Ares Capital Corporation (ARCC) Earnings Call Transcript & Summary

[Audio Gap] Financial Institutions Conference. My name is Kenneth Lee. I'm the Senior Equity Analyst, covering the business development companies, or BDC sector, and welcome to our industry panel in conversation with leading BDCs. I'm very pleased to have with us our panelists: Kort Schnabel, Co-President of Ares Capital Corporation. Kort is also a Partner in Ares Credit Group and Co-Head of the U.S. Direct Lending. Then to his left, we have Craig Packer, CEO of each of the Blue Owl BDCs, including Blue Owl Capital Corporation. Craig is also the Co-President of Blue Owl. Then to his left, we have Jonathan Bock, Co-CEO of Blackstone Secured Lending Fund as well as the Blackstone Private Credit Funds. John is also a Global Head of Market Research for Blackstone Credit. And then to his left, we have Josh Easterly, Chairman and CEO of Sixth Street Specialty Lending and also Co-CIO of the Investment Adviser. Welcome, everyone.

Thanks for having us.

Before we dive in, perhaps each of our panelists can give a quick overview of their respective companies. And we'll start off with you, Kort.

Sure. Thanks everybody for coming. Ares Capital Corporation is a $22 billion publicly traded business development company with the largest publicly traded BDC that exists out there. We had our IPO back in 2004, so we've got a 20-year public track record out there, delivering industry-leading results. Ares Capital sits within the broader direct lending business at Ares Management, which is about $120 billion of AUM, but Ares Capital is the flagship direct lending vehicle for us at Ares, the most flexible vehicle that we operate.

I'm Craig Packer. I cofounded a business called Owl Rock Capital about 8 years ago. Eventually, we merged that and became Blue Owl Capital, publicly traded alternative asset manager with about $160 billion-ish of AUM. About half of that is the credit business that we originally started, which I run, primarily in upper middle market direct lending business, the very first fund. Our second largest fund is OBDC, which is our publicly traded BDC, which, again, primarily upper middle market first lien sponsor-backed lending, second largest by market cap, depending upon what day you measure it, about $13 billion worth of assets. We have 6 other BDCs, 4 in the diversified space and then 3 in the tech space software lending primarily.

Jonathan Bock. I'm at Blackstone Secured Lending. And so we have both have a public BDC, BXSL. I'm also the Co-CEO of BCRED, Blackstone Private Credit Plan, which is a nontraded BDC. So there will be some questions on that. Blackstone is a $300 billion credit franchise, roughly half of that in private credit strategies. And of that, roughly half is tied to the BDCs. So a pleasure to be here.

Great. I'm Josh Easterly. I'm the Co-Founder of Sixth Street. We talked about Sixth Street is about $75 billion of assets under management, focused predominantly on credit and credit-like investing. And we have, I don't know, $14 billion of AUM in direct lending, and SLX has been -- TSLX has been public for 10 years now, which has about $3.5 billion assets.

Great. Well, we're going to keep this discussion relatively interactive. So periodically, I will pause to open it up to the floor and see if there's any questions from the audience. And obviously, the panelists can always chime in on various topics as well.

So let's just kick it off. Let's start off at a high level here. And I'll direct the first question to you, Jonathan. Let's start off at a high level. BDCs, as a sector, has really evolved over the past few years, and we've been hearing a lot about private credit. Could you talk about where the industry has been and how has evolved more recently?

Maybe starting about where it's been. So believe it or not, maybe a sad statement, my entire career has been nothing but BDCs. So I graduated the University of Illinois, which means 2 things. I'm good at accounting and bad at football. And then my wife and I went to the big city. We went to St. Louis, Missouri. And so starting with A.G. Edwards, right, had an opportunity to see what effectively was the institutionalization of this space from the very beginning. And so just to talk about that evolution, think about what you saw back in 2004 early on, and you'll hear that from those esteemed managers on this panel, smaller transactions, smaller companies, predominantly [ missed ], asset-liability mismatches because no one thought anything could go wrong. And then you now you fast forward 20 years here, you see a substantial influx of very talented, very well-known institutional managers in the space that are, in my view, operating and working to operate and make this space better. The level of transparency only continues to increase. And so from that evolution, what you're seeing is the space is more investable, more transparent, generally with larger transactions and, over time, allow you to make better informed decisions on managers to support or managers not to. That hadn't -- didn't happen because there wasn't enough information. You only had 2 -- effectively 2 back in the day. So it's a remarkable evolution. There's still more to go. But looking back to where we've been starting 20 years ago, it's a remarkable change.

I think this path accelerated in the Global Financial Crisis, which the fractionalization of risk was the intended consequence of the regulatory environment out of the Global Financial Crisis. So taxpayer wrote a $700 billion put that put -- caused people to basically make the decision to utilitize banks, make them utility like, increase capital requirements. And I think credit formation is the lifeblood of growth in any economy. And so credit formation had to find a landing place, and it found a landing place in BDCs, particularly. We started one out of the Global Financial Crisis. Craig did it on a much larger scale. But I think this was the intended consequence of that regulatory environment where people didn't want to have to talk about bailing out banks. So -- and quite frankly, the model -- when you look at what happened at Silicon Valley Bank, the model is much more durable as a provider of credit than the bank model. The bank model is this idea of lending long and borrowing short, and they have a low inherent asset-liability mismatch. And the rating agencies who I think have got it wrong and wrong over and over again had thought the panacea was the ability to hold deposits. Those deposits went elsewhere. They weren't able to borrow at [ Fed window ]. And when you look at our business model, we're much more -- if anything, we probably borrow long in the margin and lend a little short but particularly pretty matched, and so we don't have that inherent risk, and there's no tax credit put. So I think this space and alternative credit, no matter what Jamie Diamond says, is here to say, and that narrative is protectionist. But I think this was born out of the Global Financial Crisis and, quite frankly, is the intended consequence of that regulatory environment.

It's a function of who also managed the capital because I'd say early on, we still had even years after the Global Financial Crisis, let's say, managers of different size, different scale, different levels of professionalism. And now given the fact that the industry and the asset class itself is truly that, oftentimes, folks like to think of investments as asset classes and early on until it really transitions. Now you have every large brand name involved, which is important. There's good and bad about that, which we'll get to, but it doesn't happen without a change in terms of who was running the capital early on, and the folks here are a testament to that.

That was a great overview. And then for the next topic, let's talk about the origination side, and I'll direct this question to you, Craig, to start off. Last year, BDCs were able to take advantage of a muted broad-based syndicated loan market. Right now, those markets look normalized. Could you talk about the potential impact on the origination activity and return profiles in light of the normalization?

Sure. So it's so interesting, the framing of this question. I find that I grew up really in the broadly syndicated markets. I ran the leveraged finance business at Goldman Sachs and spent 25 years at Goldman and Credit Suisse originating higher bonds and leveraged loans to distribute. When I decided to join my partners in launching a credit business, the question for the first 4 or 5 years is like why would you do that. Now could there possibly be enough opportunities for a product that like rightly belongs to the banks to distribute? And then that came roaring forward because we had a period of time when the public markets were dislocated, and it became so obvious that the banks don't, in the market, actually lend. There's this like a nostalgic sense that like bank -- or competing with banks that are making loans, which stopped 30 years ago. They're in a short-term commitment to sell it into the public loan and higher bond market. And so I ran that business. It's very simple. Can we sell it or not? And when you can't sell it, you don't commit to it, and there was a period of time that, that got really highlighted, first half of last year being at the end of the year prior, when the public markets were shut, the banks have a lot of -- they couldn't sell, they got out. And so in that period of time, it really showcased what we all can offer, and direct lending like the capital -- the financing was available, just was being provided by direct lenders 100%. And it was great -- shooting fish in a barrel, we can get great returns, great deals. But that's not the normal state of affairs. And so now the bank's -- the public markets are open, so the banks are willing to underwrite, and it just shows you how far it's come that just a simple act of them doing what they've been doing for the last 30 years seems noteworthy that they're even able to do it. And so you just have to -- the normal state of affairs is a well-functioning public market with banks willing to commit with direct lenders such as ourselves, able to provide similar solutions in greater and greater scale and more choices for the private equity firms in which market and choosing. Now I will tell you that the secular shift continues to be towards direct lending. Their preference is to do it with direct lending. Why? Certainty, privacy, customization, the fact that we're always open, the fact that we can grow, the fact that they know their lenders. That's the trend, and that is continuing to head in our direction. But there's going to be this cyclical -- there are going to be periods of time when the public markets are shut, we're going to get really high market share and more normal -- we're in normal now, and it's going to shift back and forth. So there's nothing profound in the current market environment. It's the normal market environment. And we compete with the public markets. We compete quite effectively, but it's a price check. The sponsors are well aware of what their options are in the public markets. We're always going to get a premium. We're always going to get way better covenant protections. But when the public market is very strong, we have to offer some relative value, and there will be some deals that go in that direction. And that's healthy, and that's really where we are right now.

Yes, I find it fascinating, all the talk out there about banks competing with private credit and the world is going to explode and the structures are going to collapse, and it's just -- and we think exactly as you just said, Craig, which is just back to normal. And the thing we always point to is 2021 was a record year in volumes for us, and I'm sure all of us up here. We had fantastic years putting new money to work. Banks were extremely active in 2021 as well. And it's just a different product. It's simply just a different product, and the borrower has a choice. And by the way, we work collaboratively with banks as well. And banks lend to us, lend -- provide financing against our funds, give us credit facilities. We hire banks to sell unsecured bonds for our BDC. So there's a collaboration and a symbiotic relationship that we've sort of worked on and grown up with together as well. So back to normal, I think it's the right way to say.

And just to tie the first question or the second question, the evolution of direct lending [ in this path ], why we have so much to do, like why -- it's because the pie is growing. Because the direct lending space can offer bigger and bigger solutions, the sponsors are able to use direct lending for bigger and bigger companies. And so we are -- when [indiscernible] capital chasing the same deals, it's more capital now accessing a bigger part of the market, the evolution point, and I think this is very important and powerful to investors, and you guys touched on it, generally, the bigger companies we're financing today, they're just better companies. So the assets that we're putting into BDCs or at large is just higher-quality assets because they're much bigger companies, and I think that along with the institutionalization of the space, it's just the higher-quality asset class.

That was great. And then the next topic -- and I'll direct this one to you, Kort. M&A activity was really slow last year. And could you talk about expectations around a potential pickup in M&A activity later this year? And what are the key drivers for those expectations? And just to close off this thought, how dependent would originations be on a pickup in activity?

Sure. Yes. So a couple of different questions, I guess, in there. In terms of just overall M&A activity in the space, look, I think the ingredients are in place for M&A activity to continue to rebound and come back to more normalized levels, maybe even exceed normalized levels. I think you're seeing a few different factors going on that are driving that. So first of all, LPs to private equity firms have been patiently waiting for a return of capital, and getting return of capital on a relatively normal basis is important to those LPs. And it's been a long time now, 12, 18 months, where we've had really kind of a logjam in the M&A market and buyers and sellers not being able to transact. And so there is absolutely increasing pressure being put on private equity firms by their limited partners to sell assets and return some capital, get it reinvested in the new vintage, satisfy liquidity needs on the part of those LPs. So that pressure is building for sellers. On the buyer side of the equation, there's a lot of dry powder that's been raised by private equity firms that has remained unspent for the last 18 months, and there is a time clock ticking on that capital. And so those 2 forces on both ends of the equation are going to create a better environment for buyers and sellers to transact. I think at the same time, we're seeing stabilization and more certainty in the overall interest rate environment. We're seeing that the economic underpinnings of the economy, revenue and EBITDA are growing, and their economy remains healthy despite everyone worrying out the lag effective rate increases, credit tightening. We're still seeing the economic activity continuing to be strong. So from a buyer perspective, the inputs they're putting into their model in terms of expectations on where rates will go, in terms of expectations on performance of the portfolio companies is in a tighter band. There's more confidence. And that's going to allow buyers to be more aggressive when they're bidding for assets, right? So all of these ingredients, I think, started to create -- we saw the pickup in M&A activity in the third and fourth quarters last year. We at Ares, and I'm sure all of us up on this stage, saw our volumes start to pick up in the third and fourth quarter. And as I said, those ingredients are in place for that volume to likely continue to pick up here across the industry as we head in 2024. I will say it's been a little bit of a slower start to the year than we might have expected, but it's still early. And certainly, we're seeing more volume than last year at this time. So those are my thoughts on the environment, the activity. I think how dependent is our originations on the M&A environment was the second part. And certainly, it's -- our activities depend on our originations, depend -- having M&A and assets trading will drive activity. But it's not the only factor, right? And I think as a large BDC, one of the larger BDCs and all of us up here enjoy the benefit of having a large portfolio, right? So at Ares, we have $120 billion in the ground in companies -- 600 different companies in our U.S. Direct Lending business. Those companies are dynamic companies. They're always changing. They're looking for new capital. They're -- need capital for their growth initiatives, their CapEx initiatives, their tuck-in acquisitions. And tuck-in acquisitions has remained still relatively robust. And so we have the good fortune to be able to provide capital into those existing portfolio companies. We all enjoy the fact that there is a little bit of a competitive moat around our existing portfolios. It's difficult for each of us to come in and provide financing to our competitors' portfolio companies when there's an existing lending relationship in place. And so through this past period where things were slower, we just provided more capital into that existing portfolio. So it's a driver. It's not the only driver, but we are looking forward to the activity hopefully picking up across the industry.

And then just on a related note, and this one, and I'll direct to you, Josh. On new investments, wondering if you could just provide a little bit more color as to what you're seeing in terms of documentation, in terms of pricing, any other if you can provide.

I get that question. Look, I think if you look at compared to Q4, Q3 of '22, in first half of '23, things have got marginally tighter, for sure, not shockingly. There's been -- there were people that didn't have capital during those times. We were lucky enough to have a lot of capital, but things have got tighter, the broader syndicated loan market's back. So I would say generally things are tighter by 50 to 100 basis points on a spread basis, which I think is still a pretty good risk-adjusted return for what you're doing. I think underwriting standards are still pretty high. So LTVs, multiples -- LTVs, where you are on the cap structure are still relatively low. And that's, I think, the benefit of higher rates. Higher rates have brought down leverage given the binding constraint is now debt service coverage ratio or fixed-charge coverage ratio versus the binding constraint in 2021 was probably leverage because rates were at 0. So I think it's still a pretty good vintage. I think as importantly as Kort, I think Craig mentioned like the economy is in pretty good shape. The shocking thing, I think, for many observers who have been investors for a long time, which is the efficacy of the rate move has been very much muted and earnings growth has continued to be a lot better than people thought. And I think the reason why is post-Global Financial Crisis, the consumer termed out their interest costs. And so their DV01 on every basis point of interest rate didn't really move the needle. Somebody has a 30-year fixed-rate mortgage, rates go up 200 basis points, they're not moving, but they're not like -- and they had a lot of wage growth. And so I think the earnings have been a shock to most people. And so let's think things have got tighter, but the risk of your -- just returns are still pretty good.

That's good color there. Maybe we could just take a moment to pause here and see if there's any questions from the floor or the audience before we proceed further. Okay. Then let's go to the next one, and I'll direct this one to you, Jon. And this is -- this dovetails with the earlier comments about the evolution of the industry. I wonder if you could just talk a little bit more about the competitive activity you're seeing across the industry. And in particular, we've seen a lot of new entrants. We've seen the attractiveness of private credit in general, significant growth of nontraded BDCs. Certainly, the market backdrop has been very favorable. So I just wanted to get a little bit more commentary around that.

And so if you're thinking about new entrants, maybe let's just start with a baseline, ask the audience a question. How many people think there are over 100 private credit managers in the market today? Raise your hand. All right, there's a couple. I like it. Over 200? Over 500? There are 1,400 private credit managers today. Now less than 1% of those effectively operate with the same level of scale to the folks on this panel. And so what you see with the increase in entrants, there are going to be levels of pockets where risk return can get a bit down. I think you'll hear from folks on this market -- on this panel, but you're going to see that in the smaller -- the deals, the smaller transactions because to the extent that you're able to stand up a private credit manager, that's where you'll likely compete because it's very difficult to compete for very large-scale transactions without a capital base that needs to remain diversified. And so I'd say that really where you see that pick up and where you see the competitive markets really starting to compress comes in that lower level, right? And so to the extent that there's quite a bit of competition -- this is another question. If you look at the marketplace, just looking at aggregate market data, we'll use Lincoln here, for example, I know you're familiar with it, Ken, I think they had an interest rate coverage stat or the average interest rate coverage for the market as well as the tail risk, so which is the percentage companies below an ICR 1 was roughly 17% for the whole market, and they value everyone. So I'll let you determine the efficacy of that data point, but here's the other part that I found interesting, that roughly 70% of that [ stack ], of that ICR below 1, 17%, 70% of that was the companies at $50 million in EBITDA or less. So stress in the system is being felt in the more fragile company. At the same time, that's where you start to see a higher level of new entrants. So my guess is if you look at the number of folks that are on this stage, there'll be a level of dispersion based on really where you chose to invest. It doesn't mean you won't have great managers in some areas. It doesn't mean you won't have bad managers in others. But as you have more and more interest in the space, you're going to start to find capital flowing to where it can flow easiest. It's very hard to operate at this level. And we start to say that that's going to lead to a level of dispersion in the future.

All right. Jon, this is dead on. I think it's -- by the way, I would ask Craig this. Craig, would you -- if today, would you have started Blue Owl knowing -- I mean, I know you would have done it where you did it, but like today, did you have any...

It'd be harder.

That'd be harder. It's so really -- like the fixed cost and compliance, the fixed cost and technology, 30% or 25% of our firm's engineers. It is like -- it is a really hard business to get into.

[ 30% ] of your firm are engineers?

And we're not spending enough. I'm worried.

On what they're doing -- what are they doing?

I have no idea. Our business is more complicated, and this is not [indiscernible], more complicated.

Careful, if we're talking too much about costs, we're going to sound like the banks.

I just think it's a hard business to get into. I mean...

When I -- the question I -- we -- clients ask us all the time because they're being approached by -- for fundraising for new entrants. Our collective success has attracted others to see if they can replicate it. It's a lot harder today than it was. But the clients say, "Well, I'm being approached. Is there too much competition?" And I -- the scale point is critical. You -- to be -- to compete in what -- surely what we think is the highest-quality opportunity set, we prefer upper middle market sponsor-backed. Everybody can have a view that. That's what we prefer. You need to be scaled. We're $80 billion. We provide a $1 billion check. There are a handful of us that can compete for that. When firm -- you're reading about firms that have raised $2 billion, $3 billion and they have a brand name and it might seem like a competitor, it really isn't. They were too small. It's not to say that they won't have the ability to deploy the capital. They probably will [ figure ] out a way to do that, but they're not offering a comparable solution to what we can provide, and the private equity firms, which are by far the largest generator of these types of loans, well understand that, and they're not going to invest any time in relationships with the smaller managers because it's not strategic to them. So it's really a pyramid, and it's concentrated in a handful of us. And we compete in one sense, but we are co-lenders all the time. We are aligned all the time. And we take comfort in each other having very high-quality underwriting standards and that if there's a credit that we're in together, that's going to have an issue. We are now highly aligned in protecting our collective capital, and there's just a handful of us, and it's -- we're a new entrant 8 years in, but there's very -- it's very few, and it's very difficult to come in now and recreate that.

I was going to make the point on the collaboration, especially when you think about the different segments of the market. On the upper middle market -- and these larger deals that are getting done, multibillion-dollar transactions, it often takes several of us together to put that transaction together, that club together. Versus the lower middle market, you might have bunch of different private credit providers trying to provide the transaction. Every single private credit provider can clear that deal themselves, and the remaining people would get zero, whereas in these larger deals, we're really kind of partnering in a lot of cases. So the competitive dynamics can actually be less in the larger transactions counterintuitively. You're getting larger, more diversified credits with less competition because of that dynamic. The only thing I will say that we probably do a little differently maybe in Ares is we do still provide lots of financing to middle- and small-sized companies in addition to the large companies. That's kind of core to our model. We have an extremely large team, just been at this for 20 years now. And we do think that's also important to get in with smaller borrowers and get in early, I mentioned that power of incumbency, and then be in with them as they grow, and that's been important to our strategy, but we're more selective in that smaller end of the market. And what I would say is we're trafficking in that flow. And if we're not providing financing to that company, it's because we passed on that business. And so the smaller private credit providers are generally getting access to those deals after we've already looked at it and passed on it. So there's a little bit of an adverse selection also that these smaller lenders are suffering from.

Ken, Craig made a great point because there is a point where you have to think about assets under management, specifically direct lending because there's a point where you have very large brand name asset managers that might have a lot of capital but have done so in public markets for many years. And we like to say this, right, like private credit is not hobby, right? It's never a hobby for Josh or Craig. If not, this was the dedicated career. It requires a level of specialization, multiple engineers, right, multiple -- in terms of work, it's a very dedicated talent set. So here's the issue. If you're trying to build that off the ground, even if you have a capital base or a perceived capital base saying that your total AUM to the asset manager is multiple trillions of dollars, you're effectively getting a point across, but it's not necessarily a reality because I'm not sure private credit rises to the level of a hobby.

I think what Jonathan is saying is BlackRock can write a billion-dollar check in private credit.

He said it, I didn't.

I mean, I think that's what you're saying. There's 6 guys that can do it, and BlackRock is one of them.

So that's -- but he's -- Josh is making a point because really you start to have to differentiate how long you've done this and where.

That's a great discussion point. Let's talk about credit performance here. And I'll direct this one to you, Craig. And I think Josh talked about this and alluded briefly upon this, but maybe you could just flesh it out a little bit further. For many of you, nonaccrual rates have been very low, and this is despite elevated rates, concerns around economic slowdown. Could you just talk about what's going on here? And specifically, what are you seeing within your portfolio of portfolio companies?

So a year ago, everybody was worried about credit performance. I certainly was. Rates were up already. And I think there was a general expectation of a recession, a combination of higher rates, recession, there's going to be a significant pickup in credit issues. I thought we thought there'd be some pickup, but it'd be manageable. It wound up really not. We've really not seen much of a pickup at all. Credit performance was really strong last year. And I think that in fairness, some of that was a large part because the economy didn't turn over. The economy was very good. It continues to be very good. You can all pick your favorite adjectives around it, but I think it's a moderately growing economy. We see low single-digit revenue growth, low single-digit EBITDA growth. Now we are -- I'll just speak for ourselves, we're not trying to be an early read on the U.S. economy. [ We're ] decidedly trying to be an all-weather recession-resistant portfolio. And so we avoid a lot of the cyclicals. And so we're not going to be an early read. But for the companies that we -- in our portfolio, they're doing well. I think we benefited last year also from some post-COVID supply chain unsnarling and some raw material and distribution cost reductions, and that flowed through. Sitting here right now, rates -- short-term rates are still high. There's an expectation that they're going to come down. But until they actually come down, we're going to continue to be cautious, but I think it's going to continue to be a reasonable economy for our companies, and our companies will do well. I think last year, though, was a real testimony to the strength of the quality of the companies in the direct lending space. I think that there still had been, and maybe still some of you may feel this way, a lingering misperception that we're lending to kind of subprime borrowers that in moments of weakness that there's going to be this great ripple effect. And it's just misplaced. They're big companies. Our portfolio, our average EBITDA is $200 million. These are multibillion-dollar companies backed by sophisticated private equity firms. They're large and are important in their space. They have strategic value to other companies, and they have [ hooves ]. They've really good management teams, have good sponsors. The sponsors have more equity in the companies than we have debt in the companies. If there's a problem, they bring a new management team, bring in new capital. And so even when we had issues, by and large, those issues were solved by the private equity firm to retain control of the company. We don't have to be perfect credit selectors. It's not -- you should not invest in any of us expecting us to be perfect. The companies have their own issues. We do -- our job is to make sure that, one, [ we're ] very few, we're diversified; and two, when the companies have issues, that we get very high recoveries. I think this is one of the things that's underestimated about direct lending. I find people have a knee-jerk reaction [ and ] take public market recoveries and lower them as if we're doing riskier. I think it's the inverse because of our credit selection in the sectors. We're in companies that will have higher recoveries. Our documents are way better. Our information is way better, and our time horizon to work out problems is completely different. So I think even when there are issues, we've had a few, not too many, our recoveries are actually quite good. I tell clients to model in $0.70, $0.80 on the dollar, but we're trying to get far back on our problems. And if you have a diversified portfolio and the problems get back $0.80 to $0.90 on the dollar, we're going to have great returns. So it's a combination, economy is better, credits are good, and we have a much better ability to get higher recoveries on our problems.

A couple of quick stats in our portfolio that are interesting, goes to your point around industry selection and picking good credits. You saw in the fourth quarter, we reported 9% average EBITDA growth across our portfolio companies compared to 0% flat growth in the S&P 500 EBITDA. We're looking at key indicators that show us that maybe there's still a lag effect coming from the rate rise. And we're just not seeing it. Amendment activity, flat, not picking up. Revolver draws, we're the revolver provider to a lot of our companies. People -- these companies are not utilizing their revolvers in any bigger way. In fact, revolver draws at our companies are slightly down. So you would start to see those leading indicators pointing to signs of stress if companies were struggling with liquidity. It's just really not happening.

I think -- I don't often admit that I steal something from Blue Owl. I mean, so -- I think this idea that industry selection, private credit has a -- it has a very big skew in industry selection. And I would say except for health care services, it's done a very, very good job. And so it's a financed -- like if you look at a broadly syndicated loan portfolio financed by a CLO, the diversity scores are probably somewhere between 70 and 100. Private credit is probably 30 to 35. And so like we've -- I think we've been able to be much better at picking industries and have the flexibility to do so versus being kind of own the market. And I think when you look at the alpha and credit performance, it's really because of industry selection skew and higher recoveries and a better [indiscernible] generally. So when people say, "Oh, you must get adversely selected." It's really offset by our ability to skew those things to the positive. So I don't know what the percentage of software and technology in the BSL market. It's a lot higher in private credit.

Great. And then just relatedly, and I think it was touched upon briefly, maybe Kort, if you can just talk a little bit more about the downside protections. And I think Craig mentioned about maximizing recovery rates. So where are the specific downside protections you get in these investments? So should there be a downturn?

Yes. We did touch on a lot of it, maybe just to hit on a few of the key points again, and it was talked about a little bit earlier around leverage on our funds. But yes, remember, the leverage profile of BDCs is very low, very conservative. We all operate in the low kind of near 1x debt-to-equity. Certainly the low 1x earnings were capped at 2x. From a regulatory standpoint, none of us ever go near that. That compares to buyers of syndicated loans that are 4, 5, 6x levered, banks 10x levered. So the underlying leverage is just much, much lower than other buyers of credits, and we are match funded. This was also mentioned. I'm just going to underline, and again, it's so important, right? We are not taking deposits that can be fleeting. Our liability structures are long term in nature. We're accessing the unsecured bond market in a really meaningful way now. Even our secured financing at Ares doesn't have mark-to-market features. So that strength and stability of the balance sheet allows us to be patient and navigate periods of stress in a much calmer way, right? There's no triggers that are making us sell our assets. So we can sit there and work together with our partners, the owners of the assets to achieve better outcomes. And then getting to that point, again, already a little bit touched on, but in large part, the owners of these assets are private equity firms. We've got excellent relationships with these private equity firms. We're often in many, many deals together at the same time with these firms. So our futures and our destinies are somewhat intertwined. And so there are natural incentives to work together to come up with better outcomes in a downside scenario and maximize the recovery for ourselves and for them. The first course of action is private equity firm, you're the owner, you solve the liquidity problem. And in large part, they do. They have and we expect them to continue to support the portfolio of companies, especially with the loan-to-values that today are much lower than they used to be. Loan-to-values today, we're putting money out at 40%, 45%. Loan-to-value used to be 55%, 60%. So the equity checks and the incentives are even greater for private equity firms to support. If they don't support, we're in a better position to work out these credits than broadly syndicated loan buyers are. It goes back again to that relationship, but it also goes to the fact that we are holding the majority of these loans, if not all the entirety of the loan. We structure the documents ourselves. And so we control our destiny in terms of understanding how to work these loans out. We also all have sophisticated portfolio management restructuring teams. We're not afraid if we need to, to take the keys and own the company and put more capital in ourselves and get through the other side. None of us have that business model, but in -- on purpose, obviously, but we're not afraid to do it if we need to do it. And that allows us to achieve all those factors, allow us to achieve the lower loss rates. It was already said. I'm just going to say it again. You got to look at the data. The loss rates in private credit are lower than the loss rates in the broadly syndicated loan market, in the high-yield market, and there's data over a long period of time to support this. So that misconception around lower credit quality is just really kind of not true.

And just to round out this discussion in terms of credit performance, and I'll direct this next question to you, Jon. Just talk about what your portfolio companies are seeing in terms of having to manage their interest expense, especially given elevated base rates.

I think you can expect that if you look at interest coverage, which at the beginning [ maybe ] was 2, 2.5x [ versus ] right now. Portfolios held up remarkably well, right around the -- as of the fourth quarter, about 1.8x. That's relative to market, about 1.4x if you're going to use the Lincoln data. To the extent this is a question of, I think Craig outlined, we're seeing a relatively healthy economy. I'd say this and say we're starting to see that additional dispersion come out. We've seen several folks, our BDC show the level of loss, whether it's loss of NAV or new nonaccruals. And so is it all idiosyncratic? No, not necessarily. It just depends on where folks chose to focus and the incentives that they had as it relates to how they manage the portfolio and the size and scale of the institution. Let's say this, you can expect a level of pressure defaults across the market to increase, but you'll certainly see some manage that better than others. So we're fortunate, but that was a lot more deliberate on the front end in terms of where you invest, and to Josh's point, that's generating that attract return.

That's a great segue to our next question. This is one -- it's for you, Josh. Could you just talk a little bit more about the outlook for alternative credit, more specialized financing opportunities there?

Yes. I mean, look, I think what's happened in -- I think if the market is corporate credit, noncorporate credit, investment grade, noninvestment grade, those are kind of matrixes. And I think what's happened in noninvestment-grade corporate credit for sure, you're going to see happen in noninvestment-grade noncorporate credit, and so people call -- have different names for it, specialty finance, rediscount asset-backed finance, asset-based finance. That market is a bigger TAM than corporate credit. It's harder because it's -- in some ways, it's not one vertical. Corporate credit is homogeneous except for the industries. And in asset-backed finance or whatever you want to call it, it's very heterogeneous. Consumer -- unsecured consumers [ even ] secured consumer versus autos, versus -- in autos -- prime, nonprime, subprime. And so there's equipment finance. There's [ esoterics ] like aircraft. So I think that most definitely is happening. I think, again, you have this structural -- sorry, you have this structural issue -- that was not my phone ringing. You have the structural issue with banks and this convergence between insurance companies, alternative asset managers that are converging where they are the ultimate holder of credit since banks are no longer the lenders to -- except for basically investment-grade companies, and they're providing wholesale financing to the -- all space. But because we're better holders of that credit, we have better liability structures, we're able to attract talent. There's most definitely going to continue that shift. I think there's no way around it, which again, that's why Jamie Diamond was on the stage getting upset because he has such -- the base have such an embedded fee stream from the moving business because -- that moving business, they got underwriting fees, and then they would trade the securities, and they [ flipped a quarter ] on the trade. And the market and people who need capital and issuers are saying, "God, I can just go to the person who's going to store and own it." And like that's happening across the asset class. So I think that here to stay.

Just for the record, Josh has gotten JPMorgan and BlackRock. So we'll see whether we can [indiscernible].

No way. I'm -- I used to pick on the space. And now I'm picking on -- not the space. So -- but like I calculated it. I think this was the right math. I think JPMorgan on the noninvestment-grade corporate-credit side probably has like a $4 billion to $5 billion annual high-margin revenue business between trading and underwriting. It's a -- I don't know what Goldman numbers, but you probably remember, but it's a $2.7 trillion -- sorry, it's $3 trillion market on -- between high-yield and leveraged loan, and they're making fees across that ecosystem, CLO issuance, underwriting, trading. And so yes, if you're JPMorgan, you'd get upset. And because that's being [ disremediated ], I think Goldman has not kind of been as loud about it because they're hedged. They got alternative credit business. So they're like, I'm going to win one way or the other, but JPMorgan doesn't have that business.

Let's take a moment here and pause to see if there are any questions from the floor before we proceed. We got one right over there. The mic is coming around.

You seem to be casting a scenario where the banks never come back into the sector that's noninvestment-grade lending. Is that your [ point of view ]?

Look, I never -- my view is you can't ever say never. You give up a lot of option value in the quarter. Like it never is a long time. What I would say is that the regulatory environment is only getting tougher. The business model is more painful for banks. The human capital doesn't really want to work in a bank anymore. They rather work in an alternative asset management firm. And so I think a lot of structural reasons why you could see in the foreseeable future that, that is the case. And look, when you look at the risk-weighted asset -- like if you look at the risk-weighted assets and that base get on wholesale financing in SPV format, it's a pretty good business for them. And so the return on equity is pretty good. So I just -- I think structurally, that's changed. I think the big watch out is that they're like they have a high-margin markets business. When you look at M&A for banks, JPMorgan, GS, et cetera, like they're the lead partly because they have balance sheet and partly because they're in this moving business. And like if you level that playing field, they have to compete against a lot of other people, Lazard, et cetera. So I mean, they're upset. But like this was the intentional outcome -- not the unintended consequence, the intentional outcome of the regulatory reform post Global Financial Crisis.

I just want to make sure we're all speaking the same language. The banks pulled out of holding noninvestment-grade loans a long time ago, and I would point you to Glass-Steagall going away and the convergence of the commercial banks and the investment banks. And the commercial banks chose to adopt the investment banking model of distributing risk rather than hold it. The loan market we're talking about was invented by Jimmy Lee at JPMorgan as a way for JPMorgan to be able to provide lending to clients without having to hold it on its balance sheet and sell it to institutions. They became an intermediary distributor. There's nothing preventing them from doing that right now. They can do it, don't want to hold the loans. There's high capital charges. It's not investment-grade risk. They don't want to take that risk on their balance sheets. They want to earn fees by distributing it. What's happening is that was a great model. It's a very profitable model to distribute the risk and earn fees. They were great, except now there's an alternative to the borrowers. It does not involve intermediation. It's direct. We can offer certainty. If you are a borrower in anything, you want to borrow money to buy a home, would you want to borrow from a bank that gives you a fixed rate or one that says, "It could be this, or it could be that. We'll have to see later"? It's that simple. We can give them certainty. With that certainty, they're choosing it. So that's what they're losing. They're not squawking about losing the ability to lend. They can lend today. What they're squawking about is that the market is moving away from distributed solutions to direct solutions. The borrowers are choosing to do that. We're offering them the ability to do that because we have much bigger pools of capital, where it's now a viable alternative. It's a better solution. That's why it's going in that direction.

Craig, I think you would agree. I think it's capital prohibitive from -- thanks to the whole noninvestment-grade credit in size. Like I can't be in the non -- like at least a big thing, so it's capital prohibitive.

I would agree. But again, I just take the lens back, it's no different than other asset classes. Banks are -- they use their origination and customer-facing franchise and then distribute into the markets. They don't want to hold mortgages. They distribute the mortgages, and it's the same thing in this asset class. So they never say never -- I agree, sure, never is a long time. But are the banks -- they're in business of distributing risk. They're staying in that business. They're just losing share. Are they going to go back to we want to hold for regulators, which would seem to fly in the face of -- every regulatory development in the last 20 years, say, "Okay, we want you to hold this risk more." Would they want to do it and lower capital charges? I mean, it's possible, but I don't think anybody would think it's a likely outcome.

I mean, yes, and look, I think just to put a share on that, like there was -- when the taxpayers wrote a $700 billion check in TARP, like there was like national upheaval, and politicians were like, we can't ever do this again. We can't write this -- put for the taxpayer on -- and bail banks. And so like I just -- this was the intended consequence.

Just for the record, I still like working at a bank.

Ken, do you have a boss in here?

Let's move on to the next topic. Craig -- and this one is for you, macro backdrop here and rates. If base rates were to decline later this year, could you talk about implications for net investment income, dividends, NAV?

We -- it's not complicated. We lend out at floating rates. We have liabilities. Some are fixed. Some are floating. But generally, we benefited from floating rates when rates went up. If rates go down, that's going to hurt our income. Everybody should know that. It's very clear. I tell them, our clients, that all the time. I think there's -- we use the forward curve. We don't consider ourselves to have any particular expertise or projecting out rates, but it's moving around. There's, I think, continue -- maybe it won't go down as much or as fast. But we expect at some point in the next 12, 24 months, rates will be lower. In that environment, income -- [ that'll ] hit net investment income. We may get some offset in the short term for more repayments because we're -- in an environment where rates are going down, to expect some repayments. Repayments were pretty light last year. So maybe some short-term impact. But we model out in -- and as we think about dividends and the like, we model out reduced rates over time. Net asset value is more a function of spreads. If spreads compress, the value of our assets will go up a bit. Generally speaking, we benefit from good credit performance and overearning our dividend to drive net asset value. That was -- last year, that was terrific. We earn a bit less, we may not generate as much net asset value from that. So there may be some -- there was great tailwinds last year. Those winds might shift a bit. But credit quality in that environment should be a positive. Take a step back, the asset class is designed to offer a premium, consistent dividend yield versus the alternatives in all market environments. A world where base rates are a lot lower, we might earn a bit less. You might earn a bit less in our funds, but you're just going to earn more than your alternative investment. And that will still be the case whether rates are high, rates are low as long as we do a good job for credit selection. I do think that -- again, I'll just speak for ourselves, we think about that hard when we're designing our dividend, not to get into too much specifics, but we're taking into account some expectation for base rates to come down as we think about our dividend levels. But they -- not long ago, they're below 1%, and now they're at 5.3%, and so this is dynamic. I think the expectation now is maybe rates get to the mid-3s in a couple of years. And so that will all work if rates go back to sub-1%, right now, nobody is thinking about. But if they do, you've got to look back to where we were a couple of years ago. So it's just math, and that's the way the asset class is designed.

I think it's funny how when rates are going up, everybody is worried about credit quality and the credit is going to explode the business. And then rates start going down and everybody said, rates go down, it's going to blow up the economic model. So there's always something to worry about. There are some other factors to our business model that can help offset, right? So when rates go down, they're really going to see transaction volume go up, and we benefit from upfront fees. When there's higher transaction volume, we're making upfront fees. The more loans we make, the higher the transaction fee revenue stream. That's a high-margin, drop-down-to-the-bottom-line type revenue stream that will help offset. We're running at a pretty low leverage multiple right now, to the bottom end of the range that we advertise. We're around 1x debt-to-equity as I mentioned earlier. That's another tool we have, right? We can go back up on leverage. Nothing crazy, 1.25x leverage. That's going to help move the needle a little bit on earnings. So there are some toggles that we have, and obviously, the conservative dividend policy, I echo those thoughts. We're running lots of scenarios around that as well.

Okay. Great. And then Kort, we'll stick with you then for the next one. On the liability side, how do you think about the funding mix, especially given the rate environment and the outlook there?

Yes. We just like to have diversified durable sources of funding on our liability structure, nice laddered maturities. So we're never up against significant amount of maturities in any given year and forced to issue a lot of debt in a certain market environment that might not be favorable. So we're consistent issuers in all market environments. Just did a $1 billion unsecured bond deal a month ago. Obviously, rates aren't ideal right now, still priced pretty well in this market environment. So we're going to be issuing consistently. We do have about 70% of our liabilities are unsecured debt liabilities right now, which is really nice because it means that our secured debt, which is only 30% is really overcollateralized, right? So not only do we have a lot of liquidity right now with our undrawn revolvers and cash positions at Ares Capital, but we have the ability to have more secured debt if we needed to in a rainy day, given that enormous unsecured debt mix. So we're just looking for that balance. We're not really trying to make a bet on interest rates. We don't feel like that's what we get paid for. We get paid to put in place a durable structure, pick great assets, great credits, originate as many opportunities as we can, be very selective, [ weigh ] to good industries, and good things happen when we do that.

Can I just say I'm in a bit of a mission on this. Away from the stocks, one of the most mispriced assets is BDC unsecured bonds. BDC unsecured bonds are investment grade, mid BBB, weak BBB, and they trade like weak BB, maybe high B. [ Space ] trades anywhere all of our bonds, I think, anywhere from 220 over to 320 over. It should be 150 basis points tighter, makes no sense. It's not -- it's just an early market developing. There's a lot of investment-grade buyers that just don't look at them. It's becoming an increasingly important part of the investment-grade bond market. It's a drop in the bucket in the investment-grade bond market. There should be plenty of demand. And we'll see where we are in 2 years, but 2 years at some point, it's going to be 150 basis points tighter.

This is funny one because if you sit in front of the rating agencies and [ have ] the same bucket of loans, same bucket of loans, and you say, here's that bucket of loans, and my advance is here. This is a CLO, AAA, A. You put it in a BDC, same exact loans, BBB.

BBB trading like a BB.

So you end up in a situation where this evolution, it's taking place in the equity market. It will take place in the debt markets as well. But it requires a level of time, education and, interestingly, trust. And a lot of that comes based on the folks that are leading that market and the top of the pyramid.

I think there's a little nuance here, by the way. BDCs can't retain capital.

Well, there's -- but there's a point just as it relates to the underlying [indiscernible].

I got it. But [ that was ] CLOs can retain capital. They get equity. They get cash flow, [ turn off the ] equity. They buy loans at discounts. It's [ self-care ]. BDCs can't do that.

A lender to a BDC has the ability to effectively shut down the cash flows in [indiscernible].

I had a much simpler proposition. I don't have to convince anyone we're AA. [indiscernible] actually BBB, and we trade [indiscernible] like a BB credit. That should be easy enough.

I -- we are BBB, and we should be BBB, and we trade like crap. I would say the good news is the asset class, because it's only 1x levered, it doesn't -- it moves the needle on the margin. It's not like 20 basis points in the CLO is 200, 300 basis points of return.

I want the 20 basis points.

You'll get it at some point.

By the way, the history of markets, it's -- this might -- I mean, I don't think there's ever been a moment where a dollar of unsecured bond and a BDC has ever lost a penny, entire history of market. And because there's a regulatory cap on leverage, it's just not a very levered asset class. It's almost -- go home, try to come up with a model where BDC bonds lose value. It is -- you're going to find it almost impossible to do.

And in the corner case, you can retain capital because you have NOLs, so -- to offset losses. So -- but generally, you can't retain capital.

That's a great note to end on. Why don't we wrap it up here then, and everyone, just join me in a round of applause for our panelists.