Ares Capital (NASDAQ:ARCC) Q2 2011 Earnings Call August 4, 2011 11:00 AM ET
Michael Arougheti - Principal Executive Officer, President, Portfolio Manager, Director, Member of Investment Committee, and Member of Investment Committee of Ares European Private Debt Group
Penni Roll - Chief Financial Officer and Principal Accounting Officer
Richard Shane - JP Morgan Chase & Co
Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.
Arren Cyganovich - Evercore Partners Inc.
John Stilmar - SunTrust Robinson Humphrey, Inc.
Matthew Howlett - Macquarie Research
Greg Mason - Stifel, Nicolaus & Co., Inc.
John Hecht - JMP Securities LLC
Good morning. Welcome to Ares Capital Corporation's Earnings Conference Call. [Operator Instructions] As reminder, this conference is being recorded on Thursday, August 4, 2011.
Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subjects to risks and uncertainties. Many of these forward-looking statements can be identified by the use of 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 its 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, excluding professional fees and other costs related to Ares Capital Corporation's acquisition of Allied Capital Corporation, is the net per share increase or decrease in stockholders' equity resulting from operations, less professional fees and other costs related to the Allied Acquisition, realized and unrealized gains and losses, any incentive management fees attributable to such realized and unrealized gains and losses, any income taxes related to such realized gains and other adjustments as noted. A reconciliation of core EPS, excluding professional fees and other costs related to the Allied Acquisition to the net per share increase or decrease in stockholders' equity resulting from operations, the most directly comparable GAAP financial measure, can be found on the company's website at 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 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 2Q '11 investor presentation link on the homepage of the Investor Resources section of the website. Ares Capital Corporation's earning release and quarterly report are also available on the company's website.
I will now turn the call over to Mr. Michael Arougheti, Ares Capital Corporation's President.
Great. Thank you, operator. Good morning, everyone, and thanks for joining us. I'm joined today by the senior partners of Ares Management's Global Private Debt Group and members of our investment advisors investment committee: Eric Beckman; Kipp deVeer; Mitch Goldstein and Michael Smith; our Chief Financial Officer, Penni Roll; and Carl Drake and Scott Lem, who Head our Investor Relations and Accounting teams, respectively.
This morning, we issued our second quarter earnings press release and posted an investor presentation on our website that supplements this information. We'll refer to the investor presentation later in our call. As always, I'd like to start with a brief discussion of current market trends and how they influence our business and strategy. I'll then highlight a few items from our second quarter before turning the call over to Penni, who'll then take you through our quarterly results in greater detail. Finally, I'll come back and cover our recent investment activity, the state of our current portfolio and then update you on our backlog and pipeline before Q&A.
As you may remember from our last call, during the first quarter of 2011, the broadly syndicated loan and high-yield markets saw extremely strong liquidity from fund inflows. These inflows pressured spreads and structures, drove a high level of repayment activity and influenced trends in the middle market as well. However, during the second quarter, this liquidity and elevated repayment activity slowed while the supply of new money loans, meaning loans other than refinancings, increased substantially compared to the first quarter. As a result, the technical supply/demand imbalance witnessed in the first quarter reversed during the second quarter as loan supply outran loan demand.
Specifically, according to S&P, during the second quarter, retail loan fund inflows into the broadly syndicated market declined 36% and loan repayments declined about 38% from first quarter levels. Over the same period, new money loans increased by about 30%. At the same time, ongoing Greek and euro sovereign debt issues, softer U.S. economic trends and the debate over the U.S. debt ceiling all contributed to more volatility in the capital markets.
This uncertainty, coupled with a reversal in supply and demand, has begun to create a more favorable investment climate in our core markets. Senior loan spreads first stabilized and then began to widen moderately during the end of the second quarter and into the third quarter, and high-yield spreads have widened at least 50 basis points at the -- since the end of the first quarter, with meaningful additional spread widening in the last few weeks. Over the same period, leverage in our core market has stabilized at acceptable levels, particularly for senior and unitranche investments. Middle market loan volume was quite significant during the second quarter and activity levels appear strong heading into the third quarter. According to market data from Thomson Reuters, middle market loan issuance increased 32% both quarter-over-quarter and year-over-year. Drilling down further, middle market new money loans increased 39% and LBO loans increased approximately 34% compared to the first quarter.
This stronger market backdrop expanded our opportunity set of transactions reviewed, resulting in our commitment of $889.5 million of capital, a new quarterly high. Consistent with broader market trends, we saw lower repayments during the second quarter. Accordingly, we experienced net fundings in our portfolio during the second quarter of a record $359 million, a quarterly increase of more than 8%. Our backlog and pipeline have expanded further since our last call, and we are currently reviewing a significant level of new transaction opportunities, which could drive additional growth in assets and Core earnings during the third quarter.
As we search for the best relative value in the current market, we continue to focus on quality franchise businesses with high free cash flow and demonstrated strong relative performance during the last economic downturn. We still believe that senior secured floating rate assets, including stretch senior and unitranche loans, offer superior returns throughout a full cycle. You'll notice that approximately 94% of our originations in the second quarter were in these asset classes. With current all-in returns in the high single- to low double-digits, we continue to believe that senior secured floating rate loans offer attractive relative value given lower leverage, stronger maintenance covenants, higher attachment points and lower-default high-recovery characteristics.
With short-term interest rates hovering at about 0.3%, we like owning senior floating rate interests that should offer higher returns if rates increase over the life of such loans. In addition, senior loans generally offered greater liquidity and greater incumbency advantages, serving as a great source of continuing deal flow. That said, we do continue to pursue selected mezzanine investments where we see attractive value and believe that mezzanine could become more attractive as volatility in the high-yield market continues.
Now let's turn to the results. Our second quarter results were solid as we increased our Core earnings per share at $0.34 compared to $0.31 in the first quarter, grew our investment portfolio and improved our weighted average investment spread. Our credit metrics also improved as evidenced by a quarterly reduction in our non-accrual ratios and an increase in the weighted average grade of the portfolio investments as a whole. With an additional $212 million in exits during the second quarter, we continue to make progress rotating the legacy Allied portfolio, which now represents only about 20% of our combined portfolio at quarter-end. We have also increased the legacy Allied portfolio yield from 9.1% as of the Allied Acquisition date to 11.4% as of quarter-end. And finally, we ended the second quarter with considerable debt capacity and cash that, together, are approximately $920 million and balance sheet leverage that is modest and still below our target range. This leaves us with significant capital and leverage capacity to fund our sizable backlog and pipeline.
I'd now like to turn the call over to Penni Roll, our Chief Financial Officer, for more detailed comments on our second quarter results. Penni?
Thanks, Mike. For more details on our financial results, I refer you to our Form 10-Q that was filed this morning with the SEC. To begin, please turn to Slide 3 of the investor presentation posted on our website, which highlights financial and portfolio performance for the quarter. As Mike mentioned, our basic and diluted Core EPS were $0.34 per share for the second quarter of 2011, a $0.03 per share increase over Core EPS of $0.31 per share for the first quarter, and a $0.02 per share increase over the same quarter a year ago. Our Q2 '11 and Q2 '10 Core earnings excluded $0.01 and $0.06 per share respectively of Allied Acquisition-related professional fees and other costs.
The increase in our second quarter Core earnings per share of $0.03 as compared to the first quarter was primarily due to higher structuring fees of about $0.04 per share, net of an increase in administrative expenses of about $0.01 per share.
The second quarter increase in structuring fees reflects the higher overall level of gross originations, as well as the composition of the second quarter's originations being more weighted toward new investments as opposed to refinancing transactions when compared to the first quarter. Despite the net growth in our investment portfolio, our interest income was roughly flat with the prior quarter primarily for 2 reasons. First, many of our larger investments were completed near quarter-end so these investments contributed to our interest income for only a small portion of the second quarter. Second, we experienced net exits in the portfolio in the first quarter, including the sale of our higher-yielding CLO investments at the end of February, which contributed about $0.02 per share in the first quarter. These net exits also resulted in a short period of excess cash pending redeployment in the portfolio.
Our net investment income per share for the second quarter was $0.21 per share compared to $0.24 per share in the first quarter and $0.26 per share in the second quarter of 2010. Our net investment income and GAAP earnings per share were reduced by $0.12 per share in the second quarter of 2011 and by $0.07 per share in the first quarter due to the GAAP required accrual of non-cash capital gains-related incentive management fees. The second quarter accrual was primarily related to the June 2011 amendment to our investment advisory and management agreement with our investment advisor. The application of the June amendment resulted in an accrual related to the assets purchased in the Allied Acquisition of approximately $26 million or $0.13 per share in the second quarter. As of June 30, 2011, there was no actual capital gains incentive fee payable to our investment advisor under the advisory and management agreement.
Net realized and unrealized losses for the second quarter were $0.03 per share, which included a loss on the extinguishment of debt from the early repayment of the Allied 2012 notes of $0.05 per share as compared to net realized and unrealized gains for the first quarter of $0.37 per share, which included the realized gain on the sale of the non-core legacy Allied CLO portfolio of approximately $99 million or $0.48 per share.
As Mike mentioned, during the quarter, we made significant total commitments in an aggregate amount of $889.5 million against total exited commitments of $375.8 million, including $212.1 million from the legacy Allied portfolio. Our net commitments were $513.7 million, with net fundings of $359.4 million.
We ended the quarter with an investment portfolio of approximately $4.6 billion at fair value and 148 portfolio companies. This represented a net reduction of 6 portfolio companies since last quarter. We continue to focus on reducing the number of smaller or non-core names in the combined portfolio with a continued emphasis on shrinking the legacy Allied portfolio, which again represented only about 20% of the combined portfolio at quarter-end.
Following our strong second quarter investment activity, our quarter-end portfolio reflected a higher percentage of senior debt. As of quarter-end, our portfolio at fair value was comprised of approximately 49% of senior secured debt securities, up from 43% at the end of the first quarter with 37% in first lien and 12% in second lien debt investments. We also had 16% in senior subordinated debt, 17% in equity and other securities, 2% in CLO investments and 16% in 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.
Now I would like to walk you through the changes in our yields and investment spread for the quarter. From a yield standpoint, our weighted average yield on debt and income-producing securities at amortized cost decreased from 12.8% to 12.5% quarter-over-quarter, reflecting moderately lower yields on new senior debt investing activity. However, our weighted average stated cost of debt capital decreased from approximately 5.7% to 5.1% quarter-over-quarter, as we prepaid the 6% Allied 2012 notes during the second quarter and utilized our lower cost revolving credit facilities to fund the portion of our new investments. Therefore, our weighted average investment spread improved from 7.1% to 7.4% quarter-over-quarter.
On Slide 6, we have set forth our fixed and floating rate assets and our non-accrual statistics by portfolio. Overall, our floating rate debt assets on a combined basis at fair value increased from 50.2% in the first quarter to 57.5% in the second quarter, and our fixed rate debt assets declined from 29.2% to 24.8% over the same period, reflecting our continued emphasis on investing in senior floating rate assets as Mike mentioned.
The Core ARCC Portfolio's non-accruals, as a percentage of the combined portfolio, decreased from 2.6% at cost and 1.1% at fair value at the end of the first quarter to 1.9% and 0.6%, respectively at the end of the second quarter. The legacy Allied portfolio's non-accruing investments as a percentage of the combined portfolio declined from 2.2% at cost and 1.5% at fair value to 1.6% and 1%, respectively.
The combined portfolio's total non-accruals decreased quarter-over-quarter from 4.8% at cost and 2.6% at fair value to 3.5% and 1.6%, respectively. There were no new portfolio companies placed on non-accrual during the quarter, and we exited or were repaid on 4 portfolio companies previously on non-accrual. In addition, one portfolio company returned to accrual status during the quarter. Overall, we believe the net reduction in non-accruals is one measure of further improvement in our credit quality this quarter.
Now turn to Slide 9 for more detail behind the net gains and losses for the second quarter. When you take the combination of the 3 primary line items, net realized losses of $6.4 million, net unrealized losses of $2.3 million and the reversal of prior period unrealized appreciation and depreciation on exited investments of $12.3 million, we incurred positive total net investment gains of $3.6 million or $0.02 per share for the second quarter. This $3.6 million gain was reduced by the nonrecurring loss on debt extinguishment of $10.5 million or $0.05 per share, resulting in total net realized and unrealized losses for the second quarter of $6.8 million or $0.03 per share.
Turning to Slide 10. As of June 30, we had approximately $2.6 billion in committed debt facilities and approximately $1.7 billion in aggregate principal amount of indebtedness outstanding. The weighted average maturity of our outstanding indebtedness was approximately 12 years with a weighted average stated interest rate of 5.1%. On this date, we had $349 million outstanding under our $400 million revolving funding facility, with no amounts outstanding under our $810 million revolving credit facility. We also had available cash on hand of approximately $70 million at quarter-end. Therefore, we had approximately $920 million in debt capacity subject to borrowing base and leverage restrictions and cash available to us to make new investments. Our debt-to-equity ratio at quarter-end was 0.52x based on the carrying amount of our debt, and our net debt-to-equity ratio, which is net of available cash and cash equivalents, was 0.49x. This compares to a net debt-to-equity ratio of 0.37x at the end of the first quarter. We will seek to reach our targeted leverage ratio of 0.65 to 0.75 over time, but there can be no assurance that this will be achieved.
Finally, as you may have seen from our press release this morning, we declared our third quarter dividend of $0.35 per share payable on September 30 to shareholders of record on September 15. We have now paid quarterly dividends of at least $0.35 per share for 22 straight quarters dating back to the first quarter of 2006.
And with that, Mike, I'll turn it back over to you.
Thanks, Penni. Now I'd like to discuss our recent investment activity, update you on our legacy Allied portfolio rotation progress. I'll review our performance statistics and then highlight our post-quarter-end investments and forward backlog and pipeline before concluding.
If folks could turn to Slide 14 in the investor presentation.
In the second quarter, we made 18 commitments, 8 to new portfolio companies, 7 to existing portfolio companies and 3 to companies through the Senior Secured Loan Program. Of these new commitments, 15 were sponsored transactions. We effectively used our scale and strong capital position to increase our average commitments to nearly $50 million compared to just over $30 million in the past 2 quarters. Therefore, the growth in our second quarter's gross commitments represented increased commitment sizes but not a meaningful increase in the number of commitments as shown. This result is consistent with our strategy to seek to invest up the balance sheet through senior and unitranche debt into high-quality companies.
Turning to Slide 15, you can see that 87% of our investment commitments were in senior secured floating rate debt and another 7% were to the Senior Secured Loan Program through which we co-invested with GE in senior secured floating rate debt. On the right side of the slide, you'll see that our exited investments by asset category were fairly balanced including 22% in common or preferred equity and non-core real estate investments.
Now turning to Slide 16, I'll update you on our cumulative progress rotating and repositioning the legacy Allied portfolio from April 1, 2010, through the end of the second quarter, which marks 15 months since we closed the acquisition. On a fair value basis, the size of the total legacy Allied portfolio stood at $0.9 billion at the end of the second quarter down from $1.19 billion at the end of the first quarter of 2011 and compared to $1.83 billion on the acquisition date of April 1, 2010. If I can direct you to the reconciliation at the bottom of the slide, you'll see that since we acquired Allied, we've generated nearly $1.16 billion in cash from exits or repayments of investments in the legacy portfolio, including net realized gains of about $139 million. Although we have experienced some net unrealized depreciation of about $22 million on the remaining portfolio through the second quarter, we've generated $117 million in total net gains, netting this $22 million out from the $139 million in net realized gains. This $117 million does not take into account the roughly $130 million purchase accounting gain we previously booked on these assets in connection with the acquisition.
We've also made progress in other areas related to the legacy Allied portfolio. For example, we've increased the yield at fair value on the remaining legacy portfolio from 9.1% as of April 1, 2010 to 11.4% as of the end of the second quarter of 2011. We've also further reduced non-accruing investments in the legacy portfolio from $335.6 million to $45.7 million, a decrease of 86% at fair value. And finally, we've made some progress during the second quarter reducing the common equity securities in the legacy Allied portfolio, primarily through the sale of a controlled portfolio company, which provided approximately $40 million in cash from the sale of equity and another $28.5 million in cash from the sale of debt. We expect to continue to focus on exiting or restructuring the legacy Allied equity investments, including the approximately $284 million of investments with an aggregate yield of less than 1% that we would like to exit or restructure over time. However, there can be no assurance that we'll be able to do so.
Now turning to Slide 17. On a combined basis, the underlying portfolio company weighted average last dollar net leverage increased moderately from 4.2x as of the end of the first quarter to 4.4x as of the second quarter, reflecting modestly higher market leverage levels on new transactions compared to our current portfolio and repayments of lower leveraged investments. Our overall weighted average interest coverage remained about the same, dropping from 2.8x to a still healthy 2.7x. And at the end of the second quarter, the underlying borrowers within the Senior Secured Loan Program had a similar weighted average leverage multiple of 4.4x and a slightly more conservative weighted average total interest coverage ratio of 2.9x.
On Slide 18, you can see that we invested in companies with just over $31 million in weighted average EBITDA during the second quarter. The weighted average EBITDA of the companies in our combined portfolio held steady at just under $38 million.
Skipping over to Slide 20. You'll see that the portfolio remains well diversified by issuer. Our largest investment at quarter-end continued to be in the Senior Secured Loan Program, which remained at approximately 16% at the end of the second quarter at fair value. Within the program, there were 23 separate borrowers as of the end of the second quarter, and the program continued to have no non-accruing investments as of June 30. And the largest single issuer in the program represented about 8.7% in aggregate principal amount of its total investments. The top 5 largest loans in the Senior Secured Loan Program represented just under 40% of the overall loans in the program.
Skipping to Slide 23 is a summary of the grades for the Core ARCC and legacy Allied portfolios. Each portfolio is graded on a scale of 1 through 4, with an investment grade of 1 defined as having the greatest risk to our initial cost basis and a grade of 4, having the least amount of risk to our initial cost basis. Each investment is initially graded a 3 at the time of investment or acquisition. On a combined basis, the portfolio experienced 14 ratings upgrades compared to 8 ratings downgrades, reflecting overall improved credit performance. And in the aggregate, as of June 30, the weighted average grade of the entire portfolio increased from 3 at the end of the first quarter to 3.1. The bar chart also illustrates that the combined portfolio includes more credits rated above a 3 than below measured by fair value as of quarter-end.
Now to give you additional information on how the companies in our combined portfolio are performing in this slow growth economy. Weighted average revenues and EBITDA experienced solid growth of approximately 8% and 12%, respectively, on a comparable basis for the year-to-date period versus the same period last year. This slightly higher growth rate compared to the statistics provided for the first quarter reflects modestly improved revenue and EBITDA performance from existing portfolio companies.
On Slides 25 and 26, you'll find our recent investment activity since quarter-end and our current backlog and pipeline. As of August 1, we had made additional new commitments of approximately $583 million, of which, $435 million were funded since June 30.
Of these new commitments, 93% were in first lien senior secured debt, 4% were investments in subordinated certificates of the SSLP, 2% were in equity securities and 1% were in second lien senior secured debt. Of these new commitments, 98% were floating rate with a weighted average spread at amortized cost of 6.9%. However, we plan to syndicate a portion of these investments, which we expect, when combined with the impact of LIBOR floors, will drive the weighted average yield on our final hold position in excess of 10%.
As of the same date, since June 30, we had also exited $62 million of investments, of which, $2 million were from the legacy Allied portfolio. Of these $62 million of exits, 83% were in floating rate investments with a weighted average spread at amortized cost of 7.8% and 17% were fixed rate investments with a weighted average yield at amortized cost of 13.5%. The majority of the exits were in second lien debt, collateralized loan obligations or senior subordinated debt, which in aggregate totaled 84% of the exits.
Shown on Slide 26, as of August 1, our total investment backlog and pipeline stood at $780 million and $440 million, respectively, reflecting continued strength in middle market activity. This collective $1.2 billion backlog and pipeline increased in the aggregate by over 35% since the $880 million that we discussed in our last earnings call. As you know, we can’t assure you that we'll make any of these investments and we may syndicate a portion of these investments as well.
I'd like to conclude with a few thoughts on our second quarter and our outlook. We believe we utilized our significant debt capacity to not only improve our Core earnings, but also to lift our weighted average investment spread. We hope to build on this momentum by converting a significant portion of our backlog and pipeline to funded investments throughout the remainder of the year. As discussed, we believe that we've made significant progress with our legacy Allied portfolio rotation initiatives and we'll seek to continue to do so in the quarters ahead, particularly with respect to the lower and non-yielding components of the portfolio. And from a credit perspective, we made solid progress in reducing non-accruing investments and we believe that the positive change in our weighted average investment grade is indicative of the health of our portfolio.
As for the market environment, while risk adjusted returns compressed earlier this year, the market is showing signs of stabilization and, in some cases, improvement and the volume and quality of the investment opportunities are stronger compared to earlier in the year.
That said, and today is a good example, given macroeconomic uncertainty and recent global capital markets volatility, we'll continue to remain defensively positioned with investments in primarily senior and unitranche assets, in high-quality franchise businesses as a potential hedge against any changes in the market environment. We believe that our broad and direct origination capability, coupled with our balance sheet position and strength, position us to act opportunistically in a variety of investment climates while remaining disciplined in our investment approach.
Thank you for your time and support today, as always. And with that, operator, let's open up the line for any questions.
[Operator Instructions] Our first question is from Greg Mason, Stifel, Nicolaus.
Greg Mason - Stifel, Nicolaus & Co., Inc.
Mike, could you talk about the 6.9% spread on investments you've done, even after you syndicated 10% type of yields, clearly down from the 12.4% yields in the portfolio, and that has been shrinking down from 13.4% a year ago. Can you talk about where you think your spreads on the portfolio are going and why this focus on significantly lower coupons in the portfolio?
Sure. Maybe it will help people if I just take a step back and talk about how syndication drives incremental yield and then we can talk about how the strategy we think protects principal and drives total return over the cycle. The reason for the yield being as low as it is in the investments funded quarter-to-date is we are using our balance sheet strength to ensure that we get the opportunity to invest in the highest quality companies that we see. And we've talked a lot on prior calls that given our final hold size capabilities and balance sheet capacity, we can use that to effectively underwrite a company's entire balance sheet. And then, obviously, through market syndication relationships, the Senior Secured Loan Program and Ivy Hill, we can generate liquidity at different parts of the capital structures. We try to generate what we think is an attractive risk adjusted return. So as an example, if we underwrite $100 million unitranche on balance sheet for a $20 million EBITDA company, so 5x levered and we price that at 8%, on its own, it's generating 8% yield, and that's probably a combination of a 7% spread and a 1% LIBOR floor. But let's talk just about it in terms of yield. On that investment, we're also probably generating a 3% fee. So our all-in yield, assuming no syndication in year one, is in fact 11%. Our 2-year yield, assuming no change in interest rates, is 9.5%; and our 3-year yield, assuming no change in interest rates, is 9%. Now assuming that it's out for 3 years, we're probably out of the call period and so there may not be a prepayment premium, but most of the unitranches that we structure actually have call protection associated with them as well that would serve to enhance the yield on take out. Now one of the things that we have is a very embedded and entrenched origination capability, and there are a lot of people in the market, banks, finance companies and some of our BDC peers who would like access to assets that we originate. We could take that unitranche, sell 2 turns of first-out, first lien debt to another capital provider at a very low yield, call it 3.5%. And so, if we then sold that 2 turns at 3.5%, we would be left with a final hold of $60 million. The yield on that $60 million would now be 11%, and we're probably not passing on full fees to the market. So our one-year yield, including the net fee, probably goes up to 15% to 15.5%, depending on the fee arrangement that you have with that first-out provider. So you have to, number one, have a view on duration and where you want to be investing the capital structure, but because of our balance sheet capacity, we now took a situation where we underwrote a full balance sheet solution, created an asset for a good capital partner in the market, and we're left holding a $60 million investment first lien that we control, that we diligence, that we structure, that we agent, that's generating a one-year return of 15.3% without the benefit of rising interest rates and call protection. And the attachment point on that security is at 2 turns, funding through 5 turns, which is significantly more attractive than any mezzanine or second lien, I think that you could buy were you not effectively manufacturing and originating your own assets. So understand, when we talk about syndication, we're talking about syndicating different parts of the capital structure to drive what we think is attractive yield. And sometimes, we'll sell more, sometimes we'll sell less to generate what we think is good risk return. So with that in mind, to answer your second question, I think we tend not to want to invest just given the structure of our balance sheet in assets less than 10%. That said, we do have a view on interest rates over time, and we do have a view on the importance of being first lien both in terms of the liquidity of those assets and the control and influence that it gives you. You mentioned our spreads compressing over the last year. Obviously, market spreads have compressed much more dramatically than the spreads in our portfolio. In those markets where spreads are compressing, I don't think that they're positioned to benefit from rising interest rates the way that we are. And hopefully, what people picked up on as well, that even in the face of spread tightening, our net interest margin was actually up this quarter as we now invest with our revolver, which is our lowest cost of funds. So we're trying to find the right balance between risk and return, and we're also looking at ROA and ROE. And I think the net interest margin is a nice trend to see working through the portfolio. And then, I'll just finish by saying if history has proven one thing about us as fiduciaries and investment managers, we do not let return expectations drive our risk appetite or our investment decisions. Risk always comes first, and we go to the risk that we're willing to take, and then we try to maximize the return that we can get for that risk. And in markets like the one we're in, and again, today is a perfect example, there's still a fair amount of uncertainty and volatility, globally. And those environments, I think it's prudent to potentially sacrifice some short-term return for long-term total return and balance sheet position.
Your next question is from John Hecht, JMP Securities.
John Hecht - JMP Securities LLC
I guess, following up from that last discussion on the spread. Mike, if I hear you right, you're suggesting that the spread compression is related to kind of structural opportunities, maybe kind of size and quality of the types of companies you're able to finance now. The question I have is in the exclusion of that, recent quarters, you've suggested spreads had been compressing, and it sounds like you're saying in exclusion of that, you'd actually see spreads widening now, given the increased volatility and economic uncertainty in the market. And is that, in fact, an accurate interpretation of what you've been seeing?
Yes, absolutely 100%. It's the uncertainty and the volatility but it's also the shift in the supply/demand imbalance that we saw earlier in the year. And so as deal flow has picked up, which I think we talked about on our last call as well that to the extent that deal flow picked up particularly in the larger markets that we would have expected to see stabilization in pricing. So now that we have a favorable mismatch and there's uncertainty, we are seeing spread widening. Now back to your comment though, with that spread widening, I think that, that allows us to now invest in even higher-quality companies and maintain our total return profile rather than trying to stretch for that incremental spread and go down the credit quality spectrum.
John Hecht - JMP Securities LLC
Okay. Great. Second question is coming through Q2 and it sounded like, at least, through a portion of Q3, repayments have slowed and deal activities moving up, increasing. How sensitive are both of those to the volatility in the market? You referred to today, the stock market being down somewhat dramatically. I mean, as these transactions you're looking at begin the process, do they take on a life of their own or do they start along with the volatility in the market?
Eventually, the volatility in the market will slow deal flow, but there's a pretty significant lag effect. I think generally, and this is truer for middle market private equity firms versus larger market. But for the most part, middle market private equity firms, in my opinion, tend to operate in a fairly insulated environment in terms of how they believe that global economic trends or activity or characteristics are driving their investment decisions. So I don't expect the type of volatility that we're seeing today to necessarily halt people from continuing to fund the backlog of investments that are in process. I think if the bad news continues and the volatility continues, eventually, like we saw in the end of '08 and '09, you're going to see a reduction in deal flow. It's too early to tell just how significant that potential is right now. But I would expect that if it's in backlog today, it's probably moving along a path to closing. You may see some moderate purchase price renegotiation. You may see some modest renegotiation of leverage and pricing on the debt, but it probably doesn't go away.
The next question is from Sanjay Sakhrani, KBW.
Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.
So I was wondering if this defensive posture that you guys are taking is indicative of how you feel about the economy. Is there anything in the portfolio that's leading you guys to feel that way? And I guess, second, just in terms of the pipelines -- the pipeline you guys addressed, in terms of spread, should we assume that they're comparable to what we're seeing -- what we saw in the second quarter? And then, maybe, if you can just elaborate on your prepayment expectations for this quarter, that'd be great.
Sure. So again, it's an interesting conversation to have and we started to speak about this last quarter is, we're defensively positioned but we're still seeing very, very attractive investment opportunities out there. We had a record quarter this quarter in terms of investment activity. Our backlog and pipeline are as significant as they've ever been. And so there is nothing that we're seeing that is telling us not to invest, but what we are seeing is just a view that growth is slow. There is volatility, which means that the further down the balance sheet you go, the more risk you probably have to principal given changes in enterprise values and attachment points. But when you look at our portfolio, as we said in the prepared remarks, our portfolio companies are still doing very well. We had period-over-period, so 6-month over 6-month roughly comps of 8% and 12% on revenues and EBITDA. So companies are growing period over period. We've seen that consistently over the last couple of years. However, we have a view that the rate of growth may slow. And as we start to see the rate of growth slowing, it's a pretty good indicator that, number one, you're probably in a better credit environment than you are an equity environment. And as you get to the slowest of growth, you probably benefit from being higher up the balance sheet than not. And the example I gave on the unitranche structure on balance sheet with syndication is a pretty good example, because if you're a mezz-only provider of capital who does not have the ability to originate $100 million alone -- and by the way, I think as people know, both on balance sheet and co-investing with GE through the Senior Secured Loan Program, we're actually in a position to invest $300 million or $400 million in a middle market issuer. And so if we could actually use that scale to create that same 12% to 15% rate of return at a much higher attachment point with much more significant control, both in good situations where we're refinancing or doing add-ons or in negative situations where we control our restructuring, I think that's pretty compelling. And I actually don't believe that we're sacrificing yield relative to other investment opportunities in our core market when you factor in risk position. So in terms of the economy, obviously, the economy is not great. It's slow, it's choppy. Despite the positive information coming out of our portfolio, you have to, at least, be cautious. And again, being cautious for us means that we're still finding plenty of ways to invest the capital at very attractive and accretive ways. In terms of the spreads that we're seeing, yes, I think that generally speaking, the investments that we're making this quarter and hopefully through the end of the year, we expect will be at or around the spreads that we're investing at now and should be consistent with the current yields in our portfolio. And again, the amount of volatility we're seeing today, we don't love. But volatility actually helps our business because, hopefully, it will widen out spreads, prevent marginal competitors from coming into the market and doing irrational things. And so a slow-growth economy with volatility is the best environment for our business. And so we're pretty happy about it. I don't know if I answer – there was a third question. I rambled a little bit there, Sanjay.
Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.
The third question was just prepayments. I mean, you guys talked about them slowing. I mean, should we expect -- based on what we see in the quarter today, do we expect significantly more for the rest of the quarter?
I would -- all I can tell you is I expect that the book will grow in Q3. Prepayments are -- we can predict them, but they're tough to predict perfectly. I would expect that we'll see more than we've already seen quarter-to-date. How much more, I can't tell you. But I think when the dust settles in terms of our backlog and pipeline against our repayments, I'm pretty confident that we'll have a growth in the portfolio in Q3.
The next question is from John Stilmar, SunTrust.
John Stilmar - SunTrust Robinson Humphrey, Inc.
Just real quick question going back to the idea of syndicated transactions that you've talked about where Ares sort of leads -- is a lead sponsor. In this quarter, you did -- it seemed like one very -- relatively large transaction, Anthony, Inc. Is that sort of the investment pieces that we should look towards? And then is there anything in the schedule of investments as we look back that we should towards as examples of this? And I'm kind of trying to get a sense of timing. I would have expected 1 or 2 of these syndications to have occurred last quarter or from last quarter's investments. And I just...
Well, yes, and so I think it's a function of our size now. But it's a strategy that we've always employed. So if you go back, even 3, 4 years ago, 5 years ago, we were doing this on a much smaller scale. I think we're trying to be opportunistic. I don't want people to come away from this call with a view that, that is our singular business model. But it is important to us that as we see high-quality companies, that we use every lever that we have to invest in them. And we spend a lot of time talking with you guys about what the drivers of total return are across the cycle. And position in balance sheet, we think is most important. Company and industry attributes are probably second. And size is important, but it's probably third. But when you factor all of that in, we want to make sure that when we look at the available market and we see the highest quality company that we invest in it, and that may mean we have to underwrite the entire balance sheet in order to own that company. So I would expect on a go forward basis that you'll continue to see chunkier positions, some of which we’ll syndicate. And frankly, in the case of Anthony, Anthony is a $200-plus million investment on a $5 billion balance sheet, that's not an uncomfortable position size for us. So I think it's going to be company-specific and return-specific as to whether or not we syndicate or hold. And we also always have the opportunity to hold and syndicate at a later date. So there's no rule of thumb. But I would expect particularly, in this kind of market environment that you'll see some of that activity in the quarters going forward.
John Stilmar - SunTrust Robinson Humphrey, Inc.
Okay. And then unfortunately still sticking with that same topic, to who are you syndicating towards? Obviously, the size of company has changed as Ares has changed. So what are the types of partners that you -- or if you could kind of paint a picture for me as to who the people that are going to be buying or is it banks, is it finance companies?
Yes, it depends on how -- what syndication strategy we adopt. So if we underwrite something at the security level and we choose not to change the capital structure, then we're syndicating to other alternative credit providers, be they hedge funds, other BDCs or some finance companies. In situations where we're doing what I gave the example on, which is effectively creating a really low-levered, really well-priced first-out term loan, those tend to go to regional banks. And as I think a lot of people on the call probably know, regional banks are looking to get invested. I think they have a lot of cash and liquidity. And getting an opportunity to see a unique investment and a high-quality asset with this profile is something that there's a lot of appetite for.
John Stilmar - SunTrust Robinson Humphrey, Inc.
Perfect. And then my final question, and this is directed at Penni, and this is regarding valuations. But as you've gone through the valuation this past quarter, clearly, the balance sheet is much more defensively positioned in terms of the balance sheet position with its senior orientation, but we've seen spreads kind of widen. As we think about book value from here kind of going forward, which is it that's probably a little bit more of a driver? Should we think about spread volatility as being a bigger driver or less of a driver than as we kind of look at Ares or some of the other BDCs in the past given the fact that there is a little bit more of a senior orientation to the balance sheet? Just wondering about your thoughts about changing market conditions given where you are in the capital structure.
Right. Well, clearly, market yield to the extent we have debt securities that are valued off of a market yield and looking to what other lenders or investors in those loans would want as a return on those investments. Volatility and interest rates will impact those valuations. As we sit here today, it's hard to know how much of that volatility will come into play because we only value the quarter -- or the portfolio once a quarter. But it could mean that the senior level assets that we're investing in could have valuation differentials against their cost basis quarter-to-quarter because of those changes in market rates. It's just hard to determine what that impact would be as we sit here today.
Your next question is from Rick Shane, JPMorgan.
Richard Shane - JP Morgan Chase & Co
The number that you guys had cited was about $920 million in available liquidity. And again, I realize that you can't very closely project what the originations are going to be or how capital is going to be deployed. But when you look at it internally so that we can sort of think about it within our models, what type -- what's your sort of liquidity [indiscernible]? How many quarters of available liquidity versus your expectations in terms of budget do you want to have available?
I'll let Penni just give you a couple of statistics just around debt capacity as it relates to our target leverage ratio. And then maybe I'll give a little qualitative commentary around that, Rick.
Right. With the capacity we have today, we have nothing drawn on our revolving credit facility, which has about $810 million available. I think a little less than that what was credit posted. But overall, we have about $920 million of debt capacity plus cash. If we fully funded the debt capacity that we have, the yield on -- our weighted average stated rate would be down to 4.25%, down from 5.1% today at June 30 and then, the weighted average maturity would be about 8.6 years versus 11.9 years today. So still have a good profile, good capacity, and it would allow us to draw into our lower cost debt capital that's still available to us.
And then, in terms of the leverage ratio, I think if we fully funded all of our debt capacity, with no increase in the equity base, we would be about 0.83x levered on a gross basis. So obviously, above our target range but well within regulatory limits. So now the qualitative answer, we have said we want to run the business at a target leverage ratio of 0.65 to 0.75 to 1, and that's really how we think about managing the business. We do have a lot of visibility into our backlog and pipeline, and our liquidity needs. And while we can't predict it as perfectly, we also have a fair amount of visibility into our paydowns. We do not want to be in a position where we're sitting on cash or excess liquidity and I think we've been pretty explicit that while we've been under-levered, to the extent that we see good investment opportunities, we'd rather be more levered than we have been. I'd also point out, as we've shown in the past, given the assets that we're originating, investing in, we have sources of balance sheet liquidity other than capital markets raises, and that's syndication, our relationship with Ivy Hill and other things. And so I think as you've seen us do in years past, we're obviously looking at the capital markets to continue to fund the growth of the business, but we aggressively manage liquidity through asset sale, as well as we continue to optimize and reposition the portfolio. I can't quantify in terms of 1 or 2 quarters, but I think we want to try to get as close to our target leverage range as possible, and maintain it. And it's really always a function of just where we are in the disposition of our backlog and pipeline.
Richard Shane - JP Morgan Chase & Co
Got it. Mike, and I think you guys -- I may not have conveyed my question quite the way I intended which is, what I'm trying to think about is not how quickly you will go through that $900 million of available liquidity. But over the long-term, as you manage that available liquidity number, how do you think about it? Is it -- should we assume that you will sort of roughly keep $1 billion available of dry powder at any given time or...
Yes, I understand. There's no rule of thumb that I can give you, Rick. But you should know, we run, even despite our liquidity positions, daily liquidity models. We're looking at everything that's in our portfolio and everything that's in our backlog and pipeline and it's a function of again, what we think the investment opportunity that lays ahead of us, what we think the market risk is. If we feel that we're going into a market where liquidity will be constrained, we'll run less levered with more liquidity. If we feel like we're going to be in a fairly stable market environment, then we'll probably run with less liquidity. I can't give you a rule of thumb other than to say that we aggressively manage liquidity all the time.
The next question is from Arren Cyganovich, Evercore.
Arren Cyganovich - Evercore Partners Inc.
Mike, you made some comments that you saw some mezzanine opportunities presenting themselves that you might be able to invest in. It seems as though the mezzanine market has been kind of taken out a little bit by the second lien market. Are you seeing a pullback in -- from folks that were offering second lien loans to open these opportunities?
I think 2 things. That's a good observation. I think unitranches and second liens have significantly displaced traditional mezzanine. And again, it speaks to what we always say, which is the importance of being able to invest up and down the balance sheet and not be a single-asset class provider. Second liens were very prevalent and continue to be fairly prevalent in larger companies. We have not seen second liens really find their way into kind of the core traditional middle market. Although some first lien agents in the market would love to see that occur because it allows them to maybe be more competitive with a buy and hold provider like ourselves. We just haven't seen a lot of appetite for second lien in kind of the traditional middle market. So yes, I think mezzanine -- and this is something that I think people appreciate and you see it through the cycle, not every company is a good mezzanine candidate. You're giving up a fair amount of security and investing at a pretty high attachment point in order to generate outsize returns. And to put it in perspective, a high-quality mezzanine investment today is probably carrying a coupon between 12% and 14%. It's fixed rate, so it's interest rate sensitive. And the return for that fixed rate, you need to protect your yield through call protection. And in markets where mezzanine is getting squeezed, and there's a lot of mezzanine capital available for investment, it's very hard for a mezzanine-only provider to actually remain disciplined around call protection. And so we've seen traditional mezz providers actually giving up a fairly significant amount of value through reduced call protection. And once you start doing that, the relative value of second lien and unitranches against traditional mezzanine really blows out. So we'll see how it goes. Again, as I mentioned, if there's high-yield market volatility, I think the larger end of the mezzanine market will get very active with private high-yield-type structures. But I think the traditional middle market mezz asset class right now is actually pretty challenging.
Arren Cyganovich - Evercore Partners Inc.
And then finally, the non-accrual that went back onto accruing status. Was that restructured or is that just have an improvement on the underlying business?
It was an improvement in the underlying business.
The next question is from Joel Houck, Wells Fargo.
Mike, right now, there's a couple of internally managed BDCs trading below 70% of stated book value. Neither company, in our view, has been good stewards of shareholder capital, and one in particular is trading at less than 50% of realizable NAV today with a fairly high cost structure. So given Ares' success with the Allied deal, just curious to what your thoughts are on possible M&A where you could potentially double the size of your company, probably get a 30% to 50% IRR on the deal. And also, how do you weigh potential M&A versus deploying capital right now in an uncertain environment where you're getting admittedly lower net spreads? Obviously, you're staying up the balance sheet and protecting your own shareholders' capital. But how do you view those 2 risk reward propositions?
Sure. Allied has been an absolute success for us. And I think we learned a lot through the acquisition and over the last 15 months. I think first and foremost, we were disciplined at the purchase. And if folks remember, we worked on that transaction for close to a year before we actually bought it, and there was a lot of analysis that we went into identifying what price we were comfortable buying the assets at. So for us, in order for us to take on somebody else's problems, if you will, it's really just a question of is the price right relative to the risk and the distraction? And it depends on the target, because for a company that is smaller, we could probably originate new assets with our own structure and diligence and the like in one quarter relative to the size of some of the smaller internally-managed companies. So in those situations, in particular, we're going to be very focused or we would be very focused on price. And I think the challenge is, and this also speaks to maybe some of the larger opportunities, you have entrenched management teams and entrenched boards and when it comes to buying assets, liquid or illiquid, bid-ask spreads can be pretty wide. And our experience has been beauty is always in the eye of the beholder and the price at which we would be willing to transact to generate the return that would be exciting to us is probably not a level at which certain management teams or certain boards who are entrenched would want to transact. But look, if the markets felt that they should transact or trade, we would love that.
We have one final question. That is from Matthew Howlett, Macquarie.
Matthew Howlett - Macquarie Research
Mike, just on the -- just getting back to the targeted leverage. Is there a specific equity level or even industry concentration that has to be reduced to a point where you feel comfortable going to that level?
No. One of the things people hopefully appreciate -- senior secured loans, even if they're unitranches with a slightly higher enterprise value attachment point are leverageable well in excess of our target range. As people know, prior to the dislocation, senior secured loans were getting levered 10 to 12x. And in the post-crisis world, liquid loans are getting levered, again, 8 to 10x and middle market senior loans in the structured products market are still getting levered 3 or 4x. So for us, it's a function not of what we perceive the risk of the portfolio and our willingness to take on leverage against those assets because, candidly, if we were allowed, given the strength of our portfolio and the first lien nature, I would lever them more. So from our perspective, it's maintaining prudent liquidity around our regulatory capital requirements and making sure that we never find ourselves in a position that our peers did, which was getting on the wrong side of the leverage ratio. So for us, it's managing our regulatory constraints as opposed to a view on the underlying portfolio risk because, candidly, if the SEC would let us, we would actually be in favor of leveraging our portfolio a little bit more.
Matthew Howlett - Macquarie Research
And then nothing on the equity? I mean, you wouldn't want to see the equity go down further before anything -- before taking leverage up, I mean, just into the volatility...
I think our equity, you should assume, and we said this before, our equity is still too high as a percentage of our portfolio, although it's coming down. I think we've said historically, there's always going to be a component of equity in our portfolio in and around 10% of our assets. And as we've demonstrated, over the cycle, our gains, realized gains have exceeded our realized losses. And so if you're doing all of the credit work to get comfortable on making a meaningful credit investment in a company, and there's an attractive equity story, co-investing alongside the debt as a means to enhance yield on an individual asset basis but also mitigate loss on a portfolio basis, we think is the appropriate way to invest in this market and these asset classes. But we do not have a view that we're supposed to be taking concentrated equity positions or buying companies at ARCC, and it's not something that we're going to do. So yes, we want to see the equity come down and we'll continue to chip away at it, but that in and of itself is not a driver of our willingness to take on leverage.
Matthew Howlett - Macquarie Research
Got you, great. And then just last question, I mean hypothetically, of the -- if we do go into a double-dip, I mean, would you look at your portfolio, I mean, are there just really limited a number of default candidates out there really that if we do go into double-dip given just liquidity on those portfolios have improved, there's just not that many stated mature near-term maturities? Is that -- I mean, have you looked at the cycle versus what we went into in late '07, early '08, I mean, are things just that much better with the underlying portfolio just in terms of cash level?
Yes, I'd say 2 things. Number one, if we went into a similar dislocation, I don't want to say double-dip but a dislocation, I can't envision it being as violent as the last one just because, government balance sheets aside, our markets have delevered dramatically and a lot of what we experienced in the end of '08 until '09 was really just the unwinding of structural leverage in our markets. And for the most part, that's been dealt with. So that's the good news. So there should be less rapid changes in asset values. The other thing, too, what we love about investing in this kind of a market environment is every company that we invest in, we get to see how they performed through the worst recession of their history. And so we know how management reacts. We know how their customers react. We've seen how their supply chain reacts. And so underwriting sensitivities around what happens to a company in a recession is a lot easier now than it was 5 years ago, because at that point, you were going back 7, 8 years, if not, 14 years to try to figure out how a company would perform, and the company was never at the same position. But right now, when we're investing in these high-quality companies, we know exactly how they perform and so we can underwrite downside scenarios that are much more realistic, and we can run analyses around those downsides and set covenants that are much more tested. So I don't think anybody is rooting for a double-dip, but if did happen, I think we're appropriately positioned. And as we did the last time, I think it could be as much of an opportunity than is a risk.
Okay. I think that was it for the questions. So again, thank you, all, for your time and your continued support. We appreciate it. And good luck out there, and we'll talk to everybody next quarter. Thank you.
Ladies and gentlemen, that 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 one hour after the end of this call through August 19, 2011 for domestic callers by dialing (877) 344-7529, and to international callers by dialing plus 1 (412) 317-0088. For all replays, please reference account number 10001609. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website. Thank you.
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