Ares Capital Corporation (ARCC) Earnings Call Transcript & Summary

Great. All right. Well, good afternoon. I'm Steve Valentino, I co-head our global FIG business, and welcome to the Global Financial Services conference. We're pleased today to have Ares Capital, and Michael Smith join us at the conference. As I believe, is the third or fourth year in a row for Ares. Ares Capital is the largest BDC in the U.S. with over $15 billion in total assets and had a very impressive track record of having invested close to $60 billion in capital over the last 15 years, delivering over $1 billion of cumulative net realized gains. And their equity has been a 30% return over the S&P 500 since its IPO. So great track record. Michael joining us is the Co-President of Ares Capital as well as the partner and Co-head of the Ares Credit Group. So Michael, great to have you with us, and welcome to the conference.

Great. Thanks, Steve. Appreciate you extending an offer. So hopefully, my predecessors, I think Kipp did this 1 year and Penni. And we appreciate you having us back.

Yes. No, great. We're certainly glad that you are. And so clearly, the disruption has affected all areas of life and the economy. The middle market, though, is arguably one of the most impacted areas. So great to have you here and hear your perspective. So getting right into it. Ares Capital, having the scale as the largest BDC and focused on the more stable upper middle market and being part of the overall broader Ares platform. You entered this period from a good position of strength. So talk to us a little bit about how your portfolio is holding up? What you're seeing in terms of COVID? And the impact on the business in your portfolio companies? Perhaps how this kind of compares or differs to 2008, 2009? And then steps that Ares has taken to manage both your investments and protect your capital?

Yes. Sure. Great. I think you're right. I think that we felt great about the company at year-end and heading into 2020, February, kind of had financials through February, and a lot of our portfolio companies were performing well. And I think the outlook for many of the businesses was quite rosy, I guess. I do think that today, there seems like a little bit of a disconnect between Wall Street and indices and markets and the middle market. And I think we've been uber-focused on our portfolio. And I do agree with you that the middle market and some of the more smaller businesses are going to be more affected by COVID-19 and the kind of economic recession that this virus is going to create. As it relates particularly to Ares Capital, I think stepping back, why we feel like we're kind of ready for the task and feel good about our position today, even in a post-COVID world is that we do focus on originating our own assets. As you know, we have one of the largest origination teams in the market. And we are very much the primary originators of our deal flow and our transactions. We're reviewing 2,000-plus deals a year and working closely with the companies and the potential borrowers to due diligence on those companies. We also are quite focused from an investment process, on noncyclical businesses and industry selection for Ares Capital is incredibly important. Debt investing is very asymmetric. You have the opportunity on the upside to achieve your coupon and get your principal back. And you take some downside risk. And so minimizing the downside risk by being in what we consider more defensive industries and invest in class high-quality businesses as kind of how we mitigate a lot of that company-specific risk. So we're very much overweight sectors like health care, technology, software and very underweight, the industries that tend to be more cyclical, oil and gas, automotive, homebuilding, et cetera. And then kind of furthermore, I think as you and I have talked about, we always take a very proactive approach in managing our businesses. Quite often, we're the largest lender and capital provider to these companies. Sometimes even have more capital invested than the private equity firm or sometimes an equal amount. And we manage that collateral very closely on a quarterly basis or a monthly basis, collecting financials and being on top of it. So heading into this, we are obviously on top of our companies. And as we started to think about getting our arms around the portfolio, we obviously triaged it into the industries that we thought would be most effective. And so while we were defensive in our industry selection, there are industries more effective, kind of closer to ground zero, such as travel and leisure or retail or really just the consumer-facing businesses. So good businesses like gyms or dental practice management businesses, et cetera, where the customer wasn't allowed to come were obviously, the ones that we started to triage first, but we are absolutely going out to the whole portfolio. And liquidity is king. And I say that on many levels. At the borrowers, obviously, liquidity is king, but also at Ares Capital Corp liquidity king. And you and I can talk a little bit about that further. But reflecting back to '08, '09 and how things are similar and different, I think there was obviously a similar shock to the system and a realization that markets aren't going to go up, up and up. And so you saw a real harsh market reaction to COVID in the liquid capital markets. And obviously, companies kind of took a lot of the same introspective approach, understanding where their company stood and what the liquidity situation was. I think differently that the GFC was much more of a banking crisis. A lot of the loans that were on investment banks' books that had not been syndicated, there was a mismatch of funding between lenders and the assets. And there was just a lack of certainty around the banking system. And we, obviously, we didn't see that over the past 2 months. The banking system was solid. As we think about Ares Capital Corp's funding our revolvers, all of our counterparties were incredibly responsive, forthcoming, there was no banking crisis. So our ability to draw our revolvers and pass them on to the corporate lenders that had revolving credit facilities was pretty seamless. And so we absolutely were able to then just focus on the business operations of the portfolio and the liquidity of those companies. And so that's kind of what we did. And we were able to get very intimately involved and just help fortify those company's balance sheet from a liquidity perspective.

Right. Okay. Great. Super. And did -- you've covered a couple of themes in there. So we'll kind of go through on the business opportunity side. I think when you talk about the portfolio companies, have there been many relief requests that have come through from those companies? What's been Ares' approach to thinking about and granting them? And more broadly, the approach to how you decide to support those companies. And from that standpoint, what are you seeing in terms of sponsor behavior and support as it relates to their portfolio of companies?

Yes. Yes, it's great. It was great because I think the nice part about it was companies initially got liquidity from the revolving credit facilities. And so in the very short term, making March interest payments, et cetera, the company had liquidity. And as we started to roll forward, we were very focused on kind of the 13-week cash flow of every business and the 100-day plan. That's kind of was one of our mantras, right? What's the 13-week cash flow looks like? And what's the 100-day plan? And does the company have the liquidity that it needs? The knee-jerk reaction across all of our borrowers was exactly what you would have expected. We're not going to make rent payments. We're not going to make interest payments, and we're going to have to look at our employee base and see what we need to do to -- in order to generate liquidity. And we were obviously very proactive in saying, we want to help. And if you're seeking an amendment not to pay your interest, we're more than willing to be part of the solution, but this is a partnership and you, the owners, and whether that's private equity or family-run businesses, you're the owners, and you need to be a part of the solution and typically a majority of the solutions. So when amendments came in, I thought -- I think the dialogue was generally very, very positive from private equity sponsors, particularly. And I think having been in this business for 20-plus years and Ares' reputation over the past 15 years as being a good steward of the capital because we have great relationships, we do what we say, we have a high degree of integrity around what we're doing, and we started to have very productive conversations. And to the extent that we gave any type of concessions to a borrower foregoing some collection of current interest and cash and taking it in pick, providing additional liquidity to a business, et cetera, it almost always came with an injection of capital from the private equity sponsors and concessions on their side. So we actually looked at it as a little bit of win-win, a way to really work with our sponsors, be proactive, be part of the solutions. We are able to open up documents. You and I have talked a lot about adjusted EBITDA and poor documentation over the last couple of years. We were able to change the risk-adjusted return on some of these loans by being able to charge some more interest potentially for giving concessions and cleaning up the document. So I categorize it as proactive, very hands on, very collaborative, and I think that too -- for the most part, we're getting to the right place.

Right. Great. It all sounds very constructive. And you talked a little bit at the beginning about originating your own assets. So obviously, a benefit for Ares Capital is being part of the broader Ares platform. And not just from an originations pipeline point of view, but also at Ares as extensive resources and broad perspective across both multiple asset classes, industries, how or has Ares Capital been able to tap into the full spectrum of the Ares platform to navigate this downturn?

Yes. I mean, again, obviously, as we think about Ares Capital Corp's position, uniquely positioned inside Ares management. And to your point, I just think that the best-in-class resources that we have access to from tax, legal, compliance, but information technology and then human capital. I mean we were kidding that, I think, a lot of us left work on March 13, March 14, thinking, okay, well, I'm going to be displaced for a couple of weeks. We were pretty seamlessly all working at home by Monday after a kind of a herculean effort from our IT and back office to get everybody set up. So we were immediately in a position to manage our collateral and manage the portfolios. So kind of it goes unsaid of how important just that infrastructure is. And then as we think about protecting the portfolio, again, the relationships that we've forged with our revolving credit facilities, with the Street, with institutions like your firm invaluable as we think about our counterparties and the relationships we have with them on the broad Ares platform. And how constructive those conversations were as we thought about raising more capital at the BDC or other places around the firm and just generating liquidity and making sure that we have the liquidity from our counterparties was incredibly important for us. And the relationship we've forged across the firm, we're good about that. And obviously, as we think ahead, we're continuing to operate the business, we continue to work with a lot of the lending institutions who are giving Ares a lot of attention because of our -- the size and scale of our business, as we think about capitalizing the business further on a go-forward basis. So that liquidity and those relationships on a firm-wide basis are incredibly important. And then to your point, just the information that comes off the platform, we were immediately able to do town halls and do senior-level investment committee members were able to focus on a daily by daily basis. And just talk about the markets, where is the loan market trading as a goalpost or a guidepost for pricing risk? What's going on in the bond market? What's going on with funds flows? How should we be thinking about the value of security? What else is going on in the distressed market? And -- or how are people raising money from types or comforts or tapping into the additional baskets in their credit facilities? So just the information that comes off the platform makes everybody more aware and a better investor and a crisis manager. And then obviously, that will trickle down further as we get through this crisis and get to the other side. Knock on wood, I would hope -- I hope 100% of our portfolio companies make it to the other side and 2 years from now, the LTM numbers look similar or the same. But I think that you and I know that that's probably not the reality. And I think we have the resources, obviously, the capital, but also the human resources to support businesses. And so while I told you that on my prior comments that it's been incredibly collaborative with a lot of the private equity sponsors and the businesses. We do lend to some non-private equity businesses that are family-run business, or owner operated and we kind of are the institutional capital. And we're more than happy to step in and provide that deleveraging capital or that bridge capital and become a more active owner of that business or operator of those businesses because of the resources we have at Ares management.

Right. Right. It's amazing how something like this, how quickly and you -- the ecosystem gets tested and having all of that strength is so important, encapsulated like this. All right. So if you talk about think ahead and go forward, let's change gears then. You did a great job giving us where Ares is today. But if we think about offense, Ares Capital has a -- you said a fair amount of liquidity, dry powder. So talk to us how you think about deploying that in terms of support, both to where you are, but as far as going forward, attractive opportunities, how you're thinking about the market? You talked a little bit about some of the sectors, but how are you thinking about next steps for Ares Capital today?

Yes. I mean definitely, I think that with the liquidity that we have, which we feel fortunate to be in a good position with over $2.5 billion of kind of "dry powder" at the BDC and a lot of capital on the platform, as you and I were just talking about. I think, a, first and foremost, we have the capital and we're going to support whatever portfolio companies need it. So if it's a sponsor-owned business where maybe the fund that the sponsor is in doesn't have the capital to support the business or investments a little bit longer-dated and sponsor doesn't want to support it. We are more than happy to do that. And that obviously will be the primary use of liquidity on a first and foremost basis. And again, we think that those will come as deleveraging situations or as other types of securities that have really attractive risk-adjusted return and probably come with potentially some governance and some upside on the equity. As I think more on the short term, I think, leveraging the platform to generate excess returns in things like buying secondaries in credits or in companies that we know and like that have traded down. And some of that opportunity, as you and I were talking about earlier, kind of came and went a little bit. But there might be another leg down or there still are some securities and really high-quality companies, maybe a little bit closer to the COVID-affected industries that we are looking at and still have investable opportunity into. So we're evaluating that. Remember, this platform has been around for over 16 years. So we've graduated, I don't know the number, but hundreds of companies out of the middle market into the liquid capital markets. And so we have an extensive knowledge about -- of a bunch of the liquid borrowers out there and we're involved with them. So getting reinvested in them through secondaries and things is an opportunity or providing some junior capital or rescue capital/deleveraging capital into some of those larger borrowers. As they look for bridge, those could be high-yielding shorter yield or shorter-term type of securities. We're excited about those. And then believe it or not, we've actually seen some new deals come through the pipeline. I know it's hard to kind of envision a ton of stuff getting done in this environment. But there were sale processes that were going on as we headed into 2020. And in less affected companies, transactions are getting done, while they're few and far between. And it's hard to not only price the equity, which I know is very hard for the private equity sponsors or the buyers, pricing the debt isn't that easy either. And we've done -- we actually have done a couple of deals post-COVID, where we've gotten really attractive yields and lower leverage and better credit documents, et cetera, that you'd expect. I think in the short term, as new deals come back on, we'll see less competition maybe from other platforms that aren't in a -- as good of a liquidity position as Ares and Ares Capital Corporation is. And then further down the line as we saw with the Allied transaction post great financial crisis and ACAS later on, perhaps there's some consolidation in the market that we can take advantage of.

Right. Right. And within that, as you think about these market opportunities, has there any been fundamental change to the underwriting approach or criteria that Ares Capital has been applying to the market today that may have been different pre-COVID?

Not -- we're discussing things. There's been talk in the market about EBITDAC before COVID. So isn't it an add-back and kind of is that something that you want to document or not. I mean that's probably a discussion for a year from now or 6 months from now. For us, we don't have a crystal ball. I think we're hoping for the best as the economy slowly reopens. We're working with our companies and staying in touch with them as trying to understand what their operating model is and how they're going to open and kind of going as we go. But we don't have a crystal ball, not really sure where things are going to be 6 months from now. I'm hoping for the best, but at the same time, we're preparing for the potential of companies needing more liquidity and more relief and amendments and things like that. So trying to find the right balance, and we're just having gotten to the point where there's a new norm. I do think, obviously, when anything like this happens, you will see a correction in the amount of leverage and the documentation of transactions. It's going to be interesting to see how much adjusted EBITDA turns into cash flow over the next 12 years -- I mean 12 months or a year. And I think that will hopefully give everybody pause that you don't want to add back earnings on the come into transactions. And so just a better general underwriting and quality of earnings environment should ensue.

Right, right, right. Yes. You certainly see that next-generation of asset origination and there's always definitely an element of what tightens up from the approach. So thank you. That's helpful. And you mentioned it, so liquidity. If we think about the right side of the balance sheet, Ares Capital has a fair amount of liquidity, well established, diversified funding sources, which is great. So best of class, access capital markets. You talked about bank capital and secured markets. So talk to us about as your liquidity position, how -- the unfunded commitments, how are you thinking about things today? How you feel about that? And obviously, important to folks listening in from an investor perspective?

Yes. I'm glad you asked because it's something that over the past 5 to 7 years we've really focused on. And to your point, we feel like we're in a great position, given the construction and type of securities that finance our balance sheet. So I think for those that don't know, we've been a kind of a serial issuer in the investment-grade market over the past 5 years. We actually round-trip to a deal that we -- it was about -- it was a 5-year deal that we repaid. And a vast majority of our liabilities are unsecured notes. We have a large -- that previously kind of undrawn working capital facility, which today has about $2.6 billion of availability on it, which is kind of 2x of the aggregate unfundeds that we have. And again, our unfundeds have kind of tapped out at about 70% of our revolving credit facilities and even more of de minimis amount of our delayed draws. And so we do feel like we have a significant amount of capital to invest to -- into the portfolio and into new transactions. And we continue to look at all of the levers we have in order to optimize the balance sheet, of which we have a lot. We can -- we have the Ivy Hill subsidiary, which is a -- has been a prolific purchaser of leveraged loans from Ares Capital Corp. They continue to raise new funds and be a purchaser of assets, which creates liquidity at ARCC. Like you mentioned, we've been talking to banks about other facilities, revolving credit facilities, secured facilities about -- at the balance sheet. And again, being part of the Ares platform, I think, and having done a lot of business with a lot of the different providers of that capital gives us a leg up. And then we continue to opportunistically interface with your syndicate desks and the others on the Street about where the convertible markets are, the unsecured markets are, et cetera. And continue to look there to be opportunistic if those markets open up to us. So we have a great laddered portfolio. We have 1 maturity in the next 4 years, which is 2 years out. But we have long-dated, fairly inexpensive liabilities, which puts us in a position of strength.

Right. And so flat plays a little bit in -- as you talk about it as far as leverage goes, Michael. I think you were at the 0.9 to 1.25 leverage target, kind of the high end of that towards the end of quarter 1. What's the approach from Ares' stand leverage by giving potentially ongoing NAV volatility versus new and attractive opportunities? Some of the things you talked about earlier. How are you thinking about that these days?

Yes. I think we hinted upon this in our earnings call. Target range is staying the same, but I think that we are very comfortable being at the high end of our range and even periodically over the next couple of quarters if we're over it at quarter end, we're not going to get too stressed out about it. We -- having liquidity and using it to protect investments and generate good investment opportunities, especially inside the portfolio, meaning if it's an incumbent borrower and existing borrower that needs capital, we're absolutely going to focus on that company and provide that capital. And so if we trickle up a little bit above that high end of the 1.25, we're okay with that. A lot of that, to your point, is somewhat out of our control as we're looking at mark to markets based on where the market is and some of the market volatility. And so we've kind of felt like we're comfortable doing that. But that being said, we've been in constant dialogue with all of our constituents, the Board, the rating agencies, our banks and everybody. And in a new world of 2 to 1 leverage, which in hindsight was something that we -- as the largest BDC, we're very vocal about it being an important aspect of the kind of the go-forward health of the industry. Most companies are still very modestly levered at just over 1x or 1.5x. And the relief, I think, is showing to be very valuable because on the mark-to-market side is a little bit more out of our control. And so we feel good about that target range. And if we're operating a little bit higher, we're okay with that.

Right. Okay. Great. So I think its great perspective. And obviously, with the history Ares Capital has and the expertise as you talked about the on-the-debt side, you're certainly front and center. And if you talk about at the very beginning, in the middle market. So with all the uncertainty out there. But I think -- with your experience, I think folks would be interested in your perspective on how you think this continues to develop, the lack of a better term, played out over the next few months, quarters, it'd be this -- how do you -- how you think this continues to develop? And give us some of both your and sort of Ares perspective?

Yes, sure. We don't get to stand around the coolers anymore in the office and have these conversations. So we're on Zoom, like everybody else, having these conversations, and it's absolutely something that we're talking about on a daily basis. And like everybody else, we're trying to get as much information from as many different places and digest it. And we're obviously very keen and curious about what's going to happen as more and more parts of the economy open up and people start to interact on a more normal basis as it relates to COVID. And so many unknown factors, really, and we all wish we had a crystal ball. I think the best thing that we can do is just continue doing what we're doing, stay on top of each situation. Each 1 of the borrowers is unique and has a different set of circumstances, has a different liquidity position going into it, has a different earnings profile, has a different mechanism or mechanisms for generating their revenue and variable and fixed cost structures, et cetera. And so just staying on top of it, hand-to-hand combat almost and being very much on top of each company and then that partnership orientation going forward. I think that what we have seen businesses that are opening in some of the states where they are allowed to, we have seen pent-up demand start flushing through the system. So -- and especially in some of those consumer-facing businesses. As they reopen, we've actually seen a lot of adoption into coming back to a dentist office and getting your teeth cleaned or doing some of the elective surgeries and things like that and other health care system that we're invested in. So that pent-up demand is definitely coming through. And I would expect that to play out over the next month or 2. With the biggest unknown is, is there a second wave? Or is there a mix trend of something with influenza that comes in the fall, et cetera? And I think those things weigh heavily on people. And so I think people will be -- the mobilization and the opening is going to be slow. If you look at China and some of the other places that are, obviously, from a time perspective, ahead of us. Fully open doesn't mean fully open. So if you look at the rate at which their economies are opening that if they say, 50% is open. You're seeing output at the 20% to 30% range. And then as you get up to 100%, you're in the 65% to 70% range just because of some of that fear of the unknown. And just getting back even just the earnings power, say, of the most affected individuals, if you think about it from that perspective. So I guess, cautiously optimistic. I think if people are smart and practice social distancing and all that other stuff, hopefully, it will be better. But there's just a lot of unknowns, and we got to kind of continue to block and tackle in the portfolio.

Right. No, that's great. And I think we -- it's good to hear, and you certainly -- as you said, you're in there everyday living and breathing it. So we certainly appreciate that. So with that, Michael, thank you very much. We greatly appreciate it, your insights, and we thank you and Ares Capital for joining us and participating in the conference.

Of course. Thanks for having us. Appreciate it.

Great. Thank you very much.