Ares Capital Corporation Q2 2008 Earnings Call Transcript

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 |  About: Ares Capital (ARCC)
by: SA Transcripts

Ares Capital Corporation (NASDAQ:ARCC)

Q2 2008 Earnings Call Transcript

August 7, 2008 10:00 am ET

Executives

Michael Arougheti – President

Rick Davis – CFO

Analysts

Greg Mason – Stifel Nicolaus

Sanjay Sakhrani – KBW

Faye Elliott – Merrill Lynch

Vernon Plack -- BB&T Capital Markets

Jim Ballan – J.P. Morgan

Jon Arfstrom – RBC Capital Markets

Operator

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Ares Capital Corporation second quarter 2008 earnings conference call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Thursday, August 7, 2008. In addition to Ares Capital Corporation’s earnings release and quarterly report on Form 10-Q, the company is offering a webcast and slide presentation to accompany this call.

Copies of the earnings release, Form 10-Q and the slide presentation can be obtained from the company’s website at arescapitalcorp.com under the Investor Resources tab. The earnings release is located in the Press Release section. The Form 10-Q can be found in the SEC Filings section, and the slide presentation is located in the Stock Information section. Ares Capital Corporation's second quarter 2008 earnings press release, Form 10-Q, comments made during the course of this conference call and webcast and its accompanying slide presentation contain forward-looking statements within the meaning of Section 21E 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 its 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 and market information 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 net per share increase in stockholders equity resulting from operations, less realized and unrealized gains and losses, 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, the most directly comparable GAAP financial measure, can be found in the company’s 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 condition and results of operations.

At this time, we would like to invite the participants to access the accompanying slide presentation. As previously noted, you can access the presentation on the company’s website at arescapitalcorp.com and click on the August 7, 2008 presentation link under the Stock Information section of the Investor Resources tab.

I will now turn the call over to Michael Arougheti, Ares Capital Corporation’s President.

Michael Arougheti

Thank you, operator. And good morning everyone and thanks for joining us this morning. I’m joined today by Rick Davis, our Chief Financial Officer, and other members of our senior management team, including Carl Drake, who recently joined our management team as Senior Vice President of Finance and Head of Capital Markets and Investor Relations.

Carl joined us from SunTrust Robinson Humphrey where he was a specialty finance analyst covering BDCs as part of his overall coverage. And we are very excited to have him on board. Given his diverse background, which also includes leveraged finance and investment banking, Carl will focus on Investor Relations and capital related activities, as well as provide origination support from our new Atlanta office. Please join me in welcoming Carl to our team.

Before we get into the financial details of the second quarter, I want to take a minute to summarize our recent operating results in capital markets activities. Despite continued volatility in the credit markets and a significant decline in overall leverage loan and buyout volume in the broader market, we closed $342.3 million of investment commitments in the second quarter.

As I’ll discuss in more later and consistent with the expectations we discussed in our last earnings call, these new investments generally reflected meaningfully improved pricing and structure with underlying relative leverage, comparable to or lower than what we see in our existing portfolio. Importantly, these new investments contributed to an improvement in our investment spread during the second quarter to 7.86%. This represents an increase of 46 basis points compared to the first quarter and an even more dramatic increase of 189 basis points since the end of 2007.

As you know, we have a long-standing objective of preserving capital while seeking superior risk adjusted returns through business cycles. Consistent with that strategy, we conservatively positioned our balance sheet over the last three years in anticipation of a market that would offer us better risk adjusted returns. Illustrating the continued execution of this strategy since the beginning of the year, we began to rotate into higher yielding investments with comparable or lower overall leverage levels. We believe that we are still in the early stages of this repositioning.

As I’ll discus in more detail later, we believe our current portfolio mix, balance sheet, diverse funding sources and infrastructure positions us well in the current environment and we remain very excited by the opportunities we continue to see to execute this strategy. As evidenced by some of our Q2 unrealized depreciation, we were not immune to the continued pricing volatility and economic weakness evident in the current credit market.

I do think it’s worth noting that even though we’ve reported net unrealized depreciation on our portfolio investments over the last few quarters, the total fair value of our portfolio at the end of the second quarter was only $71.5 million or approximately 3.3% lower than the amortized cost basis of $2.1 billion. The underlying credit quality of our portfolio remains very solid with 1.3% of our portfolio at fair value and non-accrual or less than 3% of the portfolio at cost.

Our ability to aggressively pursue opportunities in this very attractive investment environment is largely dependent on our access to capital. We significantly increased our liquidity during the second quarter by completing a $260 million equity rights offering and in July we opportunistically renewed our $350 million credit facility that was scheduled to mature in October and extended the maturity until July of 2009.

Additionally, with our investment grade credit ratings, we hope to access a broader range of capital alternatives in the public and private debt markets when the opportunities present themselves. However, as you all know, current market conditions render many alternatives unattractive at the present time. And therefore we are focused on a three-prong strategy to improve shareholder value over the immediate term. One, using our available liquidity to invest in higher yielding assets and to generate fee income and attractive total returns. Two, managing our balance sheet liquidity with a number of new initiatives, including potential additional managed funds and the divestiture of lower yielding assets on an accretive basis. And three, aggressively managing our underlying portfolio of credit profile.

I’ll discuss the broader market near-term opportunities in these initiatives to improve shareholder value a little later, but before that Rick will cover our Q2 financial results. Rick?

Rick Davis

Great. Thanks, Mike. We’ve outlined the highlights of the second quarter on slide three of our presentation. Basic and diluted core EPS and net investment income were both $0.40 per share for the second quarter, representing $0.04 increase compared to Q1. This increase was primarily due to higher fee income in Q2, partially offset by a higher share count resulting from the equity rights offering Mike mentioned earlier.

Our income from structuring and amendment fees was higher than normal at $11.3 million in Q2 as we took advantage of current market conditions to generate additional fee income. However, although difficult to predict, going forward we would expect to see fee income normalize to more historical levels in the range of $4 million to $5 million per quarter.

Our GAAP net income of $3.3 million or $0.04 per basic and diluted share was down sequentially from Q1 by $0.09 per share and was primarily impacted by net unrealized depreciation on our portfolio investments, partially offset by higher interest and fee income.

As shown on slide seven, we had net unrealized depreciation on our portfolio investments of $32.8 million or $0.36 per basic and diluted share in the second quarter. We also incurred a small realized gain in the quarter. As shown on slide ten, our net asset value per share was $13.67 at the end of the second quarter, down from Q1 largely due to the effects of the equity rights offering Mike outlined and to a lesser extent, unrealized depreciation adjustments on our portfolio.

Our second quarter gross commitments totaled $342.3 million, including $17 million of sales to our managed fund, the Ivy Hill Middle Market Credit Fund. Total exits and repayments were $43.4 million, resulting in net commitments of $298.9 million for the second quarter. As you can see on slide 13, the $43.4 million of exits and repayments in the second quarter is below our historic quarterly trends. Again, although difficult to predict, we expect exits and repayments and asset sales to range between $150 million to $225 million in Q3.

As shown on slide nine, we had $77 million of cash on hand at the end of the second quarter. This is a larger cash balance and we usually maintain that we drew from our revolving credit facility near quarter-end to fund investments that closed shortly after June 30. We closed the second quarter with a $2.1 billion investment portfolio covering 87 portfolio companies that have a weighted average EBITDA of $38.1 million. Excluding cash and cash equivalents, our quarter-end portfolio was comprised of approximately 57% in senior secured debt securities comprised of 35% in first lien and 22% in second lien assets, and 26% in senior subordinated debt securities with 17% in equity and other securities.

The weighted average yield in our debt and income producing securities for the second quarter was 11.28% compared to 11.24% at the end of Q1 and 11.7% at the end of 2007. 40% of our investments were in floating rate debt investments at the end of Q2, which was down from 44% at the end of Q1 and from 51.6% at the end of 2007. The decline in our weighted average yield since the end of 2007 is the direct result of the significant decrease in LIBOR rates, which fell nearly 200 basis points since the end of 2007.

Despite the significant decline in LIBOR, our overall weighted average yield was only down 42 basis points from the end of 2007, due primarily to the shift in our portfolio to higher yielding fixed rate loans and higher spread floating rate debt investments. Although we saw a decline in the weighted average yield on our debt and income-producing securities since in the end of 2007, as the portion of our assets tied to LIBOR drifted lower with market rates, we saw an even greater decline in our weighted average cost of debt as all our debt obligations are at floating rates.

Compared to the end of 2007, our weighted average cost of debt has declined from 5.7% to 3.4% at the end of the second quarter. Therefore based on these changes in LIBOR and our portfolio mix, there was a 7.86% spread between the yield on our debt and income-producing securities and our weighted average cost of debt as of the end of the second quarter compared to a spread of 6 % at the end of 2007.

Looking forward, our investment spread, our investment spread will be impacted by somewhat higher borrowing costs on our recently renewed CP facility that I’ll discuss in more detail later, but with the continuing repositioning of our portfolio, we hope to see this overall spread increase further as the year progresses.

Slide four summarizes our recent capital markets activity. On April 28, we completed a $266.5 million transferable rights offering, issuing approximately 24.2 million shares of our common stock at a price of $11 per share with net proceeds after deducting dealer manager fees and offering costs of approximately $260 million. We deployed 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 at Ares Management increased its investment in Ares Capital and purchased approximately 1.6 million shares for $18.1 million making Ares one of ARCC’s largest shareholders. On July 22, we opportunistically extended the expiration date of our $350 million CP facility from October 2008 to July of 2009. As part of this extension, pricing increase from the commercial paper rate plus 100 basis points to the commercial paper, eurodollar or adjusted eurodollar rate as applicable plus 2.5%. Additionally, the commitment fee for unused portions of the facility increased from 12.5 basis points to 50 basis points. We also paid a renewal fee of almost 79 basis points or 2.75 million for this extension.

As I discussed before and as shown on slide seven, we had $32.8 million of net unrealized depreciation on our portfolio investments in the second quarter comprised of $48.8 million of unrealized depreciation on investments that was partially offset by $16.4 million of unrealized appreciation, of which about $14.5 million that was specific to equity value improvements due to strong company performance. Of the $48.8 million of unrealized depreciation for the quarter, approximately $29.5 million was specifically related to company performance, which could manage [ph] change in cash flow, its trading multiplies, or perhaps other negative trends in our business.

The remainder of the unrealized depreciation for the quarter was primarily due to mark-to-market adjustments. Of course, mark-to-market valuation compounds the effects of any company specific issues. Therefore in our view, about half the net depreciation in our portfolio value or about $0.18 per share in the second quarter was due to company specific performance issues.

The most significant changes in net unrealized depreciation during Q2 were largely accounted for by two companies. $13.7 million was due to a change in the value of our holding company debt investment in a community newspaper company and we incurred $10 million in unrealized appreciation from an equity investment in a company that manufactures reflective products and optical films. This adjustment, which had nothing to do with underlying company performance but rather other variables impacting fair value, partially reduces previously recognized unrealized appreciation that still reflects a $24.6 million increase over the June 30th amortized cost for this investment. $16.4 million changes to unrealized appreciation in Q2 was broadly based across 14 companies with the largest single adjustment at only $2.5 million.

At the end of the second quarter, substantially all of our portfolio investments were classified as level three investments under FAS 157. As you may recall, level three investments don’t have quoted prices in active or inactive markets and no significant valuations inputs are directly or indirectly observable.

Under FAS 157, our level three investments are valued each quarter 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 company’s ability to make payments, its earnings and discounted cash flow, the markets in which the portfolio company does business, comparison to publicly traded securities, changes in the interest rate environment and their credit markets that may generally affect the price at which similar investments maybe made in the future, and other relevant factors.

In addition to management reviewing the valuations for all investments in each quarter, prior to our Board of Directors approving our final investment valuation, approximately 25% of our portfolio investment valuations are reviewed by independent valuation service providers each quarter. For the second quarter, approximately $420 million of our portfolio was reviewed by independent valuation service providers and approximately $1.1 billion has been reviewed by third parties since the end of 2007, including six of our top ten holdings. In addition, $646.3 million of investments have been made over the last two quarters.

Slide 11 shows a summary of our debt. As of June 30th, we had $847.7 million in total debt outstanding and subject to leverage restrictions had approximately $326.3 million available for additional borrowings under our existing credit facilities. The weighted average interest rate of our debt was 3.59% during Q2 and was 3.42% as of the end of the quarter. And our debt-to-equity ratio stood at 0.64 times at the end of Q2. Reducing debt by the $77 million in cash on hand at the end of June that I mentioned earlier, our debt-to-equity ratio would have been 0.58 times.

With the extension of our CP facility, we have no scheduled debt maturities until July of 2009. Although we’ve elected not to adopt FAS 159 and mark our debt-to-market, as of the end of the second quarter, the unrealized gains on this fair value of our debt on a mark-to-market basis would exceed $120 million, indicating that the nature and cost of our liabilities at meaningful strategic value in the current market.

Turning to slide 12. We paid our regular second quarter dividend of $0.42 per share on June 30th to stockholders of record as of June 16. We’ve also declared our regular third quarter dividend of $0.42 per share payable on September 30th to stockholders of record on September 15. Providing further dividend stability for this year, we also expect to carry over approximately $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’ll 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 on our recent investment activity and portfolio positioning, both of which reflect the continued execution of our long-standing investment strategy and opportunistic response to the current investment environment.

Despite broader market issues that have continued to dampen loan volume, we’ve continued to generate healthy levels of deal flow. For example, we reviewed 235 transactions during the second quarter, slightly lower than the record 250 transactions we reviewed during Q1 of this year. This total doesn’t include the numerous secondary capital market transactions we also reviewed during the quarter.

As we’ve stated before, asset selectivity drives good investment decisions and generating significant deal flow is crucial to that process. This absolutely held true during the second quarter, as even though overall middle market deal flow remained healthy, quality deal flow diminished broadly. Generally speaking, we saw more attractive opportunities in the upper end of the middle market as is reflected in our second quarter investments.

This consistent level of deal flow, even during a period of slower market activity, is we believe a testament to our established self origination capabilities, the benefits of the broader Ares management platform, our ability and willingness to invest in all levels of the capital structure, and our demonstrated ability to close transactions in this environment, which sets us apart from many other financing providers.

To illustrate this point, we recently announced the opening of offices in Atlanta and Chicago and the addition of several new senior professionals that bring unique skills and relationships to our company as well as long individual histories in the middle market. The addition of these professionals in our growing market presence reflects our continuing strategy of taking advantage of the attractive opportunities resulting from a dislocation in the credit markets.

We feel fortunate to be in a position to grow our franchise when many others in our markets are re-trenching. It’s also important to point out that as an externally managed company, we can make investments like this to expand our platform and invest in additional resources largely no additional expense to our shareholders.

Consistent with our historical trends and demonstrating our discipline and patience, we closed on 10 deals in the second quarter, reflecting a closing ratio of just under 5%. We also continue to build new and strengthen existing sponsor relationships during the quarter. As of the end of Q2, 61 separate private equity sponsors were represented in the ARCC portfolio.

As Rick mentioned earlier, in the second quarter we closed $342.3 million of new commitments across 10 portfolio companies. Six of these investments were with new companies and four were with existing portfolio companies. Nine separate private equity sponsors were represented in these new transactions and two of those sponsors are new relationships for ARCC. Also during the second quarter, we made one investment in a non-sponsor transaction. Of these new investments, 45% were in first lien senior secured debt, 5% in second lien senior secured debt, 41% in senior subordinated debt, and 9% in equity and other securities, and 47% of these investments bear interest at floating rates.

During the second quarter, significant new commitments included $100 million in a first lien senior debt commitment to a radiation oncology provider; $81.1 million in senior subordinated debt and equity for a food service distributor; $48.1 million in senior subordinated debt for a rural telephone network operator; $28.8 million in first lien senior debt, senior revolver, subordinated debt and equity for a for-profit post-secondary education provider; and $25 million in first lien senior term debt for a healthcare technology provider.

I’d like to point out that while we closed on two senior secured first lien transactions in the second quarter, this is not inconsistent with our stated strategy. In these transactions, we were able to generate mezzanine type returns while maintaining the security benefits and structural protection of a first lien lender. We believe that we are able to generate these transactions due to either our position as an incumbent agent, our relationship with management, or our ability to commit capital in a creative and flexible way.

As I mentioned earlier, our investment activity and portfolio management in the second quarter showed the continued effects of our rotation to higher yielding investments with better structured protection and with improved leverage levels than were previously available. As shown on slide 18, we saw continued improvement in our investment spread and the average leverage of our portfolio companies declined.

Turning to slide 19, 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 second quarter, our three largest industry concentrations, each representing 10% or more of our portfolio were healthcare at 18%; education at 10%; and beverage, food and tobacco at 10%. Our portfolio also remains geographically diversified. We also have limited issuer concentration risk with no investment representing more than 5% of our portfolio’s total value.

Turning to slide 20, in our portfolio quality, we employ an investment rating system with grades of one through four, with one being the lowest grade for investments that are not anticipated to be repaid in full and with four being the highest grade for investments that involve the least amount of risk in our portfolio. At the end of the second quarter, the weighted average grade of our portfolio investments was 2.9, with six portfolio companies receiving a 1 rating, a slight decrease from the 3 average rating in the prior quarter, as we incurred one more downgrade than upgrade in our rating system.

We have three companies currently on non-accrual, only one of which is a senior loan, up from two companies last quarter. And other than these companies on non-accrual, we have no delinquent loans. The fair value of these non-accrual loans represents 1.3% at portfolio value and 2.9% of amortized cost. As I pointed out in the past, moving the weighted average rating beyond the 3 is difficult, as most 4 rated companies exit the portfolio through an eventual sale or other liquidity events and with our new investments initially being assigned a 3 rating.

I think it’s also important to point out that we had eight companies with the 4 rating at the end of the quarter, representing approximately 7% of our total portfolio values. Overall, since the end of 2007, the number of investments receiving a 1 or 2 rating have remained fairly constant, and the investments receiving a 4 ranking remains greater than the 1 rank companies.

Now I’ll discuss our view of broader market conditions in more detail, the opportunities that the current market presents ARCC, and how our past and more recent strategic actions have positioned our company. We continue to see the effects of the general lack of liquidity impacting all aspects of the loan market. Following asset prices have pressured banks and finance companies to recapitalize during a time when capital is constrained and obviously comes at a higher cost. This has caused traditional commercial and investment banks to scale back new issue activity significantly, given scarce capital and a reduced risk appetite. Financing for small to medium sized finance companies, CLOs, and other non-bank providers has been pulled completely or pricing as wide and significantly housing many players to sit on the sideline or exit the market entirely.

Illustrating this point, in the second quarter overall leverage loan volume totaled $45 billion, unchanged from the first quarter but down 76% from a year ago. Second quarter leverage buyout loan volume declined quarter-over-quarter and now it sits at levels not seen since 2002, a year which with a benefit of hindsight turned out to be one of the lowest cumulative default rate vintages on record and a wonderful time to have been investing.

Second lien volume in the middle market was negligible at levels not seen since the beginning of the second lien waves beginning in 2004. And looking out to the rest of 2008, the forward calendar for the broad leverage loan market is relatively modest indicating market volumes will remain near or below current levels. That said, there remains a large pool of private equity yet to be invested, which we expect to drive additional deal flow, one seller and buyer valuation expectations recalibrate through account for a shift in financing costs.

So what does this all mean for ARCC? The continued rationalization in the markets has created a meaningful reduction in a number of active competitors providing improved opportunities for those with capital. We proved our ability to access capital in two specific instances during the last four months. First in April, with our $250 million equity rights offering, and second in July when we proactively rolled over our $350 million funding facility that was due to renew in October.

Lenders with capital in today’s market enjoy very favorable environment characterized by higher spreads and fees, our new loans, improved structural protection with full covenant packages, reduced leverage and increased equity contributions. On transactions we reviewed during the second quarter, we saw spreads incrementally improve further and are now running 200-plus basis points wide of 2007 levels on various set tranches, with fees also 100 to 120 basis points higher.

Leverages come in 1 to 1.5 turns, and fixed charge coverage is roughly 25 basis points or a quarter of a turn higher. In addition, we are receiving more attractive call protection and LIBOR floors on a higher percentage of deals. Interestingly, given the inactivity for larger investment banks in difficult high yield market conditions, the use of traditional subordinated debt by larger issuers has increased, which coincides with our desire to move down the balance sheet without taking on increased leverage.

This is possible for two reasons. First, equity contributions are rising reaching 45% on average, with some transactions even reaching 50% plus, while total purchase price multiples on a comparable basis have only contracted modestly. And senior debt is scarce with the major Wall Street bank’s capital constraint. Lenders with ARCC with one-stop capabilities are better positioned to win mandates and earn significant fee income in this slower environment.

Another favorable outcome from disintermediation occurring in the market is a new trend of larger issues coming directly to sizeable providers of capitals such as ARCC. And again, this typically allows us to garner improved fees and pricing. Since the quality of deal flow in the market has naturally declined in this higher cost financing environment, it’s important to remain very selective and cautious. Accordingly, we are making sure every new investment meets our increased return threshold and rigorous underwriting criteria.

At this point in the cycle, we are naturally biased towards larger companies with more substantial cash flow and are maintaining our focus on defensive industries and our constant pursuit for high quality investment. Additionally, we expect to under-capitalize finance companies and our entire quality portfolios might become available at various attractive prices. And we believe that we are well positioned to take advantage of these opportunities. The existing relationships we solidify and the new relationships we develop in this difficult market should serve us well when conditions improve.

Although loan pricing rebounded throughout much of the second quarter as the overhang of unsyndicated leveraged buyout loans further declined 64 billion and default rates stabilized, market sentiment deteriorated noticeably during the last ten days of the quarter triggering a reversal of much of the loan market pricing gains. Therefore mark-to-market issues continue for holders of leveraged loans as risk continues to get repriced.

Using historical risk premium and severity rates, current leverage loan pricing implies default rates that are in the low-teens are nearly double the highest 12-month rate of 7.5% for leverage loans on record. Of course, current loan pricing does not impact the economics of (inaudible) maturity investors, but it certainly does impact net asset values as we incorporate market pricing into our valuation.

Although it remains likely that macroeconomic pressures from the housing fallout and rising commodity prices will impact the company’s fundamentals in a broader sense, the leverage loan market has not seen such deterioration yet, as evidenced by the current low levels of defaults. Lagging 12-month default rates remain below historical levels at 2.6% at the end of the second quarter, but market default rates approaching 5% by year-end are not out of the question.

Our portfolio remains well positioned with a heavy emphasis in defensive industry sectors with limited or no exposure to the four primary sectors experiencing the vast majority of defaults; real estate and homebuilding, automotive, gaming, and transportation. As you may recall, we have either Board seats or Board observation rights for close to 40% of our portfolio companies and we monitor financial information on at least a monthly basis for all portfolio companies, providing us an early read on operating the financial performance as well as greater control.

Additionally, given our senior position in many of our investments, we are in a superior position to reprice our risk through increases in spread and amendment fees at the earliest sign of any weakness. During the second quarter we repriced about $31 million in exposure, resulting in an average spread increase of over 400 basis points in these investments, adding an incremental $0.01 per share to annualized 2008 core EPS. We expect this activity to continue meeting our overall portfolio yields.

Although it’s difficult to predict with certainty, we are currently tracking between $150 million and $200 million of loans that we may have the opportunity to reprice over the next six to nine months. Since the end of the second quarter, we funded $128 million of investment commitments, and our backlog and pipeline of opportunities remains relatively strong albeit down from previous levels, as we currently have commitments of $52.5 million with a pipeline of $292 million behind it. Of the $128 million of new commitments in the quarter to date, we continue to target portfolio companies in defensive industries with attractive yields and strong structural protection.

Specifically, the stated weighted average yield on such loans is 13.71% and we generated fee income of approximately 2 million on these transactions. We expect total return profiles on these new investments will be in excess of 15%. The leverage on these investments is approximately 4.2 times. So consistent with my earlier comments, the majority of the transactions in our backlog and pipeline are from mezzanine investments. We are very encouraged by the quality of these transactions and the opportunity to further boost our portfolio yield as we continue to rotate our portfolio.

The modestly reduced size of our current backlog and pipeline relative to prior quarters is a function of the third quarter being seasonally slow, the general market slowdown, and our more aggressive management of balance sheet liquidity. We continue to firmly believe that current market conditions are very attractive for well positioned capital providers with diverse funding sources and robust origination and structuring capabilities like ARCC.

Our investment spreads are increasing. New investment opportunities are the most attractive we’ve seen in years. Our credit outlook remains strong although credit in general is likely to continue to moderate with the weakening economy, and our recent capital actions have further strengthened our balance sheet.

As shown on slide 22, I’d now like to spend a little bit more time on our stated three-prong strategy for enhancing shareholder value. First, as I mentioned, we plan to continue to drive enhanced earnings by taking advantage of attractive opportunities in the new issue market and within our existing portfolio. Specifically we are rotating our portfolio into higher yielding assets while maintaining or improving leverage. As you’ve seen, our new investments in the second quarter are very accretive with higher yields, significant fee income, and comparable leverage.

Our natural portfolio liquidity continues to be driven by our shorter average life first lien loans, which serves to accelerate our portfolio repositioning. Another significant opportunity we have is to reprice risk as our border risk facilities are renewed, increased, or amended. Excluding the impact from lower LIBOR rates, we have boosted portfolio yield by approximately 180 basis points in the last quarter.

We are also building future upside by locking an attractive call protection. Although this cannot be seen by reviewing our financial statements, approximately 27% of our portfolio carries call protection, we should enhance returns as these higher yielding assets to larger companies get repriced or refinanced in a more normalized market environment. The total value of this call protection, if and when exercised, could approach $15 million.

The second area that we are keenly focused on is managing balance sheet and liquidity. We opportunistically raised equity through our rights offering in April and we renewed our $350 million credit facility well in advance of our renewal date in October. We believe that these actions significantly improved our balance sheet and liquidity and positioned us to take advantage of attractive portfolio investment opportunities, gain market share, and increase our franchise value.

We continue to explore diverse capital alternatives ranging from traditional institutionally driven capital markets, new institutional managed funds that would free up balance sheet liquidity and provide attractive fee income. We currently are in various stages of exploring numerous managed funds that could provide attractive fee income, and more importantly, free up incremental balance sheet liquidity and support our ongoing underwriting capability.

We are also at the beginning stage, as I mentioned, of exiting lower-yielding non-strategic assets, but only when transacted at attractive and accretive prices. Accordingly, this would create new capital to invest at currently attractive pricing, which should further enhance our portfolio yield and earnings.

On past calls, we’ve highlighted that an added benefit of our senior debt strategy is that these assets tend to be more leverageable and have a higher credit quality than traditional mezzanine, making them attractive to a larger universe of potential buyers across the cycle and theoretically more liquid. We currently have in excess of $350 million of investments, either yielding less than 10% and/or positions that have been identified as potential repayment candidate due to a company event.

With the potential proceeds, we expect to generate stated current yields in excess of 13% with total return profiles in excess of 15%. Although we cannot guarantee that any of these repayments will occur, we believe there is a real opportunity to boost yield should we be able to exit these investments. Within our equity portfolio, we are proactively seeking to harvest attractive realized gains among selective season portfolio companies where appropriate, which would also enhance our dividend coverage.

Our portfolio, in fact, has quite a bit of activity with 12 companies currently undergoing sales processes or reviewing strategic alternatives. And while we remain optimistic about realizing gains in many of these situations, we cannot guarantee any of these sales will occur or result in gains. In all of these cases, though, we expect to redeploy any resulting liquidity at favorable returns while reducing drag on earnings from non-interest bearing equity leaving the portfolio. And from a strategic standpoint, we are at the beginning stages of exploring mergers and/or acquisitions of other complementary finance businesses that may be undercapitalized or sub-scale.

The third and final area of our focus on proactively managing our portfolio is credit profile. Turning back to slide 18 in the presentation, this quarter we are disclosing additional statistics on our portfolio. As the data reflects, we are investing in larger companies in defensive industries while maintaining total portfolio leverage multiples relatively steady. As you can see, the average EBITDA for transactions closed in the second quarter increased significantly to over $80 million. But I think most importantly, our relatively low average total portfolio leverage of 4.4 times reflects our disciplined past asset selectivity and our election to remain relatively senior in the capital structure when total leverage multiples were at typical peaks of close to 6 times.

I should also add that our first dollar leverage is 1.1 times on average and 1.8 times on a weighted average basis. And when I talk about first dollar leverage, we use that as a measure to identify where our debt position is in a company’s capital structure and where our first dollar of risk begins. Said differently then, our debt investment portfolio on average is invested between 1.1 times and 4.4 times while generating weighted average yields of 11.28%. We hope this better clarifies what we mean when we discuss risk-adjusted returns, as many mezzanine providers over the last cycle invested capital between four times and six times plus for similar yield.

Our ability to generate this type of asset opportunity is a direct function of our one-stop originations strategy, our ability to invest at every level of the balance sheet and our asset selectivity. In addition, we believe our portfolio has the potential for greater recoveries when compared to a lender that is more leveraged down the balance sheet.

Regarding new transactions, we are receiving tighter covenant packages, fewer turns of leverage for each asset class, higher equity contributions, and enhanced interest coverage. We continue to add resources into our portfolio management group, and as always, are aggressively exploring solutions to situations where we proceed credit risk. We are also proactively monitoring our portfolio companies, and as I mentioned earlier, repricing risks upon any early sign of stress.

The execution of this strategy should validate our decision to sacrifice some meal during the peak of the credit cycle when we invest it in a higher percentage of lower leverage first lien debt, supported by high structuring fee income. This portfolio has provided lower risk and now provides us with more liquid assets to sell or exit in order to reposition our portfolio. We believe this portfolio rotation in search of relative value is a key differentiator for ARCC and will validate our goal of driving superior risk-adjusted returns through the entire cycle.

And lastly, I’d like to reemphasize that we continue to benefit meaningly from the global areas management platform, especially in these volatile and uncertain markets. Across the global platform, Ares now manages in excess of $25 billion and has close to 100 investment professionals covering in excess of 600 companies across 30-plus industries, providing ARCC not only research but a broad and real time view on relative value and risk return.

Our team is seasoned and cohesive. And we have a robust back office infrastructure supporting our business. Importantly, Ares’s scale and position in the capital markets has facilitated our access to a broad range of various capital providers and strengthened our relationship with our key financing and banking partners. Most relevant though, Ares as a firm has a proven ability to manage credit through market cycles. We continue to see broad investor support for Ares as a credit manager of choice in these challenging markets.

And highlighting this, since August of 2007 across the global platform, Ares has raised in excess of $9 billion to invest in various strategies to benefit from the market dislocation. Ares’s financial support and commitment were welcomed by us during our recent equity rights offering and was also valued in the successful renewal of our $350 million warehouse line in July.

That covers our prepared remarks. As always, we appreciate your time and thank you for your continued support. And operator, we now like to begin our Q&A.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Greg Mason of Stifel Nicolaus.

Michael Arougheti

Hi there. Mr. Mason?

Greg Mason – Stifel Nicolaus

Yes. Sorry about that. Could you talk about -- on slide 16, when we look at your portfolio percentage floating, it has decreased from 51% in Q4 to 40% in Q2. Can you talk about as you move into more fixed assets, how you think about hedging your floating rate assets since you’ve had a nice increase in spreads? What’s your thoughts about perfecting yourself from rising rates going forward?

Michael Arougheti

It’s obviously something we spend a fair amount discussing. I think, as we’ve mentioned on previous calls, we have an interest rate consulting firm on retainer and we are having formal VP reviews of our interest rate exposure. There is also some good disclosure, Greg, in our Q that shows the current balance sheet sensitivity to changes in the floating rate interests – interest rates. I think for now it’s something that we continue to monitor, but given the potential exposure and our current portfolio composition, there is really no cost effective hedge available that would be accretive to us given the shape of the forward curve. To the extent that that changes, obviously we would employ a hedging strategy to try to lock in our spread. As importantly a factor that we have to keep in mind is, as the capital markets reopen to us, we’ll have the opportunity to borrow money either at floating rate or fixed rates. And we will continue to do everything we can to stay match funded when the markets reopen.

Greg Mason – Stifel Nicolaus

Okay, great. One more question. Can you talk about more specifically what types of off-balance sheet funds you are looking at and what’s your time frame for potentially launching some of these funds?

Michael Arougheti

Sure. It’s a whole host of things. I think one of the ironies of markets today and as I highlighted some of the fund raising activity in the private markets that we are seeing across the Ares Management platform, there is a real significant appetite in the private markets for assets such as the ones that we are originating here. And that ranges from senior debt all the way down through to structured equity in mezzanine. We are talking to a number of different equity and debt providers about levered and unlevered senior loan funds similar to our Ivy Hill structure that we are currently managing. We are talking to a number of private investors about mezzanine funds on an unlevered basis and the like. So the conversations are broad and ongoing, and our hope is that we’ll be able to execute on more than one of these types of things by the end of the year.

Greg Mason – Stifel Nicolaus

Great, thank you guys.

Michael Arougheti

Sure.

Operator

Our next question comes from Sanjay Sakhrani of KBW.

Sanjay Sakhrani – KBW

Thanks. Mike, you gave a lot of color on kind of the opportunities, but how do you balance out with the liquidity constraints in this environment? It seems like from what we’ve heard from other BDCs, it’s kind of mix messages. I think you even mentioned the quality of deal flow kind of scares. So how do you balance the two? I mean, you guys have had some pretty good growth over the past – at least quarter or so?

Michael Arougheti

Yes. It’s something that you have to actively monitor and find the right balance. Again, the nice thing about our business is we have very high visibility to both our new investment pipeline as well as any potential exits or repricings or refinancings in the portfolio. We typically have a good 30 to 90-day plus view on where liquidity is coming from and where liquidity needs are. And we are constantly managing our origination and pipeline development against where we are seeing liquidity. Again I think we are fortunate as we look forward while we do see market deal flow slowing, the current competitive landscape has changed to the point where we are actually getting a shot at investing in the deals that we want to invest in. And at the same time, as we mentioned in the call, we have a very good visibility, particularly in the third quarter to refinancings, exits, realizations, et cetera in excess of $150 million. So it’s something you have to watch aggressively and manage. On balance, we are expecting that we are going to get a lot of capital back between now and the end of the year and redeploy it.

Sanjay Sakhrani – KBW

So do you think we are going to get better opportunities for capital deployment in the back half of this year?

Michael Arougheti

I think it’s going to be mixed. Our current sense is that given some of the reduced activity that we saw over the last month or two, we are expecting a short flurry of activity post labor day. And then I think going into the end of the year, it’s really going to be a function of the broader capital markets, typically in a market environment like this that the capital markets aren’t improving, my sense is a lot of the M&A activity that would otherwise have found its way into this year will probably get pushed into 2009.

Sanjay Sakhrani – KBW

Okay. And then did you guys mention an unfunded commitments number? And just I had a question on though – I mean, how much of them are firm commitments and how many can you just pull back on if you don’t want to fund them?

Michael Arougheti

Yes. It’s a whole – I’ll try to give people little bit more clarity on our unfunded commitments in general. I think first of all, since we act as agent on most of the commitments and we sit on the Boards of many of these companies, we obviously have a lot of visibility into what the projected borrowing needs of these borrowers are. And that’s something that we are modeling on a daily basis and keeping our eye on. There are obviously a number of factors that go into determining actual availability. It includes borrowing bases based on current assets, performance metrics, leverage levels, seasonal needs of companies et cetera. So, looking just at the aggregate unfunded number doesn’t give you a true picture of what our potential exposure is. As a management team, we meet weekly to analyze all of those projections and the models that we have tend to be very accurate. In terms of discretionary, a number of the unfunded exposures that we have relate to delayed draw lines and acquisition lines where we have complete discretion. The total number for that – let me just do a quick calculation. Based on the discretion I’m looking at, Sanjay, about -- of the $300 million, about $125 million we have discretion over. We’ll be syndicating a pretty significant majority of that exposure over the coming quarter. In addition then, of the $200 million that’s remaining, about $90 million of it is delayed draw where we don’t have discretion, but it’s coming at very high interest rates. 10% in one case, 13% in other, 18% in other. So again, when we forward [ph] model our liquidity needs, those are assets that we are happy to book and they are assets that are in our liquidity models. And then lastly, I think it’s important to point that most of the revolver commitments that we have outstanding to our highest rated companies, the average rating in our revolvers is that 3.1 times. There is no 1 or 2 rated companies with any available revolving commitments. And the underlying cash flow performance of the companies tends to be really strong. In fact, most of these companies have significant cash built up on their balance sheet. So we just don’t perceive that any of those revolvers will need to get drawn. So, thinking about it differently, we enjoy a 50 basis point plus undrawn fee for those lines in companies that really have no need for the lines. So we are enjoying a fairly accretive source of income without any real risk of draw.

Sanjay Sakhrani – KBW

Okay. I got one last question. I like that chart on slide 13 where it shows the average EBITDA of the companies, but that’s pretty phenomenal growth. I mean, how much of it is kind of organic growth versus just a change in mix of new investments?

Michael Arougheti

Just to highlight what the graph on page 18 is showing, the purple bar is the weighted average EBITDA in the portfolio. And the blue bar is the weighted average EBITDA for commitments that we made during the quarter. Again given the size of our investment portfolio relative to the size of the commitments that we’re making on a quarterly basis, you’ll see that – by going from 22 million to 60 million to 80 million, we took the weighted average on a portfolio-wide basis from 26 to 38. So while we do see very good year-over-year EBITDA in the underlying portfolio companies, the significant majority of that rotation is coming from investing in larger companies, given the market dislocation.

Sanjay Sakhrani – KBW

Okay. Great. Thank you very much.

Michael Arougheti

Sure.

Operator

Our next question comes from Faye Elliott of Merrill Lynch.

Faye Elliott – Merrill Lynch

Hi, good morning.

Michael Arougheti

Good morning.

Faye Elliott – Merrill Lynch

I was wondering if we could just go back over some of the trends in the quarter, degraded [ph] the capital structuring fees. I think you said they would normalize in the third quarter and fourth quarter. And I was wondering if we could just go over what drove the numbers a little bit higher in this quarter?

Michael Arougheti

Yes. It’s a couple of things. Again, one of the things that we mentioned in our last call, as we discussed the strategic rationale behind our equity offering was, having capital in this market is a strategic asset for a number of reasons. One is which we can obviously go into the market to take advantage of new investment opportunities. But more importantly, we can use that capital to unlock value opportunities within our existing portfolio. When you look at the second quarter, we had a number of situations with an existing portfolio of companies that had a need for capital and a need for capital structure accommodations where we are able to generate significant fees as a result of our position as the incumbent lender and agent. But in general, when you look at the commitment fees that we are able to generate on a net investment basis, on average the fees after syndication and optimizing our portfolio were in excess of 4% of our final hold. So one of the reasons for the reduced guidance at $4 million to $5 million is you really can’t – it’s not something you can model in, but if you are aggressive in the way that you are deploying your capital and interacting with borrowers, you hope that you can drive fees significantly in excess of the 2% to 3% that we typically use as our base assumption.

Faye Elliott – Merrill Lynch

Okay. And then going back to the, I guess, run room you have in your capital or in your leverage level, you had mentioned that – and I didn’t quite catch it, that X something you would have been at 0.58 times equity in the quarter.

Michael Arougheti

Yes. If you were to include the cash that we had – we drew a large amount of cash at the end of the quarter. So our outstanding loan balance was higher if you include that cash with it, 0.58 times.

Faye Elliott – Merrill Lynch

Okay, I got you. But that cash is deployed now?

Michael Arougheti

Yes, as we’ve mentioned, we’ve invested about $128 million since the end of the second quarter already.

Faye Elliott – Merrill Lynch

Got you. So this 0.64 kind of includes a little – gets us into the third quarter a little bit?

Michael Arougheti

Yes. Recall we’ve also had a number of repayments in the quarter as well. So when I look at the $128 million against repayments, third quarter to date and on the way, I think 0.6 leverage level, as we said, that’s probably a good assumption

Faye Elliott – Merrill Lynch

For the third quarter?

Michael Arougheti

For where we sit today.

Faye Elliott – Merrill Lynch

Today. Okay, thank you.

Michael Arougheti

Sure.

Operator

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

Vernon Plack -- BB&T Capital Markets

Thanks very much. Mike, I’m trying to get a sense for and you may have talked about this a little bit, but the statistic that you supply, the weighted average investment spread, given thoughts on the direction and makeup of the portfolio, how wide can that spread get do you think?

Michael Arougheti

It’s a good question. Our cost of funds right now is hovering around 3.5% on a weighted average basis. As you know, were we to capital markets today, we’d come in significantly higher than that. Our experience has been both in this cycle and prior cycles that even as cost of funds increases, you more than make up for based on the inefficient pricing on the asset side. So if we assume the steady state 3.5% and, as we mentioned, a weighted average yield today on a portfolio of 11.3%, that gets you in the range of 7.5% to 8.0% that we are talking about today. Remember in our call, we put forward a statistic that said that we have close to $500 million of investments that are generating less than 10% return. And that’s about 25% of the portfolio. So if all we did was take that $500 million and go out and generate an incremental 400 or 500 basis points of return in this market, that’s going to get you another 100 to 200 basis points excluding fees and call protection.

Vernon Plack -- BB&T Capital Markets

All right. That’s helpful. And in terms of – I would also just like some thoughts on your dividend management strategy or policy, and what’s your thoughts on there in looking into the dividend right now? It at least appears to me that you probably stay at where you are for a while. Does that make sense?

Michael Arougheti

Yes. I would say both for us and most of our peers in the market like the one we are in now, managing liquidity is the order of the day and staying focused on dividend coverage is obviously the order of the day. Our expectation is that we will keep the dividend at its current levels, but I would not anticipate that we’ll be increasing it aggressively over the coming quarters.

Vernon Plack -- BB&T Capital Markets

Okay. Thanks very much.

Michael Arougheti

Sure. Thanks.

Operator

Our next question comes from Jim Ballan of J.P. Morgan.

Jim Ballan – J.P. Morgan

Great, thanks a lot. The comments on the unfunded commitments is really helpful. Just one other thing on that though. How does just the existence of those unfunded commitments impact your thoughts on sort of the maximum leverage level that you’d like to be at? And then more specifically, do those commitments come into play in terms of the availability to draw down on the CP funding facility?

Michael Arougheti

As I mentioned, it’s something that we obviously pay a lot of attention to. We are looking at it on a daily basis and we are always matching available liquidity, including the need to potentially funded commitments under our undrawn facilities against new investment opportunities. Again when you take out situations where we have discretion, situations where we know we are getting refinanced and are syndicating, and situations where we don’t have discretion but know that we are going to get funded, we have a pretty good sense order of magnitude to $5 million or $10 million as to what we expect our total exposure is there. And we obviously absolutely factor that into how much liquidity we have for new investments.

Jim Ballan – J.P. Morgan

Okay. And with regards to the CP facility?

Michael Arougheti

The CP facility actually does accommodate back-to-back revolver commitments, as does our corporate revolver. So again, it’s all a function of looking at our liquidity profile and matching our available liquidity against what we think our proceed capital needs are going to be.

Jim Ballan – J.P. Morgan

Got it, got it. One other thing if I may. Just given that this was a big fee quarter and the fact that you did the equity deal during the quarter, how should we think about kind of a run rate NII per share sort of coming out of the quarter?

Michael Arougheti

I’ll say one thing. When you look at the pace of our investments in the second quarter, our investment activity was back-end loaded and back-end weighted. So when you think about run rate coming out of the quarter, it’s higher than it would look on a stated basis, just given the way that the investments were made over the course of the quarter. We are constantly balancing, as I mentioned, the desire to use our existing capital to go out and generate fee income and future income from call protection and higher yields against maintaining a prudent amount of liquidity. The one thing I think that the second quarter proved was that if you have capital, there is an outsized total return opportunity and an outsized fee opportunity. And that opportunity we don’t see going away any time soon. So we don’t want to promise that we are going to be able to deliver fee quarters like that every single quarter, rest assured every time we make a commitment, we are driving for the highest net fee opportunity that we can and obviously the highest spread that we can.

Jim Ballan – J.P. Morgan

(inaudible) Thanks a lot.

Michael Arougheti

Sure.

Operator

Our next question comes from Jon Arfstrom of RBC Capital Markets.

Jon Arfstrom – RBC Capital Markets

Thanks, good morning. Michael, can you – you made a couple of comments about possibly looking an entire portfolio of their [ph] undercapitalized finance companies. Can you, to the extent you can, give us a little more color on what you are thinking there, how you finance it, what type of size is right for you?

Michael Arougheti

Yes. There is two ways that we can go with that. One is we could take assets on balance sheet if they meet our yield requirements. And two, we can take them off balance sheet to the extent that they don’t, but they come with leverage. What’s nice about a lot of those opportunities that we are looking at, we’ve executed on a number of them at different parts of the Ares platform is, in many instances they are coming with leverage as an opportunity for warehouse providers or bank lenders to offload a portfolio and change the risk profile of their investment. Depending on the nature of that leverage and the spread, we’ll make the determination whether we should sign in as a managed fund or by the assets on balance sheet, and maybe try to deploy the leverage on balance sheet.

Jon Arfstrom – RBC Capital Markets

Would you say it’s a fairly active market?

Michael Arougheti

Yes, it’s a fairly active market in terms of the number of conversations we are having. I’d say it’s not as active as we’d like it to be. We still haven’t seen capitulation in any real catalyst for some of the larger sales or strategic activity that we would expect to see as the cycle matures. So it’s active in the sense that there is a lot of dialog and a lot of price discovery, but candidly I hope that we’d see a little bit more activity that we are seeing in that area.

Jon Arfstrom – RBC Capital Markets

Okay. All right. Thank you.

Michael Arougheti

Sure.

Operator

(Operator instructions) Mr. Arougheti, at this time, I show no further questions. Please continue with your presentation.

Michael Arougheti

Great. Thanks, Randy. I think that’s all for today. Again we thank everybody for joining the call and for their continued support. And we look forward to speaking with your next quarter. Thank you.

Operator

Ladies and gentlemen, that does conclude our conference for today. If you missed any part of today's call, a recording of this conference call will be available until through August 21, 2008. To access the replay, you can call 1-877-344-7529. To call internationally, you can call 412-317-0088. For all replays, the ID number is 418698. Thank you for your participation and you may now disconnect.

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