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Ares Capital (NASDAQ:ARCC)

Q1 2014 Earnings Call

May 06, 2014 12:00 pm ET

Executives

Michael J. Arougheti - Chief Executive Officer and Director

Robert Kipp DeVeer - Senior Partner and Member of Investment Committee

Penni F. Roll - Chief Financial Officer

Analysts

John Hecht - Stephens Inc., Research Division

Terry Ma - Barclays Capital, Research Division

Douglas Mewhirter - SunTrust Robinson Humphrey, Inc., Research Division

Robert J. Dodd - Raymond James & Associates, Inc., Research Division

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

Operator

Good morning. Welcome to Ares Capital Corporation Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded on Tuesday, May 6, 2014.

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 such 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 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 is a net per share increase or decrease in stockholders' equity resulting from operations less realized and unrealized gains and losses, any incentive fees attributable to such realized and unrealized gains and losses and any income tax 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 accompanying slide presentation for this call by going to the company's website at www.arescapitalcorp.com and clicking on the Q1 '14 earnings presentation link on the homepage of the Investor Resources section of the website.

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 in this presentation, including information relating to portfolio of 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.

As a reminder, the company's first quarter 2014 earnings presentation is available on the company's website at www.arescapitalcorp.com by clicking on the Q1 '14 earnings presentation link on the homepage of the Investor Resources section. Ares Capital Corporation's earnings release and 10-Q are also available on the company's website.

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

Michael J. Arougheti

Great. Thank you, officer, and -- the operator. Good afternoon to everyone and thanks for joining us. For today's call, I'll begin with some quick highlights on the first quarter before turning the call over to our President, Kipp DeVeer, who will update everyone on our investment activity and views on the current market. Penni Roll, our CFO, will then walk through our Q1 results and financial position in greater detail. Kipp will then wrap up the call with some comments on our portfolio performance and recent investment activity before we take questions.

Before we begin, I wanted to update everyone of an exciting development involving the parent company of Ares Capital's investment advisor. Last week, Ares Management LP priced its IPO on the New York Stock Exchange raising approximately $216 million in gross proceeds for general corporate purposes and to support growth initiatives. Following its IPO, Ares Management employees retained ownership of more than 70% of the company, with the public acquiring an approximate 5% ownership stake.

We strongly believe that this transaction is a positive for the future of Ares Capital as the continued growth of Ares Management will enhance its ability to attract and retain professional talent, strengthen the Ares platform and provide Ares Capital with a broader array information, services and investment advantages.

Moving to ARCC's first quarter results. We reported core and GAAP earnings per share of $0.38 and $0.39, respectively, fully covering our regular quarterly dividend of $0.38 per share. We also continued to generate net investment gains, which cumulatively have contributed to the meaningful amount of undistributed taxable income that we have available for future distribution. At the end of 2013, we estimated that we had approximately $0.82 per share of undistributed taxable income being carried over into 2014. We believe that this undistributed income is a meaningful asset that helps contribute to the stability and predictability of our dividend.

From a balance sheet perspective, we believe that we are very well positioned. We ended the quarter with a modest net debt-to-equity ratio of 0.6x and approximately $2.1 billion of available debt capacity under our credit facilities.

Let me now turn the call over to Kipp so that he can walk you through our investment activity and provide some detail on our views of the current market. Kipp?

Robert Kipp DeVeer

Thanks, Mike. While the first quarter tends to be seasonally slow for originations, we made $852 million of new commitments across 24 investments in the first quarter. Over half of these commitments were to new portfolio companies, which highlights the breadth and depth of our origination platform. We do continue to focus on senior secured debt opportunities with strong loan-to-value metrics with an emphasis on conservatively structured, high-quality cycle-durable businesses.

During the first quarter, 82% of the new commitments were in first lien senior secured debt and 7% were in the subordinated certificates of the Senior Secured Loan Program.

During the quarter, we also saw $849 million of commitment exit the portfolio. A portion of these exits came as a result of our continued rotation, out of some lower yielding assets, a strategy that we discussed on our fourth quarter earnings call and one we continue to execute on.

On a funded basis, we funded new investments totaling $826 million. And after repayments, we had net fundings for the quarter of $169 million.

Though the first quarter saw lower net growth in investments, we were able to earn higher yields on our new investments compared to the yields on investments repaid or exited during the quarter. Despite the spread compression over the last year, and again through the end of the first quarter, our net interest and dividend margins has remained strong at 8.4% compared to 8.7% a year ago. In addition to the interest and dividend income earned from the portfolio, we also had net realized gains of approximately $12 million in the first quarter.

Since the company's IPO almost 10 years ago, our realized gains have exceeded our realized losses in every year but one, which has allowed us to build cumulative net realized investment gains of approximately $270 million.

On the competitive front, we continue to see tremendous investor interest in private credit and direct lending as an asset class. We find that yield is of significant interest to most global investors today in a world where fixed income investments of all types fail to provide returns that many investors are seeking.

Remarkably, up until 3 weeks ago, loan funds in a broadly syndicated loan market had seen a record 95 straight weeks of inflows from investors per Lipper. However, 3 weeks ago, the tide began to turn and we are now in our third consecutive week of outflows. While we don't believe the 3 weeks of outflows necessarily indicates a significant change in investor appetite for loans, we have witnessed some encouraging pushback from buyers of new issue loans in the broadly syndicated loan market. Leverage loan buyers are seeking better structures and/or better pricing in certain transactions, which we have not seen for some time.

And while we are largely insulated from the more aggressive structures in the larger market due to our focus in the mid-market, some of the frothiness in the larger leveraged loan market has tried to make its way into the deals that we review, particularly for the larger companies that we work with.

As these outflows continue and the flex activity develops into a more lasting reality, we believe it will be a benefit to us as a company.

On the fourth quarter earnings call, we discussed our strategy of continuing to broaden our origination reach into new areas where we believe that banking sector is reducing exposure. We continue to feel there's an opportunity to build specialty industry teams to invest in these asset classes.

And during the first quarter, we expanded our energy finance capabilities and hired a team in Dallas to focus on senior and subordinated debt financing opportunities in the oil and gas industry.

Additionally, we expanded our traditional middle market sponsor coverage effort by adding 2 senior investment professionals in Chicago. We believe it will enhance our deal flow in the mid-markets, particularly on the smaller end of our target market.

And we do continue to explore other specialty lending segments that have been deemphasized by the banking sector that we believe could be additive to the business.

The strategy continues to favor the recruitment of established teams, with significant industry experience and expertise in new and complementary verticals.

I'll now turn the call over to Penni to highlight our first quarter financial results and to provide some details around our recent financing activities.

Penni F. Roll

Thanks, Kipp. Good morning. Our basic and diluted core earnings were $0.38 per share for the first quarter of 2014 compared to $0.41 per share for the fourth quarter of 2013 and $0.38 per share in the first quarter of 2013. The $0.03 per share decrease in our first quarter core earnings versus the fourth quarter of 2013 was primarily driven by lower restructuring fees in the quarter.

During the first quarter, we've benefited from $20 million in dividend income from our wholly-owned portfolio company, Ivy Hill Asset Management. Half of this dividend was a regular quarterly dividend from Ivy Hill. And the other half was an additional dividend paid to ARCC in the first quarter, which was paid from Ivy Hill to cumulated undistributed earnings.

Our net realized and unrealized gains totaled $4.7 million or $0.01 per share for the first quarter, which included $12 million or $0.04 per share in net realized gains.

GAAP net income for the first quarter of 2014 was $0.39 per share compared to $0.47 per share for the fourth quarter of 2013 and $0.32 per share for the first quarter of 2013.

We made gross investment commitments totaling $852 million in the first quarter compared to gross investment commitments of $1.2 billion during the fourth quarter of 2013 and $414 million during the first quarter of 2013. We exited commitments of $849 million in the first quarter, resulting in net commitments for the quarter of $3 million. Net fundings for the first quarter were $169 million as compared to $256 million for the fourth quarter of 2013 and $129 million for the first quarter of 2013.

As of March 31, 2014, our portfolio totaled $7.8 billion at fair value across 195 portfolio of companies and we had total assets of $8.2 billion. Our stockholders' equity was $4.9 billion, resulting in net asset value per share of $16.42.

From a yield standpoint, the weighted average yield on our debt and other income-producing securities at amortized costs at March 31, 2014, was 10.2%, 20 basis points lower than at the end of 2013. The weighted average yield on total investments and amortized costs at March 31, 2014, was 9.2%, also a 20-basis-point decline since year end.

As of March 31, we had approximately $5.2 billion in committed debt capital, consisting of approximately $3 billion of aggregate principal amount of turning down on it's outstanding and $2.2 billion in committed revolving credit facilities, which are subject to borrowing base and leverage restrictions.

Approximately, 58% of our total committed debt capital and approximately 97% of our outstanding debt at quarter end was in fixed rate, long-dated unsecured term debt. As of March 31, 2014, our debt-to-equity ratio was 0.62x, and our debt-to-equity ratio net of available cash of $117 million was 0.6x.

As you know, earlier in the quarter, we issued an additional $150 million of our 5-year 4 7/8 senior unsecured notes due to favorable market demand allowing us to issue these additional notes at a nearly a 3% premium for an effective coupon of 4.25%. These notes continue to trade well in the aftermarket, yielding about 3.9% as of the end of last week.

We've also continued to proactively extend the maturity of our revolving secured debt facilities. During the first quarter, we amended our revolving credit facility, extending the end of the revolving period and the stated maturity date each by 1 year to May 2018 and May 2019, respectively. As a part of the amendment, 5 existing lenders increased their commitments to the facility by a total of $110 million, bringing total commitments to $1.17 billion.

As of March 31, the weighted average duration of our outstanding liabilities was 7.6 years. We believe our long-dated liability strategy provides operational flexibility and financial strength. Given our heavy emphasis on longer-dated, unsecured fixed rate funding compared to our largely floating rate loan portfolio, we believe we are well positioned for rising interest rates whenever they may come.

The weighted average stated interest rate on our drawn debt capital at quarter end increased slightly to 5.4% as compared to 5.3% at the end of the fourth quarter of 2013. This increase resulted from a reduced level of borrowings under our lower-cost secured revolving credit facilities at the end of the quarter as we issued additional term debt. However, as we fund new investments, our blending cost of borrowing should decline as we access our significant revolving credit capacity. If at the end of the first quarter 2014, we were to borrow all of the amounts available under our revolving credit facilities, our weighted average stated interest rate would be 4.1%, down from 4.2% at the end of 2013.

Finally, this morning, we announced that we declared a second quarter dividend of $0.38 per share payable on June 30 to stockholders of record on June 16, 2014.

Now I'd like to turn it back to Kipp to discuss the portfolio and recent investment activity.

Robert Kipp DeVeer

Thanks, Penni. During the first quarter, our portfolio experienced stable credit metrics in the aggregate as the weighted average total net leverage for our corporate borrowers remained unchanged at 4.6x and the weighted average interest coverage for our corporate borrowers also remained unchanged at 2.8x. At these levels, we feel we have significant protection from a loan-to-value and cash flow coverage standpoint.

Non-accruals remain low, with 3.2% of the portfolio at cost, and 1.9% of the portfolio at fair value on non-accrual at quarter end. And the weighted average grade of our portfolio improved modestly since year end, ending the first quarter at 3.1 versus 3.0 at year end.

The portfolio also continues to be well diversified. Given the size of our balance sheet, our average commitment is less than 1% of our assets, and our largest single-name exposure, excluding the SSLP, is less than 4% of our portfolio at fair value. At quarter end, the SSLP represented approximately 23.6% of the portfolio at fair value.

The SSLP is well diversified, with 46 separate underlying borrowers at quarter end. And excluding the SSLP, the next largest 15 investments in the aggregate represented only 27.5% of the portfolio at fair value.

Let me finish with a quick update on our recent investment activity since quarter end and our current backlog and pipeline. From April 1 through April 30, 2014, we made new investment commitments of $303 million, $223 million of which were funded. And of the $303 million of new commitments, 90% were floating rate, 9% were fixed rate and 1% were noninterest bearing. The weighted average yield of debt and other income-producing securities funded during this period at amortized cost was 8.6%.

Over the same period, we exited $401 million of investment commitments, 98% of which were floating rate. About 1/4 of these exits were from continued proactive rotation out of lower-yielding assets. The weighted average yield of debt and other income producing securities exited or repaid during the period at amortized cost with 8.8%. And net realized gains on these exits were approximately $3 million.

As of April 30, 2014, our total investment backlog and pipeline stood at approximately $235 million and $475 million, respectively. Of course, we can't assure you that any of these investments will close, but we do feel like we're seeing a lot of good opportunities and we believe we are well positioned for growth. We plan to continue to use our broad origination platform to source investment in what we view as the best franchised companies with a view to maximizing risk-adjusted returns. And with any luck, some of the recent changes in the market that we discussed earlier in the call will provide an opportunity to make additional attractive investments.

Finally, as we approach our 10-year anniversary as a public company, we look back with great pride in the level of dividends and the meaningful value we have delivered to our shareholders during this timeframe. As always, creating long-term shareholder value will continue to be our focus going forward. Thank you for your time and for your continued support. Operator, we can now open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is John Hecht from Stephens.

John Hecht - Stephens Inc., Research Division

Real quick with respect to the IHAM, the incremental dividend at IHAM. We've seen this off and on over the past few quarters, I'm wondering can you tell us what the kind of net fee income is per quarter there relative to what you consider the $10 million average dividend payment you get from them and what would be the strategy going forward with respect to taking incremental dividends?

Michael J. Arougheti

Yes, we don't disclose the number but let me try to at least provide you some color, John. I appreciate the question on this. And as we mentioned on past earnings calls, Ivy Hill has had quite a lot success investing through the downturn. Back in the fourth quarter, they, in fact, exited a position and have done a refinancing of one of their funds that's continued to add to what we've described as already significant undistributed taxable income there that's sitting with the company as retained earnings. So I'd say there that our goal is that each quarter, obviously, Ivy Hill, through its fees and the income it produces on assets, will generate more than enough, i.e., more than $10 million to pay that $10 million quarterly. But we do look to the company occasionally and assess its capital position. In the case of Ivy Hill, as it relates to this quarter, we saw some modest reduction, I think, in their growth expectation and their need for capital, hand-in-hand with a pretty significant, again, excess retained earnings balance and thought it was a good time just to -- from a capital efficiency standpoint, obviously, take capital out of the Ivy Hill balance sheet. And the obvious beneficiary of that is ARCC as a recipient of that special dividend.

John Hecht - Stephens Inc., Research Division

That's great color. Kipp, you also had some comments you might be seeing some green shoots as a result of that kind of erratic fund flows into fixed income. You've said both structural and pricing relief. Are -- kind of can you quantify those and where is the change in the competitiveness coming from at this point?

Robert Kipp DeVeer

We think it's a handful of factors. I think the broadly syndicated loan market, the most obvious source inflows and outflows are #1, retail and obviously, #2, kind of CLOs. And CLO market in the U.S. continues to be pretty significant and it's growing. But the change in retail flows, we think, is really what has contributed to the pushback generally speaking from loan buyers over the last few weeks. And some of the deals that we've seen flex, just to quantify, it's been pushing back on structure a little bit, i.e., demanding slightly lower leverage, often at the expense of -- you'll upsize the second lien deal and downsize the first lien deal. The pricing impact we see is kind of 50 basis points over the last couple of weeks. So if a the deal went at L375, it would flex to L4 in the quarter or something, and I'm generally speaking. So look, we hope that, that's a continued influence on the middle market. Three weeks is only 3 weeks but seeing a 95-week series of inflows that we use to kind of stop is a good start.

John Hecht - Stephens Inc., Research Division

Absolutely. And last question, your -- the average investment or commitment size over the past few quarters, it's dropped a little bit. I'm wondering is that part strategic or part where you're seeing opportunity in the market or just part just the way the wind is blowing at this point in time?

Robert Kipp DeVeer

Yes. I mean, I think it's a little bit of the wind blowing. I mean, we've mentioned obviously that we've focused on some smaller companies. That being said, our core market really is always kind of $10 million of EBITDA at the bottom end up to $100 million at the top end. And in most of those deals with our size, we can always obviously originate and own the entire capital structures in any of those transactions, which has always been the goal. So I think there's no attempt to be more diversified, I guess, to answer the question directly. And if we're focused a little bit on smaller deals, which we have been, that frankly doesn't impact the commitment size. So, plus I went through in detail. I mean, I can't come up with anything else other than wind blowing, to be honest.

Operator

Our next question is Terry Ma from Barclays.

Terry Ma - Barclays Capital, Research Division

So, you guys have spoken about opportunistically selling lower-yielding assets in the past. But can you maybe just give us a sense of how much additional opportunity there is for you guys to do that and how we should think about that playing out the rest of the year?

Robert Kipp DeVeer

Look, I mean, this is -- thanks for your question, Terry. This is one of the things that we looked at obviously with deals coming down here over the last year or 2 years. This is the way that we could kind of take more out of the existing portfolio. It obviously does limit the growth a little bit for the near term. But we wanted to kind of optimize the portfolio and get it right. We do think on a go-forward basis, there'll be some room but a lot of the sales that we've gone through over Q4 and Q1, I think, has gotten us to a position that we feel very comfortable with the existing portfolio.

Terry Ma - Barclays Capital, Research Division

And can you maybe just give us an update on the activity in your Project Finance and Venture Finance verticals so far this year?

Michael J. Arougheti

Sure. We'll see if we can pull a couple of numbers. But so far this year, you mean since January specifically?

Terry Ma - Barclays Capital, Research Division

Right.

Robert Kipp DeVeer

No change, i.e., both very busy and meaningful contributors to the company. I'd say that both groups have really hit their stride in terms of having the Ares brand out in spaces that were new and have originated their fair share in each of their respective markets. But, sorry, Penni, do you have that number handy? Not sure we have at Venture. Not sure if we have the number cut exactly that way.

Penni F. Roll

Right. We don't.

Robert Kipp DeVeer

I don't think we have it exactly that way. Maybe we can take that one offline, Terry.

Terry Ma - Barclays Capital, Research Division

Okay, sure. And just one last thing, do you have any thoughts on the analysis that was put up by the Congressional Budget Office on the impact of the H.R. 1800?

Michael J. Arougheti

Yes. It's Mike. We do. We actually think it is somewhat flawed. For those that are familiar with how that CBO and joint tax, score, legislation effectively it is managed to a zero-sum output. And so part is, if you have a piece of legislation that is deemed to be tax negative, then it would have to be paired with a piece of legislation that is tax generative. The crux of the scoring as we read it was really around the flow of investment dollars out of C corps into flow-through or pass-through entities. The reason I say that it's flawed is if you think about the way that H.R. 1800 works, the expectation would be that leverage within the BDC sector would increase. Our view is that the primary source of that leverage increase would actually come from the banking sector, with no change in the investment dollars being allocated in this zero-sum universe between C corps and flow-through entities. So it's my very strong belief that if you have the same amount of dollars, but they are flowing through BDCs at higher ROEs, generating higher taxable income to the Treasury, as well as interest incomes through the banking sector and then finding its way into the coffers of the U.S. Treasury is incremental tax income, both at C corp level for the bank and dividend tax level for the bank shareholders. I find it hard to craft a scenario where it's actually not tax generative. I think the other major flaw in the argument, which I think people will understand as they go through it, the premise is that the loan would flow out of the bank into a BDC or rather pass-through entity. I think that the fundamental premise of H.R. 1800 is simply that the banks aren't making these loans to begin with. And so it's not really a case of something flowing out of a C corp into a pass-through entity but frankly from one pass-through entity in the private market to another pass-through entity that could or maybe a BDC. So there's a lot of detail that goes into that kind of economic and tax forecasting, but I think there are a couple of underpinnings to that piece of analysis that probably could be revisited.

Operator

Our next question is Doug Mewhirter from SunTrust.

Douglas Mewhirter - SunTrust Robinson Humphrey, Inc., Research Division

My first question, actually, going back to the Congressional bill in proposing higher leverage. Given the market conditions and the higher refinance activity, the net originations across the industry seem to be flowing if you net out gross fundings and refinances. I mean, can the industry absorb that extra leverage? I mean, is that -- I mean, do you think that it would have an immediate impact? I mean, do you at Ares have the capacity to put that theoretical extra money to work at a reasonable period of time?

Michael J. Arougheti

I'll make 2 comments and I'll see if Kipp has anything to add. I think that the -- one of the things that may not be coming through when you look at least Ares' net origination numbers is as we manage through the seasons and the cycle, we are active in rotating the portfolio, actively selling assets, actively selling lower-yielding assets. Frankly, letting certain portfolio companies in the portfolio go if we are negative on their credit prospects. And so that number is not just the market taking a share of our portfolio and refinancing it. There's a lot of activity and work that goes into the exit's piece of the net origination number. But with regard to the bill specifically, and we've tried to articulate this on prior calls, our expectation, were the bill to pass, is that the incremental leverage would allow us to move into other parts of the middle-market lending landscape that we can't currently service on a cost-effective basis given the lower-asset yields. So there are parts of the traditional cash flow space, there are sections of the traditional asset-based lending space that would offer meaningful opportunity and white space for us to move into and still generate attractive leveraged ROEs to the shareholders. So as we have always thought about life in a post-H.R. 1800 world, it's about growing share in markets that we're not currently in, as opposed to increased capacity competing for the existing installed base of middle market cash flow loans.

Douglas Mewhirter - SunTrust Robinson Humphrey, Inc., Research Division

That's a very helpful answer. My second and final question, you break out first lien, second lien and subordinated. What percentage of your investment asset to your loans would you consider to be unitranche deals? And is that share still growing given the popularity of the product?

Robert Kipp DeVeer

Sure. Well, the primary vehicle obviously that we're using for our unitranche investing is the Senior Secured Loan Program, obviously, our joint venture with GE. So that's a piece of the business obviously that's grown substantially. We think that we're frankly one of the leading providers in that asset specific type of lending. We do have the ability to do some unitranche as well, away from the joint venture. If for whatever reason that joint venture chooses to not pursue the loans, so you'll see that in our first lien numbers outside of SSLP. But I think unitranche continues to be an incredibly popular way for companies obviously to access leverage.

Michael J. Arougheti

Our first lien loan book is still levered in and around 4x against the weighted average total leverage on the book of 4.6x. Embedded in that average is some unitranche lending within the first lien bucket, but as Kipp mentioned, 24% of our assets are finding their way into SSLP as the primary unitranche vehicle.

Operator

[Operator Instructions] Our next question is Robert Dodd, Raymond James.

Robert J. Dodd - Raymond James & Associates, Inc., Research Division

Just following up on the CBO again. Is there a formal kind of appeals process through which you could get the CBO to kind of review its scoring and maybe take a different approach or does it necessitates going back and kind of resubmitting an adjusted bill, maybe, even if it's a small adjustment to get them to rescore a new version in time to look at that under a different framework?

Robert Kipp DeVeer

Yes, so generally, within the legislative process, there is a mechanism to appeal or challenge the scoring. That is altogether possible. And the other thing I would mention is a negative score that the CBO scoring, just to put it all in perspective, highlighted a $350 million 10-year impact, i.e., $35 million per year. I find it interesting to be able to get to that level of precision when dealing with private markets of the size that we participate in. But when you think about the order of magnitude even in the absence of a positive appeal here, the south L4 [ph] number is $35 million per annum. So I, for one, my personal opinion is that a negative score of that magnitude, even if an appeal were not successful in and of itself does not jeopardize the successful passing of the bill.

Robert J. Dodd - Raymond James & Associates, Inc., Research Division

Thank you for that color. Just one more follow-up, if I can -- well not follow-up. I just have a question. On your exposure within first lien and second lien itself, I mean, in this quarter, we saw the second lien portion of your portfolio and in gross dollars issuing the sub-op a little bit but net. Obviously, you have shifted -- continue to shift towards first lien. Is that a commentary on the relative pricing or your concern about what the credit underwriting metrics are that are currently out there floating around in second lien given that obviously, it doesn't have the best recovery rate when things do go wrong?

Robert Kipp DeVeer

Yes, I mean, specifically in the first quarter, we exited 2 substantial second lien positions that we were in. To your point, we exited them because they were both going through refinancing transactions, which we found, generally speaking, to be unattractive. We thought that the -- one documentation wasn't particularly high quality. One of them turned into a covenant light deal. We didn't like the pricing. We thought the leverage was too high, so it's sort of all of the above, yes. I mean, I think the second lien market generally speaking has come in and crowded out mezzanine over the last year or so again. And it's always our belief that when that creeps into the $50 million of EBITDA company and below, that you're talking about small tranches in smaller middle-market companies with a tremendous amount of secured debt on them. And that's why the recovery rates in those smaller, second lien tranches tend to be not so good. We've shied away from them in marketplaces in the past and continue to do that today.

Operator

The next question is Greg Mason, KBW.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

Sorry to harp on the BDC legislation one more time here. But given the CBO scoring issues with the representative sponsor of the bill having some personal issues, full calendar until the summer recess and then the November elections, what do you think is the likelihood of this bill getting done this year? Or is it more realistic to assume we're just going to have to start the process all over again with the next congressional cycle? What are your thoughts there?

Michael J. Arougheti

Yes, I wish I knew, Greg. I think we spent a lot of time on this call talking about the scoring and I gave my opinion on that. With regard to one of the original bill sponsors' current issues, I also don't believe that, that jeopardizes the bill. I think as people know, the bill did get passed through the house already on partisan, truly partisan basis. And since that's first partisan vote, I think people have picked up on the fact that there has been a lot of work on both sides of the aisle to come to a bipartisan agreement. And at least from our vantage point, it does appear that leadership on both sides of the aisle have taken up the cause. And so the original bill sponsors, I think at this point, given how evolved the dialogue has been in the process, how far the process is, I'm not quite sure has an impact. With regard to the calendar, it's really anybody's guess. I just don't know even how to handicap how the timing would play out.

Greg M. Mason - Keefe, Bruyette, & Woods, Inc., Research Division

And then one question regarding the parent going public here. Do you think that puts any pressure on doing regular equity raises and focusing on growth? Does that change the bar at the price level that ARCC would be willing to raise new equity?

Robert Kipp DeVeer

I hope not. I think if we've demonstrated anything over our 10-year history as a public company, that we are good stewards of capital. We grow when it's appropriate to grow and we don't grow when it's inappropriate not to grow. And our expectation is that as a public company, the way that we manage ARCC will absolutely not change. But as I mentioned in my opening remarks, I think that it will bring a fair amount of positives to the table just in terms of the platform string of Ares Management, as we think about our relationships with our investors industry, our access to capital, our ability to hire and retain people, information advantages that we get. So, I think it's a net positive. But you should not expect that anything will change in terms of how the BDC is run day-to-day.

Operator

Our next question is Jonathan Bock, Wells Fargo Securities.

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

Starting with the Senior Secured Loan Program. Can you give us, Kipp, a sense of spread compression on the assets within that vehicle, so at times there might be refinancing, et cetera. But when we see a driven brands go from 7 to 6, or a CCS also that moved down and several others, given that this is a levered vehicle and that if it's not growing and generating an additional fee income that's taken upfront, spread compression could put an undue or perhaps a larger-than-expected impact on interest income to the downside. So can you walk us through spread compression in that portfolio?

Robert Kipp DeVeer

Sure. I mean, I just -- generally speaking, obviously all the numbers around us has appeared disclosed. I can review a couple of them, Jonathan. Look, the loans -- the 46 borrowers that we have in SSLP are experiencing lots of the same trends that we're seeing in the broader market rise. To the extent the yield on the portfolio here has been coming down. We've seen some modest portfolio yield compression in SSLP as well. I think the disclosed numbers are the yield on the entire portfolio went from 7.1% to 7.08%. We did, I think, as you could take from the disclosure, reduce the kind of percentage that we're taking into income. That's really just a prospective judgment call on Q2 going forward to 14.5%. Obviously, we look at the returns coming from SSLP as needing to support that. But I'd say generally speaking, that yield compression that you referenced in a couple of those names that is -- that's just an active market where you're seeing refinancings and new deals getting done. So it's in line with, I think, everything that we've seen and other folks just in the business have seen broadly speaking for a while now.

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

It's fair, Kipp. We see that the limited structuring fees, given that there's not a lot of activity in SSLP in a given quarter, let's say this one. You can offset that through extra dividends coming up from IHAM. Maybe a more broad question as it relates to CLO equity, which what I would assume would account for the amount of assets -- or steady amount of assets that are owned by Ivy Hill. Can you walk us through the value of those CLO securities, as well as the value of IHAM in the event LIBOR goes up 100 basis points -- or excuse me, goes up 2 of the 100 basis point level and stays there?

Robert Kipp DeVeer

I'm sorry, John. Just so that we can maybe respond to the question, are you trying to disaggregate the value of Ivy Hill between securities and the issue?

Michael J. Arougheti

The value of the manager perhaps?

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

Maybe I'll rephrase this just in terms of the risk. So, looking in CLO securities there's, a heavy floating rate component for CLO assets that mostly have a floor, roughly 90%, all right. That floor is roughly set at a 100 basis points turning to liabilities and liabilities free flow. In the event that LIBOR rises to the 100 basis point level, you have -- well say significant NIM compression. And the question is if you're levering that NIM and CLO equity securities between 7 to 10x depending on that, my question is what happens to NAV of those CLO securities, which I assume Ivy Hill owns?

Michael J. Arougheti

Yes. Just to clarify, and again I'll put Kipp's earlier comments into context and Kipp and Penni can chime in with some of the detail but we are not actively investing in new issue CLO equity. As Kipp mentioned, the growth at Ivy Hill has moderated given the existing market conditions. And I think we talked about this last quarter when we look at the returns on new issue CLO equity with some modest default assumptions, new CLO equities pricing in the 9% or 10% range with spread risk, as you mentioned, just given where the liabilities are pricing. So I think what you are highlighting is absolutely part of the dialogue around whether or not you think that new issue CLO equity represents attractive risk-adjusted return. The reason that we've been able to generate such significant gains off of the Ivy Hill portfolio is those are older vintage CLOs that were cumulated through the downturn at very low valuations. And as valuations have come up, obviously we've either refinanced or exited some of those positions or the net asset value has come up. So clearly, if you were in an arbitrage vehicle that is levered, spread compression is an issue. But I think it's less of an issue in the Ivy Hill portfolio, given the vintage of those CLOs and the cost of those liabilities but also the leverage of the traditional middle-market CLOs relative to the new CLO 2.0 leverage. So when you talk about 7, 8, 9x leverage, the traditional middle-market CLOs were coming in with less leverage than that.

Robert Kipp DeVeer

I mean, John, I'll make one other point, just as a reminder. The securities that we're investing in at Ivy Hill are in Ivy Hill managed funds, right? We're not buying third-party manager's liabilities and/or equity in any way, shape or form. And we've made some commentary around it on the fourth quarter call and on this call, but we have been harvesting capital from Ivy Hill, to Mike's point, because we've seen the spread arbitrage on CLOs breakdown in the current market. Ivy Hill as a portfolio company has experienced less growth over the last 12 months and it certainly did during the downturn. And that's why we've positioned that company as a company where we're harvesting gains as much as we are in the existing portfolio and perhaps slowing its growth because we look at risk-adjusted returns there, as we do across the other things that we look at in day-to-day and just view it as less attractive today. And maybe that's helpful.

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

I appreciate that. I think investors always -- just because it is a nice offset to the event -- in the event that structuring fees and SSLP decline, people always wonder about the sustainability of the extra dividend that comes in kind of the recurring, nonrecurring item and your commentary there helps a lot. Last question, you talked about portfolio optimization. I appreciate that. And as we look -- can you give us a sense of kind of an absolute yield level on balance sheet that you would find in this current environment somewhat will say suboptimal?

Michael J. Arougheti

No.

Robert Kipp DeVeer

Look, I mean, I think for people involved in the company and you're one of them, Jonathan, for a while, who follow the company closely, we care most about risk-adjusted return across market cycles. We don't have a hurdle around here where we say if it's less than this or less than that, we won't do it. We try to be flexible on our approach and operate nimbly in different markets. So as Mike said, I think the answer to that is no. We don't have a specific number. It doesn't work for us on a traditional deal. Our clients keep coming back to us, hundreds of them over the years because we offer full product solutions and telling people that we don't want to engage in a certain transaction because a portion of that financing kind of doesn't fit with what we're up to right now really doesn't work.

Michael J. Arougheti

I'll make one detachable comment too because when -- if you look at how we have managed through the cycle. As we sit here today, given the balance sheet scale that we've accumulated, 30% to 35% of our deal flow is coming from existing relationships. And when you look of the length of those relationships and you think about the lifetime value of a borrower to Ares Capital Corporation in terms of fees, spread, call protection, equity co-investment gains, you have to have a long-term view as to the value of those loans throughout the cycle and throughout the lifetime of that borrower. And we have seen that if you get wetted to a return construct at any point in the cycle, you may be adversely selecting risk or you may not be positioning yourself for a long-term value creation and that's always how we thought about it.

Jonathan Gerald Bock - Wells Fargo Securities, LLC, Research Division

No, that makes complete sense. I think that the question is as people look for the portfolio optimization and as it takes place, let's say, there's $423 million of loans that are sub-6%, right, $119 million to Service King, et cetera. But not talking about an individual company but when you say that it's the time to maybe prune and get some better risk-adjusted returns elsewhere, I think that's typically where the BDC investor kind of moves to gauge what potential growth could occur.

Michael J. Arougheti

Well, I think, if you look at the pruning in the first quarter, there's a 20-basis-point positive differential between where we booked assets and where we exited asset exclusive of fees, all protection and gains. So I like the term pruning because that -- around the edges, you are optimizing the credit and the return on the portfolio and you just highlighted some numbers that represent the opportunity within the portfolio. But it doesn't necessarily follow that if we found an 8% return that we like, that we would sell a 6%. I think it's much more dynamic than that. But that's a daily conversation here.

Operator

Seeing no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

Michael J. Arougheti

Sure. I just thank everybody so much for their time and their support, and we look forward to seeing people, I guess, over the next month or so in meetings and conferences as they come through. Thanks again.

Operator

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately 1 hour after the end of this call through May 19, 2014, to domestic callers by dialing (877) 344-7529 and to international callers by dialing plus 1 (412) 317-0088. For all replays, please reference conference #10043782. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website. Thank you.

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Source: Ares Capital's (ARCC) CEO Michael Arougheti on Q1 2014 Results - Earnings Call Transcript

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