Ares Capital's (ARCC) CEO Michael Arougheti on Q2 2014 Results - Earnings Call Transcript

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Ares Capital (NASDAQ:ARCC)

Q2 2014 Earnings Call

August 05, 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

Greg M. Mason - Keefe, Bruyette, & Woods, 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

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

Casey J. Alexander - Gilford Securities Incorporated

Operator

Good morning. Welcome to Ares Capital Corporation's Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded on Tuesday, August 5, 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 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 the 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 taxes related to such realized gains. A reconciliation of core EPS to the net per share increase or decrease in stockholders' equity resulting from operations, the most directly comparable GAAP financial measure, can be found in the accompanying slide presentation for this call by going to the company's website at www.arescapitalcorp.com and clicking on the Q2 '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 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 second quarter 2014 earnings presentation is available on the company's website at www.arescapitalcorp.com and clicking on the Q2 '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. [Operator Instructions] I will now turn the call over to Mr. Michael Arougheti, Ares Capital Corporation's Co-Chairman of the Board and President of Ares Management LP.

Michael J. Arougheti

Great. Thank you, operator, and good afternoon to everyone, and thanks for joining us. It is with great pleasure that I announce some well-deserved promotions for 3 of my long-time friends and partners. Last week, our Board of Directors promoted our President, Kipp DeVeer, to Chief Executive Officer; and our Executive Vice President, Mitch Goldstein and Michael Smith to Co-president. These promotions reflect the great confidence that we have in Kipp's leadership, as well as the depth and quality of our management team.

Kipp, Mitch and Michael have been senior executives with the company generally since its inception and have been major contributors to the success of ARCC over that time. I will remain on the ARCC board and, in fact, join Bennett Rosenthal as Co-Chairman, and I look forward to continuing to help create value for ARCC's shareholders in my new role on the board, and I will absolutely stay very close to ARCC in my current role as President of Ares Management.

Kipp, Mitch, Mike and I are very proud of what we've built for ARCC shareholders as we approach our 10-year anniversary as a public company this October. As you'll hear from the team today, we feel very good about our leadership position in the market, as well as the strength of our portfolio and balance sheet. And we believe that we are very well positioned for future growth and anticipate a continuation of positive secular industry trends in the nonbank lending sector.

So now let me turn the call over to Kipp, so that he can walk you through some high-level second quarter results and our investment activity. And then he can put our results in context with our views of the current market. Kipp?

Robert Kipp DeVeer

Thanks, Mike. I really appreciate those comments and look forward to continuing to work with the board and the entire team in leading Ares Capital. We've had a consistent vision here for years, and I don't expect much to change.

Let me first start out here with some high-level comments on our second quarter results. For the second quarter, ARCC reported GAAP and core earnings per share of $0.48 and $0.34, respectively, and growth in NAV to $16.52 per share. Our strong GAAP earnings per share reflect continued net investment gains and positive portfolio performance.

While we're pleased with our GAAP earnings, which contributed nicely to growth in our net asset value, our core earnings per share were modestly behind our expectations, but within our previously announced range.

Core earnings were impacted by the timing of investments funded during the second quarter, which were more back-end loaded, and the timing of repayments, which were more front-end loaded. Of course, the overall growth in investments during the second quarter should contribute to our third quarter and fiscal 2014 earnings, and we're off to an early start in the third quarter, with strong investment activity to date through July 31 of about $390 million in net new commitments.

Despite the slow start in the second quarter, we had a very busy quarter for originations at over $1 billion of new commitments across 29 investments. Approximately 2/3 of these commitments were to new portfolio companies, which highlights the breadth and depth of our origination platform. We continue to focus on what we believe are the highest quality credits and continue to emphasize conservatively structured transactions with covenants.

During the second quarter, 51% of our new commitments were in first lien senior secured debt, 20% were in the subordinated certificates of the Senior Secured Loan Program, which also funded first lien loans, and 28% were in second lien senior secured debt.

During the quarter, we exited $767 million of commitments from the portfolio. Some of these exits came as a result of continued rotation out of certain lower yielding assets, the strategy we've discussed in the past and one that we continue to execute on. A few of the exits came from the resolution of certain lower yield, lower quality nonyielding investments, which I will discuss in a bit more detail later in the call.

We were able to earn higher yields on our new investments compared to the yields on investments repaid or exited during the quarter. And despite the spread compression we've seen in the markets and in our portfolio over the last 18 to 24 months, we believe this spread compression has leveled off. We're able to maintain our weighted average yield on total investments at amortized cost at 9.2%, which is unchanged from the first quarter of 2014.

In addition to this interest in dividend income earned from the portfolio, we had net realized and unrealized gains of approximately $51 million in the second quarter. There continues to be significant investor appetite in the market for assets that we invest in, and while the capital flows to our market have definitely increased over the last couple of years, we continue to find what we feel are very compelling risk-adjusted returns. We're encouraged that we've recently seen more fund outflows from both the loan and bond markets, and this has led to a slight improvement in market terms on new deals.

We believe capital has come into direct lending due to the absolute return potential in a world of very low interest rates. However, it's important to note this capital has also entered our market because of the general strength of the U.S. economy.

We feel highly confident in our funding sources today, and we believe we have one of the strongest balance sheets in our industry. We ended the second quarter with a net debt-to-equity ratio of 0.68x, and with approximately $1.8 billion of available debt capacity under our credit facilities. We've locked in a meaningful amount of fixed rate longer-term debt over the past several years, and we're pleased that the current market prices of our bonds have increased well above their par value. We believe this indicates that our cost of borrowing new term debt is much lower today and that the cost of incremental term debt capital may be meaningfully lower than the rates we currently pay.

We hope to take advantage of opportunities in the future to reduce our funding costs as we build in additional lower-cost term liabilities. In addition, given our strong backlog and pipeline at the end of the second quarter, we executed a $258 million equity offering at the beginning of the third quarter to support our growth.

Let me now turn the call over to Penni to highlight our second quarter financial results and to provide some details around our recent financing activities.

Penni F. Roll

Thank you, Kipp. Our GAAP net income for the second quarter of 2014 was $0.48 per share compared to $0.39 per share for the first quarter of 2014 and $0.50 per share for the second quarter of 2013. Our basic and diluted core earnings were $0.34 per share for the second quarter of 2014 compared to $0.38 per share for both the first quarter of 2014 and the second quarter of 2013. The $0.04 per share decrease in our second quarter core earnings as compared to the first quarter of 2014 was primarily due to lower dividend income. The core earnings this quarter were also impacted by the timing of originations and repayments during the quarter, which slowed the growth of interest income.

Our net realized and unrealized gains totaled $51 million or $0.17 per share for the second quarter, largely driven by net unrealized appreciation in the portfolio.

As of June 30, 2014, our portfolio totaled $8.1 billion at fair value across 202 portfolio companies, and we had total assets of $8.6 billion. Our stockholders' equity was $4.9 billion, resulting in net asset value per share of $16.52, up from $16.42 at the end of the first quarter of 2014.

From a yield standpoint, the weighted average yield on our debt and other income-producing securities at amortized cost at June 30, 2014 was 10.1%, 10 basis points lower than at the end of the first quarter of 2014. This 10 basis point decline in yield was the lowest quarterly decline that we have experienced in almost 2 years, and highlights Kipp's earlier point about spreads leveling off in the market. The weighted average yield on total investments at amortized costs at the end of the second quarter was actually unchanged at 9.2%.

As of June 30, we had approximately $5.2 billion in committed debt capital, consisting of approximately $3 billion of aggregate principal amount of term indebtedness 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 89% of our outstanding debt at quarter end was in fixed rate long-dated unsecured term debt. As of June 30, 2014, our debt-to-equity ratio was 0.68x and our debt to equity ratio net of available cash of $200 million was 0.64x.

As Kipp mentioned, subsequent to the end of the second quarter of 2014, we completed an equity offering of 15.5 million shares resulting in net proceeds of approximately $258 million. Pro forma for this offering, our debt-to-equity ratio as of June 30, 2014 would've been 0.6x and our total liquidity, including available cash, would've been nearly $2.3 billion.

We've continued to proactively extend the maturity of our secured revolving credit facilities, and during the second quarter, we amended our revolving funding facility with Wells Fargo, extending the end of the revolving period and the state of maturity date each by 2 years to May, 2017 and May 2019, respectively. As part of the amendment, we reduced commitments under the revolving funding facility by $80 million, but in turn, we upsized commitments under our lower cost J.P. Morgan-led revolving credit facility by $80 million during the quarter. So as a result, our total debt commitments of $5.2 billion remained unchanged since the end of the first quarter of 2014.

After the completion of the extension with Wells Fargo, none of our revolving facilities have a final maturity prior to May 2019.

As of June 30, the weighted average duration for our outstanding liabilities was 7.2 years. 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 dated interest rate on our drawn debt capital at quarter end decreased to 5.1% as compared to 5.4% at the end of the first quarter of 2014. This decrease resulted from a higher level of borrowings under our lower-cost revolving credit facilities at the end of the quarter as compared to the prior quarter. If at the end of the second quarter of 2014, we were to borrow all of the amounts available under our revolving credit facilities, our weighted average dated interest rate would be 4.1%.

As Kipp mentioned, we believe our current borrowing cost for new term debt would be meaningfully lower than the cost of our existing term debt.

Finally, this morning, we announced that we declared a third quarter dividend of $0.38 per share payable on September 30 to stockholders of record on September 15, 2014. As a reminder, at the end of 2013, we estimated we had approximately $0.82 per share of undistributed taxable income being carried over into 2014. We believe that this helps contribute to the stability and predictability of our dividend.

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

Robert Kipp DeVeer

Thanks, Penni. Today, we have a diversified $8.1 billion portfolio consisting investments in 202 portfolio companies. Our average commitment is less than 1% of our assets, and our largest single main exposure, excluding the SSLP, is less than 3.5% of our portfolio at fair value. At quarter end, the SSLP represented approximately 24% of the portfolio at fair value.

The SSLP is well diversified with 50 separate underlying borrowers at quarter end. Excluding SSLP, the next largest 15 investments in the aggregate, represented only 26% of the portfolio at fair value.

Our portfolio has performed well, and we believe the underlying health of our portfolio companies is quite strong. Our corporate portfolio companies had weighted average EBITDA of $54 million as of the end of the second quarter and have had solid year-over-year growth in EBITDA of approximately 8%.

For the second quarter, our portfolio experienced positive credit metrics in the aggregate. 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 increased to 3x as of June 30 versus 2.8x as of March 31.

The weighted average grade of the portfolio is stable at 3.1 at the end of the second quarter. Nonaccrual ratios declined quarter-over-quarter with 1.9% of the portfolio at cost and 1.2% of the portfolio at fair value on nonaccrual at quarter end, as compared to 3.2% at cost and 1.9% at fair value at the end of the first quarter. At June 30, 2014, we only had 3 companies on nonaccrual of any meaningful value, and no new names were placed on nonaccrual this quarter.

During the second quarter, we realized net losses from investment exit and repayment activities totaling approximately $47 million. However, these losses were already substantially recognized in our earnings through unrealized depreciation in prior periods. These net realized investment losses mostly pertain to our disposal of 2 of our more difficult situations, city postal and MVL group, both of which came in to the portfolio with the Allied Acquisition. We're pleased with the resolution of these 2 investments.

Net unrealized gains on the portfolio at June 30, 2014 were approximately $51 million this quarter. These net unrealized gains were largely driven by several investments where we see potential near-term exits at meaningful gains. Announcements have been made regarding certain of these exits, including Apple & Eve, Insight pharmaceuticals and Service King.

While we remain in a low interest rate environment, we're encouraged by these results and the opportunity to continue to generate attractive low double-digit total returns on our investments. We will seek to drive returns to shareholders through the combination of current income from interest, dividends, structuring fees and other sources of fee income, as well as the potential for realized gains.

Let me finish with a quick update on our recent investment activities since quarter end and our current backlog and pipeline. As I mentioned earlier, we had a strong start to the third quarter, making new investment commitments of $492 million, of which, $451 million were funded. We exited $102 million of investment commitments from July 1 through July 31, resulting in net new investment commitments of $390 million. We believe that the higher level of net new investments to begin the third quarter bodes well for higher interest income for the third quarter.

As of July 31, 2014, our total investment backlog and pipeline stood at approximately $390 million and $500 million, respectively. Of course, we can't assure you that any of these investments will close, but we expect a busy finish to the year. We plan to continue to use our broad origination platform to source and invest in what we view is the best franchise companies with a view to maximizing risk-adjusted returns.

We look back with great pride on the level of shareholder value we've created since our IPO nearly 10 years ago. Since October 2004, we paid cumulative dividends to shareholders totaling $14.87 per share, and by reinvesting those dividends, the shareholder would've received an annualized total return of about 14%.

Going forward, we will continue to focus on creating long-term shareholder value through steady performance and attractive and stable dividends. And I'll close by thanking our board for their support. We promise to continue to work diligently as a team to continue the success ARCC has enjoyed and to pursue strong returns for our shareholders.

Operator, can we open the line for Q&A please?

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Greg Mason of KBW.

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

First, my question is on the equity raised post quarter end. You raised $258 million. Kind of net your target leverage of 0.7 gives you $450 million of investment capital, and you just said in June, you have kind of net fundings of around $350 million at an 8.1% cost. If I do the math at 8.1% kind of fully levered net of fees, I get a 7.5% to 8% ROE versus the 9% dividend yield on the new investment. So my question is, why the equity raise? And ultimately, how can that be covering the dividend, or more importantly, accretive to shareholders on an earnings basis over the long term?

Robert Kipp DeVeer

Sure. Well, so you got the point right on the equity. We're definitely trying to build flexibility for the remainder of the year. As I mentioned, we're busy, so for us, that was an ordinary course raise, and of course, when done, above book as usual. But take some caution just looking at that 1 month of data. Number one, it's a month of data, so it's not particularly indicative of what the backlog and pipeline, in fact, looks like. Going forward, that backlog and pipeline that I laid out does have aggregate yields that are materially higher than the yields that we funded in July. So I think really taking that away and doing a calculation using the 8% isn't going to be all that helpful. When we took our Q1 and Q2 GAAP earnings and divided by where we issued stock, we were looking really at a company that's generating sort of 10% to 11% return on equity based on that earnings stream from the past 2 quarters. So I wouldn't take much away from that 8.1% I think is the key to the question.

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

And then just a broader thought process, back in 2006, 2007, you guys moved up the capital structure, put you in a great position during the downturn. You've been doing that again. In a yield compression environment that we've been seeing, how are you balancing -- obviously, you're staying conservative, but then you're still growing and raising equity capital, just kind of balancing what you're seeing in the market yields with your cost of equity capital today, and your thoughts of managing that going forward?

Robert Kipp DeVeer

Sure. Well, and we're not going to do anything that's not accretive to shareholders, whether it's investing new money or raising capital. We're in a fortunate position these days. With $8 billion of assets, we have absolutely no need to raise capital, which we remind people often. Our business is writing loans that range in size from $50 million to $500 million, and with the balance sheet and the availability that we have today, we have no need to raise equity. So as we've said, I think, individually in meetings many times, when we're raising equity capital it's because we see attractive opportunities on the investment front that we think are accretive to shareholders over time, and it's really nothing more than that. Does that answer your first question? I mean, I can add some color. There's a lot of discussion around the investment table here day to day, about what the appropriate yields are. I think you've heard from us in the past, we want to be in the best credits these days. We service a lot of different customers and a lot of different clients in the business with 202 companies, as well as a number of relationships we're dealing with. So I do just want to say that your point isn't something that's lost on us. It's something that we talk about every day here.

Operator

The next question comes from Terry Ma of Barclays.

Terry Ma - Barclays Capital, Research Division

Guys, can you just give us a sense of what's causing yield compression to level off, as you mentioned in your prepared comments?

Robert Kipp DeVeer

I think there are a couple of things. We've seen outflows, as I mentioned, from loans, generally speaking, this year and from the bond market as well. I heard on one of the other calls, I think this week, that there has been meaningful ramping back up of sort of the CLO machine this year. It's been very active issuance year for CLOs, but most of that is larger market, so I think it's definitely outflows is the lever -- is the key here. So retail seems to demand a base yield and bank loans, and then I think we may have finally reached it.

Michael J. Arougheti

I'd also just add quickly that there's probably a leveling off what was a supply demand imbalance. And when you look at the amount of deal flow in the forward calendar, there's just more transaction volume to take up whatever capital is available in the market.

Robert Kipp DeVeer

I think that's right, Mike.

Terry Ma - Barclays Capital, Research Division

All right, got it. And it just looks like repayments and exits have been pretty elevated in the last 2 quarters on a year-over-year basis. Can you just comment on how much was repayments versus opportunistic exits and maybe how you see that playing out the rest of the year as you prune your portfolio?

Robert Kipp DeVeer

Yes, I think we're always managing, as I think we mentioned on the last call, some of the lower-yielding investments in the portfolio, and of course, we look at that as one of our tools for access to capital. So on the point raised earlier about the equity raise, we've been, again, paring the portfolio back with some of our lower-yielding assets to maintain yield, to preserve the dividend and interest margin over the last couple of quarters. But when I think about that rotation, there's room, but we've gone through quite a bit of it. In terms of exits otherwise, really nothing extraordinary other than what we mentioned. We did dispose of 2 names that had been problematic for us, and I think the real positive is we're expecting some other exits as well, both in the quarter and some quarters to come here on names that have done quite well for us. We do take away from this quarter that people had some concerns, and I've mentioned modestly lower core EPS, but I just remind people to remember that this is a total return game. And at this point in the cycle, our ability, I think, to generate gains on our investments is a pretty important part of the story, and we're happy to be seeing that. That's been going on now for a few quarters, but is particularly pronounced right now.

Operator

The next question comes from Doug Mewhirter of SunTrust.

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

I just had 2 questions. First, do you have any updates on Ivy Hill, I know that you've been -- over the past several quarters, even longer, you've been saying how there's as not as much opportunity. They've been sort of winding down a bit. Is that still going to be able to make a meaningful contribution to your dividend flow to Ares over the next year or so?

Robert Kipp DeVeer

Yes, we expect that it will. I mean, Ivy Hill has been paying a regular dividend from its core earnings, so to speak, of $10 million a quarter. Just to be clear also, in answering the question, we don't think Ivy Hill is winding down in any way. It's, in my words, probably not growing as quickly as perhaps it did during the downturn when it was more opportunistic as a buyer, both of securities and of management contracts, which is not an opportunity today. So that's just to be clear on that point. But yes, we expect Ivy Hill will continue to do what it's doing. It's been a phenomenal performer for us. There's meaningful unrealized appreciation there for a reason, the investment performance has been excellent. But the fund management business continues to be successful and provide a steady stream of earnings that we expect will benefit ARCC and its shareholders.

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

Okay, great. My second question, second and final question, a little bigger picture maybe. I know that with your, I guess, a more conservative stance or a higher in the capital structure stance with the loans you're putting on the books now, and I know in the past, Mike had mentioned, if this legislation ever passed, to increase the approved leverage, that you would increase your leverage with the very senior secured, very safe securities. But -- with that being said, but keeping that same philosophy, have you reconsidered where the upper end of your leverage target would be, given that you're skewing your portfolio in a slightly safer direction? Or is the shift not meaningful enough to really, really change how you look at your capital structure and your leverage targets?

Robert Kipp DeVeer

Yes. I mean, the leverage target is ranged, typically, we say between sort of 0.6 and 0.8 to 1. We think this is a point in the cycle, frankly, where you want to have flexibility, so pushing our leverage meaningfully higher is not something that we think is a great idea these days. I don't know how far or how long we are in a credit cycle, but we're -- with high leverage multiples and tight spreads, we hope getting a little bit longer on the credit cycle, where we do want to maintain flexibility. So there's not a meaningful shift, frankly, in the portfolio, and it's mixed over the last couple of years. So when you take the assets and the context around the market, we really haven't wanted to increase the leverage or really have any change in general on our target leverage ratio. Obviously, if the legislation changed the game, we'd reconsider that, but that's probably an entirely different discussion.

Operator

The next question comes from Robert Dodd of Raymond James.

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

On fees first, if I can, obviously, the structuring fees came in a little bit below what I was looking for, and how your target was obviously. But when I look at the rate on the SSLP in particular, obviously structurally high, chops around quarter-on-quarter, but looks like a relatively low level compared to the originations. Is that a function -- or can you give us any more color on that, but is that a function of refinancings within the portfolio, maybe for lower fee structures? Or is there a market shift in those larger higher credit quality corporates that are getting these deals done now at somewhat lower fees and was the case there last year?

Robert Kipp DeVeer

I just want to make sure I completely understand the question, but I think, are you asking, SSLP you see as generating lesser yield?

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

Lower capital structuring fees relative to originations. Last year, capital structuring fees was 6.6% of originations. This quarter, 5.4%. So is there anything structural there or...

Robert Kipp DeVeer

No, we're scratching our heads here a little bit just looking at the numbers. You're right, and we have the same math you do. They're down modestly. I think the general answer is, there's no structural shift at all. SSLP basically is a mix of -- a constant portfolio again of 50 names, some entering, some exiting, it can always be growing. But certainly, if you're refinancing an existing borrower, you often charge less fee. Or if you're upsizing an existing credit, you'll take a small origination fee. So it's those sort of things in the natural course and in the mix of the way that the program works can impact that, but I don't think there's anything, in fact, I know there's nothing meaningful there in terms of the market or the types of companies that we're financing.

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

Okay, great. And one other, if I can on one of your materials, nonaccruals, and I'm going to pronounce this horribly because Spanish isn't my key -- but Instituto de Banca y Comercio has been marked down 3 quarters in a row now. It's on nonaccrual. It's in Puerto Rico, which obviously has its issues. But can you give us an update on anything that's going right there, why you feel so comfortable, frankly, with it marked where it is, when it is on nonaccrual currently?

Robert Kipp DeVeer

Well, I think we've talked about this one in the past a little bit. A [indiscernible] secondary school, which is a default business these days, and it also happens to reside in Puerto Rico, which is obviously, as people know it's a difficult geography. This is a company that we've been involved with actually, I'm going to guess, but I'm going to call it, 7 years, it has been a phenomenally successful investment up until some of the recent concerns both around the industry and some of its challenges, which are pretty well publicized in the press, as well as in Puerto Rico, which I'm sure you've been reading about too. We still think that this is a franchise business. It's the leader in its space. There's a need for this company to exist in Puerto Rico, and we believe that it will survive as a business, basically that we have today. It's just a difficult balance sheet for a lower run rate of earnings. We are deeply involved with the company today in terms of both internal portfolio management resources and external resources. And the good news is that the business continues to have the support of a very strong private equity sponsor in Avery Partners, engaged day-to-day with operating folks bringing new management in, et cetera. So we just have a very high degree of confidence that it's a good company with a tough balance sheet that we can fix.

Operator

[Operator Instructions] The next question comes from Rick Suva [ph] an individual investor.

Unknown Attendee

My question is where the spillover income sits right now. Would I be correct to believe that the net realized losses from quarter 2, which was appreciable, you must have done some housecleaning, whatever, would offset some your previous spillover income?

Penni F. Roll

If you look at the spillover at the end of '13, it's really measured on an annual basis and we had about $0.82 carrying over from '13 into '14. If you look at taxable income, you really have to measure it on an annual basis. You can't look at it on just 1 quarter's activities. And while we did have some net realized losses in Q2, we've talked a lot also today about some potential net gains on the horizon for some other investments that we think will have an exit during the course of this year, and we also had some net gains earlier in the year. So you can't really look at it in a vacuum. But when we get to the end of 2014, we'll continue to do what we always do and that's look at the taxable income for the course of the year relative to the dividend that's been paid out on a cumulative basis, and we'll reposition where we are on the spillover at the end of the year. But clearly, any net realized or any realized loss will reduce your taxable income, but we have other offsets to that through realized gains or loss carryforwards et cetera on the tax side that can also come into play.

Unknown Attendee

Okay. So you don't have a number for where it sits right now?

Penni F. Roll

No, we don't because unfortunately, a lot of -- we're only halfway through the year, so it's hard to predict where we'll be for the spillover at the end of '14. But look at all of our taxable income generated, and recalibrate that at the end of the year. But like I said, we believe we have some other gains coming in through the rest of the year that could impact or, I should say, offset some of the losses.

Operator

The next question comes from Jon Bock of Wells Fargo securities.

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

Kipp, turning to prepayment, maybe risk for a moment. If we look at the SSLP, which is amplified by the amount of leverage provided by GE, I noticed that your originating assets were looking between 6% and 7%, whereas the exits, and that whether it's coming from a Pregis or others would be roughly around the 8% mark. So gauge for us, only because these are the transactions that are most susceptible to liquid loan markets, we'll call it stretch down effect. Explain to us or maybe give us comfort around the prepayment risk in that portfolio, given that it's amplified with a significant degree of leverage that benefits on the way up and can hurt when spreads come in.

Robert Kipp DeVeer

Yes, I think we've talked about this when, I think with you John and with others before, which is we don't see any difference, frankly, in the way that the underlying assets at SSLP worked vis-à-vis the portfolio. Obviously, the vehicle itself is constructed in certainly the ways that you referenced. But the repricing and the refinancing activities that we've seen hot and heavy in the market for the last 2 or 3 years, generally speaking, have kind of played through the portfolio. That doesn't mean that we're not refinancing and repricing things. I guess it does mean we're refinancing and repricing things all the time. But there's no, in particular, sort of risk that we see as it relates to SSLP, vis-à-vis the portfolio as a whole.

Michael J. Arougheti

Just to maybe approach it from a different angle. We've talked about this on prior calls. The pricing of the senior notes in SSLP is dynamic, and it's meant to reflect the cost of capital available in the market at a particular time, so not always the case, but generally the case if there's an 8% asset, it's probably being financed at a higher cost of capital than a 6% asset today. So when you look at the net distributions to the subordinated certificates that ARCC holds, you're not experiencing that kind of spread compression either when it's going in or coming out of that portfolio. And the best way to appreciate that is if you look at the dividend income or the distribution income coming up off of SSLP, it's been surprisingly consistent despite the spread compression that Kipp talked about earlier.

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

It makes total sense. And then if we are going to take a moment, I think Mr. Dodd mentioned this in his line of questioning about the certain Puerto Rican loan that kind of looked at. Notice that, that is in the SSLP, it's a relatively small investment. But kind of walking through the workout or how kind of one approaches a potential workout, given the fact that you were the first loss in this entity. Could you maybe give us a little bit more color as to working this loan out for both ARCC proper and then also having to work with the senior lender and the fund of which this asset is also included.

Robert Kipp DeVeer

Yes. So let me comment on that. Being first loss, so to speak, if you use that terminology in SSLP if you'd like to. It really has no impact on the way that underlying portfolio companies in the joint venture is managed. So both Ares and GE, I should've said, are deeply sort of engaged in helping to fix, educate, whether it's through operational improvements, helping with management, changes to the balance sheet, deferral of interest. Whatever it may be that we're obviously providing to the company, we're doing in complete concert with GE, as if we, to make it simple, had $100 million loan together where we each own a $50 million commitment side-by-side. It works exactly as if that was the position. So we cosource for the program. We ratify investments separately and then together and manage them together. So the way that the program works really has absolutely no impact or indication on the way that we're kind of pursuing, educating and fixing it.

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

Got it, got it. And then one additional one. Kipp, of the deals that were done, let's go particularly in second lien, can you walk through, maybe just on a percentage basis, sort of the 40% or so second liens done this quarter? How many of those were you the true sole structurer and control investor? Normally, it's almost always 100%. I'm just kind of curious, are you still seeing other deals or see opportunities to partner behind people or partner in a PSL type of transaction and maybe it was originated by a larger broker-dealer?

Robert Kipp DeVeer

Yes, I mean, I think you know our philosophy, which is we really do like to kind of lead and control our transactions. Second lien these days has more or less taken the place of the mass market, and for people who have been in our business, you do see sponsors and sponsored deals bring in more than one relationship occasionally. But in terms of the second lien that we booked this quarter, I think on Totes we were the entire deal, Sarnova we're the entire deal, I think Ares we were not. Young, we were, Pelican, we were not, and RegionalCare, we were not. So it's a mix, and the reason for us being the lead versus not being the lead, have a broad range of reasons. As I mentioned, sometimes it's our choice around sizing of position. Sometimes it's the sponsor bringing another relationship into a name. We think long and hard, frankly, about who our partners are in those names. If the sponsor says, we'd like you to do 40, and so we'll start to do 40. It really does depend on who that so and so is. So when we don't lead things, we typically don't like to be 1 of 7 people in a name. We've seen difficulty managing to the downside when you have a larger group. So I guess broadly speaking, we'd like to be the lead and only or kind of 1 or 2, which is I think what you'll see in almost all these names.

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

Okay, got it. And then maybe just allowing us to drill one layer deeper using a company as an example. So for example, Pelican Products, right, $175 million second lien, of which you took 40. I understand this is on a much larger portfolio and a broader context, but would that kind of fall in -- so $40 million, other $40 million type partner situation or maybe just a little bit more on that one in particular about why you like it and invest it only because it might not maybe fit the same kind of items you've outlined in terms of straight senior control, which we've all come to appreciate.

Robert Kipp DeVeer

No, I mean it's the portfolio company that we've known for a long time. It's also one that the market knows well, so I mean I'd tell you that we tried to do the entire thing and it didn't work out that way. I think 3 or 4 other people felt the same way. I can't speak to the merit of the credit, and I think at the end of the day, the sponsor chose to have a group of relationships. You just have to take away -- there are a bunch of private equity firms that only do 1 deal or 2 a year, right? And you can expect that they have 5 or 10 people calling on them for opportunities. So where there's a good credit and they have room for a handful of different folks, they'll often make it. I think Pelican was one of those situations.

Operator

And the last question today will come from Casey Alexander of Gilford Securities.

Casey J. Alexander - Gilford Securities Incorporated

Just trying to get a sense of what you're seeing in the decisions that your investment committee is making. I'm kind of curious about the deals that you're turning down. Are you turning down more deals because of credit? Or are you turning down more deals that are good credit, but you're turning them down because of rate that you're being offered?

Robert Kipp DeVeer

Yes, I mean, it's always some of both. I don't have the numbers in front of me, but we're happy to pull them off and follow up on the details. I mean typically, first and foremost, we're looking at companies in terms of business risks, so it's do you like the credit or not. We're seeing a mix of good and bad, but the easy first turndown is just we don't love the company. But certainly, beyond that, there are plenty of deals getting done in this market that are too aggressive for us, and that can mean the leverage is too high, that can mean the loan documentation doesn't work with our standards. Very often, we pass and/or lose deals because we won't revert to a covenant light structure. So it's really all of the above. But I mean, first things first, I think we've emphasized this over the last year or so, and did it 7 or 8 years ago, we think that if the market does turn at all, really the most important thing is that you've picked the right credits. And we do always say that the one thing that we can do the most wrong in our business is simply put -- pick the wrong companies. They're the ones that turn into meaningful problems. If you're a little bit high on leverage or you're a little bit thin on spread, that's not going to kill you at the end of the day. It's when you pick bad companies to invest in when you'll get into trouble. So that's how you get [indiscernible].

Casey J. Alexander - Gilford Securities Incorporated

Then is it fair to assume in the post quarter activity that because the spread is a little upside down in the post quarter activity, which you said we'll see somewhat corrective later on in the quarter, was that because of the opportunities that you were able to close in the first month were people that you knew very, very well, and so you were willing to go down in terms of rate?

Michael J. Arougheti

It's Mike. I just want to take a step back before Kipp gives you a little bit of detail, and just maybe try to reframe the discussion, because the conversation around spread tightening has come up multiple times on this call. I scratch my head a little bit, because as Kipp mentioned in his prepared remarks, we're still generating 10% to 11% ROEs on senior secured loans at 50% loan-to-value, with very strong credit performance and very high free cash flow coverage. So I think you have to put our asset classes in our business in the context of all other investment yield opportunities available to people in this market, whether you're looking at MLPs or yieldcos or REITs, we're pretty happy that we're able to generate 8%, 9% current yields with fees and call protection with a very high selective portfolio. So while we appreciate that nobody likes to go through 2 years of spread compression, I think we all need to just take a step back and understand that when you look at the risk-adjusted returns available in almost every other yield-bearing asset class in the market, I think our asset classes really do stand out in terms of the attractiveness of the value proposition.

Casey J. Alexander - Gilford Securities Incorporated

Well, I don't think anyone is arguing with you on that point, but I also don't think that people are examining Ares within a vacuum. That spread compression has been a reality, not just for Ares, but across the other BDCs in the space, and I think that's why you're seeing this level of scrutiny, particularly on the structure of the post quarter activity.

Michael J. Arougheti

There's no doubt. I think, as Kipp mentioned, the early quarter activity is probably not indicative of the full quarter activity. The key is, and we think we demonstrated this in 2006 and 2007, folks won't have a perfect sense for the risk-adjusted return in our business or others until we get through a credit cycle. This is absolutely a market where you need to protect your best credits. You need to be a stock picker and invest in the best companies that you see. You have to have a willingness to accept the market reality and take slightly lower return for what you think are the highest quality credits in the market at any point in time. And I'm pretty confident that that's what we're doing.

Robert Kipp DeVeer

And I took the chance just to add some details just looking at our kind of weekly summaries here. But this is a number that we disclose every quarter, it just so happens that it's, I guess, lower than people might like for 30 days. But the company did almost 100 deals last year. We have 202 portfolio of companies along with the other 50 that we have in SSLP, and I think that number really is grounded in like 3 or 4 names. So I would just tell you it's sort of the number that we do disclose, but is not really material, frankly, that we're focusing on today.

Operator

And at this time, I would like to turn the conference back over to management for final remarks.

Robert Kipp DeVeer

We didn't have anything further. Thanks, everyone, for your time. Enjoy the afternoon.

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 August 18, 2014 to domestic callers by dialing 1 (877) 344-7529 and to international callers by dialing plus 1 (412) 317-0088. For all the replays, please reference conference number 10048348. An archived replay will also be available on a webcast link located on the homepage of the investor resources section of our website.

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