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Executives

Michael Arougheti - President

Rick Davis - CFO

Alison Sternberg - VP of IR

Analysts

Greg Mason - Stifel Nicolaus

Carl Drake - SunTrust Robinson Humphrey

Sanjay Sakhrani - KBW

Daniel Furtado - Jefferies

Vernon Plack - BB&T Capital Markets

Jon Arfstrom - RBC Capital Markets

Greg Mason - Stifel Nicolaus

Elliott Berk - Ironside Partners

Ares Capital Corporation (ARCC) Q4 2007 Earnings Call February 28, 2008 10:00 AM ET

Operator

Good morning ladies and gentlemen and thank you for standing by. Welcome to the Ares Capital Corporation fourth quarter and year-end 2007 Earnings Call.

I would now like to turn the conference over to Ms. Alison Sternberg, Vice President of Investor Relations for Ares Capital Corporation. Ms. Sternberg, please go ahead.

Alison Sternberg

Thank you operator. Good morning everyone. Welcome to Ares Capital Corporation's fourth quarter and year end 2007 earnings conference call. I hope you have had an opportunity to review our earnings release and annual report on Form 10-K. In addition, we're offering a webcast and slide presentation to accompany our call. Copies of the earnings release, Form 10-K and the slide presentation can be obtained from our website at arescapitalcorp.com, under the Investor Resources tab. The earnings release is located in the Press Release section, the Form 10-K can be found in the SEC filings section and the slide presentation is located in the Stock Information section.

Ares Capital Corporation's fourth quarter and year end 2007 earnings press release, Form 10-K, comments made during the course of this conference call and or accompanying slide presentation contain forward-looking statements within the meaning of Section 21-E of the Securities Exchange Act of 1934 and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends and similar expressions. Ares Capital Corporation's actual results could differ materially from those expressed in the forward-looking statements for any reason, including those listed in our SEC filings. Any such forward-looking statements are made pursuant to available Safe Harbor provisions under applicable securities laws and Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please note that past performance is not a guarantee of future results.

Also, 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 earnings per share from operations, less realized and unrealized gains and losses and adjusted for any incentive management fees attributable to such realized gains and losses and any income taxes related to such realized gains. A reconciliation of core EPS to earnings per share from operations, the most directly comparable GAAP financial measure, can be found in our earnings press release. The company believes that core EPS provides useful information to investors regarding financial performance, because it is one method the company uses to measure its financial conditions and results of operations.

At this time, we would like the participants to access the accompanying slide presentation. As previously noted, you can access the presentation on our website at arescapitalcorp.com and click on the February 28, 2008 presentation link under the Stock Information section of the Investor Resources tab.

I will now turn the call over to Michael Arougheti, our President.

Michael Arougheti

Thanks, Alison, good morning everyone and thanks again for joining us this morning. I'm joined this morning by Rick Davis, our Chief Financial Officer; Alison Sternberg, who introduced this call, and other members of our senior Management team.

We're very pleased with our 2007 performance and with our position in the current credit environment. Before we get into the specific details on the fourth quarter, I want to take a minute to summarize what we believe was a very successful year.

Despite significant upheaval in the credit markets in the second half of the year, we had record originations of $1.3 billion in 2007. As we stated before, asset selectivity drives good investment decisions and generating significant deal flow is crucial to this investment process.

Despite an overall decline in market activity in the second half of the year, we reviewed over 850 new issued transactions in 2007, compared to 675 deals in 2006. And consistent with our historical trend and demonstrating our discipline and patience, we closed on 47 of those deals in 2007 reflecting a closing ratio of approximately 5%.

We also continued to build new and strengthen existing sponsor relationships and as of the end of 2007, 61 separate private equity sponsors were represented in the Ares Capital portfolio.

Our balance sheet remains strong and during the year we demonstrated our ability to access diverse funding sources. We obtained investment-grade credit ratings to facilitate our eventual access into the public debt markets, we renewed our commercial paperbacked warehouse facility, we increased the borrowing capacity under our revolving credit facility. We raised over $355 million of public equity, and we closed Ivy Hill, a $400 million managed credit fund, which also expanded our asset management capabilities. Much of this activity came in at time when many other financing providers were having difficulty accessing funds to grow their platforms.

As evidenced by some of our Q4 unrealized depreciation, we were not immune to the mark-to-market impact of the current credit market volatility. That said, the underlying credit quality of our portfolio remains very strong with less than 1.5% of the portfolio on non-accrual and cumulative realized and unrealized gains continuing to outpace cumulative realized and unrealized losses. And while we are seeing signs of a slowing economy, generally speaking revenues and earnings in the portfolio are growing.

I will discuss the broader market and how it influences our business, as well as the opportunities we see looking forward through fiscal year 2008 a little bit later, before that Rick will cover our financial results. So Rick?

Rick Davis

Thanks Mike. We have outlined the highlights of the fourth quarter on slide 3 of our presentation. Basic and fully diluted core EPS and net investment income were both $0.37 per share for the fourth quarter, representing a $0.03 increase over Q3. This increase was primarily driven by higher interest and fee income in the fourth quarter.

Even though we generated higher core earnings in Q4 compared to the third quarter, our fourth quarter GAAP net income of $10.8 million or $0.15 per basic and diluted share was down sequentially from Q3, and was impacted by net unrealized depreciation on our portfolio investments.

As you can see on slide 7, we had net unrealized appreciation of $19.5 million or $0.27 per share in the fourth quarter. Of the investments for which there was an unrealized depreciation adjustment booked, none of those companies were on non-accrual. During the fourth quarter, we also had $4 million or $0.05 per share of unrealized depreciation related to the reversal of prior period unrealized gains for investments realized in Q4.

Our fourth quarter gross commitments totaled $476.8 million, and total exits and repayments, net of revolver commitments for $239 million, resulting in net commitments of $237.8 million for the quarter. Those exits and repayments included a $133 million of assets sold to Ivy Hill during the quarter.

We closed the year with a $1.8 billion investment portfolio covering 78 portfolio companies. Excluding cash and cash equivalents, our year end portfolio was comprised of approximately 60% in senior secured debt securities, comprised of 39% in first lien and 21% in second lien assets, 23% in mezzanine debt securities and 17% in equity and other securities, which includes our investment in the Ivy Hill Credit Fund. The weighted average yield on our debt and income-producing equity securities for the fourth quarter was up from Q3 at 11.7% and 51.6% of our investments were in floating rate debt investments at the end of 2007.

Slide 4 summarizes our capital market activity for the fourth quarter. In October, we extended the maturity of our $350 million CP Funding Facility through October 8 of 2008. The only noteworthy change with this extension was a market increase in pricing of 30 basis points to the CP rate, plus a 100. In November, we increased the commitments under our revolving credit facility from $350 million to $510 million and also increased the accordion feature which would allow for the facility to be expanded to $765 million upon obtaining additional commitments.

Also in November, we closed Ivy Hill, a new $404 million middle market credit fund. Ivy Hill is managed by ARCC for a management fee of 50 basis points on average total assets. ARCC invested $56 million into Ivy Hill. During 2007, Ivy Hill purchased $133 million of investments from ARCC at par.

We view that the third-party investor willingness to purchase the ARCC senior debt assets at par as a validation of the credit quality and attractiveness of those investments. In addition, while still too early in the Fund's life to predict returns, we feel that our timing was perfect. Given the dislocation in the credit markets, Ivy hill has seen significant opportunity to purchase senior bank loans in the primary and secondary markets at total returns significantly in excess of additional expectations.

In addition, on February 8th of this year, we filed a new universal shelf registration statement to issue up to $600 million in common stock, preferred stock, debt securities and certain other securities. And on February 7th, we filed a registration statement to issue rights to purchase common stock for a proposed maximum aggregate offering amount of $350 million. Since we are in registration with the SEC and neither registration statement has been declared effective, we can't discuss the potential rights offering or shelf at length. However, we do think it's important to point out that the rights offering is not being driven by any liquidity constraints or near-term credit facility maturities. Rather, we would like as much flexibility as possible to take advantage of the very exciting and what we believe will be accretive current market opportunities that Mike will discuss later.

In addition, as mentioned in our registration statement, Ares Management intends to support our deal with a capital commitment.

As I discussed before and as shown on slide 7, we had $15.5 million of net unrealized losses in the fourth quarter, comprised of $40.2 million of unrealized depreciation on investments that was partially offset by $24.7 million of unrealized appreciation on investments and the reversal of $4 million of prior period net appreciation on investments.

The most significant changes in net unrealized depreciation during Q4 were $10.5 million from a debt and equity investment in a company that provides outsource maintenance and repair services for diagnostic and biomedical equipment. $10 million related to an equity investment in a financial services company; $5 million from a debt and equity investment in a company that markets products in the scrap booking industry, $5 million from an equity investment in a company that designs and markets children apparel, and $3.2 million from a debt and equity investment in a manufacturer of waste equipment. The most significant change in unrealized appreciation was $20 million in an equity investment in a company that manufactures reflective products and optical films.

We continued our use of independent third parties to aid in our investment valuation process. Additionally in the fourth quarter as part of the year end audit, KPMG had their valuation group review an additional 13 portfolio investments. Combined, in the fourth quarter approximately $722 million of our portfolio was reviewed by third parties and approximately $1.1 billion was reviewed by third parties in the last six months, including four of our top five holdings. We also exited or realized eight investments during the quarter generating net realized gains of $3.2 million. Our IRR on realized investments continues to be in excess of 20% on a cumulative basis.

Slides 10 shows a summary of our debt. As of December 31st, 2007, we had $681.5 million in total debt outstanding and subject to leverage restrictions we had approximately $492.5 million available for additional borrowings under our existing credit facilities.

The weighted average interest rate of our total debt stood at 6.08% during 2007 and was 5.66% as of the end of the year. And our debt to equity ratio stood at 0.61 times at the end of the year.

While we expect some slight near-term adverse effect on core EPS due to recent movements in LIBOR given our asset and liability sensitivity, we expect that our current focus on fixed-rate investments and resetting LIBOR contracts will rapidly mitigate this issue.

Turning to slide 11, we paid our regular fourth quarter dividend of $0.42 per share on December 31st to stockholders of record as of December 15th. We have also declared our regular first quarter 2008 dividend of $0.42 per share payable on March 31st to stockholders of record on March 17th. Providing further dividend stability for this year, we also expect to carry over an additional approximate $7.7 million of anticipated undistributed excess taxable income net of a 4% excise tax from 2007. The final amount of the 2007 spillover will not be determined until our 2007 tax return is completed and filed later this year.

I will now turn the floor back over to Mike.

Michael Arougheti

Thanks Rick. Before commenting on the broader market and the opportunities we see looking forward, I want to provide a little color to our recent investment activity and portfolio positioning, both of which reflect our long-standing investment strategy and opportunistic response to the current investment environment.

As I mentioned earlier, despite continued broader market issues, we have continued to generate healthy levels of deal flow. For example, we reviewed over 200 transactions during the fourth quarter, a pace consistent with the first three quarters of the year. This number does not include the many secondary capital markets transactions we reviewed in the quarter as well. This consistent level of deal flow, even through a period of dormant activity for some, is we believe a testament to our established self-origination platform, the benefits of the Ares Global Investment platform and our ability and willingness to invest in all levels of the capital structure, which sets us apart from any other financing providers.

During the fourth quarter, we had record new commitments of $476.8 million across 18 portfolio companies. Thirteen of these investments were with new companies and five were with existing portfolio companies. Fifteen separate private equity sponsors were represented in these new transactions, with seven of those sponsors being new relationships for ARCC.

Also during the fourth quarter we made three investments in non-sponsored transactions. Of these new investments, 58% were in first lien senior secured debt, 15% in second lien senior secured debt, 12% in our Ivy Hill Managed Fund, 7% in senior subordinated debt and 8% in equity securities. 77% of these investments bear interest at floating rates.

During the fourth quarter, significant new commitments included $84.5 million in first lien senior term debt, revolver commitment and equity co-investments in a distributor of healthy juice products, $64 million on first lien senior term debt, revolver commitment and equity in a mortgage and foreclosure processing services provider, $56 million in Class B and subordinated notes in the managed fund, Ivy Hill, $44 million in first lien senior term debt and revolver commitment in a premium health club operator and $37 million in delayed draw commitments to an oil lubricants manufacturer.

This record level of investments in Q4 was in part due to a carryover from the lower pace of investments in the third quarter. As we discussed on our last call, we had completed diligence on many of our earlier fourth quarter commitments during the quarter and held off making meaningful new investments at that time, as we wanted to see a measured, pricing structure stability in the market before committing to and ultimately deploying larger amounts of capital. As we'll discuss later, the markets showed signs of stabilizing somewhat in the fourth quarter and we deployed capital at what we believe were very attractive risk-adjusted returns.

If you turn to slide 15, you'll notice that we saw continued separation in spreads between asset classes in our portfolio. Keep in mind that the trends shown here lag the current market because they represent our total portfolio of yields by asset class, including investments entered prior to the fourth quarter. We continue to see spreads widen out across asset classes and expect to see further separation between first lien senior debt spreads and second lien and mezzanine spreads going forward. Expect to see us begin to focus down the balance sheet in new investments that we believe will drive our portfolio yield up without sacrificing credit quality. This will be further reinforced when I discuss our backlog shortly.

If you turn to slide 16, consistent with our views on the credit and economic environment, we have continued to focus our investments in more defensive non-cyclical and service-oriented businesses. For example, at the end of the fourth quarter, approximately 25% of our portfolio was in service-related industries, 17% was in healthcare-related businesses, 7% was in printing, publishing and media, 7% in education-related companies and 7% in retail businesses. Our portfolio also remains geographically dispersed fairly evenly throughout the country. We also have limited assured concentration risk with only one investment, FirstLight Financial with 5.4%, representing more than 5% of our portfolio's total value.

As you may recall, FirstLight was formed in 2006 and is a private finance company that focuses on senior secured lending to middle market companies. Their approximate $800 million portfolio is very strong from a credit standpoint, with to our knowledge no covenant defaults and no loans on non-accrual. That said, they do have some exposure to syndicated loans which modestly impacted portfolio valuations at year end. FirstLight continues to be a well capitalized and underleveraged company relative to its finance company peers. Our valuation of FirstLight was confirmed at year end by a third party valuation provider.

Turning to slide 17 and our portfolio quality, as you all know we employ an investment and rating system with grades 1 through 4, with 1 being the lowest grade for investments that are not anticipated to be repaid in full and with 4 being the highest grade for investments that involve the least amount of risk in our portfolio.

At the end of the fourth quarter, the weighted average grade of our portfolio of investments was at 3 with only one portfolio company receiving a 1 rating and with only two loans representing less than 1.5% of our total portfolio value on non-accrual.

I'm now going to turn to a broader view of the current market climate and the opportunities we see for ARCC and how our past strategic decisions have positioned our portfolio, balance sheet and infrastructure to capitalize on these current opportunities. Hopefully this can frame a discussion about the business implications of the current market environment and lend support to our historical strategy. As you might expect, we are very excited about the investment opportunity offered by the current market.

The dislocation in the credit markets and repricing of risk we've seen over the last six months has significantly impacted several key sources of liquidity in the syndicated loan market, most notably investment banks, CLOs, CDOs and hedge funds. Evidence of this reduced liquidity can be seen in significantly reduced CLO issuance. The second half of 2007 saw a significant decline in new CLO issuance volume with the majority of transactions closed being holdover deals that were committed to prior to the market correction.

In a recent Lehman Brothers report, it was noted that CLO issuance in 2008 is expected to be about 25% of the $515 billion 2007 total, and even this maybe optimistic. Lehman Brothers also noted that there were close to 200 CLO managers in the US and Europe at the end of 2007 with more than half of that total managing three or fewer CLOs. For many CLO managers, with few funds under management, the chance of going out of business or not growing in the near term has increased given the lack of opportunity to grow and get funded. We also continue to see many market value CLOs and warehouse lines being unwound due to valuation concerns and lack of demand.

We're beginning to see consolidation and rationalization of finance companies in response to these liquidity pressures. Hedge fund investors who are buying loans with total return swaps are having difficulty getting funded as well and high yield crossover buyers who appeared active over the summer and early fall have now shunned the loan market as short-term rates have compressed. Needless to say, many of the issues plaguing these companies are not impacting BDC's given the statutory restriction on leverage. The significant decline in liquidity created and has sustained a large pipeline of unsyndicated loans.

At the end of 2007, there was over $150 billion remaining in the pipeline for loans that had not been syndicated. For the time being this overhang should keep new issue spread high and should keep banks on the sidelines for the foreseeable future. That said, there is still a large pool of private equity yet to be invested which we expect will drive yield flow once seller and buyer valuation expectations recalibrate.

This market correction plays in to the strategy we implemented and have been executing for the last three years. At the risk of being repetitive, as we have grown and managed our portfolio, we've being conservatively positioning the portfolio in anticipation of market dislocation and repricing of risk in market by focusing our attention on the most secure investments to best protect the principal in our portfolio and to produce strong risk adjusted returns. With shorter average lives and lower leverage levels, tighter covenants and full security packages, we believe that our historical focus on senior secured debt should allow for strong performance and higher recoveries as the markets weaken. To illustrate this point, at the end of 2004, 50% of our portfolio was in mezzanine and CDO investments with only 35% in senior secured debt and our weighted average yield on debt and income producing securities was 12.4%.

As spreads tighten between asset classes, we just didn't feel the market was adequately compensating investors like ARCC for taking additional risk down the balance sheet, and we began defensively positioning our portfolio. Since then, we have invested over $2.8 billion and migrated our portfolio composition from 35% to 60% in senior secured loans without meaningfully sacrificing yield. And as we have moved up the balance sheet to more secure investments, our weighted average yield on debt and income-producing securities has only decline by 70 basis points to 11.7%.

We have mitigated some of this yield compression by focusing on generating fee income through underwriting and syndications and have also used this period to exit investments at a profit and to realize meaningful capital gains.

This strategy seems to be working. The credit performance of our portfolio has been excellent with only one investment losing less than 0.5% of total portfolio of principle since inception, and currently only two loans representing less than 1.5% of portfolio value are in non-accrual.

As important, given our senior position in many of our investments we're in a better position to re-price our risk through increases in spread and amendment fees at the earliest signs of any weakness.

Our cumulative realized gains on equity investments have also significantly exceeded realized and unrealized losses. We don't expect the current environment to constrain exits in our portfolio and we expect that we will have opportunities to realize capital gains in the coming quarters. Our portfolio also has limited or no exposure to sub-prime, real estate, home building, commodities or the automotive sector.

As we have emphasized before then, weak credit markets typically present attractive investment opportunities that are particularly favorable to capital providers with ample liquidity and experience investing through credit cycles.

While our cautious focus on senior debt has put some downside pressure on our yields in the past we continue to believe it will ultimately lead to superior results through the cycle.

More importantly, given the current market environment, we expect yields to expand over the coming quarters with a corollary deleveraging of underlying investments. This is already evident in our investments in the fourth quarter and the first quarter and our building backlog in pipeline.

Also, I point out that we were able to accelerate a portfolio rotation away from lower yielding senior debt through the formation of Ivy Hill. Since the end of 2007, we have issued $136.1 million of investment commitments and we have an investment backlog and pipeline of approximately $244 million and $314.4 million, respectively.

As you can see on slide 13, reflecting our stated objective of seeking relative value, this $558.4 million of current investment opportunities are further down the capital structure than our existing portfolio as we're seeing superior risk-adjusted returns in those asset classes.

Illustrating that point, only 9% of these current backlog and pipeline transactions are in senior secured first and second lien debt investments in contrast to 61% of our Q4 investments in those asset classes.

While further down the balance sheet, these deals are not expected to increase the leverage in our portfolio. And as I mentioned before, we believe the weighted average yield on these potential transactions will be meaningfully higher than the 11.7% weighted average yield for the debt and income-producing securities in our existing portfolio.

Importantly, many of our junior investments are coming with significant fees and call protection, which significantly enhance the total return profile above the stated yield. And in addition, many new floating-rate investments are coming with LIBOR for us to protect against further rate reductions.

The consummation of any of the investments in our backlog and pipeline depends upon, among other things, satisfactory completion of our due diligence, investigation of the prospective portfolio company, our acceptance of the terms and structure of such investment and the execution and delivery of satisfactory transaction documentation. We therefore cannot provider assurance that any of these investments will be made.

In the current environment, we're seeing deal flow from many sources and in many areas. While the new issue market has slowed somewhat, deal flow is still steady. On all new deals, spreads and fees continue to widen, lower leverage levels persist and covenant packages are tighter. We have observed the complete disappearance of covenant light and PIK-toggle capital structures. But most interestingly, given broader market issues, larger companies are having difficulty getting financed, presenting very attractive investment opportunities.

We're finding ourselves able to invest larger dollars into larger companies with high fixed rates, higher fees, and importantly, call protection. And as I mentioned, these trends are already showing up in our backlog.

Strong performers in our existing portfolio have historically also provided many of our best investments with approximately a third of our deal flow in 2007 coming from existing portfolio companies.

As our portfolio companies continue to grow organically and through acquisition, we're seeing numerous opportunities to provide additional capital at higher rates by either re-pricing existing debt or moving down the capital structure with little competition.

And beyond the new issue market, we are seeing a wide variety of secondary market opportunities as investment banks work through their unsyndicated pipelines.

In addition, as underwriting credit weakens, we expect to see some interesting opportunities develop, either potential restructuring and workout situation, providing much-needed capital to undercapitalize or over-leverage companies or hold portfolio purchases.

Recall that our core financial opportunity is with middle market companies that cannot efficiently access the capital markets. As we emphasized before, we believe that the dislocation in the credit markets has only improved our competitive positioning. Marginal capital providers have begun to exit the market, banks have become stingy with their balance sheets.

As we have previously discussed and as we continue to firmly believe, the current market conditions are very attractive for growth and profitability for well-positioned capital providers with diverse funding sources and robust origination capabilities, like ARCC.

Our balance sheet and access to capital provide the unique advantage in today's environment. Liquidity in this market is a strategic asset and not only allows us to be more selective in choosing investments, but also provides the ability to drive improved pricing structure, and we believe that this is a market in which we should grow and not stagnate.

An additional benefit of our ability to remain active in the current environment as many others are retrenching or dealing with portfolio issues is supporting our existing sponsor relationships and our existing portfolio companies.

We believe that our ability to remain active participants in these turbulent markets strengthens our franchise as we capture additional market share and enhance our portfolio diversification while continuing to execute on our stated investment objective of achieving superior results through market cycles.

And one more thing I can't emphasize enough is that we continue to benefit meaningfully from the global Ares management platform, especially in these volatile markets. Across our global platform, we have close to 100 investment professionals covering in excess of 600 companies across 30 plus industries, providing not only research assistance, but a broad and real-time view on relative value and risk return.

Our team is seasoned and cohesive and has significant experience managing through market cycles. And we have a robust back office infrastructure of finance operations, legal, compliance and IT professionals supporting our business. But I think most importantly, Ares' scale and position in the capital markets has facilitated our access to capital and strengthened our relationships with our key financing and banking partners.

In closing then, although the current market environment is proving to be challenging for some, we are encouraged by the opportunities we see for ARCC. The fact that we are well-positioned to benefit from the current dislocation is we believe validation of the investment strategy and discipline that we have pursued.

Again, we've focused on senior debt investments in defensive industries when others were moving down the balance sheet to protect the downside in our portfolio in anticipation of a market that would offer us more attractive risk-adjusted return at every level of the balance sheet. And that time is now, and we've positioned our portfolio and our entire platform to benefit from the current market and we're ready.

And that covers our prepared remarks and we appreciate your time today and thank you for your continued support. And operator, we'd now like to begin our Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Greg Mason at Stifel Nicolaus.

Greg Mason - Stifel Nicolaus

Good morning, gentlemen. First, a modeling question. The interest expense line looked significantly higher than the yield that you reported of roughly 6%. Were there any additional onetime fees for restructuring these credit lines or anything that flowed through that number?

Mike Arougheti

No, it was really just a function of the average outstanding balance being higher. That was predominantly the reason for the increase. There was the slight increase in rates, but it was -- I think the average outstanding balance was $70 million higher in Q4 than it was in Q3.

Greg Mason - Stifel Nicolaus

Okay. And then what are you seeing on current yields today? And the reason why I asked the question is we analyze the potential of rights offering based on today's yield and your debt costs of capital. You're looking at a weighted average cost of capital of around 9.5% to 10%. How does that compare to what you're seeing in the marketplace today?

Mike Arougheti

Let me talk about the junior capital environment, because as we mentioned that is where we're seeing the most attractive opportunity.

The current market for both middle market and large market and mezzanine or private high yield is 2 points to 3 points upfront stated coupon of 12.5% to 15% and call protection of somewhere between two and four years with prepayment penalties of anywhere from 104 to half of the stated coupon scaling down. So the stated yield excluding fees, 12.5% to 15%; including fees, add 200 basis points to 300 basis points to that. And when you factor in the call protection, you're also seeing an additional 400 basis points to 600 basis points of total return opportunity.

So I would leave it to you to think about how that would play out over a two to three-year period, but needless to say we're very excited about the investment opportunity and spreads relative to our cost of capital.

Greg Mason - Stifel Nicolaus

And just one last question to piggyback on that, how do you balance a rights offering between accretive NOI earnings versus declining book values?

Rick Davis

Well, I think you have to look at book value, Greg, and try to separate and differentiate between unrealized depreciation and actual loss in the portfolio. We're going through a difficult time in the credit markets where technical pressures are putting a lot of downward pressure on book values, even in the face of solid underwriting credit performance. So I think you have to continue to drilldown and look at what is driving weakness in book value.

Again, we believe that our mandate is to continue to grow this business accretively for our investors and to continue to grow our earnings and our dividend and having the ability to invest accretively is really the easiest way to reignite growth in the platform and to reignite growth in the dividend.

Greg Mason - Stifel Nicolaus

Okay. I'll hop back in for more questions.

Rick Davis

Thank you.

Operator

Our next question comes from Carl Drake at SunTrust Robinson Humphrey.

Carl Drake - SunTrust Robinson Humphrey

Mike, can you here me?

Mike Arougheti

Yes.

Carl Drake - SunTrust Robinson Humphrey

Good morning, and thanks for the presentation. I was wondering if you could provide a little bit more color about the comments that now the opportunity you're seeing obviously great investment opportunities that cost of funding is probably going up, obviously as well overtime. Maybe we could think about in terms of incremental -- you're going down the balance sheet pretty aggressively, it looks like in the first quarter. Should we be thinking about core EPS growth per share in '08 versus '07 kind of reigniting versus the strategy in '07, which was more of a defensive strategy?

Mike Arougheti

Yeah, I think that's our goal, Carl. We have been playing defense for a long time and we actually expect the markets to improve for us as the year rolls on. We're letting our way in and continuing to focus on growing our earnings this year.

Carl Drake - SunTrust Robinson Humphrey

What type of incremental pickup do you expect over LIBOR this year? Is that something that perhaps -- I guess how fast and what kind of churn are you seeing on the portfolio as well?

Mike Arougheti

So we don't expect material portfolio repayment this year. Ivy Hill is a good example of us looking for ways to creatively rotate the portfolio away from the lower yield floating rate assets. One thing, I did mention in our prepared remarks is that where we are being asked to provide floating rate capital, we're putting LIBOR floors in to protect the total return in what could be a continuing interest rate reduction environment. So if you want to look at current LIBOR and assume it's locked in at 300 basis points, the stated yield on the new investment portfolio is 1000 basis points, plus spread to LIBOR, which when you look across the cycle is pretty attractive.

Carl Drake - SunTrust Robinson Humphrey

Yeah, that is helpful. In terms of the credit, I think you had a number of great new companies. How many companies is that and what sectors are they in?

Mike Arougheti

I am not sure that we've disclosed that. I would say that the grade two companies that are in the portfolio are company-specific issues, not industry specific issues. In terms of the number of companies that are graded two, I'd have to go back and look. But I recall the number being that we have two companies that are in the two category.

Carl Drake - SunTrust Robinson Humphrey

So, isn't that best kind of measure of health of your portfolio besides non-accruals? Was some of the depreciation in the quarter due to market multiples, or was it due to EBITDA, a slowing in EBITDA, or how would you characterize that?

Mike Arougheti

I think it's a combination of both. In some of our names, it was just pressure on market multiples or a comp in the syndicated markets that caused a potential re-pricing of our security, and some of it was poor performance. I'd say it was a mix.

But back to your point, Carl, I do think that the best proxy for overall health in the portfolio is looking at non-accruals and loans rated at 2. And as we mentioned, we only had one company that's currently rated 1, but we had two loans on non-accrual. So we tend to look at our basket of 1 and 2 as the companies that we're spending time with.

Operator

Our next question comes from Sanjay Sakhrani from KBW.

Sanjay Sakhrani - KBW

Thanks. Mike, I think you addressed the mix pretty well in terms of new originations, but what about size? I'm just trying to reconcile what some of your peers are saying on the smaller end of the middle market. And they have alluded to the fact that pricing hasn't really moved there and there's still a lot of competition. So I'm just trying to reconcile those comments.

Mike Arougheti

We completely agree. Again, I think in our prepared remarks, we discussed what is an inversion of the middle market, historical middle market value proposition where a lot of the inefficiency and pricing structure was in the smaller end of the market because of the amount of liquidity in the larger market. Today, because of the CLO and other liquidity issues that we discussed, the investment in commercial banks that we're providing liquidity to larger companies are all but out of business. And so just to be clear, we actually agree. We think that the opportunity now is a unique one to invest in larger companies and larger dollar amounts at better yields than you can get in smaller companies today.

Sanjay Sakhrani - KBW

So that mix that you guys provided of the backlog, is that concentrated in fewer companies than historically?

Mike Arougheti

It's still a lot of companies, but I would say that the average size of that company in our backlog is significantly in excess of what's currently in our portfolio.

Sanjay Sakhrani - KBW

Okay. And that would mean that their EBITDA profile etcetera is higher as well right?

Mike Arougheti

That's correct.

Sanjay Sakhrani - KBW

Okay. And just drilling down on these non-accruals, I know it's probably in the K, but could you just discuss those in a little bit more detail?

Mike Arougheti

Sure. We have two loans on non-accrual today. In both situations which we're somewhat pleased with, if you can be pleased when something is on non-accrual, the company actually has adequate liquidity to make the payments, but the payments have been turned over to the senior lenders. One of them is a company called Primus Marketing and the other is a company called Making Memories and we've been working closely with the company, the sponsor in both of those situations as well as the senior lenders to continue to rectify that situation.

Sanjay Sakhrani - KBW

Do you think there's a high probability of recovery on these?

Mike Arougheti

I think that where we currently have our positions mark is a good mark. In any situation where stuff that goes on non-accrual, there's a process that you need to go through that takes a long time and a lot of preparation to recover value, but we are cautiously optimistic.

Sanjay Sakhrani - KBW

Okay, great. Just one other thing, I was actually looking through the 10-K and I saw this section on the cost list collar. So could you just explain that a little bit? I just want to make sure I understand it correctly.

Mike Arougheti

Yes, Sanjay that actually has expired. It was something that was required of the commercial paper facility and it expired in January. And we had been looking at pricing on collars or some type of a floor on LIBOR and prices are pretty expensive right now. But that collar did expire in January.

Sanjay Sakhrani - KBW

Okay. So that sensitivity, it doesn't pertain to you guys right now?

Mike Arougheti

That's correct.

Sanjay Sakhrani - KBW

Okay, great. Thank you very much.

Mike Arougheti

Okay, thanks.

Operator

Our next comes from Daniel Furtado at Jefferies.

Daniel Furtado - Jefferies

Good morning. Thank you for taking my call. Could you just talk to me about what you're seeing in -- what exposure you are seeing in the middle market syndicated loan market since year-end?

Mike Arougheti

When you say our expose, meaning --?

Daniel Furtado - Jefferies

No. I'm sorry, I didn't mean exposure, I'm just saying could you talk about the health, how that market is performing, if it's coming under the same type of stress that the large syndicated loan market has come under? And really I am looking more for since December 31st.

Mike Arougheti

We're not seeing it. Again, there is a unique situation that we have not seen in our business before where the middle market remains very active. There is adequate capital available for smaller companies that are coming from the likes of GE Capital and others to get smaller deals done. The mezzanine need to those companies is able to get satisfied by a lot of the private independent mezzanine funds and BDCs as well. So that market feels a lot healthier right now than the broader syndicated loan and high yield market.

Daniel Furtado - Jefferies

Okay, perfect, thank you. And then, could you talk about what the potential contingencies are? I know we have got a ways go before this revolver comes up for renewal, but just in terms of what you see in terms of strategies to clear that line of credit now that the CLO and structured term markets are shut down?

Mike Arougheti

Sure. Just to reiterate, and we've given some detail on the liability side of our balance sheet, but I would call attention to the fact that our revolving credit facility comes due in December of 2010. So we have three years of runway there and the underlying on-balance sheet CLO comes due in December of 2019. We do have a CP-backed funding facility that comes due in October of 2008 and you will recognize in every quarter that that represents the least funded of all of our debt facilities, just given sensitivity to the short-term nature of that.

I would also point out that in that facility there is no wind-down provision. It really turns itself out over a two-year period. So when we look at our balance sheet relative to our peers and even some of the private finance companies, we're just not feeling the liability side pressure that other people are.

Now looking forward, we believe very strongly in diversifying our funding sources. That's why we went out and got an investment-grade rating. We think that we're well positioned to issue a public or private unsecured notes deal. And we hope as we demonstrated in November by getting Ivy Hill done that our CLO and capital markets franchise puts us to the front of the line in the structured products market to get funded when that market reopens.

Daniel Furtado - Jefferies

Okay. So I guess in a worst case scenario, you could just let that CP facility term out in kind of like a pseudo structured --?

Mike Arougheti

Yeah, that's correct, although nobody can predict the future, but I am hopeful that won't happen.

Daniel Furtado - Jefferies

Right. I understand. I'm just looking for kind of like the down, down side here. Thanks for the comments and the clarity. I appreciate it. Have a great day.

Mike Arougheti

Thank you.

Operator

Our next question comes from Vernon Plack at BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

Thank you, Mike. Just a couple of questions, I'm trying to get a sense for your thoughts on net portfolio growth for '08, you look at commitments net of exits and repayments in '07, this number was just under $700 million, in '06, it was just over $700 million. What are your thoughts in terms of the type of net growth you have seen in '08?

Mike Arougheti

Again, I think we've returned to a normalized investment pace after what was a brief low in the third quarter, and I would even say a somewhat self-inflicted lull in the third quarter, in this market. My enthusiasm wasn't made clear, I think we would like to be as active as we possibly can be over the next four quarters and beyond. So really the investment pace is going to be a function of capital availability more so than market opportunity.

Vernon Plack - BB&T Capital Markets

Sure.

Mike Arougheti

But suffice to say, I think it should be consistent with our historical experience and depending on how capital availability plays out over the year, it could be higher.

Vernon Plack - BB&T Capital Markets

Okay. And just one other question. I'm trying to get a sense for the magnitude that you would like to see the portfolio shift away from senior secured both first and second lien. You ended the year at about 60%. Where do you hope that number is at the end of the year?

Mike Arougheti

Yeah, we don't know because it's always a function of what the available returns are in the relative markets. But order of magnitude, I can see our first lien portfolio getting down to 25% of the portfolio and then the second lien and the mezzanine making up the significant majority beyond that.

One of the things I do want to highlight and it is somewhat different than some of our BDC peers; the senior debt asset class is a critical component of our go to market strategy. We believe that it provides us an origination advantage by being able to go out and originate senior debt. We feel that we see a broader opportunities ahead. So we will not be abandoning that market. We have not slowed our originations in that market. I just think that you will see us more aggressively syndicate our exposure there and look to grow the Ivy Hill portion of our business in order to manage our balance sheet exposure.

Vernon Plack - BB&T Capital Markets

Okay, thank you very much.

Mike Arougheti

Sure.

Operator

The next question comes from Jon Arfstrom from RBC Capital Markets.

Jon Arfstrom - RBC Capital Markets

Good morning.

Mike Arougheti

Good morning.

Jon Arfstrom - RBC Capital Markets

Rick, can you give us the fees for the quarter that you generated from Ivy Hill?

Rick Davis

Ivy Hill for this quarter was a fairly small amount just because it ramped up in November. So the number was less than a couple hundred thousand in 2007. Fully ramped, that fee should equate to a couple million a year once the fund is fully ramped.

Jon Arfstrom - RBC Capital Markets

Okay, that's the $400 million?

Rick Davis

Yeah, the 50 basis points on $400 million once it's fully ramped up.

Jon Arfstrom - RBC Capital Markets

And then, Michael, you made a comment early in your prepared comments about how revenues and earnings are still growing at your portfolio of companies. Is there anyway to quantify that and talk a little bit about how that changed or if it has changed over the last few quarters?

Mike Arougheti

We don't do specifics, but I'd make two comments. One, it is growing year-over-year but the rate and pace of growth is slowing. And again, generally speaking we see this across the market and across other portfolios as well. What we are seeing is, despite year-over-year growth people are falling short to expectations; i.e. companies had set aggressive budgets and are either not beating them as handily as they had been or starting to miss them, which is obviously the natural progression of the credit cycle. One of the reasons that we pursue a senior debt strategy in certain parts of the market is you want to be in a position to reprie your risk and take control of a situation when a company's growth slows and it starts to fall short of expectation. So that's not unto itself concerning to us. It's actually quite favorable as we think about our position at the top of the capital stack. I would say that what we're seeing in our portfolio is similar to what you're seeing in the public equity markets, which is good single-digit growth but shortfalls to expectation.

Jon Arfstrom - RBC Capital Markets

Okay, great. Thank you.

Operator

Our next question comes from Greg Mason of Stifel Nicolaus.

Greg Mason - Stifel Nicolaus

Thanks. Mike, I wanted to get your opinion. In talking to some institutional clients about competitive advantages versus internal and external BDCs, we have seen ACAS and now Allied do some external funds via the private equity markets. I know you guys did Ivy Hill on the debt side. What is your ability to do some other funds given that your overall management company has their own private equity division and some of these other divisions? Does that limit you in any way from an external management standpoint?

Mike Arougheti

In theory, no, there's no regulatory restriction on that. In practice it really depends on the asset class and the size of the underlying companies that we're investing in. We believe that our core mandate is to provide capital to middle market companies at every level of the balance sheet. Our hope is that we can continue to grow our balance sheet to satisfy the needs of those issuers and those clients. As you mentioned, Ares Management is a very large and growing asset manager in its own rights. But none of the existing businesses at Ares Management compete with Ares Capital Corporation or vice versa and we don't intend to see that change. So we're constantly looking for ways to grow our business on balance sheet, we're constantly looking for ways to grow our franchise, but there is no view here that we're going to be in businesses at ARCC that we're in at Ares Management.

Greg Mason - Stifel Nicolaus

And then with your pipeline, does that include some assets for Ivy Hill that you may not normally look at yourself?

Mike Arougheti

The pipeline, as stated, does not include situations that would be for Ivy Hill only. But as part of a syndication strategy, Ivy Hill would be a very logical third-party buyer of some of the underwritten senior loans that were in our backlog and pipeline.

Greg Mason - Stifel Nicolaus

Okay. And then based on what you are seeing in the bank loan market, how quickly do you think Ivy Hill can get up to your $400 million cap?

Mike Arougheti

Well, how quickly can it, or how quickly will it, I think the answer. Quickly, how quickly could it? The answer would be, yesterday. There's really no shortage of opportunities to buy senior secured debt at very attractive risk return right now. Just booking at the large market to put the dislocation in perspective, the average bid in the syndicated loan market in hovering somewhere between 88 and 90 today, which when you look at the discount margin would imply spreads of 400 to 450 basis points and default implications in excess of 14%. So there is a major technical dislocation in the bank loan market that Ivy Hill is benefiting from. That said, we don't see anything that's going to be a catalyst for change in that market in the near term, so we're being a little bit more judicious about how we invest that funds than the current market opportunity may indicate. So another couple of months I would say if we maintain our current investment pace.

Greg Mason - Stifel Nicolaus

Would it be appropriate to look at Ivy Hill in the near term as beneficial for you for enabling you to do deals that maybe if Ivy Hill wasn't there you could do, or do you just want to get Ivy Hill filled up as fast as you can?

Mike Arougheti

Ivy Hill is strategic for a number of reasons, and I would refer you back to some of our disclosures around that fund in our conference call at the time that we closed the fund. But it is a very strategic element to our business because in an environment like the one we're in now where spreads down the balance sheet on a total return basis are much more attractive than senior debt, it gives us an opportunity to continue to be actively underwriting and originating at the top end of the balance sheet without having to defer our balance sheet capacity away from the more attractive mezzanine asset class. At the same time as an equity holder in Ivy Hill as we said in our prepared remarks, we couldn't do more excited about the prospects for that investment relative to our original expectations for the fund.

Greg Mason - Stifel Nicolaus

Could we spend just a little bit of time talking about your largest investment, FirstLight? We have read some articles that they laid off roughly one-third of their employees, but still with 40 employees remaining on kind of $1 billion capital fund, it seems pretty top heavy. What are your thoughts there?

Mike Arougheti

It's a fluid situation. As I mentioned, the first part is well capitalized relative to other finance companies. It has no exploding warehouse lines or liquidity issues, so it does have the luxury of time that maybe some other people in that business do not have. And we think the management there is best in class and when you look at their track records, they have managed multibillion dollar businesses on larger platforms. So I think we have the right formula there for success. The challenge is nobody is immune from what is going on in the current credit market and we're constantly looking at the growth opportunity at FirstLight relative to availability of capital. So the reduction in force that occurred awhile back was really just a recognition that the growth opportunity given capital availability is not what we had hoped it would be and we need to right-size the infrastructure to maintain profitability at that company as well as the return profile of our investment and it's something that we continue to dialogue about.

Greg Mason - Stifel Nicolaus

One last question. I've always kind of struggled with when we see situation like this, an MPBP where we had a write down to both the equity and junior notes, but there is still equity value even though we've written down two junior notes as well. How do we have equity value but expecting losses on junior debt?

Mike Arougheti

It is a good question, and I think you strike to the very heart of the matter of valuing equity securities versus valuing debt securities. It is something that people are obviously spending a lot of time on. There is a number of ways that we and third-party valuation providers look at value both looking at bond yields, market comps, public equity comps, DCS, performance against original budget, etcetera, etcetera. So there's number of data points that go into valuing private securities as well as public securities for that matter. At any level, you get to a place where equity has optionality embedded in it where you can see equity still has value below what a debt comp we're tell you your debt is worth. I think that MPBP is a perfect example of one of the companies in our portfolio where because of the technical dislocation in the syndicated loan market it put pressure line our junior debt security as well as our equity.

Greg Mason - Stifel Nicolaus

Okay. So it sounds like you're already implementing FAS 157. What do you think the impact is going to be next quarter as we move into that environment?

Mike Arougheti

We don't anticipate a meaningful change in the way that we go about valuing our portfolio. Obviously we're spending a lot of time with our valuation providers, auditors and Board talking about the implications of FAS 157. We run a pretty robust process here from a valuation standpoint, and today don't anticipate any meaningful changes to the way that we are valuing our portfolio. That said there is some inconsistency in the market today as to what the impact is going to be and we're trying to be a part of that dialogue just to make sure we're out ahead of it. But as we sit here today, we don't anticipate meaningful changes.

Greg Mason - Stifel Nicolaus

Great, thank you.

Operator

Our next question comes from Vernon Plack of BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

Thank you, Mike, just a follow-up question on, I know you mentioned in your prepared remarks that you expect this year to be a year in which you realize capital gains, but just trying to get a sense for and perhaps a little more color on that point, particularly looking at the portfolio and knowing that most of the portfolio is not in control investments. If you could provide a little more color, that would be helpful.

Mike Arougheti

Yes. We obviously look at the underlying earnings momentum at some of the companies in our portfolio. Even though we're not a control investor, a lot of the equity investments we make as you know come alongside of debt investments and where we have meaningful debt and equity exposure we tend to have access to the Board of Directors either as a board member or a board observer. And I believe at the end of the year, roughly 40% of our portfolio we had access to the Board of Directors. So when we look at the strategic direction that those businesses are going in and in sponsored situations the thought process on behalf of the institutional sponsor we can identify certain situations where we think people will be looking for liquidity.

Vernon Plack - BB&T Capital Markets

Okay. Is there any thought in terms of -- are you looking to realize a certain amount of gains this year for either dividend coverage purposes or just don't know what the philosophy is there?

Mike Arougheti

Yes, we have always said, our hope is in a worst case, our capital gains should always outpace our losses and in a steady state our core earnings should cover our dividend. When you look at our historical performance you will notice that certain times our core EPS covers our dividend, certain times it doesn't, and that's really a function of where we are in our capital raising and capital deployment.

One thing that we have demonstrated is that capital gains have significantly outpaced our capital losses both on a realized and unrealized basis. So as a philosophy and a dividend philosophy we do not rely on capital gains to maintain our dividend stability and dividend trajectory. Rather, we factor that in on an ongoing basis as to what kind of momentum we have in our dividend and our earnings profile.

Vernon Plack - BB&T Capital Markets

Thank you.

Operator

Our next question comes from Elliott Berk of Ironside Partners.

Elliott Berk - Ironside Partners

Hi, thanks. I just wanted to ask a couple of questions about the leverage side of your balance sheet. First on the revolving credit facility, it matures in 2010 but is there any kind of renewal provision, annual renewal provision, or something of that sort that needs to -- where the banks actually need to approve the facility continuing on?

Mike Arougheti

No, there is not.

Elliot Burke - Ironside Partners

Okay. Also on the same one, the same revolving credit facility, I know it's a ways off, but just curious how these work. Is there a similar kind of amortization provision in that facility or does it all come due on maturity if in principle the banks don't choose to renew it?

Mike Arougheti

I believe so. I'd have to go back and refresh my knowledge of the document, but I believe that it terms out.

Elliot Burke - Ironside Partners

Okay. And my last question, the commercial paper facility. Asset-backed commercial papers have been one of those four-letter word buzzwords in the financial markets recently. I'm just curious, I know some facilities, some commercial paper facilities of that sorts have been doing fine and some obviously had lots and lots of problems. What's the status of that Wachovia commercial paper facility and relative to the potential for it to be renewed when it matures later this year?

Mike Arougheti

Yeah, again we cannot comment on the health of Wachovia's balance sheet, but what we can comment on is the strength of the relationship. And in November of '07, which was arguably a very turbulent market, we renewed that facility early and on time with only a slight increase in pricing. We have a very strong relationship with the bank. We do a lot of business with them and I think we're in very good standing there.

So again, I can't predict what's going to happen in October, but I think given the franchise that we have here and given the strength of the relationship that I currently don't feel like that is in jeopardy. The only thing I'd say, it's a bank supported conduit, not an asset-backed conduit so we do take some comfort that Wachovia's balance sheet is standing behind the conduit facility.

Elliot Burke - Ironside Partners

Okay, thanks. Actually more question, the potential for a rights offering, when you think about that, is there sensitivity relative to the price that the rights would be struck? The price, you would be effectively selling shares at, or do you think about or do you look at it as it's going to existing shareholders, they'll get the rights, they'll have the ability to exercise and therefore capture some of that value, even if the share price that we're selling at is somewhat lower than we'd like to sell it at?

Mike Arougheti

I think first and foremost we have to do what is right for our shareholders. And given what we're seeing in the current environment, we feel that an appropriate strategy to consider is continuing to grow the business. If you can invest in yields that are accretive relative to whatever dilution you would incur in a rights offering, that's something that we spend time on. So the corporate finance analysis would tell you that there's obviously a level at which that equation doesn't make sense anymore.

However, in a pro rata rights offering where the rights are transferable, we do believe that appropriate protections are in place for the existing shareholders that want to participate in the potential growth opportunity, and for those that don't to capture value of the right by selling the right. So, of all of the mechanisms that we can think of, I think a transferable pro rata right protects the interest of all shareholders,

Elliot Burke - Ironside Partners

Okay. That makes sense. So thanks for the answers and keep up the good work in a difficult environment.

Mike Arougheti

Thank you.

Operator

Mr. Arougheti, at this time, I show that there are no further questions. Please continue with your presentation.

Mike Arougheti

Okay. Thank you very much. We had no further prepared remarks. We appreciate everybody taking the time today and appreciate the good questions and dialogue. And as always we look forward to speaking with you guys on our next quarterly call. Thanks again.

Operator

Ladies and gentlemen, that does conclude our conference call for today. If you missed any part of today's call, a recording of this conference will be available until March 13, 2008, through March 13, 2008. To access the replay, you can call 1-877-344-7529. To call internationally, you can call 1-412-317-0088. For all replays, please enter conference ID number 416243. Thank you for your participation and you may now disconnect.

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