Ares Management Corporation (ARES) Earnings Call Transcript & Summary

Good morning, everyone. Thanks for joining us at Morgan Stanley's Financials Conference. I'm Mike Cyprys, Morgan Stanley's brokers and asset managers' analyst. Before we get started, I've been asked to direct your attention to important disclosures on the Morgan Stanley Research disclosures website. That's morganstanley.com/researchdisclosures. If you have any questions around that, please reach out to your Morgan Stanley sales rep. So with that out of the way, welcome to our fireside chat with Ares Management, and we're pleased to have with us, this morning, Michael Arougheti, CEO and President of Ares Management; and Michael McFerran, CFO and Chief Operating Officer. And we also have with us Carl Drake, Head of Investor Relations. As many of you know, Ares is a leading alternative asset management firm, founded in 1997, with roots in alternative credit investing. Today, Ares manages about $150 billion in client assets across a range of investment strategies, including tradable credit, direct lending, private equity and real estate. They also act as the investment adviser to Ares Capital Corporation, which is the industry's largest publicly traded BDC. So welcome, Mike and Mike, thanks for joining us.

Thanks, Mike. Thanks for inviting us.

Great. So I'll kick off the discussion with some questions, and we'll leave some time for investors to ask a question via the web portal. So why don't we start off with the current environment, certainly a challenging backdrop or has been, and continues to be in many respects. So maybe you could just talk about how you guys are holding up? How are your employees and your firm holding up here? And if you could touch upon maybe how you're allocating your time and managing the firm remotely?

Sure, happy to. Hey, everybody, it's Mike Arougheti, and I appreciate you spending time with us today. We were saying before we got on this call, we would've loved to have seen everybody in person. I think maybe to start hitting your question, Mike, obviously, the work from home, remote work is -- has presented certain challenges for people, but I think it's also presented certain opportunities. I think the good news from the Ares perspective is that our transition to working remotely went about as smoothly and seamlessly as we could have hoped. I think that's a kudos to good planning, good execution, part of our ops technology, risk management teams, et cetera, et cetera. Because the transition went so smoothly and candidly, because Ares is kind of purpose-built for volatile markets, the morale across the firm is as high as I've ever seen it. So despite the challenges that we all deal with of just knowing how to turn it off and creating the appropriate boundaries between work and family from a business perspective, we're operating at a very, very high level and in many respects, I think that we're probably executing better than we ever have. Part of that is in terms of how we're spending our time is we are making sure not just that people are feeling supported and equipped for this environment, but that the firm is so heavy on culture and promoting collaboration and integration in any environment. When you get into an environment like this, leaning in on our collaborative culture has been the key and so very early, bring in early March, we increased the cadence of our meetings, we have weekly town halls with all of our employees, we have daily market scrums, weekly management committee meetings. And what that's done is it's frankly made people feel, I think, more connected to each other and to the firm than prior to the crisis. But what it's also done is allowed us to really extract all of the information value that exists at the firm in a much more active and aggressive way. And so when you look at what this market has handed us pivoting from the distress in the liquid markets through March and our ability to share ideas and execute across the platform, pivoting to April and May and June when the liquid markets kind of moved away from us and we very actively started pivoting into the rescue lending business, we're doing that seamlessly, but we're also doing it across the platform. So collaboration between private equity and alternative credit and direct lending, scaling our capital base and really driving the business forward. So I'm incredibly pleased and proud with the way that people have handled the transition. The performance has been exceptional. And so most of my time, and Mike, I think, as well is that we're still managing the firm day-to-day, but we're probably spending a little bit more time than we used to on communication, collaboration and culture. And I'm probably spending a little bit more time than we used to just making sure that we are connected with all of our stakeholders. So a lot of check-ins with investors around all of the co-mingled funds that we have in the market, but also just making sure that we're staying connected and communicating ideas and sharing views with our large investors as well, which takes up a fair amount of my day right now.

Great. And this backdrop here, what would you say you're most excited about as you think about the direction and growth of the firm?

Yes. There's a lot to be excited about. When we've talked before, Mike, about the positioning of the company and our ability to grow organically and inorganically, and we've also just talked about the fact that we've been designed to really outperform in down markets. And so just the fact that we're finally here, despite all of the tragedy and misery out there. The reality is this is the kind of market that most of our investment teams were waiting for. This is where I think some of our competitive advantages around sourcing and information really, really shine through. So things that excite us generally are that the core fund pipeline is very, very strong. And as we talked about on our earnings call, we continue to see real momentum in fundraising, and a lot of that fundraising is occurring around strategies that can take advantage of the current and emerging market opportunity. So that's exciting in and of itself. I'm also excited, as I mentioned, just watching the firm operate cross-platform is pretty impressive right now because access to these opportunities is difficult. So we have to lean in on sourcing, but execution, particularly, at scale, is something that not many people can do. And so being able to work across the platform on some pretty large public and some pretty large private deals has been exciting. And then on the growth front, we continue to execute against all of the strategic growth initiatives that we had laid out pre-COVID. So we're getting very close to completing the acquisition of SSG. We've been collaborating around the integration for the last couple of months and continue to be very excited about the positioning of that business, again, particularly given they're distressed and special sits capability in Asia. We are getting close on our LifeCo acquisition and are very upbeat about what this new market environment means for the future of that annuities platform. And we're actually more excited now than we were prior. So there are a lot of things on the inorganic front that we were excited about, but I think are probably getting a little bit more exciting, given the volatility in the market. And then lastly, as you've seen historically, we believe that in markets like this, we get to consolidate share and generally see some pretty interesting M&A opportunities come out of these types of distressed markets. And while it's still early and we haven't seen the capitulation, that's something that we're excited about because I do think that there's going to be a fair amount of distress here over time that we're going to be able to take advantage of.

Great. So a lot of different areas to dive into there. Maybe first, if we could just kind of dive into the markets here, somewhat suggest equity markets here are pricing in a fair amount of optimism, given the rebound that we've seen. So I guess as you look at the credit markets, what do you perceive as priced in here? And how does that square with your expectations for the overall economic recovery?

Yes. So this is probably the biggest head scratcher. And just anecdotally, I mentioned, we have weekly management committee calls now, which is basically the senior-most people across the firm, chiming in and sharing ideas across strategies and geographies and markets. In most market environments, we have something resembling consensus, but you'll see different teams have slightly different views about the environment or the risk/return opportunity in their respective market. There's a very significant consensus view here that the recovery is going to be a lot longer and more uneven than many think. And that there's a massive disconnect, obviously, just given the amount of liquidity that's been pushed into the market, massive disconnect between the liquid markets and the real economy. And it's hard when you go through the amount of distress that we went through in March, only to see central banks everywhere step in and obviously support those markets. But when you really take a step back and think about what's happening in the real economy, it doesn't really compute. If you look at the Congressional Budget Office, just as a data point, is saying they expect unemployment in December of 2021 to be about 9%. So to be in a situation where the public equity markets are effectively flat on the year, but we're looking at an economy that will achieve, if we're lucky, the output of 2011. There's obviously a disconnect. And I think just a reflection of the significant amount of liquidity that's been put into markets and more comment on that maybe than people's view on the shape of the recovery.

Okay. And then as you look across your portfolio today, maybe you could talk about how you're supporting existing investments and maybe talk about your process around that?

Sure. Look, the good news is the teams across the platform have all been working together for a very long time. So they are cycle-tested and they're cycle-tested together. So when we began to get into the guts of the crisis, the playbook was very well established. The muscle memory was there, and we got through that pretty quickly. So the initial process was, obviously, just to "triage" the portfolio and make sure that you understood where there were immediate liquidity needs, where there were intermediate liquidity needs and where you felt that you were well positioned and able to play offense. And so each of the teams in early March got through that process very quickly and collaboratively with all of their counterparties and came out of that with a pretty good picture across the portfolios as to where the companies were, what the capital needs could be against a whole different set of potential liquidity scenarios. And then obviously, once you had that tallied up, you could then focus on offense. So we got through the defense phase pretty quickly and then quickly moved to offense and offense largely meant being in the liquid markets in March and then largely being in the illiquid markets in April, May and here early into June. Generally speaking, the portfolios are performing well. They were designed to perform, either based on the industry selection, the company underwriting and the capital stack. There are certain pockets where there's a liquidity need. I think we fortunately went into the crisis with about $33 billion as uninvested capital to support the existing book, but also to take advantage of the distress. And so there's ample capital on the platform to support the companies. And the good news is on the credit side, the private credit side, where we have exposures, they tend to be in companies or assets with institutional equity owners. And so the conversation has been very collaborative with those owners of assets and companies as to what the shape and nature of the liquidity bridge is going to be. And they've been largely collaborative and constructive. I'm not going to say that there haven't been 1 or 2 that have been a little less constructive. But I think, generally speaking, people are supporting our assets in their companies, and it's given us an opportunity to either bring liquidity into those situations at a very high rate of return and/or reopen the pricing and then structure a lot of those underlying securities. So the good news is when you're bringing capital into your existing book, you get to kind of rerisk and rerate the entirety of your exposure. And so you do come out of the other side of this with a much stronger book from a structural standpoint. So we're working our way through that as well. But you could see it in the publicly announced information around the mortgage REIT and the BDC as analogs. The payment rates have been very, very high, speaking, I think, just to the collaborative nature of the conversations, but also the strength of the underlyings.

And now that we're most of the way through the second quarter, what kind of covenant breach activity are you seeing broadly across the industry or in your own portfolio? And what sort of expectations would you have for defaults and recovery rates to cycle?

Yes. So we can't really comment on our existing book, but I'll kind of echo, what I just said, which is we're pretty pleased with the performance of the portfolios, and the borrower behavior has been constructive. We've seen a lot of capital injections coming from equity owners to support companies, and we've been able to go in and restructure covenants and definitions and reprice loans to our benefit. And that's been a pretty, pretty big positive. Our portfolio -- I'm optimistic, cautiously optimistic for the June payment period, at least, within the Ares portfolios, based on the conversations that we're seeing. I'm a little less optimistic market-wide. And when you look at the government aid programs, they've generally been structured to get us through June and July. And after that is a big question mark. And so looking across the industry, whether you're talking just about payment rates on small business and consumer loans, rent payments, mortgage interest, there is a little bit of a risk that people are underestimating the level of distress in the small business and consumer landscape, absent the government support. And that could obviously have a meaningful ripple effect through the system if the payment rates don't come through. So that's what we worry about. We're not seeing it in our book, but I would imagine that it's in the system, and it's just something that people need to keep an eye on.

And in recent years, we've seen a meaningful increase in the covenant-light issuance. What sort of impact is that having, if at all, on the marketplace today in terms of maybe delaying inevitable defaults or other sort of impacts, if any, from covenant-light -- what are you seeing?

Yes. It's very interesting because historically, covenant-light did not underperform covenant-heavy. And I think that there was a view that the amount of covenant-light was somehow an indicator of greater risk in the loan market. My opinion, it was actually just a natural evolution of that market and the institutionalization of that market. And if you actually look at, at least, price action, from a price action standpoint, covenant-light loans have outperformed covenant-heavy loans. And I think that's generally a reflection that higher-quality borrowers get to issue covenant-light and lower-quality borrowers get to issue covenant-heavy. And so if you're a covenanted loan in the liquid market, you're probably a lower-quality credit. And so you're actually seeing that play out. But I think, more importantly, in terms of what it means for this market in this environment, this is all about liquidity and when you look at the covenant-light loans and if you really dig in and look at the models underpinning the structure of those loans, these companies are running out of money before they actually trip a covenant. And so perversely, they're coming to the table anyway in the absence of covenant default just because of the depth of liquidity crisis. And so even in the small amount of loans where we are covenant-light, we're getting to the table because the equity below us is having to come and proactively think about their capital structure, either to bring in equity, bring in debt and restructure covenants, et cetera, et cetera. So the way it's playing out is it's actually not really relevant. It's more about liquidity than it is about covenants. But because of the extreme focus on everybody's liquidity, we're actually having a lot of productive conversations across the board, even in the absence of covenant breaches, which is actually a pretty healthy phenomenon.

Okay. And maybe shifting over to deployment. You touched upon this in some of the earlier questions at a high level around rescue finance. But just hoping to dig in a little bit more in terms of where you're seeing some of the better opportunities today to put capital to work? You have about $33 billion in dry powder. What areas are you also avoiding as well?

Yes. So I'd say, generally, 2 general comments, harder to price equity risk than credit risk today. So not surprisingly, more active in the credit markets, up the balance sheet than in the equity markets. And it is harder to price risk in the most impacted sectors. So we're not realigning those sectors. But obviously, we're much more cautious and measured when we're looking at kind of ground zero impacted industries. The bulk of what we're doing is it's kind of generally rescue lending, and that can take a number of different forms. One is, for example, in our alternative credit business, where we're lending to assets, not companies, we've been very active as a liquidity provider into portfolios of assets or in support of other managers who got crosswise with their liability structure. So that could be partially terming out someone's repo financing. It could be doing a term takeout of the warehouse line, things like that, but a lot of structure around portfolios of assets. And there are pockets of the market that have not benefited as much from the government support programs like CMBS market, RMBS market, certain segments of the ABS market. And so they've been pretty active with rescue loans to portfolios. Across the special opportunities in direct lending landscape we've been very active on rescue loans to companies, and that's either companies in the portfolio or outside of the portfolio. Obviously, outside of the portfolio requires a little bit more work to underwrite, but we've been very successful on deployment into that market. And then on the direct lending side, a lot of what we're doing is either bringing capital into the existing book, as I said, at higher rates of return, that also improved the existing embedded credit or bringing capital into companies that we had a historical relationship with or a sponsor that we had a historical relationship with that's coming to us to provide liquidity into a company that we're familiar with by, maybe, opening up an incremental basket or doing a partial refinancing in existing capital structure. So the flavors are slightly different, but the general theme is, what I would call, rescue loans or liquidity backstops or bridges. And I think that's going to be the investment opportunity here for the next little while. The new buyout activity is quite slow. There's some green shoots as people begin to think about a recovery and what a recovery might look like. We've done a couple of deals in very clearly non-COVID-related industries, like life sciences or software and technology. So there are some opportunities to deploy capital into the new issue market, but that pipeline is obviously not what it was pre-COVID.

Great. And just given the sort of momentum here that you're having with fundraising you mentioned earlier and this deployment backdrop, how should we be thinking about what sort of fee-related earnings growth this could translate into? And how would you sort of quantify or think about what the downside level would be on fee-related earnings growth, say, if the deployment is not as robust or if fundraising probably may take longer to play out or if there's more expense uplift?

McFerran, do you want to take that one?

Sure, happy to. Hi, Mike, and hello, everyone. Mike, I think as you recall from our first quarter earnings call, we said and we reiterated that we expect we'd be able to grow fee-related earnings this year at 15% or more. So us effectively reemphasizing that, we have strong conviction about it. And there's a few reasons about -- for that. First, if you just take a look at first quarter -- first quarter's FRE was up year-over-year, 31%. It had grown sequentially from the fourth quarter of '19 from 5% and which if you annualize that number, it's 20%. So I think we started the year with a much higher run rate of revenue than we had during the full year of 2019. So if you just annualize that number, you have growth built-in. As we've talked a lot about in the past, our management fees are not only recurring, but we think very durable and stable insomuch as they're, we think, nicely insulated from market volatility. Most of our capital is not subject to redemption, most of our capital is in illiquid assets, on our private funds our management fees are predominantly based on committed or invested capital. So that insulated nature of our management fees means we don't see a lot of headwinds against them. And then if we look at the growth of them, we have what we already are generating today compared to last year. Second, we've talked about AUM not yet earning fees, which is not an insignificant amount. Because if you think about the life cycle, the majority of capital we raise, we get paid on as it's invested. So in a year where there's a lot of fund raising occurring, it's actually less impactful to the management fees and FRE of that year, it's more impactful to future years as we're replenishing the AUM that's not yet earning fees and every day that we put $1 out there, we're migrating AUM that's not earning fees to fee-paying AUM and management fees going up. On the expense side of the equation, we did mention a couple of quarters ago that with continued scale of the business, which you've seen through our margin, that we felt that this year -- this is 2 quarters back, I mentioned this year, we thought we would grow expenses anywhere from 5% to 10%. On this last call, I mentioned that I thought expenses for the year or G&A expenses for the year would likely be flat to down compared to 2019. And a lot of that's a function of reduced spends on things like travel, today's conference is a great example. Mike and Carl and I are able to participate with you, but didn't require Carl and I to get on a plane to New York or say anywhere else and stay in hotels and all that. So we are actually experiencing a fair amount of G&A savings by working remotely, which is also complementary. And while I hope that's not a long-term recurring phenomena, I think, the overall driver of FRE is controlled expense growth, whether we're in our offices and traveling or not, coupled with the nature of our revenue progression, which is really linear. The other thing we've talked about in the past, as you know, is for so much of what we do, the expenses to drive our activities usually front-run the revenue. And I'll give one simple example of this to illustrate the point. A couple of years back, we talked a lot about how we had built out this really, what we consider best-in-class, special opportunities team, included hiring Scott Graves into the firm and when that -- we've built out this team of almost 20 professionals, this team was very additive to us from -- and complementary to our investment capabilities, but didn't actually come with a dollar of revenue. So that was just all expense borne. Now we're raising the fund around that team. That's going real well. The team is deploying capital. So now there's revenue, but that revenue is following the expense. And that's so much of what we do is we invest in our businesses, we invest in new strategies, adjacent capabilities, and then the revenue follows. And that's also a big part of what you see in our margin expansion, which, as you know, is 34% for the first quarter, up from 30% a year earlier.

Yes. So Mike, just the numbers, which we keep talking about is on that AUM not yet earnings fees, is close to $200 million of corresponding potential annual management fees just from deployment of the AUM that's already on the platform, which are earning fees. Yes, so that's a pretty -- obviously, a pretty significant number expressed as a percentage of the existing revenue.

Great. So you guys see continued growth in FRE, and you're also talking about the uplift in margin. Certainly, you've made significant improvements on the FRE margin. I still get a fair amount of questions from investors around the fact that it's a little bit lower than peers. I guess just looking out, say, 5 years or so, is there anything different would you say about your business that could result in a different margin looking out multiple years? And how would you sort of quantify any sort of differential that should exist in your view, if at all?

I think there's a few things. One, frankly, I think, a high-growth business like ours operating today with a 34% margin is actually pretty good. I don't want to be defensive at all about the margin. But I think the margin is an indicator of scale and efficiency, but what's most important to us is growing the firm the right way and FRE growth. And as we do so, the margin follows. And you've seen that. A couple of years back, we were operating in the high 20s. And we've moved that to 34%. And again, a lot of that -- the example I gave with our special opportunities business, there's a lot of examples like that. I think, at Ares, one thing that's unique about us is we continue to invest thoughtfully, but meaningfully for the long-term growth. And if you look at our growth over the last, whether you measure 5, 10, 15 or 20 years, it's consistently followed that. And I think that long-term approach of continual invest, not just for the short term, but invest for the tomorrow, invest for Ares 2025 and beyond, is really key for that long-term growth and continues to benefit us. If we weren't investing as much for tomorrow, I think, as just a core recurring business, we're operating at a much higher margin. Second, Mike just touched upon the numbers for the AUM not yet earning fees. Well, as that -- as Mike said, that capital has already raised, and the expenses related to the raising of that capital have already been borne. The investment team is already in place to deploy that capital and they're doing so every day. The non-investment teams to support the functions to make all that happen are already in place. So as we continue to deploy capital that we've already raised and it adds to management fees, those management fees are coming on, obviously, at a much higher margin than we're operating at because we've already borne the cost related to it. So that's why you keep seeing the margin tick up. Third, when you undo the compare and contrast to our peers, I think, there are some subtle differences. Our FRE, which is the revenue component of the margin is, again, driven by management fees. And there's really no transaction fees built into that. I think that's very relevant because the nature of our revenue in our margin is recurring and long term and subject to far less fluctuation. And I think you may see in the revenue profile of what's included in an FRE in some of our peers, a lot of them have heavy transactional-based fees, a lot of them include some incentive fees in there. So I think there's a little bit of apples and oranges when you look at the industry. When I've looked at our numbers and I looked at it more on a segment basis to some of our peers, I think, our actual operating margin is more in line than the kind of the aggregates some of the parts would imply.

Okay. Great. And almost just about out of time here. So just looking at the webcast. Some questions here on M&A. So maybe we'll just leave it with an M&A question. You, certainly, guys been a little active on the M&A front. So twofold here. One, what's left would you say from a capability or a distribution standpoint that could make sense for Ares today? What are you thinking could be the most attractive? And then also, maybe you can just refresh us on some of the capabilities that you're bringing over to Ares and the time line for some of these transactions to close on deals that have already been announced?

Sure. So the good news is we're closing a lot of the gaps, if you will, in the product set, the capability set and the distribution. And so you've looked at the things that we've done, whether it's the SMBC partnership, the development of our partnership with Challenger and Fidante in Australia, the acquisition of SSG and Aspida, growth in the Asia region was a core strategic priority of ours and SMBC, SSG in Australia now give us a pretty meaningful set of tools and capabilities to continue to build from. So we've kind of checked that box. And as I mentioned, timing-wise, I would expect the SSG transaction to close at the end of this quarter, not very early in next quarter. And Aspida again, I think, is kind of in a similar time line. So we don't have that many gaps yet. And to Mike's point, even using the opportunistic credit example, as we've gotten larger, we are finding it easier to build businesses organically, either by lifting out teams or lifting out teams in portfolios and then adding value to them on the capital raising and information and advantage front. So the bar for M&A is getting higher, as you would expect it would. The places where I could perceive a need would be largely around the real assets part of our business, broadly defined. So that could be either bulking up the size of our real estate business or broadening out the product offering there; or two, bulking up or broadening out the infrastructure side of our business, which, I think, as folks know, is largely focused in and around energy infrastructure and specifically about -- around renewable energy infrastructure and renewable technology. So there's probably some things to do globally around both real estate and infrastructure as pockets of need. But other than that, I mean, I actually think that a lot of what we see as growth opportunities for us already reside on the platform. It's just a function of executing well.

Great. I'm afraid we're going to have to leave it there. We're out of time. Mike and Mike, thanks so much for joining us today.

Thanks for having us, and it's good to hear your voice, and stay well, stay safe, and hopefully, we'll get to see each other in person soon.

Great. And everyone, please join us for our next session in about 25 minutes as our lunch presentation is starting at 12 noon. Thank you.