Ares Capital Corporation (ARCC) Earnings Call Transcript & Summary

Great. Good afternoon. Steve Valentino, I co-head our Global Financial Services group here at Deutsche Bank. I'm joined by Federico Chapto, a member of the team, and it's our pleasure to introduce Michael Smith. Michael is the Co-Head of Ares Credit as well as the Co-President of Ares Capital, a long time member of Ares, I believe since 2004, and great to welcome Michael back. You and I had a chance to do this last year, clearly, in a very different environment. So it'll be fascinating to talk through that. So with that, Michael, thank you. Thanks for attending. Welcome, and love to hear your opening thoughts.

Great. Thank you. Great to be back this year. I think last year, we had to do it over the phone because we probably weren't as technically savvy as we were this year. But video is good for this year. And then hopefully, next year, we can be in person together, talking about what's going on. But yes, we appreciate you including us in the conference. I think as many people know, Ares Capital Corporation is the largest publicly traded BDC. And we've had an interesting year to say the least, one where a year from now, sitting in this seat, we were very, very internally focused on our portfolio, trying to figure out what was going to happen with the pandemic and working very closely with our borrowers on their cash flow needs. I think that just generally, as we'd sequenced through the year, we became more optimistic about the portfolio and its resiliency to the point where I think if people saw Q4 earnings for Ares Capital Corporation, we were in a point where we could go more offensively into the market. We generated lots of great investment opportunities that have been pent up, and then we continue to be optimistically while being conservative -- conservatively optimistic about this year and the future going forward. So again, really excited to be here, and let's start off with some questions.

Yes. Great, Michael. And you talked a little bit about it. So let's maybe dive right in with the COVID pandemic. What do you see changes to the landscape? What changes have there been? And what potentially do you see going forward that's been altered given what we just went through?

Yes. Look, I think -- I mean, listen, I know that there's been lots of articles written about the private debt sector. And I think that just the one overarching landscape change I just think is that people really saw how resilient the asset class is. It wasn't without some work, but we are customizing private solutions for -- predominantly for the private equity community, where we're providing all or substantially all of the capital for their buyouts. And I think that, that single counterparty nature of the business, especially given the size and scale of Ares Capital, is something that the pandemic really flushed out as being a competitive advantage. There was flexible capital. They had -- the private equity sponsors didn't see their -- the debt in their paper trading to lower levels. There weren't distress people coming into their credits. They kind of had a single counterparty to come to and say, hey, it's April of 2020, and there's a lot of uncertainty. And we said to them, we're here as your financial partner and as your debt provider, let's work together to put together 13-week cash flow, 100-day plan. We'd like to keep the solution short in nature so that we can continue to get more information, but we are here as your partner in the long term. And there, we want to be a part of the solution, whether that's helping to defer some interest, apply kind of -- issuing more debt or just working with you through the volatile period as you think about moving forward. So we've come a long way, but I do think that, that resonates. And as we think about the long-term prospects for private debt, those types of events, the financial crisis, the different blips that we've had between the financial crisis and COVID. When the borrowers, both the management teams and the sponsors, have a counterparty that they trust and can work with, I think they absolutely see the value.

Right. Right. And you talked about that, I mean, the private debt market. We've seen it evolve. How do you continue to see that evolve over the coming years? It's become such a bigger part of the capital structure, right?

Yes. It absolutely has. I mean there's obviously been some huge macro trends that are driving that. The first trend is just the bank consolidation that's been going on for decades. But I think equally important is the growth of the private equity community. We've seen not only the private equity asset class grow to a point where I think there's close to $1 trillion of uninvested capital on the sidelines waiting to be invested, but single managers have amassed $10 billion, $15 billion, $20 billion funds. And so the buying power of the private equity community and the single asset buying power of that community has really opened up the direct lending market for us. I think that, that core middle market has always been thought of as direct lending, so companies with $25 million to $75 million of EBITDA, and that's still very much a core and de-core market for Ares Capital Corporation. But we've pushed up to the upper end of that. And the progress -- the private equity community buys $100 million EBITDA businesses. We're providing $600 million unitranches. We're providing unitranches all the way up to $1 billion for bigger companies than that. And then there's a growing and burgeoning junior capital opportunity that we're taking advantage of at Ares Capital Corporation for companies with $100 million to $500 million, $600 million of EBITDA, where, again, they want a private solution for a second lien or a mezzanine piece or perhaps maybe second lien and preferred, where then we can kind of bring the private high-yield type solution to the market where they could go to the CLO market for their senior needs but access privately placed capital for their junior yields. So as it relates to the borrowers, I think there's -- the flexible capital that we're providing and the partnership with private equity that continues to expand is absolutely seeing our market grow faster than other markets. There has been capital formation, but I think there's plenty for us to do. And then if you look at it as investors, our ability to disintermediate the market, meaning to provide a full solution for a $500 million gap in debt capital that a company needs, we're garnering the fees for structuring that with call protection. So we are generating, I think, really attractive returns for our shareholders and other investors across the platform. And we continue to see this opportunity continue to grow as we grow our team and our capital base and provide different types of capital for different types of companies.

Great. Great. And going back, you talked about it a little bit. Let's go back, I think, a little bit to when you talked about the communication with your customers. What's the perspective on the BDC space and portfolios and how they performed during COVID? Where do things shake out? And what surprised you? And what -- where do things -- where are they today?

Yes. I mean overall -- again, I've probably said it now twice, but just resilient, right? And again, there was a lot of hand-to-hand combat that went on with the companies and us and the borrowers in this private equity community. But in general, we saw the portfolio perform well. It was very resilient. We initially were probably looking at what we thought was upwards of 30% of the portfolio that was -- that we felt, hey, this is going to need special attention from our team. I think one of the nice parts about our team is that we have originators, we have a large portfolio management team that work together. And so we had 50 to 60 primary originators that had originated the collateral in the portfolio that immediately went over into portfolio management to get their arms around it. And so we had a ton of resources coming there. In the end, it was only about 5% or 10% of our portfolio that came to us for some sort of capital solution, whether that was more additional capital to the company or some sort of interest forgiveness for a period of time. I think the one thing that we saw was that the private equity community very much supported their businesses. So if we were making some sort of accommodation to the interest rate as it related to cash versus pick or providing additional capital to the company, our private equity sponsors were putting in some amount -- that amount or maybe even more capital to support the businesses, which again gave us a lot of confidence in our predominantly sponsor-based model to have those deep pockets behind us. And I think that we were excited about the opportunity to kind of really show how this asset class can perform and how the collateral is good. We're very focused on noncyclical businesses. So we can talk about that a little bit. But this was absolutely -- obviously, no company was immune to COVID-19. And so it was literally across the board that everybody was focused there.

Right, right. So take that away, what are some of the lessons it learned from Ares? What are some of the perspectives and you walk away and say, going forward, we could keep this way and incorporate this?

Yes. So listen, I think that we -- kind of what we know was paid off very well, meaning that we've built an organization with a large capital base and a large team. And we're extremely focused on originating our own assets. So I think, again, building that funnel and being selective around that funnel was something that obviously paid out in dividends as you rolled forward into a pandemic. We have always struggled with pricing cyclical risk or esoteric risk within this asset class. And so for the past 17 years as a public company, we very much have focused on noncyclical businesses. A very good portion of our portfolio, both in the BDC and across our platform, is in software, it's in health care services, it's in business services. And when we are touching cyclical industries, we're probably in more resilient parts of that, such as we might provide the software to an ERP -- the ERP industry, but we're doing that in oil and gas. But we feel good about the business model that we have going into the oil and gas sector or the retail sector or something like that. And so I think that, that served us well throughout the history, through the financial crisis, and obviously, through COVID. And then, we just continued to very much lean on the broader Ares platform as we think about 2 things, one, diligence. And as the broader Ares organization grows, we're leaning on all the resources we have out throughout the firm to focus on our own primary diligence and trust ourselves. We obviously get a lot of diligence and input from our borrowers and private equity communities, but we're definitely not resting on our laurels. And also, the broader platform just from an information perspective allows us to understand relative value, I think, very well and understand how markets are -- funds flows are coming in and out of the market and the pricing dynamic in the market. And so I think we have a very, very good relative lens on how competitive markets are, where we need to be from a competitive perspective. And then you marry those 2 and say, okay, it's -- I actually think the market is too overheated and will pass, but I still think that this is good relative value and I'm getting invested into a great company. And so that's definitely paid off for us. And then lastly, was just the -- is just the people part of it, right? Like I said, we have 150 investment professionals. We have a 30-person portfolio management team. And I think that, that's something that's unique. And so lessons learned is kind of -- those are the type of resources you need to manage through these types of crisis. And again, people could wear different hats along the process of going through this. And it's funny because in Q3, as we started to feel more comfortable, it's funny, our portfolio management and underwriting and valuation team was actually, where we really started that conversation about saying, hey, things are looking better. Now there was a lot of stimulus and the markets were healthy. But it gave us a lot of confidence to be more aggressive in Q3, obviously, into Q4 and continue that way into the first half of this year. And so I think the lessons learned are sticking to your knitting and really trusting that -- what you're doing. And a lot of it's on the front end, right? So the lessons learned were probably more of, hey, we've been doing the right thing for the past 2 years in our origination and management of this portfolio that when COVID did hit, we felt confident in the -- both the assets and then seeing we are managing them.

That's great. Yes, the infrastructure and all the work that you put in. So one follow-up to that would be, did COVID change any of the aspects? Was there anything that you learned -- like take the lessons learned and work well, but things going forward, say, hey, we should maybe thinking about something differently from Ares' perspective?

Yes. I mean the answer is check, not to say, yes, but it's kind of no. I mean I think it actually gave us confidence in what we're doing and what we continue to do. I think that one -- I do think that getting invested in high-quality businesses enables you to lend to them for a longer period of time. And so I think one thing that I will have taken away, though, is not to be maybe too cute on that first investment opportunity. And if you really think it's a great company, but the market is competitive, and you're saying, oh, I wish I was getting LIBOR [ 5 75 ] versus LIBOR [ 5 50 ], maybe don't be too cute, get invested into the best companies because they'll perform well through cycles. You'll have that opportunity to provide additional capital to them. And then I do think that the longer we're in business and the more our portfolio grows, the more that we do understand the value -- the lifetime value of a company or customers, so to speak. And so we've grown up with a lot of companies, but I would say that we have redoubled our origination effort into more of the core middle market. And those -- the average EBITDA has gotten up to $80 million, but we're very uber-focused on those $30 million to $60 million EBITDA businesses because those are planting seeds for those next $80 million and $100 million EBITDA businesses. And so again, it's kind of don't rest on your laurels and just grow with them. You've got to continue to grow the teams up to, like I mentioned, 150 people, promote the youngest, the most talented people on the team, give them sponsor coverage for maybe some of those new sponsors or smaller sponsors to find those deals and grow with them. And then just that -- I think one thing we've always talked about, Steve, is that we talk in assets under management for our U.S. direct lending. But I do think one of the lessons learned is that the size of the capital base does matter because the size of this BDC has allowed us to really build an incredibly diverse portfolio just from the number of borrowers that we have on there, and then the myriad of industries and end markets that we serve. And we're running 0.5 percentage hold size into the portfolio with over 400 names. So the size and scale has allowed us to kind of do everything and be across a broad swath of size companies and do that. And then lastly, I would just say, you've seen us be active on the liability side of our balance sheet. And so taking advantage of this market in order to be active in the investment-grade market, really changed the cost structure of the leverage that we have in the BDC ladder out our maturities such that we're not at any risk of kind of how the business is financed is important, again something we were doing for years but really proved out during the pandemic. You probably remember back in the financial crisis, all of us were funded by short-term revolving credit facilities, and it was scary. It was scary because you had annual maturities that were coming up and that definitely put the businesses at risk. So I do think some of the larger BDCs like ourselves that have access to those -- the bet to a differentiated balance sheet is definitely a unique and key competitive advantage. And I mean, our finance team has done a fantastic job working with The Street, taking advantage of these markets to lower our cost of capital. And that definitely played out just as we think about we had a lot of confidence in our balance sheet and our counterparties from our revolving credit facilities and warehouse facilities across the platform, which gave us confidence to, in turn, turn to our borrowers and say, if you feel like you need to pull down your revolver today because it's April of 2020, feel free to do it, but you don't have to. It's going to be there for you. You guys have availability, and we have it covered. And so the work that we've done on our balance sheet and be able to have that conversation with the borrower is unique and kind of a lesson learned, again, don't take your eye off the ball on that type of stuff because it pays dividends and makes you a better counterparty as you work through something like a pandemic.

Yes. No, that's for the active dialogue, clearly. And you're right, the capital markets have seen the hard work and the resilience that you put in, and certainly, has been very favorable going forward. So Michael, that's great. That's very insightful. So let's turn now and talk a little bit to the forward, where we are in the current market. Looking at your perspective on where you see opportunities today from a lending and investment perspective, how Ares is looking today and going forward?

Yes. We will always stick to our knitting and call on our sponsors and find the best companies and go compete against them. The market, I think, is everybody probably listening to this appreciates is very liquid. And I think we are seeing pressure on leverage and spreads like we do when the markets are hot. I'm telling you that, that doesn't preclude us from thinking that this is a good investable market opportunity. It just means that borrowers are saying, can I get a 75 basis point LIBOR floor versus 100? Can I do this 25 basis points cheaper? Could we do the fee at [ 2.25 ] versus [ 2.5 ]? So it's across the board, but I don't think that the economic proposition is different, meaning we're finding great companies to invest in at what we think are premium yields, a lot of what we provide back to our shareholders and investors across the portfolio is again that disintermediation of the banks. So being able to provide the full solution allows us to garner all of the fees are in and around that and some of that paper gets distributed and we make income off of that. It's not our core business, but just the size and scale of our platform and the fact that we have a syndication team allows us to drive that. Beyond that, we are excited about what we're building in the broader Ares and the potential opportunities that, that will drive for ARCC. Again, there's just that origination ecosphere that the more people we have out raising and waiving the Ares flag, the more deal flow that comes to us. So a debt opportunity comes into the private equity firm because a family-run business thinks that they want to sell equity in the business, but they really could probably be better served doing a debt recapitalization, and that will find our way. We coordinate very well across the platform. And so that happens in real estate and private equity. But I think even more importantly, our credit platform now globally at Ares is $150 billion. We have a large-scale business in both liquid credit. So again, that information we're getting from our counterparts in the CLO and high-yield business, very valuable to us. And we have significantly grown what I would call our alternative credit business. And so we're seeing strong opportunities coming out of that, which could be anything from lending to other finance companies or lending to any asset-backed facility that has cash flows coming off of it. So just as credit availability, again, comes out of the banks, a lot of these companies are looking at firms like Ares in order to finance themselves. So we've seen really unique opportunities in the solar panel deployment, where firms are building portfolios of solar panels that need to get financed in order -- and ramped up in order to get those -- the capital necessary to put the panels on there. We're kind of "helping those businesses," finance those -- the growth of that and "securitizing them with capital" as one opportunity that we're seeing out there that's kind of unique and differentiated. And also playing on, obviously, part of the administration's -- the new administration's effort into renewables and green. So we're seeing great opportunities there just across the platform for things. And then, again, as with any kind of crisis, we're seeing some unique, I would just say, opportunities and good businesses that have been affected by the pandemic more so than others. And so businesses that we believe in, airport services, things like that, we're looking at some of that, some specialty retail. We're looking at the sports and entertainment and media industry. So industries that are reopening and are desperate for capital, we think that there's interesting senior and middle of the capital structure opportunities to help the best businesses in those different areas get back on their feet. There's a lot of diligence that goes into that, too, because something like the airline industry might not fully come back to where we thought it was, given maybe lack of international travel or something like that, that might change. So we're very keen to whether there's been permanent shifts in those businesses. But across the board, we're seeing unique opportunities to try to be a capital provider to those industries that are desperate for capital in order to reopen.