Ares Management Corporation (ARES) Earnings Call Transcript & Summary

Okay. Thank you very much. Good afternoon. Welcome back. Hopefully you guys have been able to grab some lunch. I see some plates out there, so it's fantastic. My name is Bill Katz. I am the asset manager and retail broker sell-side analyst. I also covers the group. On behalf of Crédit Suisse, excited that everyone came out to our 24th Annual Financial Services Conference forum. This is our first year on the Team. So we're super excited. We don't cover Ares at this point in time, but we've gotten to know the company a little bit, and they were generous enough to come on down and do a fireside with us. So we're super excited to hear a little bit more and the story. From Ares, we Jarrod Phillips, who is the CFO. We also have in the audience the strong IR team, Carl Drake is here, who was just telling me he no longer works on the sell-side. So thank you very much for that. Greg Mason and also [ Karen Rod ]. So gentlemen, thank you so much for coming today. Ares was founded in 1997, is a leading asset manager. As of the end of the year, about $350 billion of assets under management. The firm has grown rather dramatically over many years, both de novo and through acquisitions to help support expansion beyond credit into real estate and secondaries as well as continued leadership position in the private credit area, feeling what's been significant growth to the credit franchise overall. And Jarrod joined by 2016, if my notes are correct, and he's also the CFO of Ares acquisition Corp as well. So first of all, thank you very much for coming. Nice to spend some time with you. And if anyone has any questions, we'll try and get a microphone around, a pretty small room. So try and keep it somewhat intimate despite the microphones and the lights.

So first question, maybe big picture a little bit. Obviously, big footprint, see a lot of different things going on in your portfolio companies. Can you give us a sense of what you're seeing in terms of inflationary pressures. Obviously, we've got CPI number today. That was relatively in line with expectation. But what are you seeing in terms of inflationary pressures or growth or maybe even some of the asset quality trends?

So what we've seen in both the credit and actually in the private equity portfolio as well as EBITDA growth year-over-year. So while we have seen inflation, we're aware the inflation pressure is at our portfolio companies. They have been able to, let's say, pass some of that through and continue to grow EBITDA. In both direct lending and our private equity, we grew about 9% year-over-year in EBITDA. So we continue to see strong growth there, and that was combined in the credit portfolio with strong interest coverage and LTV is around 45%. So overall, while we certainly aware of inflation and we see it happening. The industries that we invest in and the areas where we specialize, they have been able to successfully navigate it and still grow despite the macroeconomic environment.

Great any signs of stress that you're seeing across the portfolio?

No. Ultimately, that's -- all those data points lead to a pretty strong portfolio. Now the thing to always step back and really zoom out when you're talking about credit is we invest in the top half of the capital structure. So when I'm talking about LTVs of 45%, that means there's 55% of equity underneath it or mezz and equity that's underneath it. So what happens in a time like this is you see interest rates rise. You have the rising EBITDA to go along with that to cover some of those cash payments. But in the event that you're having more cash and liquidity pressures, what really happens is there's a transfer of value between equity and credit. So while the interest rate increases being normally one of the sole lender or the only person in that position or the lead, it allows us to negotiate with those portfolio companies should there be pressure and say, hey, well, here's the cash level yield that we can go with and we'll take the rest and pick or do some other sort of equity transfer noncash change that allows us to continue to support our portfolio companies, allows them to continue to service their debt and actually provides attractive economics in the long run.

Okay. It's a consistent theme we've been hearing for the couple of days we've been doing this. Okay. So maybe another big picture question, then we'll dive into Ares in a moment. Just given your breadth, it's always great to hear what you're seeing as well. There's been a lot of delay in terms of fundings through 2022, just given the market volatility, uncertainty with interest rates, the macro backdrop more broadly, the denominator effect, pick your boys along the way. As we're working into 2023 now, any shift in allocation trends that you're seeing? And then how might that influence what's happening for the Ares footprint?

Sure. We've certainly heard of the denominator effect, and we've seen it, but not so much experienced it. So the denominator effect has largely been in the private equity side, and we haven't had a sole private equity fund out in the market over the last couple of years. Ultimately, what we've seen is investors who understand the vintage of private credit that they're at right now that we're at right now and they've been very interested in continuing to deploy into that market, so continuing to invest with us. We've been very happy about that. I mean if you go back to when I joined and maybe go back even a little further, I think private credit has become more and more popular. It's become more and more understood as the risk that you're getting paid for ultimately when you do it. And it does sit right in the middle of your investing allocations. So as interest rates go down and people are looking for a higher yield, they migrated over the last couple of years to private credit. That allowed more investors to come into private credit. Now as interest rates have risen and we're seeing a vintage where 10% to 13% returns are common, you're seeing investors maybe change their allocation from private equity into private credit. So sitting in between those 2 bands has been very valuable. And our investors certainly have understood that. And as more people have allocated to private credit, we've been a beneficiary of that. So in terms of our fundraising outlook for the coming year, we have several of our larger commingles in credit. We feel very bullish about this, and we're excited to have those out there. And I think that the rest of the portfolio has also been equally strong. We will have a private equity fund that is currently in the market. We'll probably have a close later in the year, but we're excited about that one as well. However, based on the business, as you've noticed -- as you've noted that we're highly focused on credit that one private equity fund doesn't make or break the success of a fundraising year.

Right. Understood. Okay. Maybe just turning to some of the Ares opportunities to give the sort of the lateness of this kind of question. But on your 2021 Investor Day, you laid out what seemed to be your ambitious goals but nonetheless, here we are, and you're moving along very nicely. We laid out a goal toward $500 billion of AUM. It doesn't feel quite so far now -- sorry, not all the way there but certainly on the way as well as 20% annual growth in FRE and in a similar type of growth rate in the dividend as well. So can you help us unpack a little bit, maybe start with the AUM of how you sort of take that glide path from here to there? And where do you see the best opportunities?

And if you just take a look back at 2022 and what we did there. So we said in our most recent earnings call that we expect this year 2023 to be more like 2021 and approach the record number that we had there. 2022 was a little bit more of a quite year. We didn't have a large number of our biggest commingled funds. In fact, really the most significant commingled fund we only had one in there, and that's our special opportunity is our second fund there. . If you look, we did $57 billion against $77 billion in the prior year, but that's $57 billion without having a major fund beyond ASOF II out there, which, by the way, it actually started in 2021 and had its largest bit of fundraising there at the end of 2021. So that gives us kind of a good feel for what we can do without those major flagships out there, that $57 billion number. So this year, we have 7 of our largest 10 that we'll be fundraising -- 7 of our largest 10 fund families that we'll be fundraising this year. Now those won't all start and finish within this year. There will be some that start this year and finish 12 to 18 months later. But when you take a look at that and you just take a look at 2 of the largest, our sixth European direct lending fund and our third senior direct lending fund in the United States, the prior vintages together were $30 billion. So when you take that $57 billion and then you think about things like, okay, 2 of our very largest funds coming at $30 billion coming into the market, plus another 5 of the largest -- of the 10 largest families, all of that gives us a really clear picture of what we could do over the next 12 to 18 months. And by that time, you're only about 6 months away from the end of 2025. So I think when you kind of look at it that way and you see how our successive vintages have performed and then raised, that's what gives us a lot of confidence over that number.

Great. And then tethering that to -- actually, before we move on, let me just ask a couple of questions here. Will always multi-vector growth opportunities, it's hard to sort of now announce so a few questions in 40 minutes, so I apologize for thinking I'm trying to think on a fly here a little bit. In some of the growth here, the 2 flagship funds that you mentioned, where do you think you are in terms of the J-curve for successive funds being larger than the predecessor fund. I appreciate you may be in registration perhaps, and you can say specifically, but directionally, how we think about bigger funds from here?

As you go to those larger-sized funds, I think you definitely compress and I typically think of things in the 1.2 to 1.5, even up to 1.8 or 2 in certain circumstances, times the size of the prior vintage. Now that frequently happens when we go from, let's call it, a $2 billion fund to a $4 billion fund. You're exactly right though, as you hit those larger-sized funds as you're talking about a $15 billion fund, it's -- a lot of people have given you their kind of full allocation. They've given you their $500 million. That's not going to really grow. So I expect that -- we still generally expect growth, but we don't expect it to be at that 1.5 to 2x level. Generally, where we're going to be in is that 1 to 1.2x. Now the unique thing is -- and I think it's important to think about it. The industry has always thought about things in the private equity sense, which is, you raise a fund, it's paid on committed and then it steps down its fee when the next fund is launched. Credit, actually, the focus is more on your deployment because we get paid on deployment. So when you're thinking about it, you really want to be able to raise, close and deploy the fund and raise the next one. Because when the next one goes online, you don't stop paying management fees and you don't reduce your management fee on the prior fund. So that stays out as long as the underlying portfolio exists. So really, it's as important in credit that you have a good deployment pipeline, the ability to deploy as it is that you have larger successive funds. Now still we have -- we certainly have equity style funds. And there, we do focus on, okay, we want to see sequential growth. But there are times where it makes sense to just launch a fund and build the next fund right after it. That being said, we're very excited about the next vintages here, and that's not something that we're looking at.

Right. Got you. Okay. I want to come back to the FRE growth in a moment. But the question I have now is that there's many of your peers are in the market raising capital. And obviously, these are very seemingly doable, but nonetheless, you have a lot of competition out there and still some uncertainty. So when you think -- when you step back and you think about the business model itself, what are the 2 or 3 factors that really differentiates Ares? Obviously, a lot of folks are getting into private credit, you were early. You sort of recognize that powerful theme, but a lot of competition is out there and they will try and raise capital as well. So how should we think about that?

Again, maybe taking a more macro view of the platform, specifically within credit is we have an executive team that has been together for a very, very long time. We have had minimal turnover across that team. These guys have worked for 20-plus years together. We just celebrated, as you know, our 25th anniversary. And a lot of these folks have been together for that entire period. A lot of people joined in 2004 when ARCC was launched. And so we have an extended track record with those actual employees being in seat. So they've navigated through different market environments. They understand the underwriting process, the origination process, and we train that next level of employees with that in mind. And so that -- and we have the largest footprint in terms of employees indirect lending. That is a pretty large moat to get over because those people have built sponsor relationships. They've built company relationships. People know what to expect if there's a problem when they're dealing with us. And that can't be undersold how important that is when they're making a borrowing decision because they want to go with a borrower that's not going to knee-jerk, have a reaction at a first sign of trouble. They want a partner that will help them work through issues that will help them succeed ultimately. They don't want to see their loan sold off to another person or another company when there's the first sign of trouble. So having that long history of being able to work with sponsors, being able to work with borrowers and really create long-term relationships is something that I think that's a very strong moat.

Okay. When you -- you didn't mention performance in that. Obviously, I think it's implicit to the tenure of the team. Having gone through credit cycles is pretty robust underwriting standards, if you will. When you think about that -- any sense of how you sort of foot up against some of the other peers that are out there? Or does that matter at this point in time? Or is it more protection of capital, if you will? Or both?

I think it's probably a little bit of both. I think when we go in and underwrite, we know what we're willing to underwrite it at. We don't try to compete on price. We -- and we've definitely seen people come in and they might compete on price, but that's going to create a performance issue down the road. So we know that we need to deliver both to the LPs and to the sponsors in terms of a partner that they can rely on. So having a deep experienced team that understands how to work with the sponsor understands how to work with the borrower, but then can deliver those returns to the LPs is important. At the same time, we've seen other people come in and try to win maybe on the LP side and cut their fees there, but then not be able to deploy because they're not able to underwrite to originate. We've then -- we've seen actual LPs that have said, well, we went to this party, and now we're actually -- we're going to come to you because we believe you can deploy. And so there's an importance in the ability to have all those relationships and to be able to deploy into that private credit market that matters, too. An investor doesn't want to make a $2 billion commitment and then have that just sit there as they're waiting to deploy it because that's a drag on their own returns. So there's 2 sides to it.

Right. Within the direct lending footprint, how important is origination capability distressed and/or private equity ultimately either support the upfront origination process what you're just talking about or haven't [ bid ] something where you go sideways a little bit, the ability to sort of work through that model and sort of retain -- minimize the net losses at the end of the day?

Yes, I think if you look at what we call our portfolio management group, that's the group that does that. And if people are interested, they can go to our ARCC investor deck that we put out over the summer that walks through what that group does and how they do it. It is absolutely vital to the success of the franchise and to the returns, as you've mentioned. The ability to work out with the company once they've gone into defaulter, once they're experiencing financial difficulties that's one of the main drivers of outperformance in the long term. What happened back in the credit crisis is when you had assets and liabilities mismatched. As soon as a borrower have difficulty and the lender would then have to sell it because they didn't have that right match, that's when you saw these distressed sales going at pennies on the dollar that people were really able to take advantage of. . So by having long-term locked-up capital and by making sure that our financing duration matches our asset duration, it allows us to spend time focused on those companies to manage through the difficulty. And you'll see there -- when you include equity, not just defaulted loans, but we actually have a gain overall on the portfolio whenever we've held equity. So it's definitely been something that's worked to our advantage over the long term. And it's, I think, really an important part of the value proposition.

And does that -- that value proposition, does that resonate with the LP base when they look at selecting Ares as sort of the mandate versus one of your competitors?

I think it does. I think it does because it goes into your long-term steady returns. They know it's a return number that has been through cycles, cycle tested and they see the end results.

Great. Maybe we can circle back to just the other part of the equation, so the earnings growth. You already operating at a pretty high margin. But what's the building block for the 20%? I think you've been exceeding that, but what's the building block for what seems to be a conservative 20% at this point in time for FRE growth?

Sure it's -- a lot of it has to do with what we talked about in terms of when we begin to earn fees. So as we look at the funds that we're currently raising, frankly, the funds that we've already raised as well and as we deploy those funds, that gives us an excellent line of sight to what management fees will be. So that we know the offset is primarily compensation in a small percentage of our G&A. So looking at that base that we're building off of and then thinking like we just talked about, okay, my next fund series is going to be somewhere between 1.2 and 1.8x the size of my prior vintage that then knowing when that should occur, when in the life cycle we are for those funds, we can map through all of our funds and say, okay, here's about when we expect to launch. Here's the deployment pipeline that we expect to put in place. Here's when we expect to earn those management fees. And then obviously, here's what we expect our headcount and comp growth to be that works with that accordingly. So I'll remind you, again, we have to hire ahead. So the expense is always front run the revenues, which creates a bit of margin compression that then expands. But when we raise a larger credit fund as a predecessor fund, in order to have the right originations, we need to be able to write -- we need to be able to underwrite more. So we underwrite right now a tremendous amount of loans, but we only originate 4% of this. So if you say, okay, I've raised now a fund that's 1.5x the size of the prior vintage, you have a choice. You can either originate 6% or you can view more loans and you can view more companies. Ideally, we never want to move above that 4%. That's -- you don't want to make a credit decision in order to fill the fund. You want to make the right decisions that you believe in for your returns, as we mentioned earlier. So that means that we need to have more bodies to look at, more companies to be able to do more underwriting, which leads then to your increased originations, but your relatively stable percentage of loans muted that you've originated.

Got you. So just to make sure I understand it. When you say originate, so 100 loans come in you're taking 4? It's not like you're underwriting more and then you syndicate out some and you're sticking with 4 -- just 4?

That's right.