Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Ares Capital (NASDAQ:ARCC)

Q3 2012 Earnings Call

November 05, 2012 1:00 pm ET

Executives

Michael J. Arougheti - President and Director

Penni F. Roll - Chief Financial Officer and Principal Accounting Officer

Analysts

John Hecht - Stephens Inc., Research Division

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

Jasper Burch - Macquarie Research

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Arren Cyganovich - Evercore Partners Inc., Research Division

Richard B. Shane - JP Morgan Chase & Co, Research Division

John W. Stilmar - JMP Securities LLC, Research Division

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

Operator

Good day. Welcome to Ares Capital Corporation's Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded on Monday, November 5, 2012.

Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of the words such as anticipates, believes, expects, intends, will, should, may and similar expressions. The company’s actual results could differ materially from those expressed in the forward-looking statements for any reason, including those listed in the SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results.

During this conference call, the company may discuss core earnings per share, or core EPS, which is a non-GAAP financial measure as defined by SEC Regulation G. Core EPS is the net per share increase or decrease in stockholders' equity resulting from operations less realized and unrealized gains and losses, any incentive management fees attributable to such realized and unrealized gains and losses and any income taxes related to such realized gains. A reconciliation of core EPS to the net per share increase, decrease in stockholders' equity resulting from operations most directly comparable GAAP financial measure can be found on the company's website at www.arescapitalcorp.com. The company believes that core EPS provides useful information to investors regarding financial performance because it is one method the company uses to measure its financial condition and results of operations.

Certain information discussed in this presentation, including information relating to portfolio of companies, was derived from third-party sources and has not been independently verified and accordingly, the company makes no representation or warranty in respect of this information.

At this time, we would like to invite participants to access the accompanying slide presentation by going to the company’s website at www.arescapitalcorp.com and clicking on the Q3 '12 earnings presentation link on the homepage of the Investor Relations -- excuse me, Investor Resources section of the website. The company will refer to this presentation later in the call. Ares Capital Corporation’s earnings release and Form 10-Q are also available on the company’s website.

I will now turn the conference call over to Mr. Michael Arougheti, Ares Capital Corporation’s President. Mr. Arougheti, the floor is yours, sir.

Michael J. Arougheti

Great. Thank you, operator. Good morning to everyone, and thanks for joining us. It's been a long week needless to say. So before we get started, I'd just like to extend our deepest sympathies to the victims of Hurricane Sandy, and our prayers and thoughts go out to all of those impacted by the storm. And we're with you as you begin the process of rebuilding your homes and your communities.

So now turning to our results this morning. We reported another strong quarter driven by our increased investment activity and positive portfolio performance. Our third quarter core earnings per share were $0.42, a 5% increase compared to the second quarter and in line with per share levels from a strong quarter a year ago. Our third quarter core earnings per share also fully covered our regular quarterly dividend of $0.38 per share. On a GAAP net income basis, we earned $0.59 per share for the third quarter, which included realized and unrealized investment gains totaling $0.20 per share. Our GAAP earnings per share for the third quarter were ahead of the second quarter and year-ago per share levels of $0.41 and $0.20, respectively.

We also declared a regular fourth quarter dividend of $0.38 per share, consistent with our third quarter's level and another $0.05 per share additional dividend for the fourth quarter of 2012. As you may recall from our last earnings call in August, we currently have excess undistributed taxable income, and we expect that we will continue to carryover an excess amount into 2013.

We had an active quarter with over $1 billion in gross commitments and fundings resulting in net investments funded of about $403 million after exits and repayments. Although the third quarter gross commitments were higher compared to our second quarter levels, they were down from the same period a year ago when we committed over $1.4 billion.

During the third quarter, we continue to primarily invest in senior debt, reflecting our view on risk-adjusted return under current market conditions. More than 3/4 of our commitments during the third quarter were in first-lien senior secured debt. Our investment portfolio continues to perform well despite the current slow growth environment. Our weighted average portfolio grade was stable at 3, and our nonaccruing loans remained low at 2.6% of our portfolio on an amortized cost basis and 1% on a fair value basis.

Interestingly, the slow and somewhat mixed economic environment is at odds with the current market technicals. Central bank easing and promises to keep interest rates low for extended periods of time have had a significant market impact through the creation of abundant liquidity and changes in investor risk appetite. Consequently, we've witnessed significant inflows into high-yield and syndicated bank loan funds as investors search for yield. The high-yield bond market in 2012 has already set a record for the most volume in a single year, and the broadly syndicated loan market reported record third quarter volume.

Since LBO and M&A loan volume has been relatively light, opportunistic refinancing transactions have increased as issuers take advantage of greater risk appetite. Further, as a result of this increased demand for risk and yield in a low interest rate environment, new issued terms in the liquid markets have naturally become more issuer-friendly, leverage has increased and spreads have tightened. Now while the middle market is more insulated from these fund flows and offers better relative value than the high yield and leverage loan markets in our view, we too have seen leverage levels creep higher and credit spreads tighten in the middle market.

While the market environment for new investments is less favorable, the good news is that it's been and continues to be very favorable for us to access capital as an issuer. Accordingly, we raised over $1 billion in capital during the third quarter and the early part of the fourth quarter. On the debt capital side, we increased capital availability through the unsecured notes, convertible debt and secured bank debt markets. And in each case, the new capital that we raised was our lowest cost of capital for that particular class of debt.

On the equity side, we issued new shares at an attractive price, raising $427 million in net proceeds. As a result of these actions and our net investment activity, we ended the third quarter with approximately $1.3 billion in available debt capacity, and we continue to have no debt maturities until 2016.

So while these market conditions persist, our strategy continues to be to leverage our relationships and to use our advantages in origination, flexibility, scale and structuring to uncover the most complete opportunity set and then to underwrite only the best credits. We are still finding plenty of quality investment opportunities that meet our strict full cycle underwriting standards. However, in keeping with the same strategy that we have used during similar markets in the past, we are staying highly selective with a focus on senior loans in larger franchise businesses.

We will also look to invest further into our best existing portfolio companies or other former ARCC portfolio companies. And given the financial risks in the system and the potential for geopolitical events that trigger capital market and economic volatility, we'll continue to position the portfolio in defensive industries and recession-resilient companies. And we'll seek to take advantage of any future volatility should it appear, and our excess capital position clearly supports this strategy.

And now, Penni, if you could walk us through additional detail on our third quarter's financial results?

Penni F. Roll

Yes. Thanks, Mike. For those viewing the earnings presentation posted on our website, please turn to Slide 3, which summarizes our financial and portfolio performance information.

As Mike stated, our basic and diluted core earnings were $0.42 per share for the third quarter of 2012, a $0.02 per share increase over our core earnings of $0.40 per share for the second quarter of 2012 and in line with the level of a year ago. Our net investment income for the third quarter was $0.39 per share compared to $0.40 per share in the second quarter of 2012 and $0.48 per share in the third quarter of 2011.

Net realized and unrealized gains for the third quarter were $0.20 per share compared to $0.01 per share in the second quarter of 2012, a net loss of $0.28 per share in the third quarter of 2011. Our GAAP net income for the third quarter was $0.59 per share compared to $0.41 per share for the second quarter and $0.20 per share for the third quarter of 2011.

At September 30, 2012, our total assets were $6.3 billion, and our total shareholders' equity was $3.9 billion, resulting in NAV per share of $15.74, up 1.5% from $15.51 at the end of the second quarter of 2012 and 4% higher than the $15.13 NAV we reported a year ago.

Now I will turn to our investment activity. As Mike highlighted, we made growth commitments of over $1 billion in the third quarter of 2012 compared to $728 million and $1.4 billion during the second quarter of 2012 and the third quarter of 2011, respectively. We exited commitments of $653 million in the third quarter of 2012 compared to $473 million and $972 million during the second quarter of 2012 and the third quarter of 2011, respectively, which resulted in net commitments of $370 million in the third quarter of 2012 compared to net commitments of $254 million in the second quarter of 2012 and $458 million during the third quarter of 2011.

Primarily as a result of new investment activity, our investment portfolio grew to $5.9 billion at fair value at quarter end and now consists of 153 portfolio companies. Our portfolio mix shifted further towards senior debt with approximately 58% in senior secured debt investments; 21% in the subordinated certificates of the Senior Secured Loan Program, the proceeds of which were applied to co-investments with GE to fund first-lien senior secured loans; 7% in senior subordinated debt; 4% in preferred equity; and 10% in other equity and other securities.

From a yield standpoint, our weighted average yield on debt and other income-producing securities at amortized cost declined slightly from 11.7% to 11.6% quarter-over-quarter, primarily reflecting a greater weighting toward lower yielding and lower risk senior debt in the portfolio. In addition, the weighted average stated interest rate on our debt as of the end of the quarter increased modestly from approximately 5% to 5.2% quarter-over-quarter and therefore, our weighted average investment spread declined sequentially from 6.7% to 6.4%.

The 20 basis point increase in the stated interest rate on our debt reflects the stated rate on our actual borrowings at quarter end, which were more weighted toward higher cost, fixed rate, unsecured term debt at September 30 after we used the proceeds from the issuance of additional fixed rate unsecured term debt and equity during the quarter to reduce our lower cost secured revolving debt. To put this into context, if all of our revolving facilities had been fully drawn as of the end of each quarter, the weighted average stated interest rate on our debt would have actually declined from 4.3% as of the end of the second quarter to 4.2% as of the end of the third quarter.

I would like to make one other point now on our portfolio yields. While we have experienced a decline in the yield on our debt and other income-producing securities portfolio over the past year as we have shifted into more senior debt, our total portfolio yield, including non-income-producing securities, has remained steady at approximately 10.3% year-over-year. The steady yield on our total portfolio over the past year reflects our rotation towards a greater mix of yielding securities, amount of [ph] equity and other non-yielding investments following the Allied acquisition. As shown on Slide 5, you can see that our equity and other noninterest earning assets declined to 10.9% of the portfolio at fair value at the end of the third quarter compared to 11.1% at the end of the second quarter and compared to 14.2% at the end of the third quarter of 2011.

Our portfolio remains significantly weighted towards floating rate loans with LIBOR floors. Floating rate assets were 73.8% of our portfolio at fair value at the end of the third quarter 2012 compared to 71.6% at the end of the second quarter. Of these floating rate assets, approximately 97% featured LIBOR floors, including our investment in the Senior Secured Loan Program as all of the underlying first lien senior secured loans in the program had LIBOR floors.

On Slide 8, we highlight the components of our realized and unrealized gains, totaling $47.1 million or $0.20 per share for the third quarter. Our portfolio performed well during the third quarter, and our gain components were fairly balanced with $27.7 million or $0.12 per share in net realized gains and $19.4 million or $0.08 per share in net unrealized gains.

Now let's turn to Slide 10 for a discussion of our debt capital. As of September 30, we had $3.6 billion in committed debt capital and $2.3 billion in aggregate principal amount of debt outstanding. We believe that the long weighted average maturity of our debt provides significant stability and strength to our balance sheet.

As of September 30, 2012, the weighted average maturity of our outstanding debt was over 10 years, and we have no debt maturities until 2016, which improves our operating flexibility. The primary changes in our debt capacity during the third quarter came from issuing $175 million of 10-year senior unsecured retail notes, upsizing the revolving funding facility with SMBC by $200 million to $400 million and adding $40 million through a new lender to the revolving funding facility with Wells Fargo, which increased total commitments there to $620 million.

Additionally, during the quarter, we primarily used the net proceeds from the $427 million equity raise to repay outstanding indebtedness under our revolving facilities as well as for other general corporate purposes. Since September 30, 2012, we issued an additional $7.5 million of the new 10-year senior unsecured retail notes pursuant to the partial exercise of the over-allotment option granted to the underwriters in that offering, and also issued $230 million of 5-year 4.75% unsecured convertible notes with a 17.5% conversion premium. Pro forma for these 2 transactions, our total committed debt capital would have been approximately $3.87 billion as of September 30, 2012.

As of the end of the third quarter, we had approximately $1.3 billion in available undrawn debt capacity, which increased to approximately $1.57 billion after quarter end. As always, our ability to borrow this unused capacity is subject to borrowing base and leverage restrictions. At September 30, our debt-to-equity ratio was 0.57x, and our debt-to-equity ratio net of available cash was 0.54x.

As Mike stated, we declared 2 dividends this morning, a $0.38 per share fourth quarter dividend and a $0.05 per share additional dividend, both of which will be paid on December 28 to stockholders of record on December 14.

With that, Mike, I'll turn it back over to you.

Michael J. Arougheti

Great. Thanks, Penni. I'll now discuss our recent investment activity and portfolio performance in more detail and then provide an update on our post quarter end investments, backlog and pipeline before concluding.

Folks, if you turn to Slide 13 in the investor presentation, you'll see that in the third quarter, we made 22 commitments totaling just over $1 billion, with 17 directly to new portfolio companies and 5 through the Senior Secured Loan Program, 3 of which were new to the program. As you can see, our average commitment moved higher again to about $46 million. As many of you know, our strategy continues to be to use our scale advantage in the middle market to originate and underwrite investments in the highest-quality companies. By underwriting and holding larger facilities, we offer a solution that not many others can provide on their own.

Highlighting this strategy of our over $1 billion in gross commitments in the third quarter, the 5 largest investments combined made up more than 60% of the total new commitments. In certain situations, a sponsor will pay more through fees and spread for execution certainty and for a partner that can provide additional capital for add-on acquisitions. And consistent with our past practice, we've syndicated a portion of some of these investments as we seek to diversify our portfolio further and enhance the investment income on our final hold amounts.

On Slide 14, we summarize our third quarter investments by asset class. We invested 83% in first and second lien senior debt, 9% in subordinated certificates of the SSLP, 6% in senior subordinated debt and 2% in other equity. The proceeds from our exits and repayments were similar with 85% in first and second lien senior debt plus another 10% in senior subordinated debt with the remaining 5% in equity and other securities.

Now turning to Slide 15. This chart reflects no material changes during the third quarter in the credit statistics for our corporate portfolio companies. Weighted average total net leverage for these companies remained stable during the third quarter at 4.4x, and underlying portfolio weighted average interest coverage for these companies held steady at 2.6x quarter-over-quarter. At the end of the third quarter, the underlying borrowers within the Senior Secured Loan Program had similar metrics, with weighted average total net leverage of 4.5x and a weighted average total interest coverage ratio of 3.1x, both of which were in line with last quarter's levels.

Turning to Slide 16. You can see that we made investments in corporate portfolio companies during the third quarter with a weighted average EBITDA for the most recently reported LTM period of approximately $45 million. Using the data available as of September 30, 2012, the weighted average EBITDA of our corporate portfolio companies was about $45 million as well. For the third quarter of 2012, weighted average EBITDA for the SSLP's underlying borrowers remained steady as well, also around $45 million.

Slide 16 also highlights a relatively strong weighted average EBITDA growth rate for our corporate investments of approximately 11% on a comparable basis for the fiscal year-to-date period in 2012 versus the same period in 2011. We're very pleased with this continued strong growth rate, particularly when the slow growth in the overall economy is considered.

On Slide 17, you'll see that the portfolio continues to be well diversified. Our largest investment at quarter end continued to be in the Senior Secured Loan Program at approximately 21% of the portfolio at fair value. As a reminder, this program was comprised of investments in 37 separate borrowers as of September 30, 2012. And as of September 30, none of the underlying borrowers in the program were on non-accrual, and the largest single underlying borrower in the program represented about 5% of the total aggregate principal amount of loans extended under the program. Excluding the program, our remaining largest 14 investments totaled approximately 28.6% of the portfolio at fair value at the end of the third quarter.

As you'll see on Slide 20, our non-accrual rates continue to remain at low levels, reflecting the strong credit environment and our defensive investment strategy. On an amortized cost basis, portfolio non-accruals as a percentage of the portfolio increased slightly from 2.3% at the end of the second quarter to 2.6% at the end of the third quarter. And on a fair value basis, these same percentages did not meaningfully change with just 1% on non-accrual at the end of the third quarter compared to 0.7% at the end of the second quarter of 2012.

On slides 21 and 22, you'll see detail on our recent investment activity since September 30 and our current backlog and pipeline. From October 1 through November 1, 2012, we had made new commitments of approximately $163 million, of which $141 million were funded. Of these new commitments, 45% were in first lien senior secured debt, 36% were in other equity securities, 13% were in the subordinated certificates of the SSLP and 6% were in preferred equity securities.

Of the $163 million in commitments, 42% were noninterest bearing, approximately 35% were floating rate and 23% were fixed rate. The weighted average yield of debt and other income-producing securities funded during the program at amortized cost was 10.3%. We may seek to syndicate a portion of these commitments to third parties although there can be no assurance that we will do so. And as we've discussed on prior calls, post syndication, we generally expect to see an increase in the weighted average yield on new investments.

Also from October 1 through November 1, we exited $137 million of investment commitments, of which 35% were first lien senior secured debt, 32% were senior subordinated debt, 29% were other equity securities, and 4% were second lien senior secured debt. Of the $137 million exited, 37% were floating rate, 32% were fixed rate investments, 29% were noninterest bearing and 2% were investments on non-accrual. The weighted average yield of debt and other income-producing securities exited or repaid at amortized cost was 9.1%. In addition, net realized losses on these exits totaled approximately $7 million.

As shown on Slide 22, as of November 1, 2012, our total investment backlog and pipeline stood at approximately $515 million and $535 million, respectively, or about $1 billion in total. But of course, we can't assure you that we'll consummate any of these transactions, and we may syndicate a portion of these investments as well.

The size of our backlog and pipeline is relatively consistent with the level reported on our last call in August and primarily consists of transactions where we're choosing to continue to back some of our best portfolio companies and/or in some cases, invest in former ARCC portfolio companies that we know very well.

And now with a few closing thoughts before we open up for Q&A. In our view, our overall performance has been consistent over time, and the third quarter was no exception. Our core earnings per share held steady with where we were a year ago and grew modestly compared to the second quarter. At this level of core earnings, we're currently generating a low double-digit return on equity, and we're fully covering our regular dividend. Our third quarter net asset value increased 4% year-over-year, and our non-accrual credit statistics have trended down over the past year, currently standing at relatively low levels. Our underlying portfolio of companies continue to perform well in the aggregate despite a relatively slow growth economy.

We've continued to access debt and equity capital effectively with the goal of driving down our cost of capital over time, and we believe that our franchise continues to be very strong with advantages in origination, flexibility, scale and structuring, permitting us to see a broad view of the market and to choose quality investment opportunities. Given the current market environment, we believe it is a time to be cautious, defensive and highly selective. We'll be patient with a rigorous focus on credit, and we will not stretch for yield in this market. The potential for significant future market volatility is clear, and we enjoy the luxury of almost $1.6 billion in debt capacity should we encounter pockets of volatility that present opportunities to make investments that we believe offer attractive risk-adjusted returns. We continue to believe the longer term outlook is bright for scaled, non-bank capital providers to small and medium-sized businesses like Ares Capital as the implementation of stricter bank regulations could be advantageous for us.

And that concludes our prepared remarks. As always, thanks for your time and support, and operator, we would now like to open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question we have comes from John Hecht of Stephens.

John Hecht - Stephens Inc., Research Division

First one is, Mike, I think you mentioned that of the $163 million of new commitments, 42% are noninterest bearing. What type of assets are those?

Michael J. Arougheti

Sure. Maybe we should just take a step back and talk about that in the context of not just noninterest bearing but also the amount of equity. And maybe, Penni, do you want to walk through that particular transaction?

Penni F. Roll

Yes. I think one of the things, and you'll see it actually looking like a higher level of equity securities going into our new investments post quarter, and that's juxtaposed against a higher level of access of equity securities since quarter end as well. But there was a transaction that we did back in October where our portfolio company, Ivy Hill Asset Management, and our portfolio company, Firstlight Financial Corp., were -- had a transaction such that ARCC contributed its entire investment in Firstlight to Ivy Hill. And in that transaction, Ivy Hill's equity interest grew by $54 million -- or $58 million, sorry. And as a result of that, the Firstlight Corp. investment went away, which totaled about $84 million, and we recognized a net loss of $26 million. So basically, it was a contribution of the interest in Firstlight to IHAM that increased the percentage of allocation of new equity investments post quarter end. You'll also see the higher level of repayment, which is reflective of, yes, Firstlight financial's commitment going away, and that commitment included about $6 million in equity at fair value.

Michael J. Arougheti

So maybe just to bring it back to the noninterest bearing. While Ivy Hill, I think as everybody knows, pays a consistent dividend up to ARCC, being that there is no stated coupon on our equity interest in Ivy Hill, we consider that to be noninterest bearing, which is why that number looks inflated as well.

John Hecht - Stephens Inc., Research Division

Okay. That makes sense. Second question is, are you guys aware of any portfolio companies that might have had operations in a geographical zone where they could have been negatively impacted by Sandy?

Michael J. Arougheti

Yes, we're still, as you could appreciate, compiling that data and working with our companies and management teams. I think thankfully, we've had no company where we've seen significant damage or significant disruption. But we have begun a preliminary assessment of portfolio companies that could either be negatively impacted or unfortunately, in this case, benefit from the events of last week. At this point in time, while still early, we believe there are about a dozen companies out of 153 within the portfolio. Total fair value for those companies is about $570 million at the end of the quarter. And in those 12 companies, we've identified the potential for moderate to high impact from the storm just as a result of the business plan. As an example, we have certain restaurant franchisees, like ADF Pizza, which operate in the Northeast region. We have a food distribution business called Performance Food Group, which operates along the Northeast corridor. So we have certain business models that we think will experience temporary disruption but have not been put out or permanently impaired. On the flip side, we've also looked through the portfolio and have identified a number of situations that, again, would benefit from the events of last week. As an example would be The Dwyer Group. The Dwyer Group is a service provider for HVAC, cleaning, environmental remediation, et cetera, et cetera, around the home. And we have a number of insurance-related investments in things like Global Claims and CCC that should see, again, a temporary impact from the storm. So any time you have something that's disruptive, you have to dig deep. I think the good news is, again, nothing has been, we think, permanently challenged. We know of no major issues in any of our companies, and now we're really just trying to get our arms around what kind of temporary impact we'll have.

Operator

The next question we have comes from Greg Mason of Stifel.

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

Mike, can you talk about -- your very last comment about that you want to be defensive and patient seems to be in stark contrast with the $1 billion of capital you deployed. And you talked about the market seems to be very competitive, yet 17% of your portfolio was invested this quarter. Why -- how did those 2 actions and those statements reconcile? And should we be concerned that you're deploying that much capital in what you kind of self-described as a very competitive environment?

Michael J. Arougheti

Yes, I think in order to discuss this issue, for us, you have to think of it in the context of the size of our balance sheet and the size of our platform. As I highlighted in the prepared remarks, if you look at the top 5 investments that we made, over 60% of the $1 billion was in 5 very large investments, the largest of which was a $250 million underwriting. So what we're trying to do is use our balance sheet scale to underwrite large positions in large companies at low leverage levels and high risk-adjusted return. So the best way to think about it is in terms of number of deals that we closed relative to the number of deals we saw and not get hung up on a number that seems large relative to the peer group at $1 billion. The other thing I think you need to keep an eye on if you want to understand the discipline within this kind of market is obviously the leverage levels within the portfolio. And as we showed for this quarter, the weighted average leverage levels in the portfolio are holding steady in the 4.4x range, interest coverage statistics are holding steady in the 2.6x range, and we're seeing similar performance within the SSLP. So when we talk about being defensive, we're talking as much about asset selectivity and the underlying companies and industries we're investing, not necessarily stepping out of the market. I think as you and others have seen and highlighted, when you look at the spread environment, the spread environment is still fairly attractive relative to historical levels. What gives cause for pause here, and you can see that a little bit in the amount of investments that we've made since quarter end, is the speed with which money has flowed into the market and that we're seeing things transition. So it's something that we need to keep an eye on. It's not to imply that there aren't attractive investment opportunities to be had. I think it just means, as we've said in the past, you can't stretch for yield, and you have to be more focused than ever on credit quality and the quality of the underlying businesses that you're underwriting.

Greg M. Mason - Stifel, Nicolaus & Co., Inc., Research Division

And then just one follow-up to all that [ph]. You said you've moved up to more first lien, 76% first lien. As we think about -- you talked all -- the capital flows that are coming in. As we see it, a lot of that is coming into the first lien market. Are you seeing significant impact in yields and leverage multiples even in that first lien market? Even though it's going to be more safe relative to the subordinated market, it would seem that that could be as competitive or even more competitive than the subordinated market. How do you view those 2?

Michael J. Arougheti

Yes, I think you have to, again, separate what's going on in the large liquid markets from what's going on in the middle market. So one of the reasons that we enjoy the returns that we do is capitalize a very difficult time moving into the middle market quickly. So you don't see as much volatility in leverage levels and spreads and structure as you do in the liquid markets. That said, when you're in a period of prolonged change like the one that we've been in, over time, capital finds its way into the market. And if it doesn't, at least the behavior you're seeing in the liquid market informs behavior in the middle market. So we've seen spread tightening. We've seen leverage levels increasing, but not nearly to the same extent that we've seen in the liquid markets. And you can see that when you look at the net interest margin and spread trends within our portfolio relative to the spread trends in the liquid market with our portfolio showing roughly 40% to 50% of the spread deterioration over the last year relative to the liquid markets. So yes, we're seeing it, but it's not nearly to the same extent. Senior secured loans in the middle market have not tightened nearly to the same extent they have in the liquid market. And what we're trying to do to mitigate some of that tightening, which again is one of the reasons behind being a little bit more concentrated in the investment activity, is we can actually underwrite larger facilities because of our scale and outcompete a traditional club market solution and then syndicate out portions of that loan to other investors who have an appetite for bank debt. And oftentimes, what we'll do, as we talked about I think last quarter, is structure and syndicate a first-out term loan without giving up control of the underlying position, and that allows us to sell into the spread tightening and maintain excess yield on that piece that we hold. But there are ways to structure around it, but it's not nearly as frothy as the liquid markets are yet.

Operator

Next we have Jasper Burch of Macquarie.

Jasper Burch - Macquarie Research

Starting off with, it looks like one of the trends on your balance sheet is sort of taking on more revolver capacity but lowering the actual revolver debt outstanding. I was just wondering if you could speak to that a little bit and sort of -- why maintain large revolvers? Is it to take advantage of market disruptions or what's sort of the driver?

Michael J. Arougheti

You're saying for the way that we're structuring our balance sheet or the way that we're...

Jasper Burch - Macquarie Research

Yes, the way that you're structuring your balance sheet.

Michael J. Arougheti

Yes, the way to think about the revolver is -- and again, $1.6 billion of revolving credit capacity as an absolute number in the middle market may seem significant. But when you have a balance sheet that is targeting or has the ability to hold $150 million to $250 million in a name and still be prudently diversified, that capital can get invested pretty quickly in the right market environment. The way that we've always thought about our revolving credit capacity is we want to use our revolvers to fund up our backlog and pipeline. As Penni mentioned, those are obviously our lowest cost of capital. So when you look at our net interest margin now, it's skewed slightly lower because we've been extending the duration and increasing the cost of our capital slightly. As we invest those revolvers, obviously the cost of our capital comes down by close to 100 basis points, and then we could either do one of 2 things: term out the revolver fundings as we continue to develop the appropriate laddering of maturities and interplay between secured and unsecured, or we can clean it down with an equity raise. And that decision is really just going to be a function of what the backlog and pipeline and the capital markets look like at any point in time. So our preference is to use the revolvers to fund up and then look at the capital markets, both debt and equity, to put in more permanent debt and equity solutions.

Jasper Burch - Macquarie Research

That's helpful. And then looking at just -- it's hard for you guys maybe to -- you can't necessarily manage your business to it, but I was wondering, are you focused on any sort of either political risks or maybe benefits going forward depending on tomorrow's election? Maybe a more hawkish Fed under Romney or rolling back of some of the Basel III capital requirements. Are there any sort of things that you're focused on that we should be thinking about?

Michael J. Arougheti

Yes, I think it's so hard to predict. We're not going to -- we're not in the business of predicting who's going to win the election and then structuring our investment portfolio around it. That said, and again, I think we've talked about this a couple of quarters ago, we're constantly looking at where we could see disruption either through changes to health care law, changes to education, changes to bank regulation, et cetera. So we have an eye on those. We analyze the portfolio for all of those outcomes. I think the good news is, similar to the discussion we just had on the impact of the hurricane, it's fairly balanced. If you talk about health care or education reform, we have a number of companies that benefit, and we have some companies that may get hurt. But on balance, I think the portfolio is well hedged regardless of who wins tomorrow.

Operator

The next question we have comes from Jonathan Bock of Wells Fargo.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

First, Mike, just a technical question related to a new investment. I see in the press release, you provided $250 million to Service King, but I see only $126 million of Service King in the statement of investments, nor do I also see it in the SSLP. So would it be safe to assume that that meaningful portion of asset was syndicated out to other financing providers?

Michael J. Arougheti

Yes, that's a perfect example of the dynamic I just got through discussing is the ability to come in with a sizable first lien underwrite and then structure in other first-out or syndicate into the market.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay. Great. And maybe if we could kind of look at that example in context. I see that it has 8.5-ish percent coupon. But, I mean, I'm just curious that if you sold such a significant portion of that out to a financing provider at obviously a lower spread, what really is the kind of net return to you once you think of syndication fees, et cetera? What can that 8.5% yield investment become once all is said and done and that asset is syndicated out?

Michael J. Arougheti

Yes, it's -- without giving you a specific answer, effectively, what you want to do is you want to structure in a first-out term loan or a first lien loan ahead of ours without giving up control of the tranche. So you'll notice when we have a final hold, we still want it to represent at least 50% of the structure or have other first-out providers give their vote to us, which is critical to executing on the strategy well. And then the amount that we need to charge, if you will, the interest rate on that first-out loan is going to be a function of how deep in the capital structure they go and it will flex. But hopefully, if we're structuring it well and we get the right partners, we could take a stretch first lien loan and by structuring and syndicating, turning into a low double-digit type of return.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay. Okay. And if we think about future syndication, obviously with each deal having its own specifics, would the general kind of bid for that coupon be between L plus 450, L plus 550 in general for that first tranche that you mentioned. Could that be...

Michael J. Arougheti

It depends how senior it is. It could be as low as 350. It could be as high as 500 or 550 depending on the company or how deep in the balance sheet it goes.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay. Great. Now the SSLP at roughly 21% of total investments at fair value, do you believe there is room to allow this asset to expand as a percentage of your total investments?

Michael J. Arougheti

I think we're going to continue to manage it in and around the 20% range. And with that said, I think that there is capacity to grow it as we continue to grow the balance sheet around the program. So I don't expect that it will become a more significant percentage of our assets, but I do expect the program to grow over time.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay. Now with spreads tighter and a generally, I say, generally stable equity market, maybe some additional views on being a willing seller of assets in this environment? We mentioned the syndication earlier, but perhaps maybe some of the equity positions on the balance sheet.

Michael J. Arougheti

Yes, as you've noticed in the quarter and we discussed it a little bit in our prepared remarks, we continue to exit equity securities in favor of yielding securities. And we are constantly looking for liquidity either in the market or in partnership with Ivy Hill for lower yielding loans that sit on the balance sheet. So that's an ordinary course -- part of the business, which is continuous liquidity for some of our lower yielding and nonyielding names.

Jonathan Bock - Wells Fargo Securities, LLC, Research Division

Okay. And then Penni, just one small question related to the dividend spillover. Could you maybe give us a rough guesstimate as to the dividend spillover, including the realized loss, I believe, that was taken in Firstlight?

Penni F. Roll

We have given you the estimated spillover from 2011 into 2012, and that has been disclosed as we wrapped up our tax return for 2011, which was about $0.79 per share. We have not done a final calculation of where we'll be at year end because to do a calculation of the spillover from 2012 to 2013, we'll have to actually finish up the year. But as Mike had said in his earlier remarks, we expect that we'll continue to have a spillover amount into 2013. But at this point, that number hasn't been finalized.

Operator

Next we have Arren Cyganovich of Evercore.

Arren Cyganovich - Evercore Partners Inc., Research Division

Maybe just getting back to the market environment. Can you talk about how the middle market maybe looks comparative to other frothy periods like back in '07? And maybe from a competition standpoint, we had -- back then there were a lot of other parties that are no longer in the market. Have you seen a resurgence of any new institutional folks coming back into the middle market [indiscernible] out there?

Michael J. Arougheti

Yes, I'd say generally speaking, we're seeing less of that than we did in the '06, '07 timeframe. I think part of that is the equity markets, both public and private, learned their lessons from '06 and '07. I think the lending community has learned its lesson. So we are seeing people attempt to set up middle market finance companies to go after this opportunity. They are few and far between, and those that are having any success continue to be very small, in our opinion, subscale. As we've talked about competitive advantages and success drivers in middle market lending, we think you need a significant investment in direct origination, you need a scaled balance sheet, you need a flexible product set and so on and so forth. And so even with good sponsorship, I think, in markets like this, a new entrant with no scale and very little comparative advantage is going to have a very hard time constructing an attractive portfolio. So we're seeing it. There's a lot of dialogue around it, but it's not nearly to the same extent that it was 6 years ago.

Arren Cyganovich - Evercore Partners Inc., Research Division

So in general, with roughly $1 billion backlog and pipeline, do you feel comfortable with -- much more comfortable today in this competitive environment than say 5 years ago?

Michael J. Arougheti

I think, again, there's less competition, and I think that we have more strength in terms of our own platform and franchise and balance sheet than we did in 2006 and 2007.

Arren Cyganovich - Evercore Partners Inc., Research Division

Great. And then the -- maybe with a lot of the newer loans coming through on the refi side, do you expect to have a higher proportion of prepayments of any of your existing debt over the near term with this current market?

Michael J. Arougheti

You saw the numbers in Q3, and it was -- we had a fair amount of repayments and refinancings. And then the quarter-to-date activity has been roughly the same in terms of new investments were made and investments rolling off. I'm not sensing elevated repayment right now. And as I mentioned, what we're trying to do more than anything is to protect our best portfolio companies and reinvest further into our best performers and the best quality investments in the portfolio. So my expectation is is that we continue to play the backlog and pipeline out, and a big chunk of that will be with companies that are already in the portfolio or companies that once were in the portfolio or we have a real knowledge of the business model and the management team.

Operator

Next we have Rick Shane of JPMorgan.

Richard B. Shane - JP Morgan Chase & Co, Research Division

Two questions this morning. First, what we've seen during the year is basically a transition to a higher percentage of term debt, and essentially what that's doing is masking what is essentially a decline in your funding costs. And if we look to sort of comparable securities, whether it's the converts or the 20-year notes that you issued throughout the year, we're seeing call it a 90 to 112 or 120 basis point decline in funding costs. It's actually probably a little bit greater -- the decline is a little bit greater than what you've seen in terms of asset yields. When you're looking at originations now, is that the metric that drives your pricing?

Michael J. Arougheti

If you're asking does a net interest margin target drive asset pricing, the answer is no. We try in every investment that we make to structure what we believe is the best risk-adjusted return for any particular security within a company's balance sheet. That said, obviously, managing this company, we are mindful of the total portfolio yield and our cost of capital. What you're seeing, and it's in the investor presentation, is you've seen a slight decline in yield on the portfolio from 11.9% to 11.6% over the last 12 months, and the stated rate on our debt go up by 0.2%. So it looks as though we had a net interest margin decline of 50 basis points. The reality is when you look at the debt capacity through our revolvers, as Penni mentioned, on a fully funded basis, our cost of capital would be about 4.3%. So the way we think about it is to understand what the investment capacity is against the tightening in asset yields. I'd also point out that as we talked about, we're accepting reduced asset spreads because we're not willing to stretch for yield in this kind of environment. And we're quite pleased with the fact that even on an actual-to-actual basis, to experience this level of spread tightening against the market that has tightened significantly more than that I think is a testament to the position that we enjoy in the market. So we're mindful of it, but it's really an output of the investment process as opposed to something that is driving the investment selection.

Richard B. Shane - JP Morgan Chase & Co, Research Division

Got it. And then second question, Mike, basically 18 months ago, you embarked on what we thought was perhaps a cyclical shift in the portfolio moving up to more senior loans. And at the time, I think it was described as a relative value play, and that's obviously been a very pronounced shift within the portfolio and frankly, a very successful one. Do you -- should we see this now as more of a permanent shift or will be -- there will be an opportunity, and are you, at this point, evaluating the relative value across the stack in the same way that caused you to make such a big bet 18 months ago?

Michael J. Arougheti

Yes, we are with one key exception is I think that the information that we've gotten from the market just given Fed activities at the interest rate environment is different. But when you look at the mezzanine asset class, particularly now, there's actually an unfavorable supply-demand imbalance in the mezz market, and we've seen some pretty significant deterioration in returns and risk within the mezzanine market. So one of the things that we've talked a lot about is we believe that mezzanine is a fairly cyclical asset class. So not surprisingly, more often than not, you'll hear us positioned higher up the balance sheet than lower. And while we've been talking about this now, as you pointed out, for 1 year to 1.5 years, the environment is very much the same, which is there is an underlying sense that the U.S. economy is stable but having challenges growing, and that there are any number of macro issues that will continue to create lots of volatility in the market from Europe to China to the Middle East, et cetera, et cetera. So the defensive positioning right now is less about our views on the fundamentals of the U.S. economy because you can see in our portfolio, it would indicate that we're doing okay, and more just a recognition that the success of our business is predicated on understanding the capital markets and how to be in and out of the capital markets, both as an issuer and as a lender. And I think we've gotten quite good at that. So I'd expect it to continue barring any major market disruption. We just don't see a lot of value deep down the balance sheet right now.

Operator

Next we have John Stilmar of JMP Securities.

John W. Stilmar - JMP Securities LLC, Research Division

Mike, just really quickly. I wanted to make sure I understood. When you're talking about syndication, is it the same thing that we should be thinking about in terms of bank land, where everybody takes a pari passu-rated portion of a deal and it's just a pro rata, or are you really referring to more of a first in, last out type structure? Clearly, you have the opportunity for both. But is -- when you're talking about syndication, which is it or maybe can you give us like a relative mix of that activity? Because they do have differences at least in terms of the economics.

Michael J. Arougheti

It's both, but I'd say it's disproportionately structuring first outs than pari passu.

John W. Stilmar - JMP Securities LLC, Research Division

Okay. Perfect. And then in terms of deals that you've lost or walked away from, can you potentially give a range of reasons? And are those reasons a little bit different today than they might have been, let's call it, 6 to 12 months ago? And if so, what are the potential sources? I mean, we certainly read about expanded risk preferences and maybe a certain return hurdles that might have been there. But there still is a certain barrier to capital for unitranche like senior debt at a certain size. So I'm just curious as to who those investors might look like in terms of category for transactions that may have gotten down if they're not going to be done with Ares.

Michael J. Arougheti

So we obviously turn down -- I mean, I think people know this, but generally speaking, we invest in about 5% of the investment opportunities that come through the platform. So we say no 95% of the time, and so there's any number of reasons why we're saying no. In markets like this, more often than not, it's going to be structural more than it's going to be company specific where we're seeing leverage levels get too high relative to the price being offered, or we've seen structural deterioration in the form of loose or no covenants or definitions within a credit document. So in these types of markets, a lot of times things are just getting kicked out based on structure before we even get into underwriting the company's business plan or evaluating the investment pieces for the security. Obviously, within the company specific, it could be any number of issues with regard to margin drivers or performance deterioration or what we perceive to be cyclical exposure, et cetera, et cetera. And that's constant, obviously. When you say no 95% of the time, most of the businesses that we evaluate, we just don't feel offer appropriate risk return. In terms of who the competition is, at the upper end of the market, there is some competition from some of the investment banks moving into the market to try to offer a distributed solution. Again, that's at the very upper end of our market. It is the private high-yield market, which is funded by private credit funds either structured as opportunities funds or large mezzanine funds. And then at the lower end of the market, the competition is from all over. Other EDCs. In certain cases, small regional banks, et cetera, et cetera. It's much more diverse competition the lower end of the market you go.

John W. Stilmar - JMP Securities LLC, Research Division

Great. And have any of these sources or reasons for turndown started to change in the past 6 to 8 months?

Michael J. Arougheti

Yes, I think we're -- like I said, I think -- you've seen a lot of structural deterioration. You've seen leverage levels creep up pretty significantly. And so things are not making it through the filter based on structure more so than they were 6 to 9 months ago, no doubt.

Operator

The next question we have comes from Bob Martin, investor.

Unknown Attendee

I'm used to seeing information on PIK income in your 10-Qs. This quarter, I was not able to find any information. Can you give me some details on the amount of PIK income in Q3?

Michael J. Arougheti

Sure.

Penni F. Roll

Yes. If you look at our statement of cash flows, which is on Page 4 -- 40, sorry, of the 10-Q, you'll see more data there and this is where you can actually find it. But during the course of the 9 months ended September 30, 2012, the PIK income that we accrued was about $19 million or roughly 3.6% of our total revenue. And if you look at that on a net basis, because we also had some collections during the quarter, the net PIK for the quarter was about 2.2% of revenue. So relatively speaking, it's a very small percentage of our income stream.

Operator

The next question we have comes from Robert Dodd of Raymond James.

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

Just a question on kind of the market dynamics again. I mean obviously, you've talked about a lot of competition coming in. Where do you think that stands in terms of prospects of some leveling out? Obviously, if we look at just your senior, not the SSLP or other parts, I mean, looks like loans maybe 6 months ago, you issued a senior first lien at 10% last quarter, 9.5%. And it looks like the early part of the fourth quarter, I back into a number around 9%. So I mean, where do you think you stand in terms of that leveling out? Or is competition continuing to flow in and getting even more frothy still?

Michael J. Arougheti

Yes, right now it feels like we're seeing a leveling out in spreads, and people are expressing increased risk appetite with increased leverage and structural deterioration. One of the reasons I think that that's happening is there is a theoretical absolute return requirement for a lot of the money that is in the market today, either in the form of CLOs or institutional funds. So barring a meaningful change in return expectation on the part of the public and private investor community, I think you should start to see spreads level out. It's interesting, I mentioned it earlier. When you look at the spreads today, they're still high relative to historical averages. And people should remember, at the peak of the market, we saw senior loan spreads in the 225 to 250 over context, and that was with the base rate that was 400 or 500 basis points. So the all-in return that was being offered at the prior market peak versus today is actually fairly comparable given where base rates are today. So you're going to have to see a little bit of a change in investor mentality and a focus on spread as opposed to total return to see the spreads continue to really grind down. So it feels like over the last couple of months, the rate of change has slowed, and we're settling in a little bit. Once people give away the leverage and the structure, then we'll revisit spreads again. But least as we sit here today, it feels like it's trying to find a little bit of a bottom.

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

Okay. Great. And on -- just kind of extending that, any difference in color that you can give us between say the senior market on the one hand and the unitranche? Obviously, I'm talking about the -- your direct versus the SSLP-type market. Any basically significant changes in competitive behavior between the 2?

Michael J. Arougheti

No, I think the unitranche has become a fairly commonplace type of security now. I think what makes our approach to it so unique is the size of our offering relative to what others in the market can do either themselves or as a club. And what we've experienced is in most market environments, we can get paid a premium because of the lack of competition at size. The other thing that hopefully isn't lost on people, when you look at our Senior Secured Loan Program with GE, the weighted average leverage, as we highlight it right now, is about 4.5x. And I think when most people think about unitranches, there's an expectation that the senior loan is stretching to subsume the entirety of what would have been the second lien or the mezzanine, which in today's market could be 5x to 6x, if not more, for certain companies. So what we've been able to do, again, because of the size capability we have is when we're doing unitranches, we're stretching just beyond a competitive traditional first lien structure. But we're not stretching nearly to the extent that you would as a junior capital provider. And we've seen over the last 12 to 18 months more and more people coming in with mezzanine behind one of our "unitranches." And that's been a little bit of a change in the market that we've seen over the last little while.

Operator

Well, it appears that we have no further questions at this time. We will go ahead and conclude the question-and-answer session. At this time, I'd like to hand the conference back over to management for any closing remarks.

Michael J. Arougheti

Great. Well, we appreciate everybody spending so much time with us today. And again, we know that folks have a lot on their minds with the recovery here. And we appreciate, given everything that's going on in the world, that everybody dialed in and took the time with us today. And good luck with everything, and we will talk to you guys next quarter. Thanks.

Operator

And we thank you, Mr. Arougheti and Ms. Roll and the rest of management. Ladies and gentlemen, this does conclude our conference call for today. If you missed any part of today’s call, an archived replay of this conference call will be available approximately 1 hour after the end of the call through November 19, 2012, to domestic callers by dialing (877) 344-7529 and to international callers by dialing (412) 317-0088. For all replays, please reference conference number 10018375. An archived replay will also be available on the webcast link located on the Home page Investor Resources section of our website. This concludes today's teleconference. At this time, you may disconnect your lines. Thank you, and take care, everyone.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Ares Capital Management Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts