arescapitalcorp.com under the Investor Resources tab. The earnings release is located in the Press Release section. The Form 10-Q can be found in the SEC Filings section and the slide presentation is located in the Stock Information section.

Ares Capital Corporation 2008 earnings press release, Form 10-Q, comments made during the course of this conference call and webcast, and its accompanying slide presentation contain forward-looking statements within the meaning of Section 21-E of the Securities Exchange Act of 1934 and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of the words such as “anticipate,” “believe,” “expects,” “intends,” “will,” “should,” and “may” and similar expressions. Ares Capital Corporation’s actual results could differ materially from those expressed in the forward-looking statements for any reason including those listed in its SEC filings. Any such forward-looking statements are made pursuant to available safe harbor provisions under applicable securities laws and Ares Capital Corporation assumes no obligation to update any forward-looking statements.

Please note that past performance or market information is not a guarantee of future results. Also during this conference call, the company may discuss core earnings per share or core EPS which is a non-GAAP financial measure as defined by SEC Regulation G. Core EPS is the net per share increase or decrease in stockholders’ equity resulting from operations less realized and unrealized gains and losses and any incentives, management fees attributed to such unrealized gains and losses, and any income taxes related to such realized gains. A reconciliation of a core EPS to net per share increases/decreases in stockholders’ equity resulting from operations to the most directly comparable GAAP financial measures can be found in the company’s earnings press release. The company believes that the core EPS provides useful information to investors regarding financial performance because it is one method of the company’s using to measure its financial conditions and results of operations.

At this time, we would like to invite participants to access the company’s slide presentation. As previously noted, you can access the presentation on the company’s website at arescapitalcorp.com and click on the November 6, 2008 presentation link under the Stock Information section of the Investor Resources tab.

Now, I would like to turn the conference over to Mr. Michael Arougheti, Ares Capital Corporation President.

Michael J. Arougheti

Thank you, Operator. Good morning everyone and thanks for joining us this morning. I’m joined today by Rick Davis, our Chief Financial Officer, Carl Drake and Scott Wims from our Finance team, and Kipp deVeer, Mitch Goldstein and Mike Smith, senior members of our Investment Advisors Management team. I hope you had a chance to review our press release and our investor presentation posted on our website.

Before we get into the financial details of the third quarter, I want to take a few minutes to comment on current market events, how our long-standing strategy plays into the current market, highlight our results and then explain how we continue to manage our business through this challenging period.

As you all know, we continue to experience an unprecedented period of market volatility and uncertainty. These markets are not only presenting unique opportunities but also unique risks and challenges. For all, these syndicated loan and high-yield markets were more or less stable for much of the third quarter, however, intensified selling pressure resulting from bank failures and a collapse in confidence adversely impacted these markets towards the end of September and even further through October. This was partially a result of economic weakness but it was also driven by heightened risk aversion and exacerbated by forced deleveraging among financial institutions and other highly-leveraged market participants.

This supply and demand in balance has resulted in historic lows for broadly syndicated leverage loan and high-yield bond pricing. The current pricing applies to fault rates which are well in excess of the historical peak levels during past deep recessions. Although the loan market has bounced off its lows, it is still too early to know when we will see stability or recovery. Therefore, we remain cautious and highly selective on making new investments and are focused on staying liquid. We believe we are well-positioned to navigate the turbulent markets given our balance sheet and solid credit performance.

As many of you know, business development companies are prohibited from carrying leverage beyond 1:1. That lower leverage, together with having long-term debt funding in place at attractive costs, distinguishes us from many of the financial institutions that have been making headlines.

As we have noted previously, a cornerstone of our investment philosophy has been to preserve capital while seeking superior risk adjustment returns throughout business cycles. We believe that if we focus on the downside and invest in good companies, the upside will take care of itself. Our investment philosophy is built upon a self-origination and lead agent model which in addition to enhancing our assets selectivity, provides us more flexibility to invest where we see relative value and to optimize our portfolio mix over time.

Consistent with this strategy, we positioned our portfolio during the highly liquid markets for late 2005 to mid-2007 and to a higher proportion of senior secured debt. In addition, we positioned the portfolio in historically defensive sectors and lower-leveraged structures. At the same time, we used our position as lead agent or investor to control business and legal due diligence, capital structure, and documentation. We are hopeful that this strategy will bear fruit for Ares as the economic cycle plays out and it will result in lower overall loss rates relative to our peers throughout the cycle.

Importantly, we believe that our position as lead or agent on our facilities separates us from many peers as we have the ability to drive amendment pricing and structure at the first sign of weakness or covenant breach. In situations where loans are repriced or restructured through higher spreads, and in some cases, additional capital contributions are collateral; the asset quality improves and should be worth more than it otherwise would be in a mark-to-market or bond yield analysis. Later in the call, I’ll share with you some numbers regarding the accretive benefits of repricing.

In the not so distant past, the market was full of large syndicated covenant life transactions where loans were completed that had few if any covenants. The repricing of risk on these deals by definition has to be reflected in declining bid prices since repricing alone may not be possible without tight covenants or documentation. To some extent, we are seeing this in the pricing of obvious syndicated loans which has been more volatile than what is being experienced in the middle market and in particular, our portfolio.

While the broad loan industry certainly yields negative trends in the loan market, we do not believe our portfolio is directly comparable to the broadly syndicated large loan market. For example, Standard & Poor’s tracks a widely followed loan index called the LSGA Leverage Loan Index that is comprised of mostly large syndicated loans. For the quarter ended 9/30/08, the LSGA Leverage Loan Index declined approximately 7% and continued to trend down significantly since quarter-end. There are very important distinctions between our portfolio and the broad loan market that’s generally reflected in S&P’s data for the LSGA Leverage Loan Index. The index consists of approximately 16% covenant life loans, a weighted average initial spread over LIBOR or 265 basis points, and only contains 11% of loans originated after July 1, 2007. When comparing our portfolio as of September 30, 2008, we have one covenant life loan, an average spend over LIBOR over 800 basis points, and 48% of investments originated after July 1, 2007 when the credit dislocation began and market underwriting terms began to tighten.

Another major difference is industry concentration. Of the 10 worst performing industry sectors within the third quarter of the Leverage Loan Index, we were underweighted in those sectors by over 20% and have diminished exposure to four of them, auto, hotels and lodging, media excluding publishing, and radio and TV broadcasting. Of the top 10 best performing sectors for the third quarter, we were overweighted as compared to the index by over 20% as well including nearly 10% overweighted in health care with other overweights in food, beverage, and aerospace.

As I mentioned, about 16% of the index is covered light and 16% of the index is weighted toward the four sectors incurring the highest defaults so far accounting for more than two-thirds of total defaults in the market. These sectors are real estate, auto, gaming and transportation and our exposure to these sectors is negligible.

Lastly, the investors that own large syndicated loans tend to be highly leveraged participants like hedge funds and market-value CLOs that have long-term or stable financing and they may be forced to liquidate such loans as pricing declines.

Turning from the state of the market spend to our results for the quarter, please turn to the first slide in our investor presentation.

Despite continuing challenging market conditions, we reported third quarter core earnings per share of $0.34 versus $0.33 a year ago and $0.40 last quarter, including net realized gains of $0.05. Our core earnings per share and realized gains provided about 93% coverage of our third quarter dividend.

Our results reflected continued rotation of our portfolio. We invested $236 million during the quarter with an aggregate yield of over 13% and with a total return profile in the mid-teens when one includes fees and call protection. Consistent with our strategy, we invested this capital while lowering our overall portfolio risks as evidenced by our improved leverage and inference-covered statistics. In addition, we experienced healthy repayments of $160 million in investments yielding less than 9% and we were able to redeploy the investments and proceeds yielding an aggregate 400 basis points higher. As a result, we boosted our portfolio yield by nearly 100 basis points to 12.3% during the quarter. Importantly, our investment spread also improved by approximately 39 basis points during the quarter and 252 basis points since the third quarter of last year.

The decline in our net asset value to $12.83 resulted primarily from marking our portfolio to market as of 9:30 am and to a lesser extent from credit or performance weakness in some of our portfolio companies. However, we feel good about the overall health of the portfolio with only four issuers on non-accrual out of 90 representing approximately 1% of the portfolio at value and just over 3% at cost. Our weighted average portfolio credit rating of 2.9 was unchanged from last quarter and our portfolio in the aggregate continues to grow revenues in EBITDA on a year-over-year basis.

Now a few words about our dividend. We have a policy of not providing dividend guidance but we do want to provide investors some framework to understand how the current market impacts our dividend. As you can see in the release, we declared our fourth quarter dividend of $0.42 consistent with prior levels. Through September 30, 2008, we have generated $1.24 from the combination of core EPS, net realized gains and our 2007 spillover of excess earnings of approximately $0.09 per share. This compares to our dividends declared for the first three quarters of $1.26.

Going forward, the external factors affecting our dividend and/or our dividend coverage are obviously the potential desire to carry higher liquidity and invest less in the volatile markets, the more difficult capital gains in M&A environments, and a weakening economy which ultimately may adversely impact credit quality.

Offsetting some of these negative factors are the positive investment opportunities for new capital as evidenced by the 400 basis point pickup this quarter in yield which has improved further since quarter-end as well as higher income and fees from the repricing of risks on existing investments. So while our march to full dividend coverage is not getting any easier under current market conditions, it’s still difficult to predict how long this pricing volatility will last and we are fortunate to be in a position of relatively strong liquidity.

Now, before I turn the call over to Rick to walk through our detailed financials, I want to address how we’re managing the business through these turbulent markets.

Recall last quarter that we highlighted the following three key initiatives that we continue to pursue. One, enhancing core earnings per share from our portfolio, principally by employing available capital, recycling and repricing; two, managing our balance sheet and liquidity; and third, aggressively managing our credit profile.

With respect to enhancing our earnings, I touched on our third quarter capital deployment and highlighted that our new investment yields exceeded those repaid by more than 400 basis points excluding call protection and fees. $160 million of capital that was recycled translates to an incremental annual EPS contribution of $0.05. Additionally, we repriced $94 million in investments this quarter which translates to an incremental annual quarterly EPS contribution of $0.02.

The success of our portfolio rotation strategy is already seen in our portfolio composition by vintage. As I mentioned earlier, as of September 30, we had either repriced or originated about 48% of our portfolio since the credit dislocation began around July 1 of last year. This is significant since post-credit cost loans generally carry wider spreads, lower leverage and tighter covenants making these loans more valuable in the market today. Just by way of example, S&P’s LCD unit reports that 2008 vintage loans were trading a full 13 points higher than the Leverage Loan Index in late October.

On the capital front, we recently closed a new ARCC managed middle-market credit fund, Ivy Hill II with an estimated size of $250 million that brings us strategic advantages as well as fee income. Ivy Hill II will be initially unleveraged with all third-party institutional equity but is structured to grow in size with potential leverage in the future. We will receive a 50 basis points management fee on the average total assets in the fund. We believe that our ability to raise third-party capital from managed funds in a difficult market speaks to the attractiveness of the current market opportunity and validates the strength of the global Ares platform, our chosen investment strategy and our performance. We expect Ivy Hill II will be an active purchaser of first lien and second lien bank debt and mezzanine securities as middle market companies originated by both us and other third parties and subject to certain approvals and restrictions we may in the near future sell Ivy Hill II up to $75 million in investments. In the future, we may from time to time sell additional loans and investments through the fund.

Due to the current market volatility, it’s our strategy to maintain a prudent amount of liquidity and conservative leverage profile until the market stabilizes. Given our strong balance sheet with over $330 million in credit facility capacity in cash and a debt-to-equity ratio net of such cash of 0.67X, we believe that we are well-positioned. In fact, since quarter-end and reflecting recent repayments and asset sales, our net debt has been reduced to $808 million, down from our net debt of $841 million at quarter-end.

Lastly, turning to credit management, the most significant tool we have is our ability to reprice and restructure credits. These actions allow us to reduce unfunded commitments, reprice loans, receive additional concessions in the form of new capital injections for collateral or force asset sales to reduce our risks. Since we are lead or agent in many situations, we are often in a position to drive this process.

We are obviously aggressively monitoring our portfolio companies, proactively restructuring companies when needed, and analyzing various impacts of commodity prices, currency fluctuations and other operating impacts in order to stay ahead of potential future weakness. We’ve also been reducing our overall portfolio leverage while at the same time investing in larger companies in what we deem to be defensive sectors.

I will discuss the broader market near-term opportunities and then conclude our prepared remarks following Rick’s comments covering our Q3 results in detail. With that, Rick, if you can walk us through the financials.

Richard S. Davis

Great, thanks, Mike. Please turn to slide 3 in our presentation.

As Mike outlined, our basic and diluted core EPS and net investment income were both $0.34 for the third quarter, a penny increase over the same period last year and a decrease of $0.06 from the second quarter of this year. The decline was primarily due to lower structuring fee income of about $8 million compared to the second quarter’s unusually high level and a higher share count as the incremental 24.2 million shares from the April rights offering were outstanding for a full quarter. This decline was partially offset by higher net investment spreads of 39 basis points and growth in net earning assets.

The weighted average yield on our debt and income-producing securities for the third quarter was 12.26% compared to 11.28% at the end of Q2 and 11.63% during the third quarter of last year. Despite the repricing of our CP funding facility, our investment spread increased by 39 basis points over the second quarter and 252 basis points since last year reflecting our rotation strategy, improved investment returns and our attractive low-cost funding.

Looking forward, we hope to see our investment spread continue to improve in the next few quarters so that we might experience a temporary minor disruption of this trend in the fourth quarter due to the volatility of LIBOR. During the spike and retreat of LIBOR in October, we incurred various timing mismatches between our asset and liability LIBOR contracts which may impact us modestly in both our assets and liability contracts reset.

We closed the third quarter with a $2.1 billion investment portfolio at value covering 90 portfolio companies that have a weighted average EBITDA of $38.9 million excluding cash and cash equivalents. Our quarter-end portfolio was comprised of approximately 54% in senior secured debt securities comprised of 31% in the first lien and 23% in second lien assets, 30% in senior subordinated debt securities, and 16% in equity and other securities.

Now turning to slide 4. Although we report net realized gains of $0.05 per share for the quarter, we reported net unrealized losses of $78.8 million which contributed to our GAAP net loss of $41.4 million or $0.43 per share for the quarter.

As shown on slide 7, our net asset value per share was $12.83 at the end of the quarter reflecting primarily lower mark-to-market values on our portfolio and to a lesser extent, some credit-related write-downs. Our third quarter net gross commitments totaled $183.2 million down from $342.4 million last quarter as we pulled back later in the quarter on new investment activity. As expected, we experienced robust repayments with $179.6 million of commitments exited including sales of $22.1 million to our Ivy Hill I managed fund resulting in net commitments of $3.6 million during the quarter. However, net fundings for the quarter were $75.4 million representing $235.9 million of fundings against $160.5 million in principal repayments. We expect to see a strong pipeline of potential repricing activity in our portfolio in the first quarter of 2009 and beyond.

As shown on slide 6, we had $74.2 million of net investment losses which include a $78.8 million of net unrealized depreciation on our portfolio investments in the third quarter partially offset by $4.6 million in realized gains. Our net unrealized depreciation is net of approximately $10.3 million of unrealized appreciation due to either strong company performance or M&A valuation indications in certain portfolio companies.

In the end realized depreciation for the quarter, we think of these as occurring in three general categories: first, the market write-downs, second, some combination of mark-to-market write-downs and an element of company underperformance but not including any of our 1-rated companies in the portfolio and finally, primarily credit-related write-downs which for the third quarter consisted of a handful of names. When combining our credit-related write-downs net of our write-ups due to stronger performance and expected gain activity, this amounted to less than 20% of our total net write-downs for the quarter. In addition to management reviewing valuations for all investments each quarter prior to our Board of Directors approving our final investment valuations, approximately 25% of our portfolio valuations are reviewed by independent valuation service providers each quarter.

Slide 8 shows a summary of our debt facilities. As of September 30, we had $902 million in total debt outstanding with approximately $272 million of capacity remaining for additional borrowings under our existing credit facilities subject to leverage and borrowing base restrictions. We have $61 million in cash on hand. Reducing debt by the $61 million in cash, our debt to equity ratio was about 0.67X. That’s why in the fourth quarter, we’ve experienced net repayments of about $44 million and we expect to sell assets to Ivy Hill II of up to $75 million. As we sit here today, our debt net of cash on hand has declined to approximately $808 million using our 930 stockholders’ equity balance, this would place our adjusted net to equity ratio at 0.65X.

We have no scheduled debt maturities until July 21, 2009 when our CP maturity is scheduled to mature. As of today, we have cash and availability under our revolving credit facility to pay our CP lending facility down to about $40 million and we have no other scheduled maturities until the end of 2010. Although we have elected not to adopt FAS 159 and mark our outstanding borrowings on these facilities to current market prices as of the end of the third quarter, we estimate that the unrealized gains on the fair value of our debt on a mark-to-market basis would exceed $175 million indicating about a $1.80 per share of value is not reflected in our net asset value. This value reflects the attractive, low current market interest rates on our long-term funding in place.

Turning to slide 9, we paid our regular third quarter dividend of $0.42 per share on September 30 and we also declared our regular fourth quarter dividend of $0.42 per share payable on January 2, 2009 to shareholders of record as of December 15, 2008. I will now turn the call back over to Mike.

Michael J. Arougheti

Great. Thanks, Rick.

Now I want to say a few words about our recent investment activity and portfolio positioning before I comment on our prospects and risks under current market conditions.

As Rick mentioned earlier in the third quarter, we closed $183.2 million of new commitments across 11 portfolio companies. Five of these investments were with new companies and six were with existing portfolio companies. Eight separate private equity sponsors were represented in these new transactions and one of those sponsors is a new relationship for ARCC.

Slide 10 outlines our new investment activity. Of our new investments, 7% were in first lien senior secured debt, 19% in second lien senior secured debt, 62% in senior subordinated debt, and 12% were in equity and other securities. While 2% of these investments bear interest at floating rates and 86% bear interest at fixed rates. From a repayment standpoint, 80% were in first lien, 6% in second lien, 11% in subordinated debt, and 3% in equities.

During the third quarter, significant new commitments included a $50 million subordinated debt investment to one of the nation’s largest outsourced laundry equipment and service providers to multi-use facilities and the #1 player on the West coast. We also committed $40 million in sub-debt to a leading dental practice management company and $35 million in a second lien term loan to the third largest outsourced physician and administrative service provider to hospital emergency rooms. Finally, we committed $22 million in mezzanine to a leading government services firm serving the DOD and related organizations.

In total, our new investments provide a blended yield of 13% however, this doesn’t include any structuring fees, call protection and original issue discounts that we received in these transactions. Including such items, these investments in total returned profiles in the mid-to-high teens.

Now turning to slide 11 for updated portfolio quality statistics. As the data reflects, we are investing in larger companies at higher spreads while our overall portfolio company leverage is declining and interest coverage is improving. I would like to point out a couple of important things. First, our weighted average total leverage multiple continues to decline and it is now down to 4.34X, down from the peak of 4.65X in Q1. Our interest coverage ratio has improved from 2.4X to 2.8X quarter over quarter reflecting the strong health of our underlying portfolio. As you can also see, the average EBITDA for transactions closed in the third quarter continues to run higher than the overall portfolio average at $64.2 million while the overall portfolio average EBITDA notched higher to about $39 million. What’s not shown and as we discussed on our last call is that we are lending on a weighted average basis between 1.9X EBITDA and 4.3X EBITDA with a portfolio yield of 12.2%. We are sure that this compares favorably to the lien lenders who may have lent between 4X and 6X EBITDA with yields perhaps 50 basis points and 75 basis points higher than ours.

Another key takeaway here is the improvement of our portfolio covers statistics shown could not improve without solid underlying EBITDA growth in the portfolio. As I mentioned earlier on average, our portfolio companies are experiencing year-over-year revenue and EBITDA growth.

Turning to slide 12, consistent with our views on the credit and economic environment, we’ve continued to focus our investments in more defensive, non-cyclical and service-oriented businesses. For example, at the end of the third quarter, our three largest industry concentrations each representing 10% or more of our portfolio were health care at 20%, education at 10%, and beverage, food and tobacco at 10%. The overall portfolio sector weightings compared very favorably to the broad leverage loan market in terms of pricing performance and default experience that I touched on earlier in the call. Accordingly, we believe that our portfolio will continue to be less volatile compared to the broadly syndicated loan market indices given our negative exposure to real estate, autos, gaming, lodging, transportation and media, and our underweighted exposure to publishing in favor of overweights in health care, education, and food and beverage.

Slide 13 provides another view of our portfolio quality. As a reminder, we employ an investment rating system with grades of 1 through 4 with 1 being the lowest grade for investments that are not anticipated to be repaid in full and with 4 being the highest grade for investments that involve the least amount of risk in our portfolio. At the end of the third quarter, the weighted average grade of our portfolio investments remained at 2.9, unchanged from last quarter. We did have some movement with several new 2-rated credits offset by a new 4-rated credit. Overall, our 4-rated credits continued to outweigh our 1-rated credits and other than our core portfolio companies on non-accrual, we have no companies in payment default.

Now a few comments on the market opportunities and risks. As I mentioned earlier, the pricing declines at the end of September and through October are unprecedented for loans traded in the secondary market. This has been both a blessing and a curse. From a new investment perspective, the secondary market offers tremendous opportunities considering purchasing. However, returns available in the secondary market affect new market pricing as many market participants weight purchasing second market issues compared to primary new issues.

Consequently, new issue terms have lightened substantially in the last six weeks alone for those transactions that are able to be completed in this volatile market. To give you a sense on where new transactions would clear today if at all, senior first lien transactions would price at LIBOR 600+ with an original issue discount of 3 points or more, with subordinated debt clearing in the 16%-18% range with similar OID and meaningful call protection. When factoring in the three-year payment assumption, all of our new terms are in the low teens for first lien debt and around 20% for sub debt. Leveraging terms have also improved considerably with first lien leverage limited to 3X or less and subordinated debt leverage limited to 4.25X or less.

Given the scarcity of capital and market uncertainty, there has been a dramatic pullback of participants willing and a lot of cases able to commit capital including some major capital providers and this is the blessing.

The curse is the obvious lower market pricing for assets and the lack of liquidity in the financial system in general. During the last week or so, fortunately we have seen some stabilization in the secondary trading levels but still far too earlier to call any bottom. Industry default rates although clearly rising are just above average historical levels and now stand at about 3.6% measured by the number of defaults which market participants expect to either trend higher by year-end and well into next year.

If we now turn to slide 15 and 16 for a brief discussion of investments to date and our backlog and pipeline. You’ll see since the end of the third quarter, we closed $10.8 million in new commitments and we have exited $44.4 million of investments. Slide 16 shows that our backlog and pipeline of opportunities is down substantially reflecting the current market slowdown. We have a backlog of commitments of $90.5 million with a pipeline of $56 million behind it. This excludes any potential secondary market purchases we may pursue. Our backlog and pipeline continues to be targeted towards companies in defensive industries with attractive yields and strong structural protections. If the investments in our backlog and pipeline were consummated under the terms currently contemplated, the stated weighted average yield on such loans would be about 15% with total return profiles including fees, call protection and OID in excess of 18% and we would expect such investments to generate approximately $4-5 million of incremental fee income.

In conclusion, while we prepared ourselves for a market correction and believe that risk was significantly mispriced in certain asset classes in the peak of the cycle, it is difficult to have predicted such a severe dislocation. That said, we believe that our strategic portfolio posturing with more significant senior debt composition, lower first dollar and overall portfolio leverage and strong interest coverage serve us well. Our strategy today is to recycle, reprice and reposition the portfolio for more attractive risk-adjusted returns and to be intensely focused on managing our balance sheet and liquidity.

One more note, earlier this week we filed for exemptive relief with the Securities and Exchange Commission that if granted will enable us to co-invest with our Capital Markets group within Ares management. While any order would contain certain conditions, if granted, we would generally have more flexibility to create a greater amount of capital to our clients and provide more flexibility in jointly pursuing attractive opportunities in the secondary markets.

We do believe the current market offers compelling risk-adjusted returns on new investments if you have available capital. Using data from the past recession, the lowest default vintages occurred during the beginning of the 2001-2003 credit cycle when leveraged multiples declined, spreads widened out and we experienced tighter lending terms. Of course, the opportunities tempered in today’s extremely volatile market with a need to maintain additional liquidity and lower leverage. This temporarily impacts our core EPS potential but we believe it is a near-term tradeoff until the markets return to normal levels. Our liquidity is solid with over $330 million in debt capacity and cash on our balance sheet. Our leverage is modest with a debt-to-equity ratio net of such cash at 0.67X and as of today, we have cash and availability under a revolving facility to pay our CP funding facility down to about $36 million.

We believe we have been proactive in managing our capital by completing an equity rights offering earlier this year, building our asset management business and extending our credit line early. Our overall credit quality is solid with only four companies in payment default out of our 90 portfolio companies representing a 3.2% non-accrual rate at cost and 1% at value. Our portfolio is currently weighted away at worse-performing and highest default industry sectors and overweighted toward the better-performing sectors compared to the broadly syndicated loan market.

Finally, our portfolio has powerful repricing and recycling power given our natural liquidity and lead agent status. We believe we have already proved our ability to reprice assets and recycle capital as higher returns in the first half of the year.

That covers our prepared remarks for today and as always, we appreciate your time and thank you for your continued support. Operator, if you would now open up the line for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Vernon Plack from BB&T Capital. Please go ahead.

Vernon Plack - BB&T Capital

Mike, I perhaps wanted to get a little more color from you regarding the exemptive order that you are applying for. I know you just talked about it but maybe perhaps a little more anecdotal evidence or an example of how you see that helping both you as well as Ares management, and maybe some thoughts too on, I have no idea how long a process like that will actually get exemptive relief if possible.

Michael J. Arougheti

Sure. The order as it’s drafted, and you’ll all be able to access it if you’re not able to do it already has two components to it. I want to remind everybody as a publically traded company we are unable to co-invest currently with other parts of the Ares organization which as we sit today manages in excess of $25 billion of assets that’s 250 professional worldwide. We spend a lot of time talking to you all about the synergies and benefits of that affiliation. We are one of the most active participants in the leveraged finance market across the Ares platform, however, we are currently unable to invest in transactions either in larger loans, opportunities in the secondary market or even to syndicate a ARCC originated loan to other parts of the firm.

As I think about the advantages, it is really two-fold. One, it would give us the ability and a period of constrained liquidity and growth opportunity in our own balance sheet to access other pools of capital within the Ares organization to bring to the market and provide service and product to our issuers. Two, to take advantage of our capital markets’ infrastructure and research infrastructure and trading infrastructure, to be in the market taking advantage of some of the dislocation we see in the secondary markets. Some of our peers do pursue these activities on their balance sheet at the BDC and they are really not having the conflict that we do with some of the other parts of the organization.

In terms of the timing, in a normal market atmosphere, it is normally a 9 to 12 month process. I remind everybody that we went through a similar process shortly after our IPO but chose for a variety of reasons not to pursue the process at that time. We have asked for an expedited review from the commission given everything that is going on in the market and the benefits to shareholders. We like to try to get people focused on it sooner rather than later but we can’t guarantee that that’s going to happen.

Operator

Our next question will come from Troy Ward from Stifel Nicolaus. Please go ahead.

Troy Ward - Stifel Nicolaus

There is a ton of information on the call and I apologize if I am asking you to go over something but I’ll get a lot of it on the replay. Can you talk about the portfolio rotation, you talked about $160 million recycled and another was it $190 million repriced?

Richard S. Davis

$94 million repriced.

Troy Ward - Stifel Nicolaus

$94 million repriced which you added 2 cents and recycling added about a nickel, is that correct?

Richard S. Davis

Correct.

Troy Ward - Stifel Nicolaus

How do you view portfolio growth, overall portfolio growth going forward? I saw where in the quarter, some of that I guess would fall in the recycling, the $22 million went into Ivy Hill I, is that correct?

Richard S. Davis

Correct.

Troy Ward - Stifel Nicolaus

That’s at about $350 million. How do you view net portfolio growth going forward?

Michael J. Arougheti

Again, the balance we need to strike given all of the volatility and the uncertainty in the market is to conserve liquidity until we get better visibilities to the underlying market trends and economic fundamentals while trying to judiciously take advantage of the market opportunity that sits in front of us. You will continue to see us putting capital out in this market. We’re doing as best as we can to match the capital deployed with the capital that we’re getting back and we’re using our excess liquidity, as I mentioned we have close to $350 million of liquidity now, we’re really using that to go out into market and use our scale and size to drive pricing and terms that are very attractive to us right now. I would expect over the next quarter or two to see modest portfolio growth on a net basis but I would expect to see a continued deployment of capital as we continue to aggressively recycle our underlying portfolio.

Troy Ward - Stifel Nicolaus

On the theme of capital preservation, as far as the dividend goes, I understand that if you add back in gains, you’re still over from ’07 to ’08, you got a very high coverage of your dividend, but clearly in this market, I think it can be surmised that late ’08 and into ’09, gains are going to be harder to come by and clearly the spillover is probably not going to be available either. How do you view the dividend in ’09, your current dividend versus your potential in ’09?

Michael J. Arougheti

I really think that’s the question that financial institutions have to face right now. As we mentioned the last time we all got together on a call and today, we have a very clear path and strategy to grow the core earnings and get to full dividend coverage through cash distributable and operating income. The leverage that we have to pull that we talked about, are obviously deploying our current balance sheet liquidity, growing our asset management business and increasing our fee income, recycling our portfolio, repricing our portfolio, and then trying to harvest gains. We are in a market environment that is exhibiting unprecedented volatility and there is just a lot of general uncertainty. We think it would be a mistake right now to make any long-term strategic decisions and generalizations as we sit here today. We think we will get a lot better sense for where the markets and economies are going as we get through year-end and we get a look at the economic picture, as we get a look at the health or lack there of bank balance sheets, as we get some of the recent Fed action a chance to work its way though the system. I think it’s important that people appreciate that we do have a pass to get the full coverage. We are operating very significant coverage now but we have to be judicious in pulling those levers because as we sit here today, we just think that staying liquid and sitting in cash is really the most prudent thing to do right now.

Troy Ward - Stifel Nicolaus

I agree, I think you have the ability to get to that, but in this environment, it is going to take longer than our modeling definitely anticipated three quarters ago, and it is probably going to take even longer after we do the models this quarter. At what point do you say, we need to pull the dividend back versus it’s just going to take longer for coverage?

Michael J. Arougheti

It’s going to be an ongoing process. We’re going to do it in dialogue with our investors in the market and it’s going to be a consistent reference to our existing liquidity position and where we perceive opportunities to use our liquidity. Again, as we sit here today, there’s a balancing that needs to occur as we get through this fourth quarter and the end of the year and see what the market opportunity is. I also want to remind everybody, that we opportunistically did a rights offering in April and communicated to our investors and market that we would be taking at least a year to fully develop and deploy the strategy that we laid out. We are executing very well against that strategy in all respects but we are really only eight or nine months into it and we want to give that strategy a chance to bear out in full. It’s something that we obviously pay a lot of attention to as I think the market should as well but from our seat, everything we said that we were going to do a year ago, we’re doing and the market opportunity is still there for us to grow the core earnings.

Troy Ward - Stifel Nicolaus

One final question. Can you give us a little bit of color on the portfolio at First Life Financial? I know this is a larger investment and it is in an area that has had considerable turmoil. How large is the portfolio at First Life and what does that portfolio look like and how comfortable are you with the ability with that portfolio to continue to meet and make your investments accrue?

Michael J. Arougheti

We don’t provide specific commentary on underlying portfolio companies but we have said in the past and I will reiterate it now, the portfolio is very diversified, it’s very granular, it is predominantly senior secured debt at low leverage levels and attractive pricing. The structure of that company’s balance sheet has no mark-to-market triggers or risks on the liability side so the cash-on-cash return opportunity and that investment continues to be very sound from our perspective.

Operator

Our next question will come from Sanjay Sakhrani from KBW. Please go ahead.

Sanjay Sakhrani – Keefe, Bruyette & Woods

I just had a question on credit quality. I think there were four additions to the grade 2 category. I was wondering if you could just briefly touch on those and if there were any changes in the grade 1 bucket.

Michael J. Arougheti

It’s interesting, we spend a lot of time on the call talking about our industry overweightings and underweightings and one of the things, I think it is important for people to recognize is our portfolio is not immune to general movement or headwinds in certain industries. Most of our credit tends to, or credit weakness or credit strength, tends to be driven by company-specific performance issues. The four companies that were moved to a 2 are in a variety of industries. One is in the food business, the other is in the commercial printing business, one is a specialty retailer and one is a waste management and environmental services business. I think that when you look at those industries, clearly the printing company is experiencing pressure given what is going on in the overall economy. Our retail investment that we moved to is actually up significantly year-over-year but based on our expectations for Q4 performance in the retail environment, we are taking a cautious stance there. As we sit here today, the company is actually out-performing revenues projected year-over-year.

The color there is on two rated credits for us, those are credits that make our watch list. We either have actual performance that gives us pause or we have some visibility to future performance that means we want to increase our monitoring. None of those companies are past due on their interests. We are in active dialogue with the management teams and the sponsors of those companies. As we sit here today, we don’t perceive that there is loss of principal otherwise it would be categorized as a 1.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Just on Ivy Hill II, how much money has been raised towards that $250 million?

Michael J. Arougheti

All of it.

Sanjay Sakhrani – Keefe, Bruyette & Woods

All of it, okay. That $75 million that you guys expect to sell to the fund, it’s possible and probable.

Michael J. Arougheti

Yes, I would say it’s both possible and probable. There’s a number of restrictions just driven by tax and others that will affect the timing and nature of those deals. Our expectation is that those deals will occur.

Sanjay Sakhrani – Keefe, Bruyette & Woods

One final one. Just broadly speaking on kind of a BDC model in the context of the present environment and the technical dislocation, I was just wondering what your thoughts were on it, is there any type of regulatory relief that’s being discussed or being vetted upon?

Michael J. Arougheti

Just in terms of our views of the vibrancy of the BDC model?

Sanjay Sakhrani – Keefe, Bruyette & Woods

Yes.

Michael J. Arougheti

I think that everything is relative. I continue to believe that if you look at what is plaguing the financial sector in general, the primary culprit is leverage. The BDC model is given its leverage restrictions and its diversification requirements will prove to be extraordinarily resilient in getting through the current market climate. It’s obvious that there are some specific challenges that we all face as a BDC such as the slippery slope of a FAS 157 accounting its impact on NAVs, the inability to grow the balance sheet and sell stock below NAVs. There are some structural constraints to the model. As I sit here today, I view those as opportunity costs and not as real risks to the model. Just referring back to Ivy Hill II, the irony is that in the private markets, there continues to be a significant amount of demand for the assets that we are originating and that we are investing in, but I just think that the financial markets obviously have an aversion now for a whole host of reasons in investing the financial space. I don’t think that that is an indication that the BDC model is not viable, I just think that means that you just need to aggressively manage to model until you get back to normal market environments.

Operator

Our next question will come from Jim Ballan from J.P. Morgan. Please go ahead.

Jim Ballan - J.P. Morgan

There is a pretty significant number in terms of the exits in the quarter which is great from a liquidity standpoint. Just given the unprecedented volatility, you had a net realized gain in the quarter. Can you give us some detail around that net gain to get me a little more comfortable with that? I know Rick might have covered this but if we could talk about that a little bit.

Michael J. Arougheti

When you go through the queue, you will see the realized gain was predominantly from a company called Daily Candy. It is an ad-based web publisher. It was bought by Comcast for a very nice multiple and we made a very nice return on the investment. As we said on our last call, at the time that we had our last conference call, we have an extra 10 portfolio companies that were engaged in various strategic process fees and review strategic alternatives while we have to accept the current economic and M&A environment will affect some of those processes. I don’t believe it will affect all of those processes. The strategic acquirers are more cautious but still active. They’re liquid, their balance sheets are healthy. I think we will see a slowdown in repayments but as we look forward, we don’t think it will be a complete shutdown.

Jim Ballan - J.P. Morgan

The investment activity in the quarter, was there any portion of that was a drawdown on the unfunded commitments? How much of the decrease in the commitments of this quarter was due to draws as opposed to just adoptions of those commitments now that the commitments have gone away?

Michael J. Arougheti

In the quarter, about $34 million was drawdowns under our line. Let me just take a step back and spend a couple of minutes on the unfunded lines so that people appreciate exactly what those are because I know Jim you brought it up last quarter as well.

If you look at the quarter, for the quarter, we reduced our total unfunded commitments which included letters of credit by about $58 million from $333 million at the end of Q2 to $275 million. Some of that is funding. It’s important to really understand what those $275 million are. When you look at the $275 million and only about $216 million of it is available subject to loan-opt restrictions and borrowing availability, etc, etc. If you then try to further boil down the $216 million, you have to think of it in two buckets. I want to make sure that people understand this. One is true revolvers that people use for their daily capital requirements and those are revolvers where there is an ability to draw down at a day’s notice. The second bucket is what we would categorize as delayed draw, CAPEX lines or multi-year acquisition lines. That first bucket of working capital revolvers was about $86.5 million at the end of the quarter. Our borrowers based on their borrowing basis were to draw down about $82 million.

While we can’t be exact what their cash on hand is today, as of the most recent financial statements that they have given us based on our interaction with them, they had to collect about $76 million in cash on hand against that $82 million. As we mentioned on the last call, those revolvers are to some of our strongest portfolio companies.

Just to illustrate how those revolvers are performing, during the third quarter, we experienced net repayments under those lines of $7.6 million and since quarter-end, we only experienced net borrowings of $3.8 million. There’s daily draws and the lines, but the lines have been net undrawn or being paid down even through this period of volatility.

The second bucket is what we would call delayed draws or acquisition lines and that bucket was at $134 million. Those lines tend to be used in tandem with events that have already been approved in a contract or are subject to some kind of a corporate event happening, an annual earn-out subject to budget performance, an acquisition being negotiated, and those events particularly require additional equity contribution and are subject to achievement of budgets and verification of all sorts of stuff.

Back to the question about what we’re seeing on our own exits, we are experiencing minimal, if any draws on those lines given the general M&A climate and even in situations where those lines are going to get drawn, we tend to have significant advance notice and visibility as to when those acquisitions may occur and we can manage them accordingly. A portion of the investments we made in this quarter were drawing down under that line but about $140 million of it was new investments.

Jim Ballan - J.P. Morgan

The Ivy Hill II and I guess Ivy Hill I as well would also be available as some sort of funding if they were drawn down more than you expected?

Michael J. Arougheti

I’m sorry Jim, you cut out. Can you repeat the question?

Jim Ballan - J.P. Morgan

If the availability you have in Ivy Hill II would be available as additional liquidity to cover?

Michael J. Arougheti

Oh, of course. We have $350 million of balance sheet capacity. We just raised a $250 million fund to invest in the market in partnership with our balance sheet. We have excess capacity in Ivy Hill I and again, net for the quarter today, we are seeing paydowns under these lines and they tend to be cash collateral lines. As we think about our pipeline, we’re always factoring in whether or not we see acquisitions coming down the pipe but as we mentioned last time, when they get drawn, they are very attractive assets for the balance sheet and we’re happy to own them. In theory, if we funded some in the balance sheet, we could also fund some into Ivy Hill II and liquidity is liquidity. But we do not perceive the acquisition and delayed draw lines as a significant risk to our liquidity position.

Operator

Our next question will come from Adam Waldo, a private investor. Please go ahead.

Adam Waldo - Private Investor

Given the really almost historically unprecedented in the leveraging environment that we’re in, presently with a slight carry-over at year-end, given the significant discount that the stock is presently trading, can you give us some sense on how you think about stock buybacks and the use of liquidity, particularly given some recent movements by other credible BDCs like Corporate Capital, or Black Rock Capital in that regard?

Michael J. Arougheti

I think as you come to know us as a management team, we like to be thoughtful and judicious in making strategic decisions and move. I think, to date, obviously some of our peers have announced share buyback programs but they have not really utilized them so well. It’s nice to acknowledge that it’s a tool that’s available to potentially create a quarterly increase in our dividends, but we want to make focused to the extent that we are in the environment that we think it makes sense to buyback stock and we are actually buying back stock. You have to look at the accretion/dilution analysis from a buyback program. You have to weight the benefits of the buyback program against the risks of deploying significant amounts of liquidity in today’s market. I do believe personally and it is something we spend a lot of time talking about here amongst the management team, if you were to do something like a share buyback, you would want to do it meaningfully so that it would have the desired impact in creating modest incremental change. Parting with liquidity right now is something that is challenging. Just to put it in perspective, at our current share price, in order to have a share buyback and just based on the math and not the risks to potential liquidity. Just the math would require that we invest in 20%-22% returns in new money as a break-even against the share buyback. As we sit here today, we’re seeing opportunities to invest capital at those returns and higher. It’s something that’s on our radar screen. We understand the arithmetic. As we get a better sense at where this market is headed and what our opportunities to deploy capital are, it may make sense in the future. As we sit here today, we don’t see it.

Adam Waldo - Private Investor

Just one quick follow-up if you’ll permit me. As you look at the general environment, can you give us a sense for how you are planning for ’09 from a macro backdrop as you analogize to prior deep recessions? What is your current best guess? Do you think in the credit markets we are likely to see something like the early ‘70s, early ‘80s, early ‘30s, just general views on that given your experience?

Michael J. Arougheti

Our hope, and again, I don’t think anybody has seen the technical dislocation that we are living through right now. Our hope is that we will get through the worst part of it through the first or second quarter of next year. One thing I will say and this is also a risk but we’re seeing significant deflation and a lot of pressure receding on the gross margin line for a lot of our portfolio companies. While we’re seeing consumer weakness and a general slowdown in corporate spending, we’re also seeing a very rapid and very significant reduction in commodity pricing and raw material input pressure which was kind of the story last year. As we look at revenues and profitability for our companies, we are seeing and we do expect to continue to see revenue slowdowns. It is being mitigated somewhat by a pretty significant margin pickup in the reduction of input costs. We are, again, being very cautious. We’re seeing a significant slowdown in October-November then we would expect in December as people try to hit the pause button and try to get a sense for where the economy’s going. Liquidity is still very, very tight and if you saw some of the feedback out of the most recent Fed survey, the market is generally liquidated in capital restraints and small businesses are finding it difficult to get capital. We have every expectation that the recent Treasury and Fed action will start to get liquidity back into the system. We think the lower interest rates are obviously going to help company cash flow. We can’t tell you exactly but we look at a lot of companies here and a lot of companies across Ares’ management platform, our expectation is that it will be deeper and longer than we saw in the last go-around. We think that all of the tools are in place and we’re seeing some evidence that we’ll try to get through this by the end of ’09.

Operator

Our next question will come from Jasper Birch from Fox-Pitt Kelton. Please go ahead.

Jasper Birch - Fox-Pitt Kelton

I was just wondering if we could get some commentary on sort of how you have September, October LIBOR dislocation and you set repricing GAAP, does that expect the price flow in your CLOs?

Michael J. Arougheti

Say that again.

Jasper Birch - Fox-Pitt Kelton

There was a LIBOR dislocation, spiking up in September, October, I was wondering how did that affect your debt securitization in terms of the cash flow and the funding base? Is that something we should be looking at right now?

Michael J. Arougheti

Rick, maybe you want to handle this quickly about where we are in regard to our fixed versus floating interest rate management and then Jasper, I will try to address the CLO question.

Richard S. Davis

I think just looking at the September 30 balances, from a matched spending standpoint, roughly $130 million or so was of the exposure with our floating rate, assets exceeding our floating rate liabilities. As we have mentioned, we’ve recently put a $75 million additional hedge in place to where we will pay fixed LIBOR, 2.98% for two years to somewhat mitigate that factor. Mike, you can get into more details but the LIBOR contracts that we’ve had, we were fortunate on our facilities where we didn’t really have to reset any LIBOR contracts during the spike. There were a couple contracts that came due but it so happened that we had the options to select the prime rate instead of LIBOR, and the prime rate happened to be lower than the prevailing LIBOR rate plus our spread. We were fortunate in that regard but there may be a little mismatching just with the assets side too from our portfolio companies.

Michael J. Arougheti

I would just highlight when you look at the net spread increases as we mentioned of 250 basis points over the last year, obviously a portion of that is a result of higher yields on new investments. A portion of that is obviously a result of interest rates coming in. I will also highlight that a lot of the new vintage loans that we invested in have LIBOR floors set at 3% or 4% and that is obviously going to be a value driver into ’09 and ’10.

Back to the CLO question, if I understand it directly, the way to think about our on-balance sheet CLO is that we are borrowing floating rates and we are investing floating rates. We have $314 million in floating rate liabilities as LIBOR 34 and based on the way that financing is structured, there is a diminished amount of fixed-rate investments in that particular structure. So there is nothing in the interest rate movements that would impact that financing vehicle, if I understand the question correctly.

Jasper Birch - Fox-Pitt Kelton

So there is essentially no pricing gap either in the term?

Michael J. Arougheti

Nothing material.

Jasper Birch - Fox-Pitt Kelton

I have another question, it is sort of more general especially with the Ivy Hill II fund and the investments that you are looking at right now, one, are you still looking at primary market or is it more secondary market? In the secondary market, we have been hearing from some people that there are a lot of entire asset platforms out there from funds that are getting liquidated, is that something that you guys are considering for the new investments?

Michael J. Arougheti

Again, as I mentioned, when you look at Ares’ management as a firm, we are one of the most active participants in the liquid credit markets in addition to us being one of the more active participants in the illiquid markets. At Ares Capital Corporation, we are spending a lot of time looking at those opportunities as well as the primary market. As I mentioned in my prepared remarks, secondary markets’ pricing is driving a lot of the new structures and pricing requirements in the primary markets. It is also true that almost every day, there is a new thing that is coming out where there is a portfolio getting liquidated as a result of a hedge fund on TRX or some market-value CLO getting unwound. Again, one of the things that people have to appreciate is the dislocation in the senior loan market pricing is really a function of that phenomenon and not necessarily a perfect manifestation of credit weakness. All of these facilities are short in duration, have market value triggers and as you put out significant supply in a very short period of time and the buyers know that there is another one around the corner, the bid side of the market continues to come down very quickly and you’re in this negative feedback loop.

That said, I think it’s also important that the market is very inefficient right now. On average, we’re seeing $400-$500 million a day in portfolio sales coming through the market but on average, 30%-40% of those assets are actually getting sold and the remainder are not. The bid/act spread in many of those situations is you can see something in the magnitude of 10-20 points. There is a lot of rumor and energy around loan prices but in some of these situations, the prices just aren’t clearing.

Operator

Our next question will come from John Arfstrom from RBC Capital Markets. Please go ahead.

John Arfstrom - RBC Capital Markets

Just one quick question, guys. In your prepared comments, you talked about the strong pipeline for repricing in the first quarter of ’09. Can you just comment on how significant that might be or how it might compare to what you did in the current quarter?

Michael J. Arougheti

It’s going to be a function of company performance. It’s interesting and I’ll be careful as I say this. As a senior secured lender, the best environment for you to operate in is a flat cash room environment where companies are still liquid and are still prospering but have set unrealistic expectations for themselves and for their loans. What we are beginning to see now and we saw the beginnings of it in Q2 and Q3 is given the vintage of the loans that we hold in our senior secured portfolio, people are now starting to get to the point where they continue to perform year-over-year but are faced with significant covenant step-downs based on budgets that were set 2-3 years ago. The number can be quite significant, multiples of what we experienced in the third quarter but I think it’s going to take some time and it’s obviously going to be a function of how the economy performs here in the fourth quarter and first quarter.

Operator

Mr. Arougheti, at this time I show there are no further questions. Please continue with your presentation.

Michael J. Arougheti

Great. That’s all we had for today. We appreciate everyone taking so much time to spend with us this morning. We look forward to speaking to you again next quarter. Thank you.

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Source: Ares Capital Corporation Q3 2008 Earnings Call Transcript
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