Ares Capital Q2 2010 Earnings Call Transcript

| About: Ares Capital (ARCC)

Ares Capital (NASDAQ:ARCC)

Q2 2010 Earnings Call

August 05, 2010 12:00 pm ET


Richard Davis - Chief Financial Officer

Michael Arougheti - Principal Executive Officer, President, Portfolio Manager, Director, Member of Investment Committee and Member of Underwriting Committee


Faye Elliott - BofA Merrill Lynch

Vernon Plack - BB&T Capital Markets

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

John Stilmar - SunTrust Robinson Humphrey Capital Markets

Jasper Birch - Fox-Pitt, Kelton

Donald Fandetti - Citigroup Inc

James Ballan - Lazard Capital Markets LLC

Greg Mason - Stifel, Nicolaus & Co., Inc.

John Hecht - JMP Securities LLC


Good morning. Welcome to Ares Capital Corporation's Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded on Thursday, August 5, 2010. 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 its SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that the 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 SEC Regulation G. Core EPS, excluding professional fees and other costs related to the Allied acquisition, is the net-per-share increase or decrease in stockholders' equity resulting from operations, less professional fees and other costs related to the Allied acquisition, realized and unrealized gains and losses, any incentive management fees attributable to such realized gains and the income taxes related to such realized gains and other adjustments as noted.

A reconciliation of Core EPS, excluding professional fees and other costs related to the Allied acquisition, to the net-per-share increase or decrease and 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 its financial condition and results of operations. Certain information discussed on this presentation, including information relating to portfolio companies, was derived from third-party sources and has not been independently verified, and accordingly, the company makes no representation or warranty in respect of this information.

At this time, we would like to invite participants to access the accompanying slide presentation by going to the company's website at, and clicking on the Q2-10 Investor Presentation link on the homepage of the Investor Resources section of the website. Ares Capital Corporation's earnings release and quarterly 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. Sir, you may begin.

Michael Arougheti

Great. Thank you, Operator, and good afternoon to everyone, and thanks again for joining us. On the call with me today are the senior partners and the senior management team of Ares Capital’s Investment Advisor as well as our Chief Financial Officer, Rick Davis.

I hope you’ve had a chance to review our second quarter earnings press release, including our third quarter dividend announcement this morning, as well as our second quarter investor presentation posted on our website. We will refer to this presentation a little later in our conference call.

I'd like to start off by briefly discussing recent economic and market events that influence our primary market, update everyone on the progress and benefits that we believe we have realized to date from our recent Allied Capital acquisitions that closed on April 1, and then highlight our combined company second quarter results before I turn the call over to Rick Davis.

After Rick provides the detail behind our second quarter results, I'll walk through the recent investment activity, portfolio statistics, portfolio management strategy and our backlog and pipeline before we close and take Q&A.

Please note that for ease of presentation, in a number of places, we provide information separately for the legacy Allied portfolio as well as for the Core ARCC portfolio.

As we highlighted in our last earnings call on May 10, the capital markets have recently experienced a significant amount of volatility. For a period of time after early May, the market experienced increased uncertainly over sovereign debt risk, financial reform and mixed economic data. This impacted public equity and high-yield markets, which in turn, reduced risk appetite in our market towards the latter part of the second quarter.

High-yield volumes softened in May and June from the robust levels reached in April, and spreads widened. However, since June 30, high-yield volumes are recovering and high-yield spreads are once again narrowing.

I remind everyone that while the high-yield market may from time to time have an impact on the upper end of our market, as evidenced this past quarter, when a few of our larger portfolio companies managed to refinance our loans with high yield, high-yield market volatility or uncertainty can also create additional opportunity for us, particularly when larger middle-market issuers require transaction certainty.

For example, this quarter, we earned a meaningful commitment fee by providing a mezzanine backstop for a high-yield bond financing in conjunction with a larger LBO transaction where the high-yield financing was successfully completed.

Regardless of the state of the high-yield market, our core focus remains on middle-market companies unable to access the high-yield markets, and this opportunity has remained fairly consistent as the year has developed.

In spite of the high-yield market volatility, the conditions in the second quarter in our core middle-market were similar to the first quarter, with a few noteworthy exceptions. Loan volumes were substantially higher and the tightening trend in primary markets' senior debt spreads finally reversed course.

Per S&P data, middle-market leveraged-buyout lending volume was up sharply during the second quarter, with an increase of over 50% from Q1 2010 levels. Spreads on senior debt transactions averaged around LIBOR plus 4.5% to plus 5% with an approximate 1.5% to 2% LIBOR floor.

Mezzanine pricing remained in the 12% to 15% range, and Unitranche pricing averaged out in the 9% to 10% range, including LIBOR floors. I'd also add that total leverage levels in buyout transactions appear to have stabilized, after a modest upward bias during the second quarter, to around 4.5x to 5x total debt to EBITDA.

While not as attractive as 2009, the spreads relative to leverage levels are still significantly greater than historical averages. In addition, loan-to-value ratios continue to be attractive by a historical standard as private equity sponsors continue to pay higher purchase multiples, often contributing 40% or more of transaction consideration in equity.

From our vantage point, middle-market-sponsored finance activity is fairly healthy, as evidenced by our level of new commitments this quarter and our strong backlog in pipeline. The second half of the year for the market in general looks promising from a new-issuance standpoint.

Looking out longer term, we are very encouraged about a continuing potential supply-demand imbalance in our market. Demand for credit should continue to be driven by two main factors: 1) there is an abundant amount of uninvested capital from private equity funds that will need senior and junior debt providers to leverage their capital; and 2) there's a significant amount of maturing debt between 2012 and 2014 across middle-market, large LBO loans and high-yield bonds, not to mention commercial real estate loans and other forms of credit originated during the peak years of 2006 and 2007.

On the supply side, we believe credit may still be constrained as a result of continued systemic deleveraging and increased financial regulation. Given the magnitude of the future opportunity, we will continue to be measured and selective in the current market.

Although expectations for economic growth have moderated recently, we have not seen any significant impact to our underlying portfolio company results in either the core ARCC portfolio or the legacy Allied portfolio.

The economy has been strong enough to enable corporate default rates to decline significantly in the leveraged loan and high-yield markets, and credit rating agencies forecast continued improvement for the rest of 2010.

We believe our core Ares Capital portfolio and our recently purchased legacy Allied portfolio will follow along this path of improved credit and investment performance. The slow-growth environment, in fact, favors credit investing over equity, particularly in debt investments with contractual amortization and maintenance covenants.

Importantly, we believe that we can take advantage of opportunities regardless of market direction. If the market overheats with increased liquidity, we may slow our investment pace or accept lower returns but accelerate the disposition of certain non-core and lower-yielding assets from the legacy Allied portfolio and, to a lesser extent, the core ARCC portfolio.

On the other hand, if the market softens, causing spreads to widen and structural terms to improve, we may slow disposition but accelerate our capital deployment using our significant excess debt capacity.

Turning to our Allied acquisition. I'd like to take a few minutes to remind you of the transaction rationale and highlight a few benefits we believe that we've achieved.

Our enhanced scale and capital resources following the acquisition allow us to be even more competitive in the sourcing and execution of attractive investment opportunities. As I stated on our last earnings call, we believe that the Allied transaction strengthened our competitive position by bringing us increased commitment and hold capacity. It brought us improved market knowledge and better access to the debt-and-equity capital markets as well.

While competition has increased this year, we believe the investment environment remains attractive, with few of our competitors possessing comparable origination, underwriting and commitment capacity. Our deeper origination coverage, coupled with what we believe is our relatively more complete product offering, comprised of senior, Unitranche and mezzanine debt, has enabled us to review a greater percentage of opportunities in the market. And as a result, we believe that we are able to increase our asset selectivity as we search for superior companies and relative value investment opportunities within capital structures.

The rationale for our acquisition of Allied Capital was also based in part upon the opportunistic purchase of a stressed portfolio at an attractive price, with the idea of benefiting from not only an improving economy, but also from the rotation and repositioning of a portion of the portfolio into higher-yielding assets.

We believe we got the price and timing right, as it is clear that we are now in a stronger market environment than last year for both asset dispositions and asset values. I'll walk you through what we believe our opportunities to rotate and reposition the portfolio a little bit later in the call.

As I stated before, we are confident that, over time, we will execute well upon this strategy. But it is likely to take the remainder of 2010 and into next year to fully implement our plans and realize many of the other expected benefits of the acquisition.

While Rick will go into our second quarter in detail, I'd like to highlight several key takeaways. First, from an earnings standpoint, we increased our core earnings per share sequentially by $0.04, from $0.28 to $0.32, excluding certain fees and other costs associated with the Allied acquisition, despite a reduction in our net originations for the quarter. Our portfolio appreciated during the quarter, with net realized gains of $0.06 a share, including $0.02 of prepayment fee income and $0.38 in net unrealized gains.

Our second quarter GAAP earnings per share were a record $1.73, driven primarily by a $1.03 gain associated with the purchase of Allied assets below Net Asset Value. These earnings, along with the issuance of common stock in connection with the Allied acquisition, lifted our Net Asset Value by nearly 20% to $14.11 compared to $11.78 last quarter.

Second, although we experienced significantly more repayments than we made in new investments during the second quarter, we are encouraged that we continue to be able to reinvest repay capital at higher yields than on investments repaid.

During the second quarter, we exited or we repaid on approximately $162 million in primarily non-core assets from the legacy Allied portfolio. As a result of repayment activity, we ended the quarter with lower leverage of 0.41x net of available cash.

And finally, credit performance improved from our perspective, as neither the core ARCC portfolio nor the legacy Allied portfolio experienced any new non-accruing loans, and both portfolios incurred net appreciation during the second quarter.

We're very pleased so far with our purchase and remain excited about the opportunities that we believe lie ahead of us to create value for our shareholders through our active management of the portfolio.

Lastly, as you may have seen from our press release this morning, we declared our third quarter dividend of $0.35 a share payable on September 30 to shareholders of record. Following payment of this dividend, we will have paid a dividend of at least $0.35 per share for 19 quarters in a row, dating back to the first quarter of 2006. We continue to work toward our goal of providing full-dividend coverage from our core earnings per share. With $0.32 in core earnings per share this quarter, we step closer towards this goal. And in addition, while not part of our core earnings per share, we incurred $0.06 per share this quarter in realized gains, including $0.02 per share in pre-payment fee income.

We believe we have embedded earnings potential in the over $900 million of debt capacity and cash available for new investments and additional earnings potential from the opportunity to rotate a portion of the legacy Allied portfolio into higher-yielding assets, particularly via investments through the Senior Secured Loan Fund. However, there are no guarantees that we will achieve this goal or grow our core earnings per share.

With that, I'd like to turn it over to Rick Davis, our Chief Financial Officer, for a more detailed discussion of our second quarter financial results. Rick?

Richard Davis

Thanks, Mike. Beginning this quarter, we will be reporting a number of our core portfolio statistics separately from the legacy Allied portfolio stats so that investors can continue to track the performance of the core ARCC portfolio as well as the progress we are making with respect to the legacy Allied portfolio.

Please turn to the financial and portfolio highlight slide in our presentation, which is Slide 3. As Mike mentioned, our basic and diluted Core EPS were $0.32 per share for the second quarter, excluding $0.06 per share professional fees and other costs related to the Allied acquisition, a 4% per share improvement over Core EPS last quarter, excluding $0.03 of such acquisition-related expenses and a $0.01 lower compared to a year ago.

Note that the $0.06 per share of professional fees and other costs includes our merger-advisory fee that was expensed this quarter. The core earnings per share quarterly increase was driven by higher structuring fees, an increased yield on our debt investments and higher management fee and dividend income, which was partially offset by lost income from the net reduction in our fundings and the higher interest costs from the unsecured notes we assumed in the Allied acquisition.

We had strong net investment gains for the second quarter of $0.44 per share, comprised of net realized gains of $0.06 per share and net unrealized gains of $0.38 per share. In addition, as Mike mentioned, we booked a one-time realized gain of $1.03 per share associated with the Allied acquisition. This gain was the result of our purchase of Allied at a discount to their Net Asset Value.

After accounting for our purchase price of approximately $908 million, we booked a gain of approximately $196 million, reflecting the difference between our purchase price and Allied's Net Asset Value as determined on April 1. This gain, along with our core earnings and net investment appreciation for the quarter, contributed to our GAAP earnings per share of $1.73. After paying our $0.35 second quarter dividend, our Net Asset Value was $14.11 per share, an increase of 19.8% from last quarter.

Consistent with the increased liquidity in the market and higher levels of transaction activity, we experienced both higher levels of new commitments and, as expected, higher levels of involuntary and voluntary exits and repayments during the second quarter.

In ARCC's core portfolio, gross commitments of $409.9 million were offset by $530.3 million in exit commitments, resulting in a net reduction in commitments of $120.4 million. Gross fundings of $275.5 million were offset by higher exits and repayments on fundings of $458.2 million, resulting in a net reduction in the size of the ARCC core portfolio of $182.6 million. This level of quarterly portfolio turnover is much higher than we have experienced over the last year.

During the second quarter, I'd also like to point out that in the aggregate, we were able to reinvest a portion of our capital and debt investments with yields in excess of the yields on debt investments that were repaid during the quarter. Our new debt investments made during the quarter yielded approximately 14.2% on a weighted-average basis compared to our debt investments exited, which had a weighted-average yield of approximately 13.3%.

Given all of the realization activity on investments, we thought we'd provide an update on our performance on fully realized investments. As of June 30, we have now recorded accumulative realized Internal Rate of Return of approximately 13% to ARCC across 97 exits on invested capital of $2.2 billion, including the exits of the three investments acquired in the Allied Capital acquisition.

Regarding the legacy Allied portfolio, we were successful on exiting or receiving repayment on legacy Allied investments totaling about $162 million during the quarter at a small gain. Importantly, these assets in the aggregate had a relatively low weighted-average yield of just over 8%.

We continue to be focused on additional restructuring, repositioning and divestitures of non-core Allied assets. We'll seek to reinvest the proceeds of these future exits into core assets with a higher blended yield, although there can be no assurance that we will be successful with this strategy. A little later in the call, Mike will outline the attractive opportunities that we believe we have with respect to the additional portfolio rotation and repositioning.

We ended the quarter with 188 portfolio companies on our balance sheet. They're valued at approximately $3.8 billion, of which 102 were included in the legacy Allied portfolio, totaling $1.7 billion at fair value.

Our quarter-end portfolio was comprised of approximately 38% of senior secured debt investments, with 31% in first-lien and 7% in second-lien debt investments, and 33% in senior subordinated debt; 6% in CLO investments, many of which are managed by Ares Capital or our portfolio company, Ivy Hill Asset Management; 17% in equity and other securities; 5% in the Senior Secured Loan Fund, which we co-manage with GE Capital; and 1% in commercial real estate.

Now let me walk you through the changes in our yield and investment spread, which were driven primarily by the Allied acquisition. Our overall weighted-average and investment spread at June 30 was 8.66%, a decrease of about 126 basis points compared to last quarter. From a yield standpoint, we bolstered our weighted-average yield on debt- and income-producing securities at cost for ARCC's core portfolio from 12.17% to 12.79% quarter-over-quarter, and we acquired Allied's portfolio with a comparable weighted-average yield of 14.29% at amortized cost.

Our overall weighted-average yield increased from 12.17% at amortized cost last quarter to 13.4% this quarter when combining the two portfolios and from 12.33% to 13.39% measured at fair value. However, our weighted average cost of debt has also increased from 2.25% last quarter to 4.74% in the aggregate this quarter, primarily due to the assumption of Allied's unsecured notes, which had a weighted-average cost of 6.54%.

On Slides 4 and 5, we provide additional quarterly detail, but I'd like to turn to Slide 6 to highlight our fixed- and floating-rate assets and our non-accruals statistics by portfolio. On a combined basis and using fair values for our portfolio, our percentage of fixed-rate debt assets of 51.9% is largely unchanged from last quarter. Our floating-rate debt assets declined from 32.5% last quarter to approximately 23.7% this quarter, with about 57% of those assets carrying a LIBOR floor, and we've continued to obtain such floors on most of our new floating-rate transactions.

Given the fact that we are benefiting from LIBOR floors, we are slightly more sensitive to rising interest rates going forward. We continue to monitor interest rates and the yield curve with the continued goal of being match-funded as practical.

Staying on Slide 6, I'd like to highlight the second quarter's credit performance for both portfolios. We are pleased that we did not experience any new non-accruing loans in either portfolio during the quarter. Regarding our ARCC portfolio, credit performance continued to be solid in our view, with no new non-accruing loans added, and with one non-accruing loan repaid at a modest discount to par after the first quarter end, as we discussed on our last call.

Next shown on the slide, at the end of the second quarter, non-accruing loans as a percent of the total combined portfolio was 2.3% and 0.2% at cost and fair value, respectively. Excluding the legacy Allied portfolio, the comparable non-accruing loan-to-total-portfolio ratio would have been 4% and 0.4% versus the 4.2% and 1% for the first quarter.

Turning to the legacy Allied portfolio. Total investment for the portfolio was approximately $1.7 billion at fair value, comprised of 102 different securities as of June 30. Since April 1 and through June 30, the legacy Allied portfolio has incurred no new non-accruing loans, while one non-accruing loan has been exited.

As of June 30, 7.1% of total investments were in non-accrual status at cost, with 7.4% at fair value. The small difference between the percentages at cost and fair value reflects a slight improvement in the value of those non-accruing investments that we experienced during the quarter after the Allied acquisition on April 1. On a combined basis, our portfolio had total investments on non-accrual as a percent of our total portfolio of 9.4% and 7.6% at cost and fair value, respectively.

Now let's skip over to Slide 9 for a discussion of portfolio gains and losses during the second quarter. Before I begin, let me provide an update on the valuation of our portfolio from independent third-party providers.

In connection with the closing of the Allied acquisition on April 1 and in addition to our own review of the entire portfolio, we employed third-party independent valuation providers to review approximately 95.5% of the legacy Allied portfolio. In addition, at the end of the second quarter, third-party independent valuation providers reviewed approximately 50% of the combined portfolio, including the legacy Allied portfolio, based on fair value.

In total, approximately 94%, or $3.6 billion, of the combined portfolio has been reviewed or has been newly originated into the portfolio over the last two quarters. On Slide 9, you'll see that we reported net realized and unrealized gains in total of approximately $85 million, or $0.44 per share.

For the core ARCC portfolio, we incurred net realized gains of $11.8 million in the second quarter, driven primarily by prepayment fee income, par repayments on securities purchased at a discount and equity co-investment gains.

The core ARCC portfolio also incurred $35.9 million of net unrealized appreciation. Combining these two categories, and after backing out previously recognized depreciation of about $9.3 million on the net gain realizations, the core ARCC portfolio contributed $38.3 million in net realized and unrealized gains.

Turning to the Allied legacy portfolio. Second quarter net realized gains were modest at about $0.5 million, but net unrealized appreciation totaled about $46.3 million. Therefore, the Allied portfolio contributed $46.8 million in net realized and unrealized gains during the second quarter.

In the aggregate, our net unrealized appreciation was broad-based and reflects mark-to-market gains from slightly tighter spreads and a higher leverage on primary market loans, stronger credit investment performance and improving asset values for our structured products portfolio.

Slide 10 shows a summary of our debt facilities at quarter end, including the debt assumed in connection with the Allied acquisition. As of June 30, we had approximately $2.1 billion in committed debt facilities, with a weighted-average maturity of 9.2 years and a weighted-average cost of 4.74%. We had approximately $1.3 billion in total debt outstanding, of which only $357.9 million was outstanding under our two credit facilities that have total capacity of just over $1.1 billion, leaving $790 million available.

Adding in availability from our on-balance-sheet debt securitization plus cash on hand of approximately $139 million, we had approximately $946 million of debt capacity in cash, subject to leverage and borrowing base restrictions.

As shown on Slide 10, we assumed three series of unsecured notes in the Allied acquisition totaling about $736 million in aggregate principal amount. Note that our carrying values for this debt are moderately lower than the associated principal amounts, reflecting the lower fair values at the time of the acquisition in accordance with the GAAP. This purchase discount was primarily attributable to the notes maturing in 2047.

During the second quarter, we exercised the accordion feature under our revolving credit facility and increased the size of the facility by $60 million to bring total commitments to $750 million.

This June 30, we received an additional $25 million commitment from a new lender to our revolving credit facility under this accordion feature, which brings the total facility size to $775 million. We're also having very productive discussions with additional lenders to further increase the total facility size, although there can be no assurances that these discussions will result in additional commitments.

As a reminder, the accordion feature of our revolving credit facility allows us to increase the total facility to just over $1 billion. These actions highlight our continued access to debt capital.

On Slide 11 is our balance sheet. Our debt-to-equity ratio at quarter end was 0.46x times, based on the carrying amount of our debt, which when reduced by cash and equivalents, our net debt-to-equity was even a more conservative 4.41x. This net debt-to-equity ratio is substantially lower than our targeted leverage of 0.65x to 0.75x. Therefore, as Mike discussed, we plan to invest a portion of our available debt capacity in accordance with our investment objective, with the intention of bringing our leverage more in line with our target range and increasing core earnings. However, there can be no assurance that we will be able to execute on this strategy.

Now I'll turn the call back over to Mike.

Michael Arougheti

Great. Thanks, Rick. Now I'd like to say a few words about our recent investment activity, review performance stats for both portfolios, discuss our portfolio-rotation initiatives and highlight our backlog and pipeline before concluding.

If folks could turn to Slide 13, you'll see that in the second quarter, we booked 13 new commitments totaling about $410 million, with average commitment sizes approaching $32 million. We hope to continue to consistently increase our average commitment size given our greater ability to underwrite and hold logic commitments.

We expect to accomplish this by making larger commitments to our existing target borrowers rather than altering our target area focus to larger companies. As Rick stated, our investments exited were rather significant in the quarter at $681.3 million, which more than offset our gross new commitments by over $270 million. Most of the repayment activity was involuntary from the core ARCC portfolio, reflecting the increased liquidity, repayment activity and velocity prevalent in the market, particularly early in the second quarter.

Turning to Slide 14, you'll find more detail behind the specific asset classes of the investments and exits. The table on the left illustrates that we were particularly active with first- and second-lien debt investments, representing 56% and 18% of new investments, reflecting our strategy to move up the balance sheet into higher attachment points as the leverage finance markets transition.

A select few of our most significant new commitments included $103 million in senior-subordinated and delayed-draw debt to a healthcare-technology provider, $73 million in second-lien senior-secured and delayed-draw debt to an airport food service operator, $43 million in first-lien senior debt to a collection services provider, and $33 million in subordinated notes in the Senior Secured Loan Fund to finance a post-secondary education provider. These investments have an aggregate yield of 14.2% at fair value compared to the weighted average yield of 13.3% on the assets repaid during the quarter.

In addition, about 38% of new commitments made were to existing portfolio companies, highlighting the importance of incumbency and our own portfolio in winning new investment opportunities. We hope to continue to mine the almost 500 portfolio company relationships that exist on balance sheet or in the portfolios managed by ARCC or our totally owned portfolio company, Ivy Hill Asset Management, for new opportunities.

Regarding the exits from our core ARCC portfolio, approximately 71% were from first- and second-lien debt investments. In the legacy Allied portfolio, of the $161 million in exited investments, the asset allocation was more balanced, with 46% first-lien, 25% second-lien, 22% in sub-debt and 7% equity and other, all at fair value.

Now let's turn to Slide 15, and I'll highlight our rotation initiatives to date and the potential opportunity with the legacy Allied portfolio. For the second quarter, we exited or received repayments of $161.7 million in investments, with a yield of 8.2% at fair value.

As shown, this amount included $53.1 million in non-income-producing investments and $45.3 million with a yield of 6.2% at fair value. We did experience repayments on $61.6 million of assets, yielding 17% at fair value, but in the aggregate, our exits were considerably lower-yielding than the overall legacy Allied portfolio yield and well below the yield on our new investments made this quarter.

As of quarter end, the legacy portfolio had various categories of low- or non-yielding assets at fair value. $162.2 million of lower-yielding debt securities, defined as having a yield of less than 10%, and which yield 8.6% on average; $273.9 million of non-accruing loans with no yield; $251.9 million of non-yielding equity securities; and $39.4 million in commercial real estate and other assets with a 2.8% yield.

We believe there is an attractive opportunity to rotate and reposition a substantial portion of this over $700 million in low- or non-yielding securities into higher-yielding securities over time. In fact, since June 30, we have exited an additional $66 million of legacy Allied portfolio investments at a weighted-average yield of 10.47%, and one investment totaling approximately $10 million has been removed from non-accrual.

Now turn to Slide 16 and I'll review the leverage and interest coverage statistics for each portfolio. In the core ARCC portfolio, the underlying portfolio company weighted-average last-dollar net leverage remains stable at 3.7x. Note that interest coverage on the underlying core ARCC portfolio improved from 2.9x to 3.3x.

Turning to the legacy Allied portfolio, the initial last-dollar weighted-average total net leverage is higher, as expected, at 4.5x, and interest coverage is lower but still well over 2x. On a combined basis, our weighted-average total net leverage was moderately higher, increasing from 3.7x to approximately 4.1x, with interest coverage down only slightly, from 2.9x to 2.8x.

On Slide 17, we break down weighted-average EBITDA for the two portfolios. Overall, weighted-average EBITDA for the core ARCC portfolio remained relatively steady at approximately $44 million. And as you can see, new portfolio companies funded during the quarter generally averaged about $30 million in EBITDA.

The legacy Allied portfolio had underlying portfolio company weighted-average EBITDA of about $23 million. So on a combined basis, our total weighted-average portfolio company EBITDA was approximately $35 million at the end of the second quarter.

Skipping to Slide 19, you can see that the portfolio was more diversified on a combined basis with the Allied portfolio. Our largest single investment, representing 5.35% of the portfolio at fair value, is in a fund we co-manage with GE Capital called the Senior Secured Loan Fund, which has approximately 12 portfolio companies. We're very satisfied with the risk-adjusted returns from this fund. Last quarter, our fund investment returned approximately 21% cash on cash. We continue to be excited about the opportunity to put more dollars to work in Unitranche loans in this fund in partnership with GE.

Beyond the Senior Secured Loan Fund, you can see the next-largest investment is less than 2.8% of the portfolio at fair value, and the top 15 represent just over 33% of the portfolio at fair value.

Slides 20 through 22 provide a snapshot of the portfolios by asset, industry and geography.

On Slide 23 is a summary of the grades by category for the two portfolios. In addition to various other risk management and monitoring tools, our investment advisor grades the risk of all of the investments in our portfolio. This system is intended primarily to reflect the underlying risk of a portfolio investment relative to our initial-cost basis in respect of such portfolio investments, i.e. at the time of acquisition, although it may also take into account under certain circumstances the performance of the portfolio companies’ business, the collateral coverage of the investment and other relevant factors. Specifically, the portfolio is graded on a scale of one through four, with an investment grade of one defined as the lowest grade, generally indicating that the risk to our ability to recoup the cost of such investment has substantially increased since origination or acquisition, and the portfolio company likely has materially declining performance, and an investment grade of four defined as the highest grade, with the least amount of risk to our initial cost basis.

All newly acquired or originated investments in our portfolio are initially assessed a grade of three. Accordingly, at the closing of the Allied acquisition, we initially graded each acquisition acquired as a grade three. We did not experience any rating changes in respect to these investments between April 1 and June 30, and consequently, each of these investments continue to have a grade of three at June 30.

Importantly, our grading system does not account for the period when Allied Capital originated or acquired such portfolio investments or the current status of these portfolio investments with respect to compliance with debt facilities, financial performance and similar factors. Rather, it is only intended to measure risk from the time that Ares acquired the portfolio investment in connection with the Allied acquisition. Accordingly, the grade of these portfolio investments may be reduced or increased in the future.

Within the core ARCC portfolio, we experienced an equal number of rating upgrades as downgrades, two each way, but the ratings movement was confined to our two highest rating categories of three and four. As of June 30, the weighted-average grade of the core ARCC portfolio is three and the weighted-average grade of the entire combined portfolio was also a three.

Consistent with our past practice, I'd also like to update you on the weighted-average revenue and portfolio performance in our underlying portfolio. As I mentioned in my opening remarks, the underlying core ARCC portfolio companies continued to experience solid comparable revenue and cash flow growth on a year-to-date basis.

Weighted-average revenues and EBITDA for the portfolio companies in the core ARCC portfolio increased 9% and 21%, respectively, on a comparable basis for the year-to-date period versus the same period last year. We have not seen signs of slowing growth, and in fact, revenue growth trends are very similar to the improved levels we saw in the first quarter.

The legacy Allied portfolio is more weighted towards lower growth sectors, but we're encouraged by the roughly 10% cash flow growth it is experiencing on generally flat revenue. The slower growth is primarily related to differences in industry selection compared to the ARCC portfolio.

The overall combined portfolio companies increased comparable year-to-date weighted-average revenues and EBITDA by about 5% and 16%, respectively, versus the same period last year.

On Slides 25 and 26, you'll find our recent investment activity since quarter end and our backlog and pipeline. As of August 4, we have made additional new commitments of approximately $138 million since June 30 with, 80% of such investments in the Senior Secured Loan Fund and about 18% in other floating-rate investments. We had also exited $81 million of commitments, of which $66 million were from the legacy Allied portfolio, with $15 million from the core ARCC portfolio.

As the data indicates, our new investment commitments since quarter end carry higher weighted-average yields in the exits of such commitments. On this date, our total investment backlog and pipeline stand at $376 million and $355 million, respectively. Of course, we can’t assure you we will make any of these investments, and we may syndicate a portion of these investments as well.

As a reminder, we define our backlog as committed transactions that are under a letter of intent. Our pipeline is defined as transactions with no formal commitment but where significant due diligence has been performed and there is a good probability of us consummating transaction. Our pipeline does not include the more than 50 transactions that are currently being reviewed at various stages by our investment teams.

Looking beyond what has occurred since quarter end on the repayment side, we currently do not expect repayments to exceed new investments again during the third quarter.

Now let me conclude by reiterating some key takeaways of our quarter before opening it up to Q&A. We increased our core earnings per share by $0.04 quarter-over-quarter, excluding $0.06 of professional fees and other costs associated with the Allied acquisition, despite the fact that repayments exceeded new investments during the quarter and we inherited a higher cost of capital. While our portfolio rotation initiatives have only begun, and there can be no assurance as to the outcome of these initiatives, we believe that these initiatives may provide opportunities to increase our core earnings per share, even if market conditions are uncertain or not supportive of significant balance-sheet growth. I stated earlier, we believe the more liquid market presents us opportunities to manage the legacy Allied portfolio more aggressively and rotate it into higher-yielding assets.

That said, at this point in time, we do, in fact, expect to grow our investment portfolio during the third quarter and increase our balance sheet leverage. Our net leverage was only 0.41x at quarter end, and we had over $900 million of debt capacity and cash subject to leverage and borrowing base restrictions. And consistent with our investment objectives, we intend to bring our leverage more in line with our target range and increase our earnings per share.

Our backlog and pipeline remains strong. Although lower in the aggregate from last quarter, they remain near historically high levels, totaling well over $700 million, and in addition, the backlog category, which consists of investments that are committed and are under a letter of intent, represent over 50% of the total.

As I outlined, the credit and investment performance of the core ARCC portfolio remains strong, and the legacy Allied portfolio is performing well within our expectations. And finally, we've been successful in continuing to add additional commitments to our revolver, which can incrementally help lower our average funding costs.

We hope that you share our enthusiasm for what we believe is our unique competitive position and enhanced capabilities that leave us well positioned to pursue the exciting market opportunities in front of us. Thanks, as always, for your time and support.

And with that, Jamie, let's open up the line for Q&A.

Question-and-Answer Session


[Operator Instructions] And our first question comes from John Hecht from JMP Securities.

John Hecht - JMP Securities LLC

The first one is just looking at the facts for the quarter. You had a pretty substantial increase of structuring fees, dividend income and other income. Are these good new run rate figures to think about in a pro forma situation or are there some noise in there that we should think about?

Michael Arougheti

Well, you have to look at both categories separately, John. With regard to dividend income, I think that's much more of a steady-state number based on investments that have already been made and are in the book. I think as everybody is aware, structuring fee income is obviously a function of new investment activity. So as we continue to grow the book, I think you should expect to see continuing structuring fee income, but it will be a function of the size of the new investment portfolio on a quarter-by-quarter basis.

John Hecht - JMP Securities LLC

And then in thinking about the relatively high turnover of the Ares' core portfolio and the payoffs, what are you seeing in the market -- what's driving these payoffs? And what type of rate would you expect through the second half of this year?

Michael Arougheti

The amount of activity that we saw, or repayment activity we saw, really came in a pretty significant way early this quarter, and subsided towards the end of the quarter. As we talked about in the prepared remarks, a lot of that was really being driven by significant inflows into the high-yield market and risk aspect in that market early in the quarter, and we’ve not experienced that towards the end of the quarter as well. Also as we highlighted in the prepared remarks, we don't expect our repayments to exceed our new investments in Q3 based on what we see in front of us today. If you were to go back and look at our historical averages, even through the downturn, we were experiencing roughly 20% to 30% annual velocity in a portfolio. So the best thing I could point you to is to be to look at the historical experience as a proxy for what you could expect in a portfolio like ours.

John Hecht - JMP Securities LLC

Okay. And final question is I wonder if you could characterize the pipeline. I know you did mention that you expect to increase the average size of commitment. But are you changing your focus in terms of where you might invest in a capital structure? Will that just change over time with something like a Unitranche Fund at your fingertips?

Michael Arougheti

Yes, I think as we mentioned, quarter-to-date, Q3 to date, most of the new investment activity is occurring with the Unitranche product either within the Senior Secured Loan Fund or without the Senior Secured Loan Fund. That's a function of two things: number one, it's an extremely compelling product to borrowers, and that provides a good blended cost of capital, certainty of closing, et cetera, et cetera. It's also driven by our view that, that offers an unbelievably attractive risk-adjusted return. And so it's a win-win for us as the lender and a win-win for our borrowers. I think generally speaking, given where we see interest rates and given where we are in the recovery, I do think we have a bias towards Unitranche and floating-rate Senior Secured Loan product. But given the scope of our origination activity, we continue to see attractive mezzanine investments. And if we do see them, we're obviously going to invest in them. But generally, I think you'll see a bias towards off the balance sheet investment.


Our next question comes from Greg Mason from Stifel, Nicolaus [Stifel Financial Corp.]

Greg Mason - Stifel, Nicolaus & Co., Inc.

Great. I wanted to spend a little bit of time focusing on the liability side. First, the interest expense in the Q, you reported $15 million of Allied debt yet, kind of multiplying the principal times the coupon rate, that was $12 million. Can you talk about the difference? And then, the remaining interest expense of $8 million was kind of in line with last quarter, yet your borrowings declined by about $200 million excluding Allied. Can you talk about the movements in the interest expense?

Michael Arougheti

Yes, I think part of it is you need to also include the accretion with the discount, the purchase accounting discount of the unsecured notes. And then, we also had a full quarter of amortization with the upsized revolver that also flowed through this quarter. So that may help as you're trying to reconcile.

Greg Mason - Stifel, Nicolaus & Co., Inc.

Okay. And can you talk about, do you want to keep the Allied debt out there given that it's a significantly higher rate than your current borrowing credit facilities? What is your thought towards that debt?

Michael Arougheti

Yes. I think in order for us to successfully achieve our objectives over a long period of time, we have to be focused not only on cost of capital, but diversity of funding sources. Having a presence in the unsecured markets is important to us in developing those relationships. I think it's key to the long-term success of our business. The nice thing is the debt that we inherited, waterfalls nicely from maturity standpoint, and we have a lot of options in how we choose to ultimately resolve those maturities. We're obviously in a rising interest-rate environment, or at least, we believe that we will be. And in that type of environment, we have to look to all of the debt markets to get not only efficient pricing, but efficient access. So yes, I think for the time being, our goal would be to leave those out and either resolve them at maturity or prior to maturity through new debt issuance or extensions.

Greg Mason - Stifel, Nicolaus & Co., Inc.

Great. And then can you talk about for alternative debt sourcing, the ability of new on-balance sheet securitizations, what you're seeing in that market? We saw Galav just closed one. What’s your thoughts there?

Michael Arougheti

Yes, I think the Galav transaction is a pretty good indicator of where that market is today. Generally speaking, I think we talked about this on our last call as well. Depending on the nature of the asset and some of the restrictions that you would incur in a securitization, you can lever middle-market assets somewhere between two and 3x. And your cost on those, excluding fees, but just on a spread basis is probably going to be somewhere between LIBOR 200 and 300, probably closer to the high end of that range. If you look at where that market had been, obviously, leverage is lower and spreads are wider. Given the amount of liquidity that we're finding still remains in the bank-loan market, as evidenced by the fact that we're still bringing people into our accordion feature, at LIBOR 300 there's so much more flexibility in terms of how you manage your balance sheet through bank lines that for us, at least for the time being, while we're looking at the securitization market on a relative basis, it’s not all that attractive to us, but clearly signs of life in that market, and I think we'll continue to see improvement there as well.

Greg Mason - Stifel, Nicolaus & Co., Inc.

To follow up on John's question on the structuring fees, are those fees generally paid on the commitments or the fundings? You had $409 of commitments, but $275 million of fundings. Which number should we think about going forward for structuring?

Michael Arougheti

Generally speaking, it's paid on the fundings. I think from a modeling standpoint, you'll get a much better proxy. This quarter was slightly different in that, as we mentioned in the prepared remarks, we did provide a mezzanine backstop to a transaction as a commitment that actually did not fund. So from a percentage standpoint, it's actually a little overstated if you try to back into the actual fee percentages. Generally speaking in the market today, we're getting somewhere between two and four points of structuring fee for new commitments. Obviously, there's going to be some play between the commitments and the fundings to the extent that we're syndicating. We obviously tend to syndicate at a lower fee than what we generate as an underwriter.


Our next question comes from Jim Ballan from Lazard Capital Markets.

James Ballan - Lazard Capital Markets LLC

I was looking at the non-accrual rate. It was considerably lower than what we had estimated, just looking at the Allied book as of the end of last year. And so, I was just wondering where -- it looks like it was just based on what I saw in the slides, there wasn't a lot of sales of Allied non-performing assets. So were there a number of assets on the Allied side that either came out non-accrual? Did you invest incremental capital into some of those to bring them off non-accrual? Can you just comment on that?

Michael Arougheti

I think it's a combination of all of those things. We were very active, or I should say, Allied was very active in working through the portfolio prior to the April 1 closing. And so a lot of that work was getting done prior to our acquisition on April 1, where they were, in fact, disposing of some of the more challenged names in the portfolio. Since we have acquired the portfolio, some of it has come from either restructuring and rehabilitating those companies, and some has come from actually selling some of those companies. So it's really a combination of all of those things. Lastly as you saw, and we're quite happy with it, but the Allied portfolio showed 10% cash flow growth on flat revenues year-to-date. And so, you also have the benefit of just improving underlying performance that helps not only those who are already on non-accrual, but obviously those that may have been close.

Richard Davis

Jim, the other thing too, if you were comparing or looking at the 1231 Allied balances, it's obviously that, that's a little different from the numbers we're reporting as our fair value at 41 is now our cost basis. So that may be part of the difference you’re looking at too.

James Ballan - Lazard Capital Markets LLC

Yes, I was trying to look at it on a cost basis. But that’s helpful. The other thing I just wanted to follow up here on the capital structure questions. And when you think about -- obviously, you have kind of two capital structures that were put together here. When you think about kind of the optimal capital structure, of where you'd like to be within a reasonable time frame, how do you think about that? I mean, are you happy where you are? Is there a way that you think you'd be better off?

Michael Arougheti

Yes. We're happy where we are. Although we'd be happier if we had longer duration and cheaper costs. So we're looking at all of the available avenues out there. That includes unsecured notes in the private and public markets. That includes unsecured or secured notes in the retail market. It includes looking at various convertible structures. It includes the securitization market. It includes continuing to try to tap the bank-loan market. So our goal is to manage our balance sheet as aggressively as we can. I think when you look at where the portfolio is positioned relative to the liability side of the balance sheet, we're actually quite happy with it. I think we can continue to improve it from here, but by no means are we unhappy. I think the key is, there's a lot of volatility in the capital markets, generally speaking. Windows in all of our available funding markets are opening and closing with more frequency and much more volatility. So we're adopting the view that we're going to keep an eye on our debt capacity, we're going to keep an eye on our interest rate exposure. We're going to keep an eye on our pending maturities, and we'll continue to try to optimize it. But I think the good news is while there is always a sense of urgency about getting that right when you look at the maturity schedule and the net spreads that we’re able to generate off of our current balance sheet, it's still very compelling.


Our next question comes from John Stilmar from SunTrust.

John Stilmar - SunTrust Robinson Humphrey Capital Markets

Two quick questions for you, the first of which has to do with the fair value, the write-up on the core portfolio after you've acquired Allied, which was I think $0.44 this quarter. The question really is, is the growth from better-than-expected portfolio performance? The statistics you referenced in both in Allied and your own portfolio are certainly impressive, but it sounds like you also may have anticipated those. So I guess, my question comes in is, is this really a relative of how you're valuing the portfolio because the structures are different than current market conditions? Or is it because the fundamental business performance is better than your anticipation in aggregate? I know there's lots of moving pieces, but wondering if you could kind of broadly characterize sort of the general trend underneath in some of those vests [ph 1:14:26].

Michael Arougheti

Yes, I think it's broad-based and we mentioned it in our prepared remarks. But the good news was, it was across asset classes, across companies and across industries. It was clearly a combination of improved underlying revenue and EBITDA performance in the portfolio, as well as just looking at the data points in the market with higher leverage, obviously, helping mark-to-market valuations on certain companies. And as we also mentioned, there was a fair amount of rallying that occurred in the structured-products market, generally. And so there was a fair bit of appreciation in that part of the portfolio, but I can't attribute it to one of those things disproportionately. It was really all of those things.

John Stilmar - SunTrust Robinson Humphrey Capital Markets

Okay, great. And then obviously, the portfolio rotation story has been certainly very much discussed for this year. But as I look at your own page, Slide 15, the debt securities and non-accrual, and then looking through your schedule of investment, the average cost fair value is if you're holding those it’s about $0.80 on the dollar. So from here on out, should we really be focused on the debt securities or how a non-accrual is really having the most opportunity for near-term portfolio rotation? Or should we look at the performing securities because they might be more liquid? How should we be thinking about over the next quarter or two in sort of gauging your performance?

Michael Arougheti

I think one of the reasons we laid this out and again, we'll continue to report against this and look for new ways to help you all understand what we're trying to accomplish here, but I would look at all of these things, John. If you look at, obviously, performing equity investments, those don't carry any current yield in a market such as the one we're in now. Those are fairly liquid investments and those have as much impact on our ability to generate income as it does if we were to sell some of the performing investments as well. So I would expect that you'll see continued changes in each of these categories as the year progresses.


Our next question comes from Sanjay Sakhrani from KBW.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

It seems like the credit metrics was pretty good and some of your commentary seems to indicate the worst may be over, or the worst may be behind us. And I was just wondering if you guys felt that way about the portfolio and kind of what the portfolio of companies were telling you guys as far as the economy was concerned.

Michael Arougheti

Yes. I think if you look at the revenue and the EBITDA trends that we’ve reported out of our portfolio over the last 12 to 24 months, I think consistently you'll hear that. There may be some sectors where you're not hearing that. But I think generally speaking, people have made appropriate adjustments to their operating cost structures that they're feeling pretty good about the world today, and they have good balance sheet liquidity, et cetera, et cetera. So yes, it does feel like the worst is behind us. It's interesting though because Ares as a credit manager has a slightly different view and sentiment. As we've said in our prepared remarks, as a credit investor, we actually favor slow growth to no-growth types of economic environments because that's where we generate outsized risk-adjusted return. So we don't require meaningful economic recovery to generate outsized return unlike you would see if you were heavily weighted in the equity-asset class. So yes, I think the worst is definitely behind us. A lot of the volatility right now in the public markets feels sentiment-driven and maybe it's difficult to reconcile with some of the fundamentals, but the data continues to be mixed. So I guess that’s it. We feel that we’re in a recovery. Our portfolio companies and the performance of those companies would seem to corroborate that.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

As far as like the growth, where is that going to come from in terms of asset class, industries and sourcing, maybe over the next three to six months?

Michael Arougheti

Well, you look at where we're sourcing business, and we're sourcing it across the entire country from the sponsored community and the non-sponsored community. We do believe that we have very compelling, competitive advantages both in terms of the scale of our origination capability and the scope of our product set. So we continue to invest very heavily in originations to try to drive good credit decisions, and I don't think that, that's going to slow. As I mentioned earlier, though, when you look at where we're focusing and where we're getting the most traction, the Unitranche product, whether it's in the Senior Secured Loan Fund or not, seems to be a very compelling product in the market today that is getting a lot of uptake. So I'd expect to continue to see that, that product represent a fairly sizable piece of our origination numbers. It's interesting because I think you hear different things from different people depending on the size of their platform and the breadth of the relationship network. We look at our pipeline and our backlog today, and we look at the amount of activity that's flowing through the shop, and we are extremely busy. The pipeline is growing. There's quality deal flow coming through the house. And so as we mentioned, Q3 we expect that we will actually begin to net grow the assets again, and I don't expect that trend necessarily to reverse itself.


Our next question comes from Vernon Plack from BB&T.

Vernon Plack - BB&T Capital Markets

Mike, I'm trying to get a sense for, from a modeling standpoint, there is an agreement that you have where you could defer up to $15 million in base management and incentive fees if certain earnings targets are not met. And I don't know what those earnings targets are, but will you in fact -- do you think you’ll actually be deferring some of your base management and incentive fees in order to hit targets?

Michael Arougheti

It's still too early to tell, but based on everything that we're seeing to date and based on some of the things that hopefully we've demonstrated this quarter in terms of our ability to show the accretion in earnings and NAV, at least as we sit here today I don't think that we're going to hit that hurdle. And therefore, I don't think that we will need to defer fees in order to prove that out.

Richard Davis

Just to keep in mind too that, that's a deferral so we would continue to accrue that fee.

Vernon Plack - BB&T Capital Markets

Sure. What are those earnings targets? Have you disclosed that?

Michael Arougheti

We haven't disclosed that.


Our next question comes from Don Fandetti from Citigroup.

Donald Fandetti - Citigroup Inc

Michael, I mean obviously, it looks like the Allied acquisition’s shaping up pretty nicely for you. As you sort of look over the landscape, do you see that as a model? Would you consider other deals? And also as your company gets bigger, do you sort of hit that law of numbers where it's harder to grow and you feel compelled to make bigger bets?

Michael Arougheti

Two separate questions; I'll handle the first one first. You should assume that if there is a company for sale or there's a portfolio for sale in our core market or in an adjacent market, we're looking at it. That said, we're not seeing very many opportunities either through acquisition of portfolios or companies that are attractive to us right now. The unique opportunity that was in Allied was the scale of the portfolio, the timing and the overlap of our skill set and capital base with that portfolio opportunity. The reality of it is given the rally in the market, the valuation on some of the portfolios that are "for sale" are just really not that attractive. And it's all well and good to try to acquire something to show that you can do it, but if you can’t actually say that it's accretive to earnings and book value in a relatively short order, it's difficult to justify putting the time and resource in capital behind it. Secondly, most of those opportunities are actually quite small. And when you look at what we believe is the opportunity in front of us in the new issue market and our continuing access to capital, it's hard to justify putting the amount of resource it takes behind that type of activity versus just going out and continuing to grow the book on a regular-way basis. So we'll continue to look at things and if there's something that makes sense and we can be opportunistic, we'll obviously do it. But I think one of the nice things about Allied is, we timed it well and the market recovered. I'm not quite sure that there are very many Allied-type opportunities left out there in the world. The second question, I apologize, I can't actually remember what it was.

Donald Fandetti - Citigroup Inc

It was just more that you're a larger company. Do you feel like there's enough opportunities in your footprint to grow the portfolio? Do you feel the need to...

Michael Arougheti

I think this is why we're investing heavily in origination. And as I mentioned in our prepared remarks, a lot of the growth in the short term is going to come from reducing the number of portfolio of companies that we have and increasing the average final hold position. But we don't expect to increase the average final hold position by changing our strategy or changing the way that we approach the market. It's really to become more relevant and more impactful than our existing market. So that's fairly straightforward. If you have a $50 million EBITDA company that's looking to borrow $250 million at a different point in our development cycle, maybe we were holding $25 million. Whereas today, we could hold $150 million and still have it represent a 3% portfolio position size. So I'm pretty confident we can maintain appropriate diversification without taking bigger bets relative to the portfolio. But I do think that you highlight an issue that we will necessarily have to grapple with years from now, which is at some point, obviously, the growth of the portfolio will be always challenged by continued velocity in the portfolio, but we're not quite there yet.


Due to time constraints we have time for two additional questions. Our first question comes from Jasper Birch from Macquarie Capital.

Jasper Birch - Fox-Pitt, Kelton

Just starting out looking at the 14.29% yield on the Allied book, can you remind us what portion of that is due to purchase discount accretion? And does that include any prepayment assumptions and sort of what is your outlook for prepayments on the book?

Richard Davis

We had about $3.5 million of total accretion coming through in the second quarter to be included in that yield. Your second question, I'm sorry.

Jasper Birch - Fox-Pitt, Kelton

And then just sort of modeling out prepayment assumptions on the book, I know that you said this coming quarter you expect less divestiture than investments, but on the Allied book specifically, do you have any visibility, any prepayments that might be coming through?

Richard Davis

No, only what we've done to date is a good indicator of the types of things that we think we can do. But again, our goal is to rotate that book as aggressively as we can. It's obviously going to be lumpy and it's going to be a function of where the markets are, but I think you'll continue to see pretty significant movements in that portfolio as the year unfolds.

Jasper Birch - Fox-Pitt, Kelton

Just looking at your taxable income. Clearly, could you remind us what the actual number was in the quarter? And I mean just looking at your dividend, I'm assuming that you're committed to maintaining it even if you have taxable-income shortfall?

Michael Arougheti

We don't disclose the taxable-income number and have not on a quarterly or – we will give some information at the end of the year as to what that is, but we don’t disclose that.

Jasper Birch - Fox-Pitt, Kelton

Okay, great. FirstLight Financial, I saw it was written down just slightly in the quarter. I was wondering what’s going on with that. Do you see upside in the name? And was the, sort of, quarter-over-quarter right now, is that just due to spread widening in general or company-specific?

Michael Arougheti

FirstLight is effectively a portfolio that is in wind-down as we've talked about before. Ivy Hill Asset Management took over the management of that portfolio about a year ago. The good news is the velocity on the book has been pretty significant and continues to shrink, which is always good when you're seeing a wind-down. The challenge is obviously the more velocity you see in a wind-down, the more challenged your IRR becomes as you don't capture excess spread. So the write-down was really a function of two things. Was number one, a change in the spread environment. And number two, frankly, just increased velocity in the portfolio, which constrained the IRR opportunity over time. What we’re playing for there, frankly, is we want to get all of our principal back that we made in the original investment. I think given the nature of that investment at the time that we made it, that would be a big win. Given where we have written it down to, obviously, we believe that it’s now written down to a level to generate an appropriate IRR based on what we're seeing in the market today.


And our final question comes from Faye Elliott from Bank of America-Merrill Lynch.

Faye Elliott - BofA Merrill Lynch

Is there room for additional gains to be recognized from the Allied purchase? And can you just give a little bit of color around why, why not?

Michael Arougheti

Yes. I think the answer is yes, that opportunity will come either through the equity book continuing to appreciate and us being able to realize gains upon the exit of some of our equity investments. As we mentioned, we've seen some pretty meaningful improvements in our structured products portfolio. And I think as those markets continue to heal there’s opportunities in that book as well. And when you look at some of the names that we inherited and where we mark them, I do think that there's still upside to those marks over time, but depending on whether it's performing or not performing, it's obviously going to take more or less time and require more or less incremental capital. I think the nice thing about the deal given when we bought it and where we bought it, if all we did was recover fair value for it, it was a wonderful transaction for the shareholders economically, not to mention all the qualitative advantages we had. But obviously, that's not what we're playing for. We’re looking to continue to drive both gains and incremental income from rotating the portfolio. So, yes, I think, it's a part of the opportunity. I don't think it’s as big of a part of the opportunity in the short-term as the income rotation, but over a long-term I think it could be pretty meaningful.

Faye Elliott - BofA Merrill Lynch

And then what would your strategy be for, I guess, returning that or passing it along, given that it is a bit chunky? I assume you wouldn't want to increase the dividend.

Michael Arougheti

Yes. I don’t think we’re, as we said, we believe that our dividend should try to approximate our sustainable core earnings. To the extent that we have capital gains, we'll make that determination when and if we have them. But again, I think all things being equal, we would probably roll those over versus pay them out.


Ladies and gentlemen, that does conclude our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available one hour after the end of this call through August 20, 2010, to domestic callers by dialing (877) 344-7529 and to international callers by dialing (412) 317-0088. For all replays, please reference conference passcode 442579 followed by the pound sign. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website. And at this time, I would like to turn the call over to management for any final remarks.

Michael Arougheti

Great. Sorry to have kept everybody so long, but we really do appreciate everybody spending time with us today. We're excited about everything we were able to accomplish this quarter, and really look forward to giving everybody a progress report at the end of next quarter. Thanks, again.


We thank you for attending today's presentation. That concludes today's conference call. You may now disconnect your telephone lines.

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