Ares Capital Corporation (ARCC) Earnings Call Transcript & Summary

Hi, everybody. Thanks for joining us today. I'm Vilas Abraham, the BDC analyst here at UBS. And for this session, I'm pleased to be joined by Kipp DeVeer, the CEO of Ares Capital Corporation and Head of Ares Credit Group as well as Scott Lem, the newly appointed CFO at ARCC. As many of you know, ARCC is the largest publicly-traded BDC with $23 billion in assets as well as one of the longest-running public BDCs with a nearly 20-year track record in direct lending. So with that brief introduction, why don't we jump in? Thank you for joining us, Kipp and Scott.

Thanks for having us.

Maybe we can start, Kipp, with your perspective on the U.S. economy. Through the lens of your middle market direct lending business how would you characterize the health or lack thereof of the economy as we move through '24?

Yes, I mean, I think the -- by way of background, our company has investments in over 400 middle market companies, a pretty broad set of industries, but I guess the ones I might overlay is we're not investing to a benchmark. So actually kind of a key to our strategy has actually been to position the portfolio in what we think are more defensive areas of the economy, different industries that we think will be more resilient. So when we look specifically at our portfolio, we actually feel pretty good about the economy, maybe better than I might have expected, 18 months ago in the face of a pretty dramatic rate tightening cycle. We use a couple of metrics just to describe the overall health. We grade our portfolio, which I think you're aware of, 1 through 4, you come on as a 3, which is a new underwriting means you're at plan. So our average portfolio weight today is just above 3. And then we look at 2s, which are the underperformers and 1s, which are really the troubled companies as kind of the need to monitor more closely if we added those 2 buckets up to date, it's well below 10% and really in line with historical average. So quick summary, we feel pretty good about the economy and about the portfolio today.

Okay. And how about inflation dynamics specifically? Are you seeing anything that would suggest that the direction of travel may not be lower in the way that most folks may be thinking about it?

No, I'm actually probably in the camp of inflation has, I think, largely been controlled by this tightening cycle. We started just as evidence in the portfolio to see real signs of inflation pretty much after everybody got unlocked from their houses. Again, and call it, summer of '21. So it was pretty apparent to us looking at the portfolio that a combination of very vibrant demand to go buy things and do things and not be stuck in your house with the pandemic, coupled with some of the supply chain disruptions that we've all read a lot about, price increases really started rolling through in a lot of our companies fall of '21. And they've really -- most of our companies tend to be, again, defensive service-oriented. They tend to have a lot of pricing power, but in certain places, seen companies raise prices 6, 7, 8x in 2 years. That really started to stop by last summer, I'd say. It's really not evident in the way that it was for us 2 years ago.

Got it. Okay. That's helpful color. Let's talk about competition a little bit. So after 1.5 years of private credit seeming to be the only game in town, broadly syndicated loan market is bouncing back, spreads on large deals seem to have narrowed considerably. The recent reports of the $3 billion Ares led deal for Ardonagh closing with a spread of 475 basis points. And it feels like just a few months ago, we were closer to the 600ish. So is this is a new fee level for pricing in your opinion and in terms of deal structure as well as anything changing?

Yes. I mean, look, I mean, I think if you look broadly at credit spreads, they're pretty tight. I think that reflects an environment where the default rate remains pretty low. And I think folks are more constructive on the economy than they might have been at least than I was 12 to 18 months ago. So I don't know if it's a soft landing or whatever we want to call it. But I think that confidence is narrowed credit spreads. The other thing that has contributed to that is actually just frankly a lack of deal activity. The good news though was last year with a lot of the banks having issues and not being very aggressive in the leveraged finance markets, particularly the single B and below leverage finance markets. Direct lending kind of was the only game in town. We think the group of us and others did probably 75% of the new LBO financings in the market, and the press is all over your question these days. The banks are back and they're going to kill you guys, and we remind them that you guys and a lot of the other banks are very significant partners to us in a lot of different ways. So we're happy that we're in just what I think of as a much more balanced environment where there are public leverage finance alternatives and then there are private credit alternatives. But I think those market share gains that we do build up over time and the fairway that expands for direct lending over time leaves some lasting gains for us. So -- but I think it's a very balanced and healthy environment for new deals. Hopefully, it picks up pretty slow.

Okay. Yes, that kind of relates to my next question, right? So despite this more recent kind of uptick competition from the BSL market. On the earnings call, you were constructive on origination volumes for '24 guided to an uptick in deal activity this year for ARCC from the $6 billion in commitment in '23. Can you just give us a little bit more color on how you get there? Is it really simply just a smaller share potentially, but a bigger pie? Just how do you think about that?

Yes. I mean I think our -- we had -- last year was a little funny because we had a very significant fourth quarter, right, which made us feel very enthusiastic about things healing and transaction volume picking up into this year. While it's been -- okay, I would, frankly, have expected it to be a little busier. I was just at another one of the conferences going down -- going on down here that you're probably aware of around the corner with people that are pretty active in the leveraged finance space too. And whether it was banks or nonbanks, everybody was saying it's a little slower than I might have expected. And I personally thought that a lot of the deal activity that we saw in Q4 would carry over into Q1 and 2, in particular, with, I think, an election that's going to be a little bumpy, come November that people would try to pull some activity forward. It's okay, but it's not rebounded as quickly as I think a lot of us might have hoped. I do think, and I've said this publicly before the real pressure that should compel transaction activity is the fact that the LPs in private markets generally today, particularly in private equity, really are looking for capital to get returned, right? They're desperate for capital to get returned. And the thing that maybe is gumming it up a little bit is everyone's dealing with a different valuation environment because rates are so much higher. So I think there's just a little bit of that mismatch of expectations continuing between buyers and sellers.

So do you feel -- still feel good about higher commitments in '24 versus '23?

That's our base case. Yes. That's still what I think our base case is. So I'm not going to say we've made any changes, but we're scratching our heads a little bit that it's February, and we thought it might be a little busier by now.

Okay. Okay. So prepayments obviously, very difficult to predict, but you have a feel for how net growth could trend through the year? And how much of a risk is a meaningful spike and prepayments, particularly as it relates to BSL market potentially refying away, '22, '23...

I mean our base case, again, is for a better gross originations year. We also think that will drive a growth in net originations. BSL takeouts of our portfolio is not as significant as probably a repricing trend in some of the larger names where companies are looking to just simply reduce their interest cost but stay with their existing with their existing borrowers. But it's equally hard to predict, perhaps, is how you see originations in February. But if environment feels very ordinary course maybe a little on the slower than I might have expected side, but I think healthy. And again, I think this need for LPs to turn things over as going to compel transaction actively for the year.

Okay. Fair enough. And then just on the fundraising side of things for direct lending more broadly. How have things been trending lately? And where do you see it going from here?

Yes. I mean, I can't comment, but we've had a couple of direct lending funds in the market that are all either closed or marching towards closing and not a lot has changed, frankly, in the institutional environment. I think that we and others have demonstrated that there's great risk/reward in this asset class. And it's lived through now a financial crisis and a pandemic and all of this other stuff with pretty good results, particularly if you're smart about selecting which managers that you want to be with. So 2023 was largest fundraising year we had at Ares. Direct Lending was a significant contributor to that. But it's not just the BDC, right? So I mean we have a BDC, we have perpetual BDC in the wealth management channel. We've got a series of commingled funds that do private credit. We have a business in Europe. We're in Asia. So it's pretty broad-based. But not a lot of change on the fundraising side.

Okay. Taking a step back a little bit, I wanted to touch on strategy. So over time, ARCC's portfolio has been 60% to 70% senior secured, 30-ish percent junior, 10% equity. Why do you think that's the right mix? And do you see any change to that in the foreseeable future?

I don't see any change because it's the same group of people that have been doing it together with pretty much the same strategy for 20 years. So look, there are folks -- let me back up for a second. There are folks who say, oh, I only do senior, right? I have focused on senior because that's the lowest risk asset class. It's like well, yes, of course, it also generates the lowest return, right? So I think we have an approach where we want to bring the most flexible set of capital and tools to our borrowers, it helps us increase originations, right? So if you say we're capable of being senior lenders, we can be mezzanine and junior capital investors, and I'll get back to the equity as well, but most of the folks we do deals with like that we're minority equity partners and their companies, too, for alignment and all sorts of other things. But first and foremost, it gives us what we think is the broadest origination tool. And when you drive a ton of originations with a really scaled platform, it actually allows you to say no more. And we would say the hardest thing about our job is we close 5% of the deals that we look at, right? We tell people know 95% of the time. So really being able to maximize that origination goes hand in hand with the flexible toolkit. But I'll go back to the equity piece. The lending business is a very asymmetric business, right? You make a commitment, you get paid upfront fees, you collect a coupon and you hopefully get paid back. Guess what? it's impossible to be in the lending business without generating losses. Hopefully, you can mitigate them and keep them as low as possible. But the way that we've always believed that you offset that is by being capable and willing to go in and invest in some of the higher risk reward areas, which, of course, is junior debt and equity. And our track record would tell you that we're pretty good at that, and it's an important part of the strategy. I don't want an asymmetric lending portfolio that can only generate losses and not generate gains. So I think it'll -- I think we'll keep doing what we're doing. We've been successful doing it for 20 years. So I think we'll stick to what we do.

You offered some stats on the earnings call about still being active in the traditional middle market, call it sub $50 million EBITDA-type companies. It sounds like there's still interest there, but at the platform level as Ares continues to grow, do these smaller deals still make sense? I think Kort addressed this a little bit last week in some public conference. But just from your perspective, does it move the needle?

No, I mean, look, the reality of the business is it's changed a lot, right? Our team has been doing it for a long time. When this asset class was all getting developed, it was core middle market, it was $10 million to $50 million of EBITDA, right? Then it became $10 million to $100 and is pulling up the text from our IR team. But we still look at deals that have $10 million of EBITDA and we look at companies that have $400 million of EBITDA because we've got a better market opportunity and a broader product set. But if you look through some of the stats that we publish, the median LTM EBITDA in our portfolio today is $70 million, right? So that to me is core middle market. Of course, when you're doing bigger deals, the math weights you that your weighted average number gets pulled up. So we get a lot of questions because our weighted average number is $275 million. But that's not really our target borrower. I mean we're capable there, but the target borrower really remains $25 million to $150 million of EBITDA, right? Any $1 billion or less financing things have absolutely no interest in. It offers no aftermarket liquidity to more traditional loan and high-yield buyers of which we're one. And Ares, on its public side is skewed away from that. So we'll absolutely do small deals. The only thing I'd add is I do think smaller deals are riskier, right? You inherently have less sophisticated management teams. You probably have more of reliance on 1, 2 or 3 products instead of 10, 20 or 30 products, you're probably not global. You may have more of a regional bent. So our inclination has always been have more pricing to compensate for the risk. And I would tell you that at the bottom end of the direct lending competition where you have some newer and smaller people, they can all compete in those smaller deals. And the premium has sort of gotten sucked out of that market by the capital there. The pricing that we see in $2 billion unitranche is, frankly, not all that different than the pricing in a $200 million club direct loan that a bunch of folks can kind of kill each other competing up.

It's interesting. It's surprising.

It's surprising to me, too. I think it's just fragmented competition at the lower end of that market.

Okay. Let's talk about the balance sheet management a little bit. So ARCC as well as the whole industry, frankly, brought down leverage meaningfully in 2022, 2023. Now leverage at ARCC is around 1.05-ish. What's the normalized level there? And just how do you think about the path for leverage in different potential rate scenarios?

Yes. I mean Scott, obviously spends a lot of his day doing this. So I'll let him chime in. But just a big snapshot is the company has roughly $11 billion of NAV and about $10 billion something of debt and about half of it is secured bank financing. And about half of it is unsecured notes that we've been able to issue in the market. So we've consistently said we'd like to operate in that 1 to 1.25x range. We don't think it introduces significant risk to the earnings or to the balance sheet. It can amplify our earnings a little bit, but unlike a bank or a mortgage REIT or whatever that uses a lot more leverage than we do or other BDCs do. We really just view it as a way to enhance returns conservatively. It tends to modulate in that range based on originations versus repayments. So if we're in a net originations quarter, we'll draw a little bit more on the facility. And if we're in a net repayments quarter, we'll pay down debt, which is a little bit of what's happened lately. And Scott, I'll turn it over to you a little bit, just talk about how we thought about financing markets. But the one real constraint is that 1.25-ish on the top end when we spend time with the rating agencies as an investment-grade rated company, which is something we intend on remaining. They really don't buy off, and I'm not sure I agree with them, but they really don't buy off on leverage in BDCs north of 1.3 to 1.4x.

Yes. I mean I think on the leverage front, the fact that we're earning such -- even with spreads tightening on new deals, the overall return is still 11%, 12%. We're generating nice earnings for the company without necessarily having any stretch for more leverage. So I think we're operating at a comfortable level right now.

I think the only other thing that's probably worth noting because maybe it's underappreciated, maybe it's not, but just having been involved with the company since its inception 20 years ago. The liability structure in the industry is so much better now than it used to be, right? So when we were a smaller company, we had no choice, but we had an asset liability mismatch that obviously exists in other financial services companies that we were cognizant of and not very happy about, i.e., we made loans and investments that tended to have a duration of 3 to 4 to 5 years. And we're funded almost entirely through 1-year credit facilities from folks like you guys. We sorted through all that during the financial crisis, but one of the things that we did to be sure that we could keep developing and scale was really get larger, get that investment-grade rating, be able to tap the unsecured market, and that allowed us to extend the duration of our liabilities such that today, we probably have an almost perfect match of assets and liabilities, both with duration of about 4 years.

So then yes, just in terms of the liability stack and in the near term, you guys have been active in unsecured market back half of last year in January. Are you thinking about anything else major in the near term to optimize it further? Are you comfortable there?

No, I think we're always very opportunistic about how we raise our capital. And clearly, we want to make sure we have enough capital to support our clients. But I think we feel like we're pretty much resolved all the maturities for this year. We do have a little under $2 billion maturing next year. So we may look at it opportunistically. I think we're pretty happy we've got the deal done and we did given where rates have [indiscernible] that a little bit.

Okay. So why don't we move on to everyone's favorite topic, credit quality. So my old colleague like to use the phrase, "Waiting for Godot," a lot. And I feel like that's what this credit cycle has felt like so the sector credit quality has been fine, ARCC even better. But how do you see the cadence of defaults over the next 12 to 18 months. And if it's a slow bleed, how do we know when we're past the peak and which maybe pockets of direct lending would you think may show issues first, if there are, meaningfully...

Look, I mean I think the leaders in the direct lending industry have continued to grow their importance, advantage, relative strength. So to your question about underperformance, I think that you're going to see more dispersion of results depending on managers. Because inevitably, we think we have better origination, more origination, more diverse originations, better product set than others. So we think there are a lot of other people getting adversely selected on new deals. We think our ability to see the best credits is key. So I don't think there's a particular pocket. But I think some of the scale experienced managers who have great origination know how to manage risk or to do better than the other folks, right? My prospect for the year is -- I don't know if it's waiting for Godot or slow bleed or whatever, I think it's pretty traditional credit cycle where people usually think defaults are going to go up this year. Like, of course, they're going to go up this year. And like by how much? Our nonaccrual rate is about 1.4% today, the historical average is 3%. The peak during the GFC when we also happen to buy a pretty troubled portfolio in Allied Capital, I think, went to 5.5%. So my expectation is that defaults will go up to the historical average. I don't expect them to materially exceed the historical average because I think the economy is pretty good. And defaults are fine, and it's part of the business, right? Defaults are not losses. So if you get into a situation that's underperforming, you have a good asset management team that can go out and figure out how to minimize losses where you have defaults. That's the key. So that's my guess for what happens over the remainder of the year. The reality is you've got a lot of companies that have higher borrowing costs. They have good liquidity today, but they've been exhausting it. right? So depleting cash, strong revolving credit facilities, and that will take some time to roll through, and I think that will continue to roll through this year and maybe even into next year, but nothing of epic concern, I think, for us, it's natural as to what some of your colleagues were saying that you should expect that's what will happen for the next 12 months.

And so in terms of nonperformers, about 10% of ARCC's investments are under 2 rated, so below average performance. So that's not an excessive number. But curious, are there any common themes around those companies? And what are the nature of the conversations happening now between ARCC, those companies and their sponsors since historically ARCC is very good at getting ahead of situation.

Yes. I mean, look, I mean, being proactive and understanding where you think the issues are is key, good communication, getting good information from those companies is key. The 2 things that -- the 2 areas where maybe if there are some common themes, and I think you've heard this from some others has been certain parts of the health care business, particularly that are heavy on staffing and saw real wage inflation, whether it's a dental practice or a group of nurses. There's still a lot of wage inflation in that population. Remember however long it was a year ago or 18 months ago and nobody wanted to go to work. I mean, that was a contributor in those businesses. And again, because they're billing on a capitated basis, either Medicaid or Aetna or whoever else, they have less pricing pressure than other parts of the health care business. So I think you've seen that in public companies. And the other one was simply -- it sounds dumb, but it's the companies that make things, right? So we have companies that make socks, we have companies that makes food ingredients for food service. They were all able to increase prices because they were seeing cost side pressure coming out of COVID with supply chains, but you can only increase prices on things that are a little bit more commodity-oriented so much. And obviously, when you're talking about going direct to consumer in some of these businesses, that world is changing a lot. With Amazon and the way that people shop and buy things and the shrinking of retail. So probably those 2 areas of the portfolio more common or more similar stress than anything else. But away from that, and then what are we doing? I mean it's all about early prevention. A lot of this maybe increase in defaults, I think, will be a result of less cash flow at companies. So for the first time, I don't know if it's in my career, but in a while, you're actually seeing companies that are growing. Maybe they're not hitting plan, but they're growing. They just have a lot less cash flow around because the cost of servicing debt went up by so much. Most of them, we calculate an interest coverage ratio in the portfolio. It's still 1.7x, right? So most of the companies, 90-plus percent of the companies [indiscernible] portfolio, while they're tighter, they're still current and they're growing, and I don't have any expectation that they're going to turn into nonaccruals anytime soon. So it really is our focus, looking at the 10%-ish that we've identified as 1s and 2s and how do we get ahead of that. And the typical solution as you look to the owner of the company, very often being private equity firms and say, cash flow looks like it's getting tight or the company is not performing with your sort of the first line of defense here? What's the plan? Are we going to deleverage, are we going to bring in new capital but that's ongoing. So that's kind of what we're doing today with those names.

Okay. Makes sense. Let me ask one more question here and then open it up to the room for questions. This is maybe a bit of a loaded one, but just given it's also been in the media a bit. Just the regulatory future of private credit as an asset class. How do you think about that? And is there anything that you can do to prepare for any changes?

Yes, we spend a lot of time -- we're -- Ares is a public company. We -- the BDC is a public company, they're obviously both regulated by the SEC, and we get looked at in a whole host of different ways. Again, it's not a bank, right? So when the bank regulators come to talk to us because they're curious about the asset class I found, for the most part, they don't really understand our business very well. We try to be incredibly transparent to explain it to them. And for the most part, they get through their questioning trying to understand, I think, good questions, how do your leverage facilities work? How levered are you? Do you match the duration of your liabilities to your assets? And we give them the answers, some of which I've spoken about, and we're like, oh, great. So what happens if the asset level performance isn't what you expected? And we said, well, instead of delivering a 12% return for investors, we deliver 6%, right? And then the LPs either hire us again to manage fund for or they don't, right? So it -- the performance is what regulates who gets to operate in this space away from the bank regulators, obviously, or insurance regulators, neither of which are frankly all that relevant, but come to us and ask questions. I don't really understand what the increased regulation direction of travel is, right? I mean, the BDC in particular, publishes a really, really thick Q and K that details every investment we make, every term of every financing facility that we have. So people are always like, "Oh, shadow banking," we're like, we're not in the shadows, like we disclosed lots and lots of information about what we do every quarter. So I just don't see any change. Nothing has really shifted in the last bunch of years. The press likes to write about it and they've been wrong for 15 years now. So -- but I don't see any real regulatory changes coming.

Okay. Do we have any questions in the room?

Just -- you're just talking briefly right, you're seeing growing and performing companies getting their cash flow squeezed. So I guess the returns to equity have been compressed with the higher rate environment. Just curious how you perceive like credit quality if we do end up in a higher for longer environment. I guess because sponsors may be okay with those low returns on equity for 12 to 18 months, right, but maybe hoping for some rate relief. But if that rate relief doesn't come, can we see further stresses to credit?

Yes. Somebody asked me this in one of the one-on-ones. I don't -- so I think an increase in interest rates from here would create a lot of problems for a lot of people in a variety of different businesses. My belief is that's unlikely. I think that the current landscape for leveraged finance and private equity broadly has adapted to this new higher rate environment and higher for longer. But it's still making its way through and some of the regulatory questions and the press about private credit and all that, that I think has been hugely wrong, I think is missing the point that you're making, which is you're seeing slow growth and higher debt servicing costs, which means less cash flow, less deleveraging. And again, with a higher base rate, inevitably a lower valuation environment. And private equity, in particular, has paid very high prices for companies over the last 5 to 7 years. I think it would be very difficult for them to exit them anytime soon at remotely similar calculations, which, as we described -- the current dynamic is much worse for the equity in a lot of these companies than it is for the debt, right? And I think that's why the system is stuck up a little bit, right? Folks are not compelled to go out and sell things that they think they're going to generate a 6% return on when the hurdle to generate carry in their fund is 8% and their LP's expectation is that they're going to do at least net 15%, right? And that's not available right now. So -- but we keep reminding people, we're like, "Oh, credit, it's going to be a huge bloodbath." And we're like, what about all this private equity that's going to work in the last 5 to 7 years that I think is really challenged to meet return expectations.

Just the example of some of the [indiscernible] Class 1 and 2 loans. When you go to the private equity [indiscernible] them for more equity, what -- if they say no, what's the next step?

I mean it's a little bit of a delicate negotiation, but luckily, we've kind of been doing this a long time. The good news, frankly, even since COVID, which was a real liquidity disruption in a lot of these companies. The playbook has and continues to be in our underperformers, we're happy to be part of the solution, right? We're happy to provide amendments and modifications and maybe we can decrease the cash interest that we're taking in relative to probably getting a higher all-in interest rate, but a lot of it accruing in PIK for a certain period of time. When we make those modifications, we make them with pretty much a requirement that the owner supports the business with new liquidity if it needs it, and we've had very good success of driving that. It's a little bit of a funny conversation. So if you ask for equity and they say no, the next conversation is probably -- we try to get equity to come into the company to deal with liquidity [indiscernible] no, I mean we're looking 6 months ahead. And to me, it looks like companies going to run out of money. And if it does, what would you expect us to do other than file Chapter 11 and go reorganize it in the courts. But this is a discussion, right? Because bankruptcy tends to be a very value-destructive process. It's incredibly expensive in terms of hiring advisers and lawyers. So that's never -- our goal is never to get there, right? We want to have a collaborative relationship with our partners. And the good news is particularly on the private equity side, there's a lot of repeat business there, right? So we have sponsors that were in 80-10 portfolio companies with. It tends to be a pretty productive dialogue, and they understand the balance of what their responsibilities is versus what they can reasonably ask for from us as a lender.

Anybody else? Maybe I'll end with the dividend question. So at the $0.48 level that the dividend is at, so that's well covered by core earnings, right, that was at $0.63 in Q4. So it almost seems like the dividend is set to absorb even more rate cuts than the forward curve has priced in. Just how are you thinking about setting that base? And just generally, do you think about just kind of excess earnings on a continual basis to support NAV, which has done actually pretty well.

Yes. I mean we sort of made our way in the space way back when -- with even Allied Capital and American Capital for a long time kind of over paying dividends relative to their core. So we definitely want the core to exceed the dividend over a pretty long projection period. So -- but the team agonized when we raised the dividend to $0.48 because it was obvious to everybody that with higher base rates, the company had significantly more earning power. But of course, the question was back then, in a world of BDCs where you can't cut your dividend, how do we raise it to justify. Obviously, higher levels of core without having to turn back around and pick your time frame 2 or 3 years and say, oh, we overshot it, and now we need to cut it. So typically, what we've done is make sure we have a very safe core dividend, which we think is very attractive. And again, is built on income streams coming off 400-plus companies. So the diversity of what actually contributes to that dividend is much higher than other BDCs. So I'd argue it's a much safer dividend. And then we build NAV over time. And to the extent we think we've materially outearned the dividend. As you guys know, we have a history of occasionally declaring special dividends, some of which will pay at year-end. That's typically when we look to clean it up as around year-end. And we've done everything in the past from issue one special dividend to a special dividend payable over 4 quarters. But at the core of it is we want a really high quality, really stable dividend that everybody has a tremendous amount of confidence in. We can always supplement that through other distributions.

Fantastic. All right. Thank you Kipp and Scott, for joining us.

Thanks for having us.