Ares Capital Corporation (ARCC) Earnings Call Transcript & Summary

Good afternoon, everybody. I'm Terry Ma, and I work on the consumer finance team here at Barclays with Mark DeVries. And we're pleased to have Ares Capital Corp. with us today. Ares is the largest BDC in the space, and it has a long and successful track record of investing in the credit markets. I'm joined today by Kipp DeVeer, the CEO. So great to have you here with us and welcome to the conference, Kipp.

Thanks, Terry.

Yes. So just from our listeners, we'll go into a fireside chat format today. I'll also break it up with a couple of polling questions for the audience in-between. If investors have questions, they can also enter it in on the upper left-hand corner of the screen or alternatively email me and I'll try my best to address it during the chat. I'm going to kick it off with a polling question for the audience, if you can just register your response on the left-hand side. The first question is, what do you view as the biggest catalyst for ARCC over the next year? Is it, one, competitive environment easing; two, improving origination volumes; three, M&A opportunities; four, better-than-expected credit; or five, other?

And then just to kick it back to you, Kipp. I just wanted to start off with a mark-to-market. So can you maybe just talk to us about how your portfolio is holding up-to-date with COVID? And maybe talk about all the various impacts of COVID that you've seen across your portfolio of companies.

Yes, for sure. And thanks, Terry, and thanks to Barclays for having me here today for this chat. So we try to be pretty clear with folks obviously because it's such a strange economic and health situation that the country finds itself in about where we sit in terms of the portfolio. The good news is our portfolio is really diversified and has been set up to be weighted towards defensive sectors. We also, as one of the larger companies in the space, tend to invest in larger businesses than most of our other sort of BDC brethren. And we're underweight a lot of the really tough COVID-impacted sectors, things like entertainment, retail travel, restaurants. We have some, but I think we're underweight a lot of the difficult places. So the way that we talk about the quality of the portfolio is really with 2 metrics. We talk about nonaccruals, which are obviously the companies not paying us. And those numbers are up slightly in Q1 and Q2 to around 5% at cost, well below where we were during the financial crisis. The other thing that we've done, and this is probably most instructive, is look to our portfolio grading system. So we do grade every quarter the portfolio with a number ranging from 1 to 4. Without getting too technical, we underwrite everything to a 3, which means it's at expectations. If we're seeing an exit or if we see the potential for real appreciation, it gets marked up to a 4, which is the best grade. A 2 is something that is off expectations, and a 1 is something where -- to keep it short and sweet. I'd say we probably expect some impairment, and it's highly likely that the company is on nonaccrual. So in response to all the questions that we got throughout Q2, we looked and kind of saw some negative migration, 3s to 2s, 2s to 1, as a result of the COVID situation for the most part. And that number of kind of our aggregate 1s and 2s went from around 9% of the portfolio to 20% of the portfolio. The good news is I don't really expect any material kind of slippage from there. I think the way that we're thinking about things are it was easy for us to identify the companies that had material COVID impact, right? It was, of course, things that actually required attendance. We're a company that potentially even had to close, whether it was a restaurant or a professional services business or a health care clinic for portions or maybe all of Q2. But I think that we've largely identified the companies that have been COVID impacted, and I would put it at around 20% of the portfolio today that we're sort of hard at work on. But we still feel like we're in good position. We tend to be senior secured in most of our names. We serve as a lead investor in almost every deal that we do. So we've got a lot of influence on the outcome. And we think that there is a good road to recovery. But we need to get back to obviously a more stable economic environment, which, of course, can only be supported by a better environment in terms of the general health.

Got it. Got it. That's good color. So with the industry that you are invested in, are there any that has fared maybe better or worse than you initially anticipated? And are there any industries where you maybe look at and be like, "Gee, this could actually take several more years to recover"?

I think it really depends on the duration of the health crisis, right, in terms of the recovery, right? If we're able to have good therapeutics or better therapeutics but certainly a well-distributed vaccine in reasonable time that people feel comfortable going back to living their lives the way that they did perhaps in the fall and the winter of 2019, I think you can see a pretty quick recovery. But look, most of the businesses that we've seen across the U.S. have had some impact from COVID certainly to varying degrees, right? Travel and leisure, restaurants, retail, hotels, oil and gas are probably the most impacted and I think will lag the recovery. Really, anything consumer-facing. Again, as I mentioned, that requires folks to show up in person for that company to generate revenue. But we haven't seen any surprises. I think early days, call that the end of March, early April, we were all starting to surmise what businesses might have issues. And it did finally start to occur to us that everyone was going to be stuck in their homes for a while and some businesses would be closed. And something like a dental clinic, we didn't think of at first, but within a couple of weeks, we said, "Oh, all of these things that require patients to come in are actually not going to be things that are going to be open for a while." Certainly, there are other businesses that we're involved in that were much more obvious than that. But between probably May 1 and today, we haven't seen a lot of surprises. Again, we think we've identified the areas of concern and the companies that have been most impacted. And we've been able to do quite a lot of amendments and modifications, where private equity supporting companies were making some concessions in terms of covenants and all of that to get companies to the other side. And I think that's really the key. We think we're invested in some really great franchise companies that we simply have to figure out with owners and management teams how to get to the other side and how they can get back to past levels of profitability. And we have a lot of confidence that they will.

Okay. Got it. So for transactions, that was a topic on the last earnings call. Can you maybe just remind investors about the thought process and rationale for granting them? And how have those portfolio companies been performing since you granted them?

Yes. I mean the playbook that we pursued was typically one where we look to the owners of companies to come in with new capital beneath our loan positions, right, so private equity partners and owners. And we were largely successful in that happening over the course of the last 6 months. In exchange for that, we would typically provide a short amendment to covenants, typically institute a minimum liquidity covenant. And when I say short, by the way, think quarters, not years because it's too difficult to forecast things right now. And the goal for us, I think, is to get -- we, the debt and the equity owners as well is to get these businesses through to the end of the year, where we can reassess things. And I think in most cases, we've built sufficient liquidity and sufficient time for them to get to the back half of the year so we can evaluate where we're going forward 2021. The other thing I'd say is we've asked for additional compensation in all of these situations. We've understood that some of the other folks that we tend to compete with in the market haven't done that, which we think is imprudent. We think we're in a riskier position obviously in some of these COVID-impacted names. And while we might be providing some concessions on companies need to pay cash interest in the interim, we certainly think that we should be achieving a higher rate of return all in on that position for the increased risk that we're being asked to take during this period. And everything is kind of performing as expected. I mean the challenge back to April and May, when a lot of this was happening real-time, was that it was very difficult for companies to forecast the pace of the reopening and would people show back up at restaurants and would folks book dentist disappointments and that sort of thing. And we've actually been pleasantly surprised that the businesses, now that they're reopened, are doing fine and are sort of on the plan that we all put them on. So definitely still hard at work on that kind of 20%. And it doesn't mean it's over, right? We're going to get to the end of amendment periods. And the companies may require more equity capital and some additional concessions, and that's okay with us. Again, the thing I keep reminding everybody is it's our goal as a capital partner to these companies to figure out a way to get compensated for the additional risk that we're taking as a result of COVID and all the ensuing fallout but most importantly, to get the companies back over to the other side and back to past levels of profitability because that's how we obviously maintain par on our investments. That's how we're going to get paid back without having any charge-offs.

Got it. Got it. Okay. So some questions from the audience. So the first question is that the deployment commentary on the second quarter call was naturally a bit downbeat. It feels like sponsor activity is actually picking back up. Does that match your deployment opportunity? And does it come with any compression of the attractive new dollar loan yields ARCC has been getting?

Yes. So I would say things are picking back up, right? For the first probably 6 weeks that we were really locked down, we were focused on the existing portfolio. But we never really closed for business because Ares Capital has a tremendous amount of liquidity today and really doesn't have any constraints on the right side of the balance sheet in terms of our financing. No near-term maturities, no need to pay down debt or any of that. So we've absolutely been open for business the whole way. The challenges of doing a new deal were pretty significant throughout the summer, but they're seeming to ease. And I would agree with the sort of leading question that isn't there more activity. There is. Private equity, in particular, is trying to reengage in transactions that may have launched prior to the shutdown. But increasingly, we're seeing situations that are truly new post COVID. The bankers are making attempts on those fronts and equity groups are open to doing that. We've heard that folks are actually doing sit-down meetings and trying to get together to see facilities. Albeit that sounds challenging, it's happening. So we feel good about deployment. Remember, about 50% of our deployment in the past has been from our existing portfolio. So we've got a great base to play off of even if the market is slow for new deals. And Q2, while it was a net negative originations quarter for us, was really a net negative originations quarter solely because we made an additional investment in one of our companies, Ivy Hill Asset Management, and sold them some loans from our balance sheet to seed some new funds that they're managing today. So were it not that, we would have actually shown sequential growth in our assets in Q2 as well.

Got it. So you guys have focused a lot on your incumbent relationships in the past and also in the first half of this year. Can you maybe just talk about the advantages of the incumbency position and why it also makes sense to focus more on those?

Well, yes. I mean look, there are quite a few of them. I mean incumbency, we have 300. I've lost count exactly, the 350-ish portfolio of companies at Ares Capital. The good news is we're a trusted partner for them, right, and that we have history with them. So when they're looking for new capital, we're typically the first phone call. And that creates good deal flow, but it also insulates you from price competition. The second thing that's nice is we have a fair amount of trust in both the management teams and the business plans of these companies as well as their strategy for growth. It's obviously what we've signed up for. But the initial risk of doing a new deal is always highest early, right? It's an underwriting surprise. It's a management team that you thought was really good that in the first 6 or 12 months doesn't feel as strong as you might have thought. So for so many reasons, we just view investing from the winners in the existing portfolio to be not only lower risk but probably higher return potentially than when we have to go out and compete in the market for a new deal.

Got it. Okay. That's helpful. Can you maybe just talk a little bit more about how you approach portfolio construction in recent years and how that's really positioned the portfolio to manage through the current environment today?

Yes. I mean we didn't really make any changes in terms of our philosophy. I think core to the philosophy has always been see as much deal flow as you can and be very conservative and highly selective. And the later we got in the credit cycle, and we thought we were quite late, in 2019, the more we emphasized some of the key tenets of our investment philosophies, which is pick grade companies, invest in defensive industries where you tend to see less defaults, right, where there's less cycle risk. One of the benefits in recent years as we've gotten larger is we've actually invested in larger companies, which I do think are proving to be more resilient than the smaller companies. But we really didn't make any changes. You'll see periods like this where we actually think it can be the time to be more opportunistic, right, where you're putting lower leverage multiples on probably more depressed earnings. So you're taking less risk into a company from a loan-to-value perspective and you're able to earn higher rates of return in the market today. But I think we positioned the portfolio very well on the asset side. The other thing that we've done is make sure we financed ourselves well. So something that's a little different than 10 years ago, when the BDC industry and our company as well was much smaller, is we're very reliant on secured financing. And the term of that secured financing actually tended to be inside the average duration of our assets, which is definitely not our goal. It's just the way that sort of the industry was financed and the way that things worked back then. We spent the last 8 to 10 years diversifying the balance sheet so that we have, again, no near-term maturities. The average duration of our liabilities either matches or exceeds the average duration of our assets. And that really allows us to play offense, both within the existing portfolio on the asset side but also in terms of new deals.

Got it. Got it. Has COVID actually changed your approach to underwriting at all? Or have there been any refinements that you've made or introduced as a result of COVID into your underwriting process?

I mean not really. We really kind of stuck to our knitting. I think we maintain good discipline. One of the things that we're hearing and we're considering I'd say is, is there a place for big oil and gas and energy portfolios in your company or in BDCs. And obviously, that industry is going to have some really significant long-term challenges. That might be a question we're asking ourselves. But otherwise, we're very much sticking to our knitting.

Got it. Can you remind investors of the type of advantages you have of being part of the broader Ares platform and how those advantages may be helping out today? Any opportunities that's created this year?

Yes. I mean look, Ares today is a large global asset manager obviously in the credit business primarily but also in private equity and real estate. We invest in everything from companies to assets, infrastructure projects to real assets all over the real estate spectrum. And I think across the franchise, we're owners or lenders to upwards of 2,000 companies, real properties, infrastructure assets, et cetera. And we're active in the U.S., but we're also active in Europe and increasingly in Asia as well with an acquisition that we made at Ares this year. That kind of informational advantage and breadth in these markets is just a huge positive for our company. Obviously, Ares Capital puts north of 100 dedicated people against its investing efforts. But those 100-plus people have the ability to draw on all the other informational advantages, whether it's due diligence benefits, industry research, transactions that we've seen in other aspects of the business, the ability to talk to management teams and other investees across the platform, bringing on consultants, et cetera. The last thing I'd say is I think the depth and the breadth of the platform gives us a really significant advantage with the Street. So as folks think about BDC financing, the breadth of Ares and the importance, I think, of Ares to the Street and to the banks is real. And we've gotten great support from the banking community as well. So I can't overemphasize how important that external management agreement with obviously a large and growing asset manager has been to this company over the last 16 years. And it just keeps getting better and better.

Okay. Makes sense. I'm going to pause right now and go to the second polling question for the audience. That question is, what is the biggest risk to ARCC shares? One, not increasing nonaccruals; two, in dividend cut; three, prolonged period of low originations; four, lower rates for longer; or five, other? And then, Kipp, Ares managed through the global financial crisis pretty successfully and it came out stronger. So can you maybe talk about how this crisis is different than the global financial crisis or even other past recessions? And are there any learnings that you took from those past crises that can be applied here?