Ares Management (ARES) Q2 2016 Results - Earnings Call Transcript

| About: Ares Management, (ARES)

Ares Management LP (NYSE:ARES)

Q2 2016 Earnings Conference Call

August 09, 2016 12:00 PM ET

Executives

Carl Drake - IR

Michael Arougheti - President

Mike McFerran - CFO

Bennett Rosethan - Co-Head, Private Equity Group

Greg Margolies - Co-Head, Credit Group

Analysts

Craig Sigenthaler - Credit Suisse

Michael Carrier - Bank of America/Merrill Lynch

Ken Worthington - JPMorgan

Chris Harris - Wells Fargo Securities

Michael Cyprys - Morgan Stanley

Ann Dai - KBW

Doug Mewhirter - SunTrust

Patrick Davitt - Autonomous

Eric Burke - RBC Capital Markets

Operator

Welcome to Ares Management L.P.'s Second Quarter Earnings Conference Call. At this time all participants are in a listen-only mode. As a reminder, this conference call is being recorded on Tuesday, August 09, 2016.

I will now turn the call over to Carl Drake, Head of Ares Management Public Investor Relations.

Carl Drake

Good afternoon and thank you for joining us today for our second quarter conference call. I'm joined today by Michael Arougheti, our President; and Michael McFerran, our Chief Financial Officer. In addition, Bennett Rosethan Co-Head of our Private Equity Group and Greg Margolies Co-Head of our Credit Group will also be available for questions.

Before we begin, I want to remind you that comments made during the course of this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in our SEC filings.

We assume no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results. Moreover, please note that the performance of and investment in our funds is discrete from the performance of and investment in Ares Management L.P.

During this conference call, we will refer to certain non-GAAP financial measures such as economic net income, fee related earnings, performance-related earnings and distributable earnings. We use these as measures of operating performance not as measures of liquidity. These measures should not be considered in isolation from, or as a substitute for, measures prepared in accordance with Generally Accepted Accounting Principles. These measures may not be comparable to like-titled measures used by other companies.

In addition, please note that our management fees include ARCC Part I fees. Please refer to our earnings release and Form 10-Q that we filed this morning for definitions and reconciliations of these measures to the most directly comparable GAAP measures. Our second quarter earnings presentation has also been filed with the SEC and is available under the Investor Resources section of our Web site at aresmgmt.com and can be used as a reference for today's call.

I would like to remind you that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase an interest in any securities of Ares or any other person, including any interest in any fund.

Before I turn the call over to Michael Arougheti, I will provide a quick recap of our second quarter earnings. We reported GAAP net income of $0.46 per unit and economic net income after tax per unit of $0.44. Our after tax distributable earnings for common unit were $0.31 and we declared a distribution of $0.28 for common unit holders of record on August 23th and payable on September 6th. With respect to our retail issued preferred units, we also declared a distribution of $0.54 per series A preferred unit and set this up for payment on September 30th for record holders on September 15.

I'll now turn the call over to Michael.

Michael Arougheti

Great, thanks Carl, good afternoon everyone. Against the backdrop of sluggish economic growth and market volatility the equity and tradable credit markets rallied in the second quarter sending equity market indices to new highs and driving strong returns in liquid non-investment grade credit assets. Many markets seemingly have shrugged both Brexit and extraordinarily global interest rates as investors gain support from continued central bank accommodation. The US markets are increasingly being viewed as a safe haven for global capital in search of higher returns as our economy with low growth and low interest rates offers better risk reward compared to low growth and low rates in many foreign markets.

These capital flows into the U.S. market continue to bid up risk assets some of which were at depressed levels as recently as the beginning of the year. But despite the volatility that followed Brexit at the end of the quarter the financial impact on our portfolio values and earnings for the second quarter was very limited. Approximately 4.7% of our total AUM is invested in companies or properties in the UK with about two thirds of these assets in our EU direct lending strategy, where we have invested in first lien senior secured corporate loans and what we believe are conservative loans to value.

In addition only about 2.5% of our funds are denominated in British sterling and our funds continue to be well hedged against currency fluctuations. While it's too early to determine longer term impact of Brexit we do have significant dry powder dedicated to European investing in order to take advantage of potential opportunities. We also have a strong investment footprint across European credit and real estate and we believe that the challenges facing European banks should only continue to serve as attractive primary and secondary market opportunities for us.

From our vantage point volatile markets play into our strengths as a long term opportunistic investor with locked up flexible capital. Given our very patient and value added approach to investing we're in a better position to make opportunistic investments during times of volatility and as the second quarter highlights control outcomes by exiting positions during more advantageous trades in the market.

Our significant self origination capabilities become even more valuable and important in these types of markets. Not only do volatile markets provide investment opportunities for us but they also help us promote the attractiveness of our alternative assets and our unique approach to our investors. Today investors have fewer investment choices that meet the return threshold amidst negative or low yielding fixed income assets and elevated public equity valuations. Our asset platform with higher and less correlated returns offers a very attractive alternative.

We continue to see this play out during the second quarter and throughout the last year as investors committed sizeable amounts of new capital to us. To that specific point we raised $4.4 billion during the second quarter bring our total gross fund raising over the last 12 months to approximately 24.7 billion. During the second quarter we announced the final closing of Ares Capital Europe Three our third comingled European direct lending fund which reached it’s hard cap of €2.5 billion in equity commitments.

One year after its launch this fund was oversubscribed with roughly equal participation from new and existing investors. This fund raise supports our long view that the supply demand imbalance in the European middle market continues to be attractive, a scale that non-bank capital providers gain market share from the banking sector.

Of the $4.4 billion raised during the second quarter 1.1 billion is attributable to ACE Three. Also in credit we raised more than $1.4 billion in new and add on funds in our high yield and structured credit strategies and we also added $400 million in additional commitments to a U.S. direct lending mandate. We continue to see significant interest in large strategic mandates across a number of our credit strategies.

Capitalizing on our strength in the CLO sector we priced a new $510 million CLO in our U.S. syndicated loan strategy. As discussed in our last call we also initiated a new public equity income strategy investing in higher dividend yielding public equities where Ares has specific domain expertise. During the second quarter we closed a new $300 million fund in this strategy. We also added $400 million to our U.S. and European real estate PE funds including a final closing for our U.S. development and re-development fund 2 which brought the total raise across our U.S. opportunistic real estate equity strategy over the past year to over $900 million.

We're also closing at other successor funds and we're in the early stages of marketing new credit strategies that take advantage of the broad capabilities across our integrated global credit platform. Across our firm we continue to have success expanding the investment solutions that we offer to our client base. Existing investors consistently access multiple products in our platform. During the last quarter and the last 12 months more than 80% of our direct institutional capital was actually raised from existing investors. And importantly over 42% of our investors are now invested in more than one fund with us up from 23% five years ago. As a result of all these fund raising efforts we now have more than $24 billion of dry powder of which 17.7 billion is eligible for but not yet earning management fees. And Mike McFerran will discuss the implications of this in more detail shortly.

Turning then to our investing activities, our investment teams are working hard to unlock value in a market with very low interest rates strong capital flows and generally elevated asset pricing. That said we continue to find interesting relative value opportunities during the second quarter with increased deployment in our drawdown funds compared to the same period a year ago. We deployed $4.4 billion compared to $4.1 billion for the same period last year of which 2.4 billion was deployed from our drawdown fund in the second quarter versus 1.6 billion in the second quarter of 2015.

The increased deployment was highly diversified across investments but driven primarily by our European and U.S. direct lending funds and by our U.S. and European real estate equity fund focused on value added and opportunistic investing. As I mentioned across all strategies competition is up but transaction activity is also improved allowing us to be highly selective and highly disciplined and again our broad origination capability has allowed us to source attractive opportunities in all market environments.

We generated significantly higher second quarter earnings as our funds experienced strong market appreciation particularly in corporate private equity in the U.S. and in corporate credit. In addition a number of exits across our three investment groups allowed us to generate a record amount of DE and distributions to unit holders for the second quarter. We experienced partial realizations and information technology staffing company and healthcare staffing company in our corporate private equity funds called the legacy CLO with embedded incentive fees and had multiple monetizations in our U.S. value add real estate equity strategy.

Despite the volatility in the quarter our fund performance is strong. In the aggregate our corporate private equity funds generated a quarterly NAV return of 5.8% led by our quarterly net return in ACOF IV of approximately 9%. Our loan and high yield funds generated composite gross quarterly returns of 1.7% and 3.1% and while these quarterly returns lagged our benchmarks which were up 2.9% and 5.9% as our commodity and to a lower extent energy under weights didn't allow us to fully participate in the rally. We continue to outperform our benchmarks over the past 12 months.

In our direct lending strategy our BDC, Ares Capital Corporation generated a 3% quarterly net asset value return including dividends and in our European strategy ACE II generated a quarterly net return of 1.4%. In real estate U.S. VII generated a quarterly net return of approximately 3.8% and our European fund EU IV gained 1.4% in net asset value for the second quarter.

So in summary we continue to perform well for our investors and this is validated by the expansion of our LP base and the increased allocation of capital from our existing investors. So as we sit here today I believe that we're well positioned to grow our fees and our earning, over the past 12 months we've raised a record amount of gross capital and we expect to invest this capital over time to deliver meaningful returns to our investors and to deliver growth in management and incentive fees to our public unit holders. Using the breadth of our platform, our deal sourcing and diligence capabilities are translating into strong investment performance, solid deployment and nice monetizations and now I'd like to turn the call over to Mike McFerran to give you his perspective on our financial results. Mike?

Mike McFerran

Thanks Mike. As Mike stated we are pleased with our results as we generate meaningful quarterly and year over year growth in ENI as well as record distributable earnings as a public company, reflecting strong net portfolio appreciation. While our fee related earnings have continued to be the driver of our distributable earnings over time, it's nice to see our strong performance convert into higher distributable earnings and distributions for our unit holders this quarter. As we articulated in our call in May, as expected our fee related earnings held flat quarter over quarter as we don't expect a meaningful step function increase in our fee related earnings until we experience a lift from the beginning of the investment period for ACOF V or our deployment pace of funds where we are paid on invested capital.

In addition we continue to make growth investments by developing new products where we incur the expense ahead of the associated revenue. When looking at our recent fund raising momentum and our record dry powder and our shadow AUM we believe there's a lot to be excited about as the associated earnings have not yet shown up in our results, now with those comments let me turn to our second quarter financial results.

In summary we hit on more cylinders this past quarter which drove a stronger distribution for our common unit holders of $0.28 per common unit. The distribution will be payable on September 6th to common unit holders of record as of August 23rd.

Let me now walk through some of our key metrics for the quarter. Our AUM increased by about 7.7 billion to approximately 95.3 billion a year over year net increase of approximately 9%. Our total current fee earning AUM increased by approximately 800 million or 1%. The modest increase is primarily due to the wind down of the FS LP within ARCT and runoff in US CLO and does not yet included the 7.6 billion in fee eligible AUM from ACOF V. However, we introduced a new AUM measure this quarter, fee paying AUM which reflects AUM of those funds in which we directly earned management fees.

We introduced this measure as we believe it will be useful in evaluating the periodic changes using the basis of our direct fee paying assets under management. Our fee paying AUM increased by 3.5 billion over the past year or more than 6% reaching 59.1 billion. As Mike stated earlier we have 24.3 billion in available capital at the end of the second quarter of which 17.7 billion is an AUM not yet earning fees which we also refer to as shadow AUM. This 17.7 billion is up 75% in the prior year period. Of that 17.7 billion we consider about 15.7 billion available for future deployments. Our shadow AUM carries an expected management fee rate of approximately 1.2% slightly higher than our current blended management fee rate as our backlog continues to be weighted towards our higher average returning and higher fee generating strategy. Our shadow AUM available for future deployment of 15.7 billion equates to a 186.3 million of incremental future management fees. Note that over 55% of this gross amount suggest ACOF V before the next step down of management fees for ACOF IV, with approximately 25% of this gross amount related to ACE III and our fourth special situation fund.

So once we activate ACOF V over half of our management fees tied to shadow AUM will start being earned. Of course we expect to experience some runoff and step down from fee rates as older funds transition ACOF IV and their investment periods. Assuming ACOF IV is approximately 70% invested, at the time we activate ACOF V the associated step down in fee rates at ACOF IV would reduce the 186.3 million in potential management fees by approximately 43.7 million.

Our incentive eligible AUM increased 29% from the prior year to a record 49.4 billion of which 14.7 billion is incentive generating and another 19.1 billion is to be invested. Of the 15.7 billion not generating incentive fees approximately 10.1 billion is within 1% of reaching with respect to fertile rate. Of the 10.1 billion 8.7 billion is represented by ARCC's investment portfolio where we are eligible for part 2 net capital gain fees, which have not had material impact on performance related earnings.

As stated earlier our second quarter fee related earnings of 39.6 million were up very modestly compared to the first quarter as we continue to scale our distribution capabilities, infrastructure and invest in new product development, going forward we continue to expect our FRE and FRE margins to move in a step function with a relatively flat to modestly improving trend until ACOF V begins its investment period.

During the second quarter we saw a rebound in our performance related earnings which increased a 113% versus the second quarter of 2015 and reverse losses versus the first quarter of 2016 primarily driven by appreciation in our corporate private equity funds. Our balance sheet of approximately 637 million in diversified investments provided higher second quarter net investment income for us as well. Our second quarter distributable earnings were 70.8 million which translated into DE per common unit of $0.31 compared to $73 million a year ago or $0.28 per common unit.

Despite the realized net performance fees of 30.6 million our net accrued performance fees increased by about 16.2 million to a 151.4 million driven by portfolio appreciation. While it is still early we currently expect additional realizations to aid our distributable earnings in the third quarter with the announced sale of a substantial portion of our investments and oil and gas E&P portfolio company in the Permian Basin and the pending sale of one of our industrial portfolio companies. Of course we can't provide any guarantee on the closing of this transaction.

We expect that activating management fees for ACOF V net of the assumed step down of ACOF IV I spoke about earlier will generate approximately 60 million of net growth in management fees, which will translate into approximately $0.06 per quarter of after-tax distributable earnings per unit as of June 30th. While the investment environment and our corresponding deployment will dictate when the investment period and -- starts and when active across five. We are currently targeting the end of the fourth quarter of this year from a timing perspective. Let me now address our financial support for externally managed business development company ARCC and its pending acquisition of America Capital. In May, ARCC announced a merger agreement to acquire American Capital for aggregate cash and stock consideration of 3.43 billion. To support this transaction, we agreed to provide 275 million of cash to American Capital shareholders to be paid at closing and weigh up to a 100 million in ARCC Part-1 fees for 10 counter quarters beginning the first full quarter after closing.

To finance our support, we issued 12.4 million Series-A preferred units in June for a total offering price of 310 million. The units are entitled to a 7% dividend payable beginning of September 30th of this year. We believe the transaction will enhance ARES management’s already leading position in direct lending. Additionally, since the transaction is expected to result in an increase in ARCC’s growth assets of approximately 3 billion. Increasing management fees and potential Part-1 fees on the acquired assets, we expect the transaction will be accretive to earnings and beneficial to our unit holders.

Now, I will turn the call back to Mike for closing comments.

Michael Arougheti

Great. Thanks Mike. I know we just covered a lot in a lot of detail. So let me just try to distill things down to a few simple closing thoughts before we take your questions.

First with persistently low interest rates and volatile global equity markets, our flexible alternative assets capabilities provide a compelling value proposition to institutional and retail investor. Our investment performance continues to be strong across the platform in our existing clients and new investors are validating our performance by committing new capital to us in both existing and new strategies and across multiple products.

We’re expanding our platform by introducing new or adjacent products where we can leverage our existing expertise and track records. We have a record level of dry powder and shadow AUM which is very long dated and which we expect will drive FRE growth and FRE margins overtime. As Mike highlighted we believe that the combination of our shadow AUM deployment including ACOF V and the expected accretion from the ACAS transaction will paralyze earnings growth for the next year and into subsequent periods.

We also have a record level of incentive eligible AUM providing upside potential for growth in future performance fees and most importantly everyday we’re leveraging the power of our platform across all of our activities in our investment and operational teams in order to execute for fund investors and our unit holders.

So with that, I just wanted to thank our team for their continued hard work in these ever changing markets and thanks to everyone on the phone for their time today and for our investors for their continued support. And operator with that, we’ll open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Craig Sigenthaler at Credit Suisse.

Craig Sigenthaler

Thanks, good morning.

Michael Arougheti

Good morning.

Craig Sigenthaler

First, just on the $11 billion of private equity dry powder and I know this is mostly ACOF V, but can you just comment on your ability to invest today given current public equity evaluations are getting even more stretched here. And ACOF V hasn’t started its investment period yet. I just could was wondering if you could remind us when we should expect that and also how long is the investment period with this front.

Michael Arougheti

Great. Craig, we’re going to hand it over to Bennett Rosenthal who is here with us just to talk through it specifically.

Bennett Rosenthal

Yeah, so we will start our investment in ACOF V as soon as we’re finished with ACOF IV. We would expect that we be done and dusting ACOF IV or at least and ready to invest ACOF V, we’re targeting in the end of the fourth quarter, although we can’t give any assurances obviously with the public equity markets and the private equity markets at very high multiples. We are being cautious in this environment, we are seeing some opportunities to rescue capital as well as growth equity investments on our platform that give us confidence will get to that, we’ll be able to keep that calendar but you’re right the markets are very pricey right at the moment. So we are targeting end of the fourth quarter.

Michael Arougheti

One thing I’d add Craig just specific because we’ve talked about on prior calls, the private equity strategy here we think is quite unique, has been a mention with the ability to do both growth equity investing and rescue or distress control transaction which we think smooths out both deployment and harvesting relative to more traditional LBO only oriented by out firms. I think a good example of our ability to be creative and flexible in this type of market is our recently announced Clayton Williams transaction which is in the public domain.

Bennett Rosenthal

Right. So we just add to what Mike’s saying we funded in March a rescue capital loan to give the company some breathing room and just recently as you may have seen we announced an equity investment in the Clayton Williams.

Craig Sigenthaler

Got it, very helpful. And then I heard the aggregate number in your prepared remarks for ACOF IV in terms of the CN but can you remind us what the management fee of ACOF IV is where its going to step down two and then also what is the fee rate or the management fee rate on ACOF V?

Michael Arougheti

Sure. So ACOF IV on a blended basis is currently running at 1.4% average fee rate and I believe once we turn on ACOF V that’s down to a 0.75. So from 1.4 to 1.75.

Craig Sigenthaler

And then ACOF V?

Mike McFerran

ACOF V is about similar and the investment period is 6 years. I think that was one of the questions you asked in your first round of questions. So a 6 year commitment period from the time we return on the fund.

Craig Sigenthaler

Perfect. Thanks for taking all my questions.

Michael Arougheti

Thanks.

Operator

Next question is from Michael Carrier from Bank of America/Merrill Lynch.

Michael Carrier

Thanks guys. Just a question on the incentive income in the quarter, Mike you mentioned some of the performance and I think the cross strategies it’s pretty variable in the quarter, just wanted to get some color because ACOF IV went back and if there was any acceleration that maybe benefitting in incentive income during the quarter.

Michael Arougheti

I think you highlighted the good thing about performance across the quarter was in each of our businesses, the good and the bad news about the environment we’re in is valuations are up which is helping not only our realizations actual but also the unrealized valuation around portfolios and that’s true in our U.S. and European businesses across private equity credit and real estate. As we mentioned in the prepared remarks, the benefit of that backdrop is persisting into the third quarter as we continue to have both realized investment performance coming through our PE portfolios and also a favorable valuation backdrop.

Michael Carrier

Okay. And then just to be clear, just on ACOF IV, like was there any acceleration you know unlike the performance fees.

Michael Arougheti

Yeah, I mean as far as acceleration we recall, last quarter we said ACOF IV’s IRR dropped slightly below the hurdle rates which took it out of carry. This quarter was a point in depreciation, it did cross back into it so there is a GP catch-up element to that which will benefit performance fees this question quarter.

Michael Carrier

Okay, alright. Got it. And then just on the realization outlook, I know you mentioned think 2 things that are pending in the third quarter and I know until its completed its tough to give the information. But just wanted to see if you had any color on what the equity investments are and what the multiple invested capitals, just give some sense on the outlook for the realization activity and then obviously the distribution in addition to FRE because FRE we have a pretty good eye on?

Michael Arougheti

You know for Q3, I think we mentioned in the prepared remarks, we do have visibility on a few realizations, recognizing with just a little over a month into the quarter. There are still ways to go, so we didn’t want to give any more specifics at this point. On the specific of those portfolio company investments, we usually give out those details but again you can top the remarks, we believe that there will be realization activities that should be additive to the distribution of FRE for Q3. But how much, it’s just short of this.

Michael Carrier

Okay. Thanks a lot.

Michael Arougheti

Okay.

Operator

Our next question is from Ken Worthington with JPMorgan.

Ken Worthington

Hi, good afternoon. I wanted to get a little more details on the performance in the various asset classes, you gave us some details already, but it looks like ACOF IV having such a good quarter as you mentioned, maybe what went so well there? It seems like the IRR has really picked up, and then on the other side you mentioned some real estate, it looks like to me, maybe I got it completely wrong but real estate’s team has struggled a little bit in the quarter. So, if so what happened there and then lastly on credit, you mentioned that the lower energy exposure didn’t help you this quarter. Is that what maybe weighted on performance or was there something else on the credit side?

Michael Arougheti

Why don’t we handle each of separately, Bennett can talk a little about PE, Greg and I can churn in on credit and then I’ll give you a little bit of color of real estate if that’s helpful.

Ken Worthington

Yes.

Bennett Rosenthal

In PE was pretty broad based with most of the portfolio seeing evaluation, appreciation. There was some particular value increases in our, in both our energy and our healthcare investments but I’d say it was pretty broad based across the portfolio.

Ken Worthington

Great.

Michael Arougheti

And with regard to the specific question on being underweight energy and commodities that did primarily impact performance in our loan funds given the positioning of those funds which again if we’re going to get penalized for performance, we’d always like it to be when we’re being on the conservative side in a volatile market than being on the other side of that but maybe generally Greg on the credit broadening.

Greg Margolies

Would agree, our performance in the first quarter was predominantly driven by being a little more conservative and being underweight the commodities will NP and metals and mining. That’s certainly been the most aggressive priced sector in the second quarter being up substantially off the layers and we were more conservative both in terms of being underweight in those commodity driven sectors as well as being little higher up in the credit rating spectrum, being a little more conservative in the risk taking throughout the portfolios and that has worked against us a little it in terms of the extreme risk bound nature of the market today. We continue to position ourselves to be looking for the best credits out in the marketplace, also some event driven credits where we believe we are quickly being into our market for creating alpha and the underweighting a little bit of the data risk in a more specially on the commodity side.

Greg Margolies

Okay, great. And lastly on real estate?

Michael Arougheti

Yeah, real estate I don’t know what you are referring to as you look at our real estate funds, generally the valuation environment for real estate was constructive. If you look at some of our European funds in particular EU-3 in some of our older vintage funds, they were slightly down. But across the board, performance for the quarter in terms of depreciation and net value was generally up in kind of the low single digits.

Greg Margolies

Okay, great. Thank you very much.

Operator

The next question is from Chris Harris at Wells Fargo.

Chris Harris

Thanks, hi guys. So you do a good job here in the presentation laying our Shadow AUM, laying our things that might be coming in terms of perhaps generating AUM and just growth in AUM in general. But one thing is a little less clear is what could potentially be rolling-off and I know in private equity we sort of have somewhat of a line of sight but I think credit is a little bit harder for us to kind of get our arms around. So maybe wondering if you guys could share some thoughts about we should we thinking about sort of that offset to the potential significant increase in AUM, you guys are on boarding here?

Mike McFerran

You know one thing as we look at our AUM and it’s a key reason why we introduced a new metric this quarter, the prepaid AUM, it is included in both AUM and the fee earning AUM are the commitments related to the SSLP program for ARCC and while that’s in AUM and fee earning AUM, as you know it does not directly translate in the management fees in this management. So we’ve seen one-off of that and we expect that, that will continue with that program continues to amortize down. But that’s been a bit of what I would call a headline offset to the capital we’ve been raising that after fee generating. In the credit world, we do have amortization of CLOs passed the reinvestment period, however as we continue to issue new CLOs the majority of that capital is still in reinvestment. You think that’s been modest for the foreseeable future. One other thing I just did want to highlight just to clarify the point on around ACOF is I know we were talking about the impact of ACOF IV versus ACOF V. ACOF IV is the rate of 1.5% on 4.5 billion of prepaying commitments and it does step down by half or to 75 basis points on invested capital when ACOF V turns on.

Michael Arougheti

One other thing I’d highlight again it’s difficult to know because some of the run-off just comes from redemptions not of investor capital but actual realizations. I think when we talk about the trend lines it’s important to see that in our global credit business where we are raising commingled funds, the trend has very much been to raise meaningfully larger funds from the predecessor funds. So S3 being a good example of a $2.5 billion on the hills of a billion euro fund or- for being a 1.5 billion special situations fund on top of a $750 million fund three. So the net AUM growth in trend is being supported by our success in raising significantly larger successor funds in our commingled strategies and then as I highlighted in our prepared remarks, a lot of the fund raising momentum that we’re seeing in global credit are what we will would strategic managed accounts from larger institutional LPs were looking to get broad access to the diversified way across the global credit platform.

Chris Harris

Thank you, that’s helpful. And a quick one on ACOF IV, how far above the hurdle rate are you guys now with that fund?

Mike McFerran

Just a quick look at where the IRR is. We are at, IRR is running just over 9.5% against an 8% hurdle.

Chris Harris

Thank you.

Operator

The next question is from Michael Cyprys at Morgan Stanley.

Michael Cyprys

Hi good afternoon.

Michael Arougheti

Hi.

Michael Cyprys

Just wanted to follow-up on your common earlier in competition, you mentioned that you’re seeing some increased competition, I wonder if you can elaborate a bit on that just in terms of which product areas or geographic regions that you’re seeing more competition and then also are you seeing any sort of irrational behavior in any sense, any early sense on that.

Michael Arougheti

Sure. When we talk about competition maybe a better choice of words would have just in flows and or liquidity and hopefully not lost on people given all of Central Bank accommodation that we’re seeing around the globe. There is a significant amount of liquidity that is finding its way into the market with large. So in each of our businesses, we are seeing incremental capital coming in. When you see that, I think the more important questions is the capital coming into a capacity constraint market. Is it effecting the return opportunity to your point, are we seeing irrational behavior and I think most importantly do we areas have competitive advantages in those markets to defend against some of the more fluid capital that comes into the market. And I think the good news is whether you’re talking about private equity, credit or real estate.

We believe that’s through the nature of the capital that we’ve raised through the size of our origination networks that we’ve built through the amount of dry powder that we have through the research and information advantages that we’ve created that even in markets where we’re seeing increase your heightened liquidity. We’re still able to find what we believe are very attractive risk adjusted returns and we talked about that in the prepared remarks in the context of the deployment.

In terms of irrationality, I think rational investment behavior is always in the eyes of the beholder. I think generally I wouldn’t call it irrationational because give the global rate environment and given the access to capital. I would actually say that the behavior is quite rational. But as Bennett mentioned and as Greg mentioned valuations were elevated, spreads have tightened and that's just the reality of the market that we're operating in but I don't consider that to be irrational because I think that capital flows tend to be agnostic and it's our job as an alternative manager to do the best we can to drive relative value in those markets when we see the capital coming in and out.

Michael Cyprys

Okay, thanks that's helpful, and just a follow up on your outlook for realization activity just curious how you think about this quarter's results on realization in the context of I suppose what you've done historically and where you see the firm going forward. Is the second quarter realization activity in operation, I know you mentioned third quarter, you have some activity stepping up and then just how you're thinking about that say over the next 12 months and what sort of market environment do you need for this level of activity that we've seen in the second quarter to continue.

Michael Arougheti

Sure, let me just contextualize it because we talk about it a lot but not necessarily in the context of this quarter's earnings. I think it's important for people to appreciate that our business model is different than some of our more PE or distress centric peers, public and private and the business model that we've tried to articulate and execute well against is rooted in a lot of fund diversity and a very significant percentage of our distributable earnings coming in the form of fee related earnings and predictable management fees. So quarter to quarter while naturally you're going to see some volatility, inconsistency in the amount of distributions and realizations I think it's important that even in a quarter like the one we're in now with 55% of our distributable earnings coming from FRE that's down from a historical average this number between 70 and 75%.

So even in a quarter like the one we're in now where we're seeing a significant percentage of DE from FRE we're still through the high end of the peer range for that metric and so we're as focused as ever on sustainability and stability of our earnings as we are on realizations. With regard to the realizations even though they do represent a fairly small percentage of our earnings, the realization environment's very constructive and favorable. You know Q2 was a great quarter as we mentioned, early days but we're continuing to see a favorable environment to exit positions into the third quarter and all else being equal I would expect that to continue through the end of the year.

Michael Cyprys

Great, thank you.

Operator

The next question comes from Ann Dai at KBW.

Ann Dai

Hi good morning, thanks for taking my question, I'm filling in for Rob Lee, first question Mike just earlier you spoke about being in early stages of marketing some new credit strategies, could you elaborate on some of those.

Michael Arougheti

Sure, as you know we don't talk about specific funds in the marketing phase but I'll give a general sense for the types of strategies where we're seeing significant investor demand but also significant market opportunity. First is what I just referred to as diversified credit, appreciating the comments earlier about low interest rates and correlated asset classes we are seeing a significant amount of global appetite in the form of either comingled funds or strategic managed accounts that have the ability to dynamically allocate across the entirety of our global credit franchise, so if you go back ten years the products and solutions that were on offer to a typical institutional investor would be a direct lending fund or a high yield managed account, there's been a significant amount of development of new product that's just much more dynamic in the way that the capital's getting allocated and I see that as a meaningful trend in credit.

The second is building off of our global direct lending franchise, we see a big opportunity at the upper end of the middle market to provide larger underwritten solutions and also what I would call middle of the balance sheet capital solutions in the form of mezzanine and second lien. What's accelerating that opportunity for us is as we talked about on prior calls there's a longer term trend in direct lending for assets to leave the banking, the banking system and find their way into the alternative credit system, what we're seeing now is many of the banks either did a regulatory or just economic reasons are actually reducing the investments that they've made in the distribution of certain products in the leverage finance market and so the opportunity to either underwrite and distribute loans is a big growth area for us and also as a buyer of those loans as the banks look to continue to derisk and get more certainty of execution so I think you'll see us rolling out funds that are going after the frenetic trend as well.

Ann Dai

Appreciate the color. You know also a question just on ARTC buying ACAS, I don’t know how much you can say about it, but just in terms of what you've been saying since the 10th auction was announced. Are you guys still expecting some accretion in early years even including the fee waiver?

Michael Arougheti

Yes, so Ann unfortunately we're in the early days of a proxy solicitation process so we really can’t comment other than what we've already said, and if you back and look at the already made public commentary was what we said today. Yes we do believe that the transaction will be accretive to both areas management and Ares Capital Corporation.

Ann Dai

Thank you.

Operator

Next question is from Doug Mewhirter at SunTrust.

Doug Mewhirter

Hi, good afternoon, good morning. Two questions, first I notice you're, actually your expense actually were flat to down sequentially, was there some seasonality in there or is it just sort of your sort of leveling of the big build up you had in expenses over the past couple of quarters.

Michael Arougheti

Yes, there's no real seasonality I mean there's some timing when we make investments potentially around some new launches. But overall I think we said a couple of quarters ago that we had, we were aiming to keep expenses in the 29 to under $30 million range quarterly and to the extent we could better than that we're pleased with the discipline in doing so and I think this quarter is reflective of that.

Doug Mewhirter

Okay, thanks for that, and the second question is actually I think to Ken Worthington's question about real estate. I think what he might have seen and what I saw too and I'm curious to hear the answer, on real estate the net investment income for your balance sheet, on balance sheet investments from real estate was actually negative in the quarter which seemed to belie the nice trends you've been seeing in real estate in general, I just didn't know there is one particular fund or one particular investment that.

Michael Arougheti

That's actually, that's a quirky line item, when we made the acquisition of Area Property Partners years ago we had two things that we inherited, one was a real estate joint venture in India and the other was actually a, an entity that housed historical promotes within those real estate funds. We have deemphasized our activities in the Indian joint venture and as we've actually had positive realization activity as reflected in the funds themselves, the income coming off of that carried interest vehicle has reduced.

Doug Mewhirter

Okay, that makes sense, and all my questions.

Operator

The next question comes from Patrick Davitt of Autonomous.

Patrick Davitt

Hi, thanks for taking the question, you mentioned you know a lot of the opportunity being around this intermediation and the leverage lending world, obviously there's been a lot of chatter about players like yourself increasingly filling it would left by banking institution. Are you seeing that trickle into any change in regulatory scrutiny on your business and what you're doing or is it still kind of a status quo and always kind of heavily [indiscernible].

Michael Arougheti

No, we've actually seen no evidence of that, I think it's still the status quo and again when you think about that trend we're not supplanting the banks I think we're actually just supplementing their capabilities but when you look at the amount of capital in the banking system versus outside of it I think we're a long way away from a conversation about our markets, we haven't seen anything to that effect.

Patrick Davitt

And then just a follow up on your prepared remarks, the 4.7% of UK exposure is that totally AUM or in ground AUM.

Michael Arougheti

That's total.

Patrick Davitt

Total AUM, okay, thank you.

Operator

The next question is from Eric Burke at RBC Capital Markets.

Eric Burke

Thanks, Mike, do you consider, with respect to the, taking a step back and thinking about sort of the macro environment which you've discussed, let's call it record low level of interest rates and the record level of the stock market. Both of these factors seem to me cut both ways for you for reasons that should be apparent to our earnest seller, so with the stock market as high as it is, you're paying more for properties than would otherwise be the case but you're selling for more than what otherwise be the case and similarly it seems to me on the interest rate side, the low interest rates result in I would think higher values on deployment higher cost of acquisitions but also reduce your cost of debt financing. My question, on a net basis if an outsider were to ask you which I'd like to do now, on balance do these low, extremely low interest rates or high equity values favor you, hurt you, or is it a neutral, what would you answer to that question.

Michael Arougheti

So, I would say it would be generally neutral, but I think higher rates should be a net positive for the platform, so I'm glad you brought up the question because as I highlighted earlier, I think the value in the platform resides in some of those competitive advantages I talked about earlier in origination and deployment, but part of the other value proposition that I articulated is the fund diversity and the ability to make money in any kind of market environment and that's a function that the long lived locked up nature of our capital, it’s a function of how we structure our funds with flexible investments mandates. So generally and this may be hard to fully appreciate if you're not in the alternative asset management business I think good alternative asset management firms feel that they have funds and strategies that generally can perform across market environments. And this environment is no different, when you're in market environments like the one we're in now, you have to be laser focused I mentioned on risk adjusted return and relative value which we are, reason I said generally interest rates going up, I think would be a welcome change here. If you look at the character of the investments in many of our underlying funds the preponderance of our credit assets or floating rate short of assets that should benefit from rising interest rates.

Number 2, where we have used leverage, we have typically match funded or created a favorable mismatch and asset sensitivity from where that were leveraging some of these funds. And three, generally speaking, when rates are going up and if they are going up for the right reason it's constructive for credit as an indication that fundamentals are actually improving and constructive. So I think the good news is the business is performing extremely well in this environment and I don’t think that people are worked up about nature of the opportunity now. But on balance I think raising rates will probably benefit the platform modestly.

Patrick Davitt

Thank you.

Operator

Our final question comes from Michael Cyprys at Morgan Stanley.

Michael Cyprys

Just had a question on CLOs, obviously it's a growing business for you. I was just curious if you can talk a little bit about the upcoming risk retention rules that will be going into effective, how you see that impacting your business I guess there is some opportunity perspective. But then also how much I guess incremental capital do you see yourself needing and how you kind of plan to fund that?

Greg Margolies

Sure, this is Greg I’ll take the first -- certainly first half of the question. There's been a significant alteration in the landscape of CLO managers given the risk retention rules that have been implemented in the U.S. is running at about a 50% weak relative to last yield. And Europe is also materially changed. We have continued to raise capital in both venues that are risk compliant, risk retention and or structured such that it gives us flexibility to risk retention compliance going forward. We will utilize what we think is acceptable from a regulatory perspective, structures and meet the risk retention rules both in U.S. and in Europe and we are either have in place or surely have in place the necessary set ups to take advantage of all those and we will be issuing in the future continue to issued funds that are risk retention compliant.

I think it helps folks like us to receiving the capital that is required [indiscernible] specification necessary to set up those vehicles benefits the smaller group of larger CLO managers. I think that does benefit us, I also think we will start see [indiscernible] sort of beginning of this year. And we think we'll continue to accelerate consolidation in CLO managers in terms of the smaller folks who just can't raise the capital or have the sophistication to create these vehicles to be risk retention compliant. So yes continuously a consolidation up in terms of number of managers we are looking at all there of course. But I don't think it'll change our ability to access the market to raise CLOs, we are actually more focused just on raising at the right risk adjusted return for our investors and making sure that the arbitrage is correct.

Michael Arougheti

And then one quick follow on comments because CLOs is obviously where we think we will see the bulk of the opportunities get created for us. But risk retention implementation should also have a positive impact on our commercial real estate lending businesses as well as it will change the face of the CMBS market, and I think the net positive for alternative lenders who are coming into a pretty meaningful wall of maturity right now.

Michael Cyprys

And do you see yourself needing more funding in order to take advantage of those opportunities or even to do visiting business that you have a go forward basis?

Michael Arougheti

No, I think we are very well positioned both with balance sheet capital and as Greg mentioned certain third party vehicles that will allow us to continue to go.

Michael Cyprys

Great. Super. Just one last quickie here -- I know there was a recent SEC proposal on incentive compensation for investment advisors and just been some concern out there that CLO managers could be included in the incentive comp restrictions. So I'm just curious how you're thinking about that proposal and to what extend it could pat your business on the CLO side or even outside of that?

Michael Arougheti

Yes, we are watching that, we are not convinced it's going to have meaningful impact to us -- still early days, but if I had to pick a side I would actually say that I don’t think that that’s going to have an effect on our business.

Michael Cyprys

Great thank you very much.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Arougheti for closing remarks.

Michael Arougheti

Great, we don’t have any. Again just wanted to thank everybody for all the time today, really good questions, and we look forward to a conversation next quarter. Thank you.

Operator

Thank you, gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archive replay of this conference will be available through September 07, 2016, by dialing 1-877-344-7529 and the international callers by dialing 1-412-317-0088. For all replays, please reference conference number 10088374. An archived replay will also be available on a webcast link located on the home page of the Investor Resources section of our Web site. Thank you, you may now disconnect.

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