Ares Capital Corporation Q1 2008 Earnings Conference Call

May.26.08 | About: Ares Capital (ARCC)

Ares Capital Corporation (NASDAQ:ARCC)

Q1 2008 Earnings Call

May 8, 2008 10:00 am ET

Executives

Michael Arougheti - President

Richard Davis - Chief Financial Officer

Alison Sternberg - Vice President of Investor Relations

Analysts

Greg Mason - Stifel Nicolaus

Vernon Plack - BB&T Capital Markets

Sanjay Sakhrani - KBW

Faye Elliott - Merrill Lynch

Jon Arfstrom - RBC Capital Markets

Brian Roman - Robeco Investment Management

Greg Mason - Stifel Nicolaus

Operator

Welcome to the Ares Capital Corporation first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Rick Davis, Chief Financial Officer.

Rick Davis

Welcome to Ares Capital Corporation's first quarter 2008 earnings conference call. I hope you have had an opportunity to review our earnings release and quarterly report on Form 10-Q. In addition, we are offering a webcast and slide presentation to accompany our call. Copies of the earnings release, Form 10-Q and the slide presentation can be obtained from our website at www.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 first quarter 2008 earnings press release, Form 10-Q, comments made during the course of this conference call and webcast and our companies 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 to invite participants to access the accompanying slide presentation. As previously noted, you can access the presentation on our website at www.arescapitalcorp.com and click on the May 8th, 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

Before I get into the details of the first quarter, I thought I’d take a minute to summarize our recent operating results in capital markets activities. Despite continue upheaval in the credit markets and a significant decline in overall leverage loan and buyout volume, we closed $304 million of investment commitments in the first quarter. As I’ll discuss in more later and consistent with the expectations that we discuss in our last call, these new investments generally reflected meaningful improved pricing, structure and underlying relative leverage. We also further improved our investments spread by reducing our floating-rate investments from 51.6% of the total portfolio at the end of 2007 to 44% at the end of Q1, while our borrowing cost declined by 1.8%. As you know we have long-standing objective of preserving capital while seeking superior risk adjusted returns through business and credit cycles.

Consistent with this strategy we conservatively positioned our balance sheet over the last three years in anticipation of our market that would offer us better risk adjusted return opportunities. Illustrating the continued execution of this strategy, in the first quarter we begin to rotate into higher yielding investments with comparable overall leverage levels to our existing portfolio and as I’ll discuss in more detail later we believe our current portfolio mix, balance sheet, diverse funding source and infrastructure positioned just well in the current environment and we remain very existed by the opportunities we see to continue this strategy.

Our ability to aggressively pursue opportunities in this very attractive investment environment is largely dependent on our access to capital. We have diligently work to enhance and diversify our funding sources and over the last six months in an extremely challenging environment. We have increased to extend the terms for over $600 million of debt capital and in April we completed the $260 million equity offering. Additionally, with our investment grade credit ratings we should be able to access a broader range of public and private debt markets in the future.

We are also seeking shareholder approvals to issue convertible debt securities. Rick, will provide more detail in the equity offering later, but I wanted to take this opportunity on my personal behalf and on behalf of the team to thank all of our shareholders for there support and encouragement leading up to and thought our equity offering process.

As evidence by some of our Q1 unrealized depreciation we were not immune to the continued pricing volatility, evident in the current credit market. I think its worth noting though that we reported net unrealized depreciation on our portfolio investments over the last several quarters. The total fair value of our portfolio at the end of the first quarter was only $40 million or approximately 2% lower than the amortized cost basis. The underlined credit quality of our portfolio remains very solid with less than 1% of the portfolio on non-accrual and cumulative realized and unrealized gains continue to outpace cumulative realized and unrealized losses.

I’ll discuss the broader market and how it influences our business as well as the near term opportunities we see a little bit later, before that thought Rick will cover our financial results. Rick

Richard Davis

We’d outlined the highlights of the first quarter on slide three of our presentation. Basic core EPS and net investment income were both $0.36 per share for the first quarter representing a penny decline compared to Q4 of 2007. This decrease was primarily driven by the net effect of lower LIBOR rates and lower fee income in Q1. Diluted core EPS and net investment income were both a penny per share are lower in the basic amount of $0.35 per share. The diluted weighted average share outstanding were higher than the basic weighted average shares outstanding, due to inclusion of shares related to the rights offering Mike just mentioned.

Even though this transaction closed after the end of the quarter FAS 128 requires we include the shares related to the transferable rights of this offering from March 24, the record date to the end of the quarter. Our GAAP net income of $9.2 million or $0.13 per basic share and $0.12 per diluted share was down sequentially from Q4 and was primarily impacted by net realized and unrealized losses on our portfolio investments and by the lower LIBOR rates and fee income that I just mentioned.

As shown on slide seven, we had net unrealized depreciation on our portfolio investments of $17 million or $0.23 per basic and diluted share in the first quarter. Our NAV was down by 1.9% from Q4 of ’07 to $15.17 per share primarily due to these unrealized depreciation adjustments. Our first quarter gross commitments totaled $304.1 million and including $24 million of sales to our Ivy Hill Middle Market Credit Fund totaled excess and repayments were $131.9 million resulting a net commitments of a $172.2 million for the quarter.

We closed the quarter with a $1.9 billion investment portfolio covering 82 portfolio companies that have a weighted average, EBITDA of $30.2 million. Excluding cash and cash equivalents our quarter end portfolio was comprised of approximately 60% and senior secured debt securities including 36% in first lien and 24% in second lien assets and 23% in mezzanine debt securities and 17% in equity and other securities.

Weighted average yield on our debt and income producing equity securities for the first quarter was a 11.2% and 44% of our investments were in floating rate, debt investments at the end of Q1, which as Mike mentioned was down from 51.6% at the end of 2007. The decline in our weighted average yield was a direct result of the significant lowering of LIBOR rates, which fell nearly 200 basis points during the quarter.

Despite the significant decline in LIBOR during the quarter, our overall weighted yield was only down 44 basis points from the end of 2007, due to the shift in our portfolio to higher yielding fixed rate loans. Although we saw a decline in the weighted average yield in our debt and income-producing equity securities in Q1 we saw an even greater decline in our weighted average cost of debt as all our debt obligations are at floating rates.

For the first quarter our weighted average cost of debt decline from 5.66% to 3.84% at the end of the quarter. Therefore based on these changes in LIBOR and our portfolio mix, there is a 7.4% spread between the yield on our debt and income producing equity securities and our weighted average cost of debt as of the end of the first quarter compared to a spread of 6.02% at the beginning of the quarter. We hope to see that spread increased further as the year progresses. We have not elected to mark our liabilities to mark it under FAS 159. We clearly believe that the nature and cost of our liabilities are a strategic value to us in the current market.

Slide four summarizes our recent capital markets activity. On April 28, we completed $266.5 million transferable rights offering, issuing approximately 22.2 million shares of our common stock at a price of $11 per share with net proceeds after deducting dealer manager fees and operating expenses were approximately $260 million. Our plan is to use the proceeds from this offering to repay outstanding indebtedness and for other general corporate purposes, including investing and portfolio companies.

As part of this transaction an affiliate of Ares management purchased approximately 1.6 million shares or approximately $18.1 million bringing the total Ares ownership of ARCC to close to 3% of our total outstanding shares. As we discussed on our last call, it’s important to note that this rights offering was not driven by any current liquidity constrains or near term debt maturities, rather it was completed to provide as much flexibility as possible to take advantage of the very exciting and current market opportunities that Michael will discuss later.

After taking into account, the issuance of additional equity and the application of such proceeds to repay a portion of our outstanding debt. Our pro forma leverage at the end of the first quarter would have down 0.44 times. As I’ve discussed before and has shown on slide seven, we have $17 million of net unrealized losses in the first quarter comprised of $30.1 million of unrealized depreciation on investments. It was partially offset by $13 million of unrealized appreciation on investments.

Of the $30.1 million of unrealized depreciation for the quarter, approximately $17 million was due to credit related issues, which we typically define as companies that have had negative trends in our business and in some cases, a particular credit event such as a covenant default or expected default. The remainder of the unrealized depreciation for the quarter was primarily due to mark-to-market adjustments.

The most significant changes in net unrealized depreciation during Q1 were $5.7 million from a debt and equity investment and the company that provides healthcare equipment services, $3.5 million related to a debt investment in a company that provides database marketing services, $3.5 million from a debt investment in a company that publishes community newspapers, $2.6 million from a debt investment in a company that provides healthcare information management services, $2.5 million from a debt and equity investment in a company that that provides to photography services in hospitals and $2.3 million from a debt investment in a distributor of healthy juice products.

The most significant changes in unrealized appreciation in Q1, was $7.3 million from an equity investment in a company that that manufactures reflective products and optical films and $5 million from an equity investment in a medical school operator. Q1 was the first quarter, in which adoption of FAS 157 was required. As many of you know FAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosure of fair value measurements.

We begin looking at the implications of this pronouncement about this time last year and have maintained an opened dialogue with our auditors outside corporate and 40 Act counsel, our three independent valuation providers, as well as other valuation experts and professionals at other firms in the financial services sector.

As we previously discussed, our portfolio is heavily weighed to debt investments that fall under level three assets in FAS 157. For example, at the end of the first quarter, 98% of our portfolio investments were classified as level three investments under FAS 157. Level three investments, did not have credit crises in active or inactive markets and no significant valuations inputs are directly or indirectly observable.

Under FAS 157, inconsistent with the advice of our auditors and other advisors our level three investments are based on a combination of factors, as appropriate, including looking at the enterprise value of the portfolio company, the nature and realizable value of any collateral. The portfolio companies ability to make payments in its earnings and discounted cash flows. The markets in which the portfolio company does business, compares them to publicly traded securities, changes in the interest rate environment and the credit markets that may generally affect the price at which similar investments maybe made in the future and other relevant factors.

As you may recall, prior to our Board of Directors approving our final investment valuations each quarter approximately 25% of our portfolio investment valuations are reviewed by independent valuation services. For the first quarter approximately $250 million of our portfolio was reviewed by third parties and approximately $700,000 has been reviewed by third party since the end of the 2007, including three of our top five holdings.

We also exited or realized eight investments during the quarter, generating net realized gains of $200,000. Our IRR since inception on realized investments is approximately 19%. Slide nine shows a summary of our debt. As of March 31, we had $865.6 million in total debt outstanding and subject to leverage restrictions had approximately $308.4 million available for additional borrowings under our existing credit facilities.

Weighted average interest rate of our debt stood at 5.1% during Q1, and was 3.84% as of the end of the quarter and our debt-to-equity ratio stood at 0.78 times at the end of the quarter. Our only maturity before the end of 2010 is our CP facility that matures in October of this year. Earlier this month, we repay the entire $85 million remaining outstanding on this facility, with a portion of the proceeds from the equity offering that I discussed earlier.

Turning to slide 10, we paid our regular first quarter dividend of $0.42 per share on March 31, stockholders have record as of March 17. We’ve also declared our regular second quarter dividend of $0.42 per share payable on June 30, stockholders have record on June 16. Providing further dividend stability for this year, we also expect to carry over approximately $7.7 million of anticipated undistributed excess taxable earnings, 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 and I’ll turn the floor back over to Mike.

Michael Arougheti

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 reflects the continued execution of our long-standing investment strategy and our opportunistic response to the current investment environment.

Despite broader market issues, that have significantly reduced loan volume, we continue to generate healthy levels of deal flow. For example, we’ve reviewed a record 250 transactions during the first quarter, which represents a 20% increase over the number of transactions we reviewed in Q4 of last year. This total doesn’t include the numerous secondary capital market transactions we also reviewed during the quarter.

As we stated before, asset selectivity drives good investment decisions and generating significant deal flows is critical for that process. This consistent level of deal flow, even during the period of needed market activity, is we believe a testament to our established self origination platform, the benefits of the broader Ares platform, our ability and willingness to invest in all levels of the capital structure and our demonstrated ability to close transactions in this difficult environment, which set us apart from many other financing providers.

Consistent with our historical trend and demonstrating our discipline and patients we closed on 13 deals in the first quarter, reflecting a closing ratio of slightly over 5%. We also continue to build new and strengthen existing sponsor relationships during the quarter and as of the end of Q1, 57 separate private equity sponsors were represented Ares Capital portfolio.

As Rick mentioned earlier in the first quarter we’ve closed $304.1 million of new commitments, across 13 portfolio companies. Five of these investments were with new companies and eight were with existing portfolio companies. Eight separate private equity sponsors will represented in these new transactions with two of those sponsors being new relationships for ARCC. Also during the first quarter, we made five investments in non-sponsor transactions. Of these new investments, 24% were in first lien senior secured debt, 59% in the second lien senior secured debt, 12% in senior subordinated debt, 5% in equity securities and 20% of these investments bear interest at floating rates.

During the first quarter, significant new commitments included $95 million in the second lien senior term debt of an acute care hospital operator, $66.5 million in the first lien senior term debt revolver commitment and equity of provider ERP Solutions for post-secondary educational institutions, $52.1 million in second lien senior term debt and equity of provider specialized engineering, scientific and technical services primarily to U.S. Government Agencies, $38 million in second lien senior term debt, and revolver and equity to an airport-based retail operator and $15 million in delayed senior subordinated debt in a cargo transportation provider.

As I mentioned earlier our investment activity and portfolio management in the first quarter, showed the continued affects of our rotation to higher yielding investments with better structured, protection and improved leverage levels that were previously available. As shown on slide 14, we saw continued separation in spreads between asset classes in our portfolio in the first quarter. Keep in mind that the trends shown here lagged the current market because they represent our total portfolio yields by asset class including investments entered prior to the first 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.

Consider such a dramatic decrease in LIBOR during the first quarter, we included trend information on LIBOR and our weighted average cost of debt in the graph in the left side of the slide and further illustrating the separation yield and improving investment spreads, we’ve also included a new graph on slide 14 that shows our weighted average investment spread on our first and second lien debt investments. This improvement in portfolio yield was achieved without a meaningful change in the overall leverage of our portfolio. Consisting with our long standing objective of preserving capital while seeking superior risk adjusted returns through cycles expect to see us continue to focus down the balance sheets for new investments that we believe will drive our portfolio yield up without sacrificing credit quality.

Hopefully, this will be further reinforced when I discuss our backlog. Turning to slide 16, consistent with our views on the credit and economic environment, we’ve continued to focus on investments in more defensive, non-cyclical and service-oriented businesses. For example, at the end of the first quarter, approximately 25% of our portfolio was in general service-related industries, 18% was in healthcare-related businesses, 7% was in printing, publishing and media, 10% in education-related companies and 8% in retail businesses. Our portfolio also remains geographically diverse. We also have limited issuer or concentration risk with no investments representing more than 5% of our portfolio’s total value.

Turning to slide 17, in our portfolio quality, as you know we are implying an investment rating system with grades one through four with one being the lowest grade and four being the highest grade. At the end of the first quarter, the weighted average grade of our portfolio investments was three, with four portfolio companies receiving a one rating, a slight increase from the prior quarter. Two of these loans are on non-accrual.

The fair value of these non-accrual loans represents less than 1% of our total portfolio value. We also had seven companies with a four rating representing approximately 8% of our total portfolio value. Now, I’ll finish by turning to a broader view of the current market climate. The opportunities we see for ARCC and how our past strategic decisions have positioned our portfolio, balance sheet and infrastructure to capitalize on these opportunities.

The dislocation in the credit markets and reprising at risk that have significantly impacted several key sources of liquidity in the syndicated loan market continues through the first quarter and while we have seen some firming up in the broader liquid credit markets over the last few weeks, we expect the current market environment and sentiment to remain at least through the end of this year, as improving technical potentially give way to worsening fundamental.

We continue to see the effects of a general lack of liquidity impacting all aspects of the loan market. Illustrating this point, in the first quarter leverage loan volume fell to a 4.5-year low of $45 billion compared to $78 billion in Q4 of 2007 and that was down from the near record $185 billion in the first quarter of last year. Second, lien volume was substantially off in the first quarter to a five year low $1.5 billion. The middle market faired better with total volume of $2.7 billion in the first quarter.

The significant decline in liquidity created and has sustained a large pipeline of un-syndicated loans. At the end of the first quarter it’s estimated that a $120 billion remained in the pipeline for loans that had not been syndicated, down from a $150 billion at the end of the 2007. So, while the quarter saw some significant progress in reducing this large overhang loans, we don’t expect this to fundamentally change dynamics in the new issue marketing in the near-term.

Banks still have a lot of work to do to cleanup and strengthen their balance sheet and the institution of credit buyers still having difficulty sourcing leverage. Private equity firms continue to feel the affect, of this lack of liquidity with LPO activity down and the average equity contributions to buy our transactions significantly increasing. LPO volume in Q1 was $23 billion compared to $125 billion in the fourth quarter of 2007, an own average transactions included 46% of equity compared to 30% in 2007 and to the prior high of 37% in 2002.

That said there remains a large pool of private equity yet to be invested, which we expect will drive additional deal flow when seller and buyer evaluation expectations recalibrate to account for a shift in financing costs and structure. Another notable change in the broader market during the first quarter was as expected a rise in credit issues. The lagging 12-month default rate by number of loans increased to two year high 1.8% at the end of Q1 compared to 0.26% three months earlier.

This should come as no surprise given a slowing economy with escalating inflationary pressures and we expect even further weakness in the medium term. As you may recall, we have either board seats or board observation rights for 34% of our portfolio company’s and we monitor financial information and operating performance on at least a monthly basis for all portfolio companies providing us an early read on operating performance.

Additionally, given our senior position in many of our investments, we are in a better position to reprise our risk through increases in spread and amendment fees at the earliest signs of any weakness. I remind you that our portfolio offers limited or no exposure to subprime, real estate, home building, commodities or the automotive sector. Our cumulative realized gains on equity investments have also significantly exceeded realized and unrealized losses.

Turning to page 18, in our presentation, you see that since inception we’ve invested $3.4 billion and 136 transactions. We have exited 54 of these investments, generated total proceeds of 890 million, an accumulative IR across all asset classes of approximately 19%. As you can see, 90% of these exits generated IRR’s of 10% or greater. We don’t expect the current environment to meaningfully constrain exits in our portfolio and we expect that we will have opportunities to realize capital gains in the coming quarters.

Despite fairly steady, middle market deal volumes there is a general feeling that the market is slowing. Transactions are generally taking longer to complete as the market continues to find its footing and the expectations of sellers, buyers and financing sources are recalibrated. We don’t yet know how this will be reflected in deal volumes in the coming quarters. Interestingly giving current issues playing larger financial institutions and retreat of institutional buyers, volumes, pricing structures and terms appear to be more efficient at the low end of the middle market than in larger companies.

This is a dynamic that we have not seen in sometime and we are actively looking to pursue opportunities to finance larger borrowers that historically would have accessed the high yields or syndicated loan markets. Particularly, attractive in these companies are fixed rate, second line or subordinated debt investments with total return profiles in excess of 15%. Importantly, these situations are leveraged such that they would not meaningfully increase the weighted average leverage profile of our portfolio.

In fact most of these opportunities are coming with total leverage below five times despite the dramatically increase return opportunity. In addition we should be able to target larger final holds in these situations, which will accelerate the rate of capital deployment even if overall deal volume slows. These trends are clearly illustrated in the composition of our backlog and pipeline.

Since the end of the first quarter, we have issued $2.6 million of investment commitments and we have an investment backlog in pipeline of approximately $213.8 million and $269.3 million respectively. As you can see on slide 12, reflecting our stated objective of seeking relative value this $483.1 million of current investment opportunities, is further down the capital structure than our existing portfolio as we are seeing superior risk adjusted returns in these asset classes.

Illustrating that point only 11% of this current backlog and pipeline is in senior secured first lien debt in contrast of 36% of our Q1 investments net asset class. While further down the balance sheet, these deals are not expected to increase the overall leverage in the portfolio and as I mentioned earlier we believe that the weighted average yield on these potential transactions will be meaningfully higher than the 11.2% weighted average yield for the debt and income-producing securities in our existing portfolio.

Importantly, many of our junior investments are coming with the significant fees and call protection, which significantly enhance the total return profile above the stated yield. In addition, many new floating-rate investments are coming with LIBOR for us to protect against further rate reductions. The conformation 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 cannot provide assurance that any of these investments would be made. Strong performance in our existing portfolio, have historically also provided many of the best investments with approximately one-third of our deal flow historically coming from existing portfolio companies. As our portfolio companies grow organically and through the acquisition, we are seeing numerous opportunities to provide additional capital at higher rates by either re-pricing existing debt or moving down the capital structure with the little competition.

Beyond the new issue market, we are seeing the wide variety of secondary market opportunities as investment banks work through their un-syndicated pipelines. In addition, as underlined credit weakens, we expect to see some interesting opportunities present themselves, either potential restructuring in workout situations, providing much-needed capital to undercapitalize or over-leverage businesses or hold portfolio purchases

Recall that our core financial opportunities with middle market companies that can efficiently access the capital markets. As we have emphasized before, we believe that the dislocation in the credit markets has only improved our competitive positioning. We continue to firmly believe, that 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 market. 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, with our strong platform and recently completed equity offering, we believe that we are well positioned to take advantage of any investment opportunities that need our risk return profile, as well as to withstand any weakness that may arise in our portfolio.

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 portfolio companies. We believe our ability to remain active participants in these turbulent markets strengthens our franchise as we capture additional market share and enhance our diversification.

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 manage in excess of $20 billion and have close to a 100 investment professionals covering in excess of 600 companies across 30 plus industries, providing not only research assistance, but a broad and the real-time view on relative value and risk returns.

Our team is seasoned and cohesive and has significant experience managing through market cycles and we have a robust back office infrastructure that supports our business. 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

So, in closing, although the current market environment is proving to be challenging for some, we are encouraged by the opportunities we see for ARCC. We believe the fact that we are well positioned to benefit from the current market dislocation as a validation of the investment strategy and discipline that we have pursued over the last three years.

We focused on senior debt investments in defensive industries to protect the downside of our portfolio, in anticipation of a market that would offer us more attractive risk-adjusted return at every level of the balance sheet.

That covers our prepared remarks today as always we appreciate your time and thank you for your continued support and with that, we now like to begin our Q&A.

Question-and-Answer Session

Operator

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

Greg Mason - Stifel Nicolaus

First on your $13 million of unrealized depreciation, can you give us your opinion on the breakdown of what you think is simply just mark-to-market issues versus actual marks because of the credit deterioration or fundamental deterioration?

Michael Arougheti

Yes, we talked about that in the prepared remarks it's roughly fifty-fifty.

Greg Mason - Stifel Nicolaus

Of the four companies that are now in grade four, how many are new this quarter and are you willing to give those companies that are in there?

Michael Arougheti

The number of new companies that are grade one, I believe is three. We had one last quarter and really what we saw is the rotation from companies that were prior two’s that rotated into a one and we do not disclose the company level information?

Operator

Your next question comes from Vernon Plack - BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

Michael looking at and taking into consideration your rights offering, can we assume that your debt capacity, additional debt capacity now is closed to $570 million?

Michael Arougheti

If you look at our balance sheet prior to the rights offerings we've mentioned we were roughly 0.78 time debt-to-equity. Pro forma for the rights offering we were roughly 0.4 times leveled. Our total debt capacity when you add up our revolver. Our CLO and our CP funding facility, excluding Ivy Hill is roughly $1.1 billion and our funded debt pro forma for the rights offering is roughly 600 million. So roughly it’s about $550 million.

Operator

Your next question comes from Sanjay Sakhrani - KBW.

Sanjay Sakhrani - KBW

I just wanted to get a sense of your thoughts on the migration of the mix in the portfolio I appreciate the comments on the backlog and the pipeline, but I just wanted to sort of get a sense of where we should expect you guys to go between now and the end of the year or maybe end of the 2009 also is base case assumption assuming no equity raise?

Michael Arougheti

No, equity rise in the reminder of the year.

Sanjay Sakhrani - KBW

Yes, that’s right.

Michael Arougheti

Handling the first part of the question, there is a really interesting dynamic in the market now where larger companies are having a very difficult time getting finance given the changes that we have seen in the larger Syndicated Loan market and the High-Yield market. So, while number of deals had slowed in the larger market our view is that the size and quality of those deals has increase.

There are number of companies that have to make strategic acquisitions or relate strategic growth capital and really the loan alternative is they come to providers like Ares, on the home second lean or mezzanine at very attractive total returns. So in no situations as I mentioned we are very aggressively moving down the balance sheet from a security standpoint, but not from the total leverage standpoint and given the size of those investments you should expect to see continued rotation in the portfolio out of first lien into second lien and mezzanine, that said you will not see first lien go to zero it's still very critical part of how we originate business and how we think about managing the general risk profile of the portfolio.

With regard to our traditional middle market business as I mention that’s a little bit more efficient and we are a little bit more reluctant to move down the balance sheet in those companies right now given where we are in the economic cycle. So, what you probably see us doing there is continuing to use our one stop capability and try to get as much of our capital in from $1 as possible to get drive better risk adjust return those types of situations and then with regard to the equity raise our best guess now is that given the rights offerings current portfolio activity and our debt capacity that we will not need to comeback to the equity markets this year. If we do I think that will be very positive sign as the market opportunity just continues to get better for us and we will would look to do something opportunistically, but looking forward I am not quite sure what's going to happen.

Sanjay Sakhrani - KBW

You think the seed to the sub debt portion could get to 30%, the low 30% range as a percentage of the total portfolio by the end of the year?

Michael Arougheti

I do

Sanjay Sakhrani - KBW

On the purpose of investments may take existing companies, could you just talk about that, were any of them in on non-accrual or would it just add-on financing for growth?

Michael Arougheti

All add-on financing for growth, but two companies I think we talked about on our last call that are on non-accruals. Have liquidity has actually cash to make the sub debt interest, that its been turned over to the seniors, one of those companies is actually for sale today and the other we are in an active discussion with the private equity sponsors to what a longer term capital structure fix would be. I’ll give you an example of one situation which I think will highlight the current market opportunities as well as the opportunity we see within our existing portfolio which is this investment that we made in the acute care hospital company in the second quarter that’s been an existing portfolio company of or us for about 2.5 years and the company has grown through a series of acquisitions prior to the deal that was done in the first quarter it was financing itself in the syndicated loan market even given the liquidity issues that we’ve obviously spent a lot of time talking about.

They came to us directly with an opportunity to provide $95 million of second-lien at very attractive total return in leverage levels. So what we are seeing mostly in the existing portfolio is, we are investing middle market companies that are dynamic, a lot of them grow through acquisition and a lot of them had very attractive organic growth, opportunities that required capital and given our common position with the first and sometimes the only call that they are making.

Sanjay Sakhrani - KBW

Does it make sense and can you lock in the funding rates at these levels?

Michael Arougheti

We can I think as we mentioned before we look regularly at our interest rate exposure as we highlighted, it’s actually been a big benefit over the last year for us. If you look at the, spread between our costs of funds and the rates that which we’re deploying capital, right now is continuing to widen as we mentioned. We think that it will continue to do so for the reminder of the year. It’s something that we look at closely as we go through the year and we realize some of our backlog and pipeline and we get a better sense for our fixing and floating rate assets. We may look to better match fund but for now it’s been uneconomic to actually look to locking our cost of funds.

Sanjay Sakhrani - KBW

And that sub debts coming in fixed costs, I’m sorry fixed rate?

Michael Arougheti

Yes.

Sanjay Sakhrani - KBW

And just rough area of the types of yield that you are seeing on that?

Michael Arougheti

On the sub debt today is getting roughly 2% to 3% upfront fees, stated coupons are somewhere between 12% and 14% or 15% and then, typically hard call protection of another 500 basis points scaling down to maybe a 100 basis point.

Operator

Your next question comes from Faye Elliott - Merrill Lynch.

Faye Elliott - Merrill Lynch.

You’ve raised your dividend in the quarter bringing it, further above your NOI run rate. Can we assume then from that, that you have some level of comfort with the certain level of gains to come and if so, can you give us a little bit more information on that?

Michael Arougheti

Yes, as we have said before it’s challenging to evaluate dividend coverage in quarters where we are growing significantly through equity assurance. So as a dividend strategy you have to look at what’s the earnings capacity of the businesses is once fully invested and the challenges when you look at historical period given the level of activity we've had in the equity market you will see periods of time where we are not covering the dividend from NOI and then we catch up the coverage as we invest the proceeds from equity offerings.

If you smooth that out you’ll notice that we have one of the highest dividend coverage from NOI in the peer group. Another thing that we do to support dividend stability and dividend growth is obviously to roll over excess taxable income year-to-year and as Rick mentioned in his remarks for the year we are estimating roughly $8 million of roll over income from 2007 into 2008, which could be used to bridge, the shortfall of NOI to the dividend level and then thirdly, as you point out, we do feel very good about a number of portfolio companies and the prospects for gains.

We can't promise it or guarantee it but, we expect to see some capital gains this year that will provide some further stability, but when you look at the again the run rate earnings power of the business once fully funded the dividend coverage is not dependent on those case gains.

Faye Elliott - Merrill Lynch.

Okay so, you then would imagine that, you would probably get us to about this $0.42 a quarter on a fully invested portfolio given the right environment?

Michael Arougheti

We would hope so.

Operator

Your next question comes from Jon Arfstrom - RBC Capital Markets.

Jon Arfstrom - RBC Capital Markets

Just a follow-up on the fixed versus floating, rate question. Do you have a preference at this point for what’s you’re reporting on in terms of fixed and floating and then do you have a type of rate environment you are managing the balance sheet for?

Michael Arougheti

Yes, we’ve been aggressively moving into fixed rate investments and you can see that over the last three quarters. If you look historically we have the opposite strategy and we actually rode the steepening LIBOR curve very profitably over the last 3.5 years. Our current view is that we were in a flat to rising environment towards to the end of the year and we will keep our eye on that. That said though we still have a very strong preference for fixed rate investments given where our interest rates are now and where we expect them to be in the future.

Jon Arfstrom - RBC Capital Markets

Mike in your prepared comments you talked about some medium term weakness in the market in general for asset quality not necessarily, specifically Ares, but how do you define the medium term and what level of credit weakness do you think we are likely to see in the industry.

Michael Arougheti

Well if you look historically and assume would be credit for bank loans, the historical average default rate is roughly 3% as I mentioned we are closer to 1.5% at the end of the first quarter, obviously for high yield bond its been higher almost twice that. It’s very likely that we see those levels towards the back end of this year, what we are seeing in the portfolio companies broadly across the platform is interesting. There is still fairly consistent year-over-year revenue growth, but a lot of portfolio companies in the lot of sectors are grappling with all sorts of inflationary pressure on the raw materials and labor side.

The other issue we have is, obviously leading up to the current market environment a lot of companies took on a lot of leverage and even in the situation where revenues and earnings where growing, if the rate of that growth slows you could find yourself in situations were people are having credit issue. So medium term for us is 6 months to 9 months from now and our best guess it will start to approach the mean here by the third or fourth quarter of this year.

Operator

Your next question comes from Brian Roman - Robeco Investment Management.

Brian Roman - Robeco Investment Management

Maybe I might have more than two, pick income how big was out in the quarter?

Richard Davis

It was $5.4 million for the quarter

Richard Davis

Yes, it was $5.4 million just the thick income.

Brian Roman - Robeco Investment Management

So, that would be under, that’s not the net number that just a line interest for investments?

Richard Davis

Yes it’s in the interest income line item.

Brian Roman - Robeco Investment Management

$4 million, is that change meaningfully and as you are going forward with better terms and conditions do you see less pick out there?

Michael Arougheti

Its roughly consistent, we have been hovering over the last 12 months to 18 months, somewhere between 8% and 10% thick income. I remind people that we had very few securities where they are exclusively thick typically that thick income is being generated on top of significant cash incomes, for example we might have a stuff that investments, but as 14% stated yield, 12% cash, 2% pick and that dynamic given changing so typically -- and the question that Sanjay asked earlier about the types of returns that we’re seeing. We are still seeing in most situations roughly 200 basis points of the stated yield and the subject in the secondary market coming from picking up cash.

Brian Roman - Robeco Investment Management

Next question is about the share account. Did I hear you correctly that you were made to assume that the warrants were issued as of March 24th? Did you say that?

Michael Arougheti

That’s correct.

Brian Roman - Robeco Investment Management

What’s the logic there?

Michael Arougheti

The logic is really incorporated in a FASB announcement that essentially it’s -- it doesn’t increase the basic share count, but it does the dilutive share account, and it’s just effectively it’s like a stock options and things like that were for the diluted number you include those that are somewhat of a contingent nature.

Brian Roman - Robeco Investment Management

And then that all washes out the date of deal as it pleased, it will actually close, correct.

Michael Arougheti

Yes, it will washout throughout the year, that’s correct.

Brian Roman - Robeco Investment Management

And your NAV was 517, do you know what it would be, closer to the deal assuming March 31 numbers?

Michael Arougheti

I think the additional share count was, probably a little over $1 per share, impact.

Brian Roman - Robeco Investment Management

So, 517 is closer to 417 all in?

Michael Arougheti

1517.

Brian Roman - Robeco Investment Management

1517 is now – we’ve flip the page on the transaction and the issuance.

Michael Arougheti

Yes, and I think that the impact of the rights offering was a little over $1 per share.

Operator

Your next question comes from Greg Mason - Stifel Nicolaus.

Greg Mason - Stifel Nicolaus

Two quick modeling questions, first the $197,000 of asset management fees from Ivy Hill. How does that flow into your income statement, under what lines?

Richard Davis

It’s on the other income line item.

Greg Mason - Stifel Nicolaus

Okay, on a Controlled Affiliate company or non-Controlled Affiliate?

Richard Davis

Controlled Affiliate

Greg Mason - Stifel Nicolaus

And your interest rate sensitivity analysis in the queue is that based on the average LIBOR rate from the first quarter change or changes from quarter end LIBOR rates?

Michael Arougheti

It’s on the average change.

Greg Mason - Stifel Nicolaus

Okay perfect and just senses to your largest company and there is a lot of pres on it, FirstLight Financial there has been some stories out there that there is another round of layoffs. Can you talk about what’s going on there and why you’re comfortable with no change in valuation this quarter?

Michael Arougheti

I would not quite say that there has been a lot of press, I think that as some industry lags are prone to do, people look for news where often times there isn’t. I would say that we as investors in that company and the board of that company would be remiss, that they weren’t laying people off in the current financing environment and obviously you can name the financial services company on Wall Street and obviously layoffs are not an uncommon thing today.

The way that that business is capitalized is it’s roughly $1 billion portfolio with very low leverage that is locked in for seven years at very attractive rates. The issue that’s facing that company is not that there is a lot of downside risks to the existing portfolio, the existing structure, but simply that we and the management team of that company had very high hopes for growth and market share gains for that business and given the dislocation in the credit market obviously those good prospects that we see in the near-term have changed and in order to right-size the business for the current market opportunity, the prudent thing to do was unfortunately to let a number of people go and so where that situation stands is we have a portfolio that is very healthy, that is generating consistent cash flow given it’s structure and the cost of its leverage and a very talented and sophisticated management team that is looking for ways to maximize value in that investment.

Greg Mason - Stifel Nicolaus

I know the origination can be lumpy, but $2.6 million so far in 2Q seems a little low; any thoughts on the rights offering to track you from originating new investments or any commentary there other than just lumpy business?

Michael Arougheti

No, it’s just lumpy business. Again the right offering was fairly straight forward and while some of the senior management team were on the road for a couple of days, obviously it’s a very large firm and business goes on as usual. As we mentioned we do have a significant backlog in the pipeline and we expect that we will just see some investments closings in the back half of the quarter.

Operator

Mr. Arougheti there are no further questions.

Michael Arougheti

Again we wanted to thank everybody for joining our call this afternoon and for your continued support and we look forward to speaking with all of you on our next quarterly call. Thanks again.

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