Ares Capital Corporation Q2 2009 Earnings Call Transcript

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 |  About: Ares Capital (ARCC)
by: SA Transcripts

Operator

Good morning. Welcome to the Ares Capital Corporation's Earnings Call. At this time all participants are in a listen-only-mode. As a reminder, this conference is being recorded on Thursday August 6, 2009. Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties.

Many of these forward-looking statements can be identified by the use of the words such as, anticipates, believes, expects, intends, will, should, may and similar expressions. The company's actual results could differ materially from those expressed in the forward-looking statements for any reason, including those listed in the SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements.

Please also note that past performance or market information is not a guarantee of future results. 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 the 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, any incentives, management fees attributable to such realized gains and losses and any income taxes related to such realized gains.

A reconciliation of core EPS to the net per share increase or decrease in stockholders equity resulting from operations, the most directly comparable GAAP financial measure can be found in the company's earnings press release. The company believes that core EPS provides useful information to investors regarding financial performance, because it is one method the company uses to measure it's financial condition and results of operations.

At this time, we will like to invite participants to access the accompanying slide presentation by going to the company's website at www.arescapitalcorp.com and clicking on the August 6, 2009 presentation link on the homepage of the Investor Resources section of our website. Ares Capital Corporation's earnings release and annual report are also available on the company's website.

I will now turn the call over to Mr. Michael Arougheti, Ares Capital Corporation's President.

Michael Arougheti

Great. Thank you, operator. Good morning everyone and thanks for joining us. I'm joined today by Rick Davis our Chief Financial Officer; Carl Drake; and Scott Lem from our finance and accounting team and Eric Beckman, Kipp deVeer, Mitch Goldstein and Michael Smith, senior members of our investment advisors management team.

I hope you have had a chance to review our earnings press releases this morning, and our investor presentation posted on our website. As we have on past calls, I would like to start by giving you brief overview of market events in the second quarter and discuss of current strategy, before I turn the call over to Rick to walk through our second quarter results in more detail.

The broadly syndicated leverage loan market recovery that began in the first quarter picked up considerable steam in the second quarter driven by increased liquidity, some signs of economic improvement, better than expected earnings and technical factors which led to a reduction of loan outstanding.

Consequently, secondary loan prices sharply rebounded reaching pricing and spread level not seen since before the Lehman bankruptcy last fall. During Q2, S&Ps leveraged loan index increased more than 12 points or 20% of depressed price levels of 65 at the end of Q1, to 78 by the end of the second quarter.

There were many favorable technical factors that drove the recovery. Repayments increased, investment fund flows into prime funds and high yield accounts picked up, while forced portfolio loan sales abated. In addition, the high yield market heated up during the quarter providing an outlook for issuers to refinance billions in near term maturing loans.

Due to the market rebound, secondary spreads in the broadly syndicated market have declined substantially, and the risk adjusted spreads are now in line with more typical recessionary levels. However, despite the sharp decline in secondary loan spreads, comparable primary market spreads on recent transactions that we either closed or observed in the middle market, only modestly tightened and certainly much lesser than in the larger secondary market.

From a structural standpoint, the second quarter looks a lot like the first. Leverage levels, season pricing, covenant packages and equity contributions all remained very favorable. And investment opportunities in the primary market today remain at levels that are so very attractive from a risk adjusted perspective.

In the secondary market, while quality loans still trade well above lower rated or cyclical credits, lower quality loans outperformed sharply during the quarter and investors bid up the most depressed assets with a renewed appetite for risk.

In addition, average bid levels between legacy assets and new assets have also tightened considerably. We are not convinced that the rally in lower quality assets is sustainable and we believe this fundamental performance and analysis need to play a bigger role from here out.

The primary market is still focused on quality, perhaps more than at any point in the last decade. For example, over 66% of new issuers in the primary were BB rated, the highest percentage in over 10 ten years. In terms of new investment activity, the leverage buyout market remains at cyclical lows with volumes down between 75% and 85% year-over-year.

Given the high cost of capital, lack of debts in the broadly syndicated leverage loan market and wide bid-ask spreads between buyers and sellers primary market activity remains very slow.

We believe that our broad direct origination platform covering the middle market becomes even more valuable in a slow market such as this.

Furthermore, due to the strength of our origination platform and the reduced number of competitors in the market, we believe that we are well position for a pick up in activity, if recent market momentum translates into greater buyer in the M&A volumes. Although, macroeconomic conditions remained very challenging, an increasing number of recent economic indicators point to the beginning of the recovery in the second half of the year.

Within our portfolio, with the exception of a select number of companies, we are generally seeing performance improving the aggregate, as proactive cost cutting and raw material price decreases have been combined with a slightly better demand picture. However, we believe that our portfolio as a whole may not be necessarily represent the broader economy or loan index due to our over weights in defensive industries

Given our outlook for a slow general recovery, we plan to stay overweighed in these defensive high free cash flow industries, and all of our investment and portfolio management decisions reflect this too.

Industry default rates have continued to increase on a lag basis as the credit cycle progresses and unemployment continues to rise. For example, the annual default rate on S&P's leveraged loan index increased from 8% last quarter to 9.2% this quarter measured by the principle amount of loans.

Importantly on the positive side, the industry default run rate during Q2 declined to about half of Q1 run rate, contributing to the declining credit spreads and the improved turn in the loan market.

Similarly, projected 2009 high yield default rates are now expected to be lower in the 9% to 12% range, versus earlier projections as high as 18% and versus current default rates of over 11% for Credit Suisse.

Now, let me take a few minutes to update you on our strategic priorities, which as we said in the past are one, maintaining a strong balance sheet, two, aggressively managing our credit profile and three, focussing on other core initiatives to improve our core earnings per share, grow our franchise and increase shareholder value.

We've made great progress on our balance sheet in funding initiatives, particularly with the extension and increase of our commitments from Wachovia Wells Fargo. At $350 million, we now have more debt capacity than we have regulatory leverage capacity, which totaled about 256 million net of cash at the end of the quarter.

The additional capacity provides us more flexibility for growth, should we be able to increase our equity base, grow our NAV or be in need of additional debt capacity.

We continue to remain appropriately focused on managing our leverage and maintaining an appropriate level of leverage. And during the quarter, we lowered our net leverage slightly from 0.79 times to 0.77 times. We also reported another healthy quarter of loan repayments and exits in our portfolio.

This quarter, we experienced approximately $87 million in total investments repaid, syndicated or sold. And this repayment level is consistent with our quarterly average of just over $100 million over the past year. Obviously, repayments are critical allowing us to either reduce our leverage or to redeploy capital accretively in higher yielding assets.

From a credit perspective, we believe that our focus on senior assets and defensive industries prior to the peak of the credit cycle has enabled us to perform and report strong credit performance compared to the senior leveraged loan market, the high yield market and many of our peers.

For example, our non-accruing loan percentages have remained low by industry standards representing 2.1% at fair value and 6.2% of our portfolio at cost. These figures include only one small new non-accruing loan during the quarter, representing just 0.4% of our portfolio at cost, or 0.1% at fair value.

I'd also point out that since we have not taken any realized credit losses over the past two years, and with just one realized credit loss of approximately $7 million since our IPO in 2004, our non-accruals must be understood at accumulative over this period.

That said, we may need to convert some existing unrealized losses into realized losses as this credit cycle matures and resolves itself. These may occur as a result of some type of restructuring or recapitalization necessary to position a particular company for recovery or future growth.

We do believe that we are properly reserved for unrealized depreciation against these potential realized losses. And therefore, a loss realization should not impact our GAAP EPS or our net asset value.

From a strategic standpoint, we continue to focus on ramping our asset management business, and as you may have read in our June press release, we entered into agreements which tripled the size of our asset management business increasing total capital under management from $650 million to over $2 billion through the [Coltz] in first [live] transactions.

We believe that these transactions will provide attractive fee income, greatly expand our knowledge of companies and industries within the middle market, and provide numerous refinancings and transaction opportunities for our balance sheet in the future. We now manage over 250 different portfolio companies, [solidifying areas] is one of the largest player in the middle market.

And given the evolution of our asset management business both organically and through acquisitions, we've naturally invested more capital and define specific resources in this unit.

Accordingly, this quarter we converted Ivy Hill Asset Management from a consolidated subsidiary into a portfolio company, and Rick will discuss in more detail later in the call.

With that I would like to turn it over to Rick for more comments on our Q2 financial results in greater detail. Rick?

Richard Davis

Thanks, Mike. Please turn to the financial and portfolio highlight slide in our presentation which is slide 3. Our basic and diluted core EPS were $0.33 for the second quarter, a $0.02 increase over last quarter, and a $0.07 decline from the same period year ago. Excluding transaction related structuring fee income, our Q2 core earnings per share were $0.32 versus $0.30 last quarter and for the same period a year ago.

The sequential quarterly increase in our core earnings per share was primarily due to a full quarter's impact on several re-pricings that occurred in Q1 and some re-pricings in Q2, which boosted our portfolio yield. As well as the pick up in management fee income, all partially offset by slightly lower structuring fee income. Due to the net unrealized gains of $0.04 and net realized losses of a $0.01, we reported GAAP EPS of $0.36 compared to $0.36 last quarter and $0.04 a year ago.

After paying our dividend, our net asset value per share was $11.21, up a $0.01 from last quarter. Investment activity for the quarter was modest by our historical standards. You can see our net commitments declined $38.3 million in the quarter as our $43.1 million and gross new commitments were offset by a reduction of $81.4 million in existing commitments.

This net reduction was intentional and reflects our desire to maintain an appropriate leverage cushion. From a funding standpoint, our gross spendings were $69.5 million, but net spendings were negative $17 million. As Mike mentioned, we continue to experience a relatively healthy level of exists and repayments, which totaled $87 million for the quarter with the majority from amortization and revolver pay downs.

We closed the second quarter with a $2 billion investment portfolio at value covering 94 portfolio companies with a weighted average EBITDA of about $48 million. Excluding cash and cash equivalents our quarter end portfolio was comprised of approximately 53% in senior secured debt securities with 32% of that in first lien and 21% in second lien assets, and 32% in senior subordinated debt securities with 15% in equity and other securities. The composition of portfolio was unchanged from the first quarter.

We were able to increase our weighted average investment spread by 49 basis points to 9.7% during the quarter and by 184 basis points over the past year. Despite of 60 basis point drop in drop in LIBOR, our overall portfolio yield increased 50 basis points this quarter to 11.68% at cost primarily due to loan repricing that took place in Q1 and Q2.

Our weighted average funding cost were essentially flat, or just under 2%. On the topic of loan re-pricings, they are quite common in today's marketplace as issuers loans are re-priced higher to market rates when they are need of any changes to their loan documents for any reason. Whether its for a new facility or some amendment to their loan documents including covenant relief.

As a lead agent on a significant number of our credits, we are ultimately in a position to drive the economics related to such re-pricings. As you can see, they've had a positive overall effect on our earnings particularly in a slow transaction environment.

On slide four of the presentation, we provide the detail regarding our fixed rate assets, which account for 58% of our portfolio and our floating rate assets which make up 29% of the portfolio, including LIBOR floors, which we now have on approximately 39% of our floating rates portfolio, our portfolio was approximately 69% fixed rate on an effective basis. LIBOR floors are proven to be an effective tool in managing our interest rate exposure.

During the quarter, we continued our policy of using third party independent valuation providers to review approximately 50% of the portfolio based on value. Over the last few quarters, third party independent reviews from four different valuation firms had been conducted on approximately $2 billion add value with 89% of the portfolio either reviewed or new to the portfolio over this period.

On slide five, the improvement in our GAAP earnings per share is shown. For the first six months of the year, our GAAP earnings per share of $0.72 is well in excess of the earnings for the same period last year of $0.15 a share. This is a reflection of both our steady core earnings per share and portfolio values this year as the market has stabilized.

As shown on slide six, we incurred net realized losses of $857,000 and net unrealized investment gains of $3.6 million for total net gains of 2.8 million. Within the 3.6 million of net appreciation, we incurred gross unrealized depreciation of $41 million offset by $37.4 million of unrealized depreciation.

Now, let me address the changes in our portfolio evaluation for the quarter. As Mike described in his opening comments, new issue spreads on observed transactions in our market tightened only modestly during the quarter at a level significantly less than in the secondary market.

Since our valuation policy utilizes relevant comparable transactions observed in the primary market as important inputs, our mark-to-market adjustments were less significant than movements in the more liquid, broadly syndicated secondary market.

Also important to point out that the decline in LIBOR adversely affected valuations on some of our floating rate loans that lack LIBOR floors due to mark-to-market yield requirement.

For the quarter, our portfolio evaluation was slightly positive as our unrealized appreciation for mark-to-market adjustments, solid performance across the broad group of positions and an unrealized gain related to Ivy Hill asset management that I will discuss in a moment, was offset by further credit related unrealized depreciation on a handful of lower rated credits.

With magnitude of the appreciation and the depreciation was fairly modest relative to the size of our portfolio. As Mike discussed in his opening comments, there were some changes with respect to the structure of Ivy Hill Asset Management, which had accounting and valuation implications. Because of the shift in activity from being primarily a manager with no dedicated employee of funds in which we had invested debt and equity, to a manager with individuals dedicated to managing and increasing number of third-party funds for which we have limited or no investments we concluded in conjunction with KPMG that gap requires the financial results of Ivy Hill Asset Management to be reported as a portfolio company in our schedule and investments rather than as a consolidated subsidiary.

Over the three months ending June 30thh, we made an initial equity investment of $3.8 million in the Ivy Hill Asset Management, and after review by a third-party valuation provider, also recognized an unrealized gain of $8 million on this investment, representing the future discounted cash flows expected from the management contracts in place.

Going forward, as we recognize any income through dividend and distributions from Ivy Hill Asset Management up to ARCC the future value will otherwise be reduced for that income recognition subject to potential additions or subtractions for any future revenue expected to be earned.

Slide seven, shows the summary of our debt facilities. As of June 30th, we had approximately 879 million in total debt outstanding, with about $150 million of capacity available for additional borrowings under our existing $1billion in credit facilities subject to leverage and borrowing base restriction.

After closing our $200 million undrawn revolving credit facility on June 21st with Wachovia and Wells Fargo, our pro forma debt capacity increases from a $150 million as of June 30th to $350 million, again subject to our regulatory leverage limitation. On slide eight, is our balance sheet.

You can see we also have $46 million in cash on hand. Reducing our debt by this $46 million in cash, our borrowing capacity increases to $196 million as of the end of the quarter and $396 million pro forma including our new revolving facility. Our net debt to equity ratio at quarter end was just under 0.77 times or expressed as a dollar amount, our asset coverage cushion was approximately $256 million or about $20 million higher than last quarter's level.

At quarter end, we were in compliance with all of our debt covenants. We continue to believe our most restricted financial covenant is our two to one asset coverage test, which had the $256 million cushion at June 30. We continue to seek the repurchase of our on balance sheet CLO debt at attractive discounts that we were not successful in doing so during the quarter. This was partially due to the improvement in value for our debt in the market as a whole.

Turning to slide nine, we paid our second quarter dividend of $0.35 per share on June 30 and this morning we declared our third quarter dividend of $0.35 per share consistent with our second quarter's level. The dividend is payable on September 30, the stock holders of record as of September 15th. With the improvement in our core earnings per share of $0.02 to $0.33 sequentially over 94% of our current dividend was covered by our core EPS. Although, we do not provide dividend guidance, we are pleased that we had declared to pay a quarterly dividend at least $0.35 for the past 15 quarters.

I will now turn the call back over to Mike.

Mike Arougheti

Great. Thanks, Rick. Now I would like to say a few words about our recent investment activity and touch on our portfolio performance before concluding. As everybody could turn to slide 10, as Rick mentioned earlier in the second quarter we closed $43.1 million in new commitments across nine companies, which consisted of investments in seven existing portfolio companies and two new portfolio companies.

The most significant new commitments were secondary purchases of existing portfolio companies at attractive prices. These investments included $12.1 million in first lien debt of a leading renal dialysis provider, $8.6 million in first lien debt of a different renal dialysis provider and $5 million in second lien debt of a provider of specialized engineering, scientific and technical services for the Department of Defense.

Our other activities during the quarter consisted of fundings under existing commitments and other opportunistic purchases of debt in existing portfolio companies or other companies well known to us in the secondary market. We continue to believe in this environment that opportunistic add-on purchases of secondary debt of strong companies trading at a discount are an excellent way to deploy incremental capital and build NAV.

At the bottom of the slide, we outline our new investment activity. Of our new commitments, 74% were in senior first lien debt, 12% in second lien senior debt with 14% in equity and other securities. The vast majority of the new commitments were floating rate at 74% of the total. Looking at our repayments, 89% on first lien, 6% in second lien with 5% in senior subordinated debt.

And now turning to slide 11, for an update on our portfolio quality statistics. We believe that this provides an excellent snap-shot of the impact of all of our strategic initiatives across this cycle. The data reflects our strategy of taking advantage for the market opportunity to increase our investment spread while lowering overall portfolio risk.

The left chart shows that our spread has increased to 9.6% while our weighted average leverage and interest coverage statistics have generally improved or held constant.

Our average portfolio last dollar total net debt leverage declined to 4.1 times from 4.3 times last quarter and versus 4.6 times a year ago. Our interest coverage increased to 2.7 times versus 2.6 times last quarter and 2.4 times a year ago. As you can see on the right chart, the average EBITDA for our portfolio has increased, now at $48 million versus $38 million a year ago.

While market and economic conditions are still challenging, we are encouraged by the positive portfolio performance particularly compared to the market indices. Although not shown here, our portfolio weighted average revenues and EBITDA continue to grow on a year-to-date basis, versus the same period prior year.

Our portfolio company year-to-date weighted average revenues and EBITDA were up in the mid single digits and mid teens respectively versus the prior year, reflecting the improved operating leverage from cost cutting, lower raw materials and some modest pick up in demand as I described earlier.

Although, Q2 data is not yet available, S&P highlighted that the change in EBITDA year-over within the leverage loan index was negative 18% year-over-year during Q1'09. Turning to slide 12, this illustrates our portfolio by industry compared to a chart put together by Credit Suisse highlighting defaults by industry in the leverage loan sector over the last 12 months.

As shown on the left of the slide, you'll see that our portfolio continues to be concentrated in more defensive industry sectors such as healthcare, education, food and service industries. And at the chart on the right side of page shows, the industry sectors with the highest default rates including media and telecom, transportation, chemicals, housing, gaming and leisure, forest products and energy, none of which are meaningfully invested in our portfolio.

In addition, our overall industry sector weightings have enabled our portfolio to compare favorably to the broad leveraged loan market indices in terms of EBITDA growth as I just described. To illustrate this point further, S&P report have been only six out of 27 industry sectors reported positive EBITDA within their leveraged loan index for the first quarter.

These sectors were dominated by the defensive industries that are heavily invested in our portfolio, such as healthcare, business services including education and food products.

Slide 13 shows additional detail of the diversification of our portfolio by issuer concentration, asset class and geography. Our largest investments are in the industry sectors that I just mentioned and the top 15 investments represent a little over 43% of the portfolio.

Slide 14 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 that 4 being the highest grades for investments that involve the least amount of risk in our portfolio.

At the end of the second quarter, the weighted average grade of our portfolio investments remained at 2.9 unchanged from the last several quarters. We experienced two downgrades totaling $4.2 million at fair value and one upgrade totaling $42 million at fair value. Therefore the net rating change were positive in the aggregate and we believe our reflection of stability in our portfolio.

Overall, we have 2.1% of our portfolio at fair value in our lowest rating category of 1, where we do not expect the full recovery and 5.6% at fair value in our highest rating category of 4 indicating a portfolio company that is performing well above expectations. And continuing on with a quality discussion, as I mentioned earlier, we reported a modest quarterly increase in our non-accruing loans from 2% of the portfolio at fair value and 5.7% at cost to 2.1% at fair value and 6.2% at cost.

As I also mentioned earlier, we have not had any reductions from realized losses in the past two years, so this is a cumulative number over that time period. And other than these portfolio companies are non-accrual, we have no other companies delinquent in payment.

So, in conclusion, we are pleased with our quarterly results and the state of our portfolio and balance sheet. And although, the economy in capital markets continue to be challenging, we are definitely seeing signs of strengthening in the general market and specifically in the performance of our portfolio.

For the last two quarters, our write-downs have generally been concentrated within our already identified lowest rated investments and in the quarter we didn't any new significant credit issues emerge. As discussed earlier, our leveraged interest coverage and EBITIDA performance reflect the continuous health and quality of the overall portfolio.

We believe that our capital position, which has been considerably strengthened with new longer term capital in place, provides us with a meaningful competitive advantage and the necessary balance sheet flexibility for our future needs. And we continue to believe and it's important to emphasize that our affiliation with Ares management, which had approximately $29 billion of committed capital under management at June 30th continues to provide invaluable expertise, capital relationships, industry knowledge and back office support.

Given the volatility and uncertainty that we've experienced in the marketplace over the last 18 months, we had been inwardly focused on managing our balance sheet, rotating our portfolio, renewing our credit facilities and aggressively re-underwriting credits and generating liquidity. We have now shifted from a defensive stance to an offensive stance and are placing an increased emphasis on growing our franchise and taking advantage of all of the favorable changes in the competitive landscape.

We'd like to thank our shareholders for their loyalty, support and confidence in us and as always to our entire investment team for all of their hard work managing our portfolio through these challenging markets.

That covers our prepared remarks and as always we do appreciate your time, and thank you for your support, and operator we now like to open up to Q&A.

Question-and-Answer Session

Operator

Yes, sir. (Operator Instructions). The first question we have from (inaudible) with Stifel Nicolaus.

Unidentified Analyst

Great. Thank you. Good morning, gentlemen. Could you just like to give us an update on late June, you announced the debt fund, could you give us an update, little bit color on where that is a and how that fits in the overall structure?

Michael Arougheti

I would love to try, unfortunately due to securities regulations and the fact that we are in a marketing process, we actually can't comment on the status of that fund. We can refer the people on the phone to the press release that we issued upon launch.

Unidentified Analyst

What was the yield on your new investments in the quarter, and then also what is the opportunity to continue to re-price the portfolio higher as you've seen the overall yield moving forward, how can we look at that going forward?

Michael Arougheti

You have to think about yield on the new investments in the portfolio as a total return. As I mentioned in this environment we have been focusing on increasing diversification in the portfolio and taking advantage of buying securities at deep discounts [part] in the secondary market. So the stated spreads on those securities, I mentioned about 74% of the investments were first lien senior secured debt, so the stated spread doesn't adequately reflect what we think the total return on those portfolio investments will be. But, I would comment, when we were in the secondary market buying discounted securities, we typically are looking to make an excess of 15% rates of return buying bank debt.

In terms of re-pricings within the portfolio that continues to be a significant opportunity. In this environment, particularly given the lack of liquidity in the market, those like us who have capital, can use that capital to drive some pretty meaningful changes in their existing portfolio. And as Rick mentioned often times those re-pricings are coming in conjunction with a corporate event or an acquisition not necessarily indicative of underlying credit weakness, as something that we are very focus and we actually think we will continue to contribute to core earnings growth going forward.

Unidentified Analyst

Okay. And then you made a couple of comments that I want delve into a little bit more, you said your non-accruals are basically you have to look at them cumulative, and going forward you talked to take some of those unrealized losses. And you also talked about not being convinced with the secondary rally is sustainable. So is this kind of a move towards getting out of some of the under performing assets, because you feel like you can get a decent price for those in the current market?

Michael Arougheti

I'll start with the last part first. We believe that the rally in the market for higher quality assets and high quality issuers is absolutely sustainable. Just given the liquidity dynamics in the syndicated markets and the high yield market, we don't believe that the rally that we saw in lower rated assets particularly CCC is sustainable. That said, most of our investments are private and illiquid. And as you know, not always able to be exited in a process.

We like our portfolio. We're not aggressively looking to exit investments be they lower rated assets or the higher rated assets at this point in time. With regard to the first part of the question, the comment was simply to say you need to look at non-accruals and realized losses in conjunction with one and other, because obviously to the extent if you take a realized loss of a portfolio company that is all non-accrual, by definition your percentage of loans on non-accrual would decrease. So it's really just a comment to encourage people to think of the interplay between realized losses and non-accruals. And the highlight that we've had no realized losses and our non-accruals are low relative to the industry standards and our peer group.

Unidentified Analyst

So, no real change in your expectation of moving out of underperforming credits?

Michael Arougheti

Look to the extent that we can move out of those underperforming credits or better yet restructure those credits just to make future equity value ourselves, which I think as everybody knows is a core competency of Ares management and of the team here. We'll do it, but it's not a priority focus for us right now.

Unidentified Analyst

Okay. And then one more and then I'll be back in the queue. On Firstlight Financial, with the moves we've seen in the syndicated market upward in the quarter, it's a little surprise to see the write down in Firstlight considering, I believe that's their portfolio. Could you give us a little bit of color there?

Michael Arougheti

Sure. Without getting into all of the details, Firstlight I think as everybody knows was a strategic opportunity that we embarked on in 2006 to build a broad base finance company that was investing in corporate loans, as well as other consumer and commercial credit. Given the dynamics in the market became clear to us in the middle of 2007, as the growth in that platform was going to be constraint at that.

As we sit here today, we are effectively presiding over a static pool of senior loans, which is a combination of broadly syndicated loans and middle market. Just to correct your view, in fact the Firstlight portfolio is predominantly in middle market portfolio not a broadly syndicated portfolio. So a lot of the dynamics that we discussed in our call in terms of the disparity and experience between the secondary market and the primary market and the large market and middle market holds true for Firstlight as well.

For better or for worse, Firstlight is viewed by the third party evaluation providers as a structured product and not a finance company. And as a result, one of the input that goes into valuing Firstlight financial for balance sheet purposes is what's happening in structured product land particularly in the CLO market. And we did not talk about it on the prepared remarks, but that market continues to be very dislocated and inefficiently priced. And when you look at the inputs for those types of securities, it does have some bearing in the discount rate that you used when valuing Firstlight. So it's as much a function of that as it is of an indication of anything going on in the company.

Unidentified Analyst

Would you characterize Firstlight portfolio in the most recent quarter as having a material change in credit quality or liquidity risk?

Michael Arougheti

We would not.

Unidentified Analyst

So it's more of a mark-to-market.

Michael Arougheti

Yes.

Unidentified Analyst

That's great, thanks guys.

Operator

The next question we have comes from Vernon Plack with BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

Thanks very much. Mike you mentioned that the thought is to go from sort of the defensive to the offensive, and that I think that much of the portfolio rotation that you've been working on over the last couple of quarters is essentially complete. And how does that match up with, I know that debt to equity, right now and net debt equity is 0.77. Can we expect you to grow the portfolio at this point and perhaps leverage increase?

Michael Arougheti

I think we're going to continue to keep a very strict eye on our leverage ratio. I would not expect to see it increase for any extended period of time. We do have a fair amount of liquidity on our balance sheet and we will use it opportunistically to drive total returns to the portfolio. We also believe that given the changes in the competitive landscape there will continue to be opportunities for us to grow our business at the expense of some weaker competitors.

And as we demonstrated for example with the [Coltz] and Firstlight transactions there is an opportunity to continue to grow those businesses.

And as we grow that asset management business, I would also remind people, we do have a fair amount of liquidity within our managed funds in the Ivy Hill Asset Management platform that we can bring to bear on our existing balance sheet, but also to use to expand the reach of our balance sheet in the market.

Operator

Next question now comes from Brian Roman with Robeco Investment Management.

Brian Roman - Robeco Investment Management

Couple of questions. I'm little confused as to why you had significant rally in your underlying market, but your NAV is about unchanged sequentially?

Michael Arougheti

Sure. We don't believe that the syndicated loan market is our underlying market first and foremost. And we've been pretty consistent trying to explain why there is directional correlation, but not a perfect correlation between performance in our portfolio and the broader loan indices.

Again, not to bore with all the details, but it has to do with the vintage of the assets, the industry composition of the indices versus our portfolio, the interest rate profile of those assets versus our assets, the covenant packages in those assets versus our assets, etcetera. In past calls, we've spent a lot of time walking through those difference and those value drivers. Where you to look for example at the leveraged loan index in 2008, it was down close to 30%, and our portfolio was not down 30%. And so, as those markets heal themselves and rally, we are seeing a pick up in the valuation in our underlying portfolio but it's not a perfect correlation.

Brian Roman - Robeco Investment Management

I see almost no pick up, very minor pickup, I am looking at page 8.

Michael Arougheti

As we mentioned we had a number of write-ups offset by a number of write-downs. So when you go through the portfolio, you will see there are number of portfolio companies that benefited from a change in valuation input.

Brian Roman - Robeco Investment Management

So Mike just to simplify for my mind. We are making the cases, you didn't write it down as much last year, so you don't write it up as much and everybody ends back up in the same place.

Michael Arougheti

Correct.

Brian Roman - Robeco Investment Management

Okay. Do you envision any scenario where or what index should I consider to think to consider that you will start to see some appreciation.

Michael Arougheti

I think it's important. Maybe we'll just take a step back because it comes up a lot. Our assets are self originated, self negotiated privately structured and actively managed assets that are unique to this company. We don't focus on the indices as a comp for our business whatsoever. These are assets that we originated with an intention to hold them to maturity and we tend to be control and only investor in the debt of many of these companies.

The reason we spend so much time talking about the leverage loan index is - it's an indicator of the health of the credit markets, how liquidity is flowing. We do have the ability to reference those indices as we just think about the pricing and return opportunity available to us, but I really can't point you to an index, that is going to have a good correlation to our portfolio.

Brian Roman - Robeco Investment Management

Okay. Mike but then, between June 30 last year and this year is $230 million of depreciation where that come from?

Michael Arougheti

It came from the fact that we have by the regulations and the accounting proclamation of FAS157, an obligation to look at a whole host of market inputs when we value our portfolio. And while we don't believe that we are comparable to those indices, the evaluation providers and the accountants require that we acknowledge trend in the liquid credit markets and spreads in the liquid credit markets as we mark our portfolio.

As I mentioned in our prepared remarks, for most of last year there was a pretty significant correlation between spread widening in the secondary market and spread widening in the primary market. With the rally that I discussed and that you are asking about, we've seen significant spread tightening in the secondary market, but we have not seen spread change in our primary market.

Brian Roman - Robeco Investment Management

So, you are really basing this on the primary market.

Michael Arougheti

Absolutely. The primary driver valuation for our portfolio is where do loans and investments (inaudible).

Brian Roman - Robeco Investment Management

So, let's roughly call it 300 million, We're not going to see an appreciable change in that number to the upside until your spreads or new issuance starts to come in?

Michael Arougheti

Can you repeat that.

Brian Roman - Robeco Investment Management

The $300 million what do you call it, unrealized loss on investments that's on the balance sheet today, because you are saying your focused on the primary market, what you are implying is that I will not see, and we will not see a meaningful change in that 300 million to the positive -- negative 300 million to the positive, until primary spreads start to narrow, does that make sense?

Michael Arougheti

And until loans move towards repayment and maturity, but it will not be an immediate step back. And Brian if I may, we're more than happy to spend time with you offline discussing this in detail.

Brian Roman - Robeco Investment Management

I had one other quick question Ivy Hill, you are going to carry it as an equity investment now?

Michael Arougheti

Yes. Ivy Hill is a portfolio company in which we have an equity investment and a structured debt investment, but effectively in equity investment, it is a portfolio company that manages $2.1 billion of assets. Those assets generate fee income offset by expenses to manage those funds and the excess distributions from that portfolio company worked away up through to Ares Capital Corporation as interest payments on it's debt investment and as distributions to it's equity investment.

Brian Roman - Robeco Investment Management

So this is not the management fees piece of the income statement?

Michael Arougheti

It is, it's the management fee less the expenses that shows up as distributions to our equity investment. Whereas before there was a consolidated subsidiary and we are showing up as management fee income.

Operator

The next question we have comes from Sanjay Sakhrani of KBW.

Sanjay Sakhrani - KBW

So when we think about the growth trajectory here. I was wondering if you could just help us think through the sources - the sourcing of that growth. I mean are we thinking more primary versus secondary? And then I know you can't really talk specifically on the transaction with the debt fund, but I was wondering philosophically if you could walk us through how you guys planned to invest in that fund alongside your existing portfolio at ARCC? Thanks.

Michael Arougheti

With the second part, for us unfortunately we can't discuss at all the fund for securities recs. purposes, so unfortunately I can't really address the second part of your question. For the first part of your question, we have a stated strategy of going into the market and take advantage of what we think are the most attractive risk adjusted returns. In certain situations that will be in the secondary market, buying loans at a discount in names that we know, either through our asset management franchise or on our balance sheet and in certain instances, it will be in the primary market.

And we're making individual risk adjusted return decisions, as we look at opportunities in both of those markets. As I mentioned though, we are particularly excited about the secondary market opportunity, particularly in the middle market. There has been a significant change in the competitive landscape and the liquidity profiles in our market, as evidenced by [Coltz] transaction for one, there has been a sea change in the way the capital has been managed and flowing in that market.

A lot of these loans don't trade and as I've mentioned, we here at Ares now manage about 250 unique middle market investments between our balance sheet and our asset management subsidiary. That positions us with a lot of information and a lot of visibility into where to find those attractive secondary market opportunities.

And as I also mentioned, we can generate similar types of current returns but have the opportunity to build NAV overtime as those assets get repaid or sold. So if I had to tell you which one gets us a little bit more excited right now, I'd say, we're excited about all the opportunity but in particular the secondary market.

Sanjay Sakhrani - KBW

Then just on that subject on the secondary market. Correct me if I'm wrong, but if I look at the pick income line from the cash flow statement, that was like about a third of the NOI, is that a function of kind of buying stuff at a discount in the secondary market, does it include like the original issue discount or is that straight pick?

Michael Arougheti

Its predominantly straight pick. It's a little bit inflated this quarter, because we had some fee income that was taken in securities rather than cash. So it's not a perfect run rate. I would also highlight as we've mentioned before, not all pick income is created equal. You could generate pick income in different securities.

A lot of pick income in our peer group and elsewhere in the market is being generated from HoldCo securities or HoldCo zeros that were bought at a discount at very high levels of leverage at holdings companies, and some pick income and other comparable portfolio is generated through preferred equity investments with a coupon. 93% of the pick income in our portfolio is being generated from debt securities. And I believe 100% of those situations that pick is coming on top of current cash interest. And we talked about our weighted average leveraged levels, the weighted average total leveraged level in our portfolio is 4.1 times.

So as you think about the risk characteristics of that pick income, it's important to know what security is generating the pick. Where it fits in the balance sheet and what the expected repayment of the pick is and that's how we think about just the pick in general.

I would also point that the significant majority of our pick income is coming in three rated securities. That 85% of the pick income on the income statement right now is in three or four rated securities with only 15% coming from two or one rated securities.

Sanjay Sakhrani - KBW

On a steady state environment how should pick represent of current income?

Michael Arougheti

It depends on portfolio mix Sanjay, so just to give you example of pricing. A typical piece of mezzanine debt will probably have 12%, 13% or 14% cash with 2% to 3% of pick. So, if you were in all mezzanine portfolio or you were moving your portfolio to more towards mezzanine you would see somewhere 15% to 20% of your portfolio in pick income. In the balance portfolio of senior debt and mezzanine absent the ability to re-price securities and take pick income as compensation is probably 10% to 15%.

Sanjay Sakhrani - KBW

Okay.

Richard Davis

And Sanjay, the percent of pick, was in the third of, was just under 20% I think.

Sanjay Sakhrani - KBW

I guess, when I was doing math on the cash, it was like $11 million, is that right?

Richard Davis

Yeah. Right at that.

Sanjay Sakhrani - KBW

Okay. Will do the math again. But just one more question, on the re-pricing related to covenant relief, like how much of that of the re-pricing is related to covenant relief and how much of it is related to other stuff?

Michael Arougheti

We can calculate that for you. If I had to, let me see if I have a piece of paper here. If I had to pick a number, I'd say 30% to 40% of the re-pricing are coming through acquisitions in corporate events and the remainder is coming through covenant negotiations.

Sanjay Sakhrani - KBW

And is that when companies are at or near breaching the covenant or is it just proactive?

Michael Arougheti

A lot of what we do and this is nuance about how we think about our business. But, again where the lead agent in the significant majority of investment in our portfolio and we tend to be the only investor if not the control investor in these securities. In a lot of situations in this economic environment, where companies maybe concerned about access to liquidity and their capital partner, we can actually use our balance sheets to slightly go out and proactively offer terms in return for certainty. So a number of the situations where we've actually re-priced credit it was in anticipation of covenant default or the perception of risk of covenant default but not an actual covenants default.

And in some cases it's also a covenant default, but as we've talked about a lot, as a senior secured lender which makes up the vast majority of our portfolio, a covenant default is not necessarily an indication of material credit degradation. Remember, a lot of the investments that we invested and under-wrote in 2005, 2006, 2007 were under-written against projections that showed growth that has not materialized.

And in your typical senior debt document, you set covenants to a 15% to 20% discount to managements expected growth case. So, you could have company as we have in our portfolio many companies that are actually growing year-over-year low to mid single-digits, yet violating covenants, which is actually a phenomenal place to be as a lender. So, again it's part and parcel with the commentary I gave you on pick, which a covenant violation defect though is not necessarily a bad thing for us, it really depends on the nature of the underlying company.

And just so you have the number, as I mentioned about 45% of the re-pricings were from corporate activity i.e. mergers or acquisition and 55% were part of this whole covenants negotiation discussion.

Operator

The next question we have come from Jasper Birch with Fox-Pitt Kelton.

Jasper Birch - Fox-Pitt Kelton

Hey, guys, thanks for taking my question and nice job in the quarter. I was just wondering if you can give us some commentary on how you are thinking about capital raising either internally or externally in the Ivy Hill fund?

Michael Arougheti

Well, we think about capital raising a lot and obviously it's core to our business. We have been very open and about the challenges leading up to today, but as I mentioned we are increasingly encouraged by what we are seeing in our portfolio and with the positioning of our own balance sheet. What we have tried to do through Ivy Hill and through some of the other managed funds that we have raised is to put ourselves and our shareholders in a position, where we can grow the franchise and take advantage of some of the relationships that we have at the broader Ares of management platform to make sure that we are maintaining all of our employees, that we are compensating our employees and that we are in the market actively investing and building the rich of the franchise. And we will continue to do that no matter what the market environment is.

In the current environment, obviously the tone in the equity markets is improving. The tone believe or not in the structure products market for issuers like Ares we expect to improve as illustrated by our Wachovia Wells Fargo rollover as a tone in the credit markets again for scale the issuers like Ares are improving.

So, as I mentioned the defensive stance has given way to a view where we can now look forward and try to grow our balance sheet both on the equity and the debt side. And we will continue to use our position in the market to try to grow our managed fund business as well.

Jasper Birch - Fox-Pitt Kelton

In terms of I think you already comment a little bit on leverage, but just digging into it a little bit more. I think you funded about 70 million in the quarter and you had 80 something of exits. In terms of going forward, looking at the number but should we be looking at a coming down just from portfolio appreciation, or are you more active on the asset side than the investment side going forward?

Michael Arougheti

In a perfect world, we would try to match our exits with the ability to reinvest and redeploy capital accretively. It's a dynamic calculus for us and as you know in a private market, we have a six to nine months visibility as to what pipeline of opportunity is available to us. So, our primary market investments, we have a pretty good sense as to where we want to invest money and how much we'd like to invest.

The variable comes in the secondary market and to the extent that we see attractive opportunities we want to make sure that we maintain enough liquidity to opportunities we take advantage of them. We're comfortable given the stability in the NAV and the stabilization in the portfolio performance operating in our current leverage level. So I would say, you could see modest increases or modest decreases depending on the investment opportunities that the markets gives us.

Jasper Birch - Fox-Pitt Kelton

In terms of you said that you know sort of where you want to invest your money. Are you looking to change your portfolio mix at all any more in terms of industry?

Michael Arougheti

No, we are not.

Jasper Birch - Fox-Pitt Kelton

And then just one last quick question. Sanjay and you guys digging a good amount on the re-pricing and the portfolio, going forward, do you think you are going to have the same level of opportunities in terms of re-pricing the portfolio, in terms of covenant breaches and things like that or do you think the portfolio is starting to turn a corner?

Michael Arougheti

We don't know, you know it's a double edge sword. You love to see the situation that I just described, where you have covenant violations in healthy company. I would expect more corporate events if the M&A markets normalizes, and that will result in re-pricings and redeployment into more accretive situations. As I mentioned, we did not see the emergence of any new significant credit issues in the portfolio this quarter. So as we sit here today, I would expect the pace of re-pricings from challenged companies to slowdown.

Operator

The next question we have comes from Faye Elliott with Banc of America-Merrill Lynch.

Faye Elliott - Banc of America-Merrill Lynch

Hi Good morning. Quick question. Just, given the timing of the investments that you have on your balance sheet and where the leverage levels were and the spreads were at the time, is it possible that you just won't recoup some of that $300 million or $260 million of unrealized deprecation?

Michael Arougheti

As we said we have four rating categories, one to four. Our one rated portfolio companies are companies where we expect to experience some principal loss. In some of those situations we may restructure company and ultimately recoup through a restructured security, but we do expect to experience some level of principal loss in our one rated names. And as I mentioned that represents about 2% of our portfolio at fair value.

I think it's important also to remind everybody not only we defensively position the portfolio from an industry and asset class standpoint, but when you look at the vintage of our portfolio, 65% of our portfolio is what we would call post credit market dislocation assets, new vintage, new structure, new pricing, etcetera. So, the vintage for us is not a huge driver of or not a huge initiative of credit under performance. It's actually a big differentiator on the positive for us.

Faye Elliott - Banc of America-Merrill Lynch

But I'm talking, also about just reversing some of that unrealized depreciation for those two company?

Michael Arougheti

We are working hard every day to get all of our money in every situation when we have realized mark-to-market depreciation. And we are working even harder everyday to recoup situations where we have taken unrealized depreciations, because of underlying credit weakness in the portfolio company. But, to your specific question about losses, we really think about our ones as those companies where in any situation, we probably have some risk of principal loss, not a complete risk of principal loss but some risk to principal.

Faye Elliott - Banc of America-Merrill Lynch

Okay. Maybe I miss spoke. Really right I am interested and as whether you think that overtime you might see a full recoup of the $260 million.

Michael Arougheti

That's what we are working for and we fully expect to see that happen. In our higher rate of category that's absolutely what we hope happen to over the next year or two.

Operator

The next question we will have from Jim Shanahan of Wells Fargo.

James Shanahan - Wells Fargo

This has run long and you have been very generous of our time, I just simply really brief you of my question. That's a follow-up on Ivy Hill Asset Management, is it correct for me to assume that the portfolio company was added during the period at the cost basis of $3.8 million, but then immediately written up to $11.8. In other words, of the $8.9 million and unrealized depreciation, is $8 of it from Ivy Hill this quarter?

Michael Arougheti

Yes, correct.

James Shanahan - Wells Fargo

And just to, if you can get comfortable on and I want you to ban, so probably will follow up each and every quarter to make sure that the metrics haven't changed, but how you are evaluating that business such as based on a percentage of assets under management or a multiple of cash flow?

Michael Arougheti

It's discounted cash flow analysis based on the fee stream. So as Rick mentioned in his remarks in the absence of adding assets to that platform, a portion of distributions will bring down the value overtime.

James Shanahan - Wells Fargo

I see. Okay. And are you willing or able to disclose any of the underlying assumptions and then DCF and I don't know discount rates or anything like that?

Michael Arougheti

No, we are not, but those are third party valued and if you do some work in the market I think you could get a pretty good sense for how the market things about those. But, it is not valued based on a multiple of management fee or EBITDA, so it's a DCF over the life of those management contracts.

Operator

And the next question we have comes from Andrew Murray of UBS.

Andrew Murray - UBS

Hey, guys. This is running long, so I'll be brief. I just had a quick question regards to the attempted CLO repurchase. I don't know if you guys could give any color at all if that's simply not available anymore or what pricing you are seeing on your EBITDA.

Michael Arougheti

I don't want to say it's not available, because again a lot of what creates that opportunity is stress or a needful liquidity at a particular selling institution. As we've talked about on our past couple of calls, it is a significant opportunity for us. We continue to do everything we can to execute on that strategy. That said people are probably feeling a little bit less stress than the market today than they were six months ago.

Those price negotiations become more and more difficult. And as I think, we have also said in the past the reality of how that market functions is those securities are dispersed globally and that presents various challenges, if you are just trying to source and negotiate, but it continue to an area of focus for us and depending on what happens in the market generally, but also within those holders specifically. We are not ruling out the possibility that we can continue to execute on it.

Andrew Murray - UBS

So, can you give any specific comment on how much, relative to the purchases that you made last quarter, how much you have seen an increase in?

Michael Arougheti

I can't even comment on that just because we haven't had any good any robust discussion on it.

Operator

(Operator Instructions). Mr. Arougheti, gentlemen, it appears that we have no further questions at this point.

Michael Arougheti

Great, well, we appreciate you all taking the time today. Hopefully you are as excited as we are about the future and the stabilization in the markets and we appreciate all of our time, and thank you for your continued support and we look forward to speaking with you again next quarter. Thank you.

Operator

Thank you, gentlemen. Ladies and gentlemen that does conclude our conference call for today. If you missed any part of today's call, a recording of this call will be available through August 21, 2009 at 5 o'clock pm Eastern time. To access the replay, you can call 1877-344-7529. To call internationally, can you call area code 412-317-0088. For all replays, the id number is 432-094. Thank you. That does conclude today's call. You may disconnect your lines.

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