Ares Management Corporation (ARES) Earnings Call Transcript & Summary

Good afternoon. My name is Patrick Davitt. I'm the U.S. asset manager analyst at Autonomous. It's my pleasure to welcome Ares CEO, Mike Arougheti. Congratulations on 10 years of being public.

Thank you.

And thanks for coming. As a quick reminder, if you want to submit any questions, you can do it on Pigeonhole, and I'll try to work them in as they come up on my iPad here.

So Mike, maybe to start, given we have most of the public alts here at this conference, I'm starting all these discussions with some higher-level questions so we compare and contrast easier. So given your position as one of the largest credit managers in the world, private credit managers in the world, I think it's best to start with macro. I'm sensing some increasing concern that a sticky inflation, higher for longer, slowing economic growth environment could be particularly bad for levered risk assets. Do you agree with that view? And through that lens, what is your outlook for inflation rates in the economy with a summation of do you believe we've achieved a soft land here? It's a big question.

Sure. It's like a big part question. Good to see everybody. So maybe let's -- we'll go backwards first. I would say we have a portfolio of 3,200 middle-market investments. So we do think that we have a pretty good lens into the state of the economy, health of consumer in the U.S. and Europe and, to a lesser extent but growing, in Asia. And I would say -- and we've been consistent on this for the last 2-plus years. Everything that we're seeing in our portfolio would indicate that the economy is still quite robust. Albeit growth is slowing, we're still growing. Consumer is largely healthy. We could poke around on that if you want a little bit later. And the fed is accomplishing its policy objectives for the most part, when you look at where CPI is and how the system is held up. So we're feeling pretty good about what we're seeing. Just by way of example, if you look at our private credit portfolio in the U.S., last quarter, we said that we grew EBITDA 10% year-over-year. In our European portfolio is we grew it about 13%. Our U.S. buyout portfolios, we're seeing year-over-year growth in the high teens, low 20s. Our real estate portfolios are similarly showing strong fundamental performance. So there's nothing to indicate that weaker growth is imminent. In terms of higher for longer, our base case is absolutely higher for longer. I think that's a function of stickier inflation, tight labor market and just fiscal policy. And what it means for risk assets kind of depends. And I think we have to be clear that when we're talking about credit, most of the private credit investments that we have are supported by some form of institutional equity. And so while we've seen debt service ratios come down generally into the high 1s, 1.7 range, they're sitting at very low loans to value across the corporate book. So most of our private credit instruments are below 50% loan to value, which means that you have significant equity subordination. That doesn't get talked about enough because when you're saying, where is the pain and you get felt? In levered risk assets. It's really -- it's an equity issue, not a debt issue. The debt side is obviously the big beneficiary of higher rates. And one of the benefits of private credit is, when rates are higher for longer and there's a need for any kind of a loan modification, you have a bilateral negotiation with the equity and you effectively get paid more to preserve optionality for the equity. Default rate are still really low relatively to historical averages. We've seen them stabilize, if not go down. So yes, we're feeling well-positioned.

You mentioned real estate, and I sense some investors are starting to worry more about things beyond office, which you and others obviously have a more exposure to things like multifamily, industrial. So can you speak to what you're seeing in those pockets, which are obviously much larger exposures for most of the alternative managers? And are you experiencing any slowness there?

So it's similar to what I just described, largely in corporates. Fortunately, we're underexposed to office. About 1% of our equity portfolio is in office. The remainder is in our high-conviction sectors of industrial and multifamily and then what we call specialty sectors, student housing, self-storage, single family for rent. So underexposed to office by design. And if you do put office to the side, we are seeing very significant strength in the industrial and multifamily book. Just to give some perspective there, occupancy rates in our industrial portfolio is in the probably 97% range. In our multi portfolio, it's somewhere between 95% and 97%, depending on the portfolio that you look at. we're rolling over new industrial leases, about 45% up from prior. Our commercial exposures, we're rolling over leases up about 25%. And in residential, call it, low single digits, 3% or 4%. So I would say on multis, still growing but slower growth. But in terms of the industrial experience, we're still seeing some pretty significant tailwinds.

Great. So moving to credit. I'd be remiss and not pointing to Jamie Dimon's comments this morning. They're getting a lot of press. I think he mentioned that he sees some bad lenders in private credit, and there could be "hell to pay" if the broader private credit world sours. He also had some complementary things to say, but the press is obviously ignoring.

About who?

Not You. Although I'm sure he was talking about you. To that point, I'm sure he thinks you're one of the good and smart players, but seems to think there's irresponsible behavior happening elsewhere. So are you seeing that? And if he's right, is there a risk that these bad apples kind of spoil the party for everyone else?

I don't think so. Look, I respect Jamie as one of the greatest financial service executives that's ever been in the business, continues to demonstrate that day-to-day. I don't know where the narrative of private credit banks has really kind of emanated from because the reality is, and I don't know if he said this, we're one of their largest clients and have been, and we continue to grow with them. And if you really think about what has happened over the last 20 or 30 years, because of the structure of bank balance sheets and because of the regulatory capital framework, appropriately, certain types of risk assets have left that system to find more natural holders of risk. And that's just the nature of capital markets generally. We've been in the private credit market for 30 years. We've probably put out a couple of hundred million dollars in a couple of thousand investments. Our loss rates have been, I think, 11 basis points. We do it with a higher margin and a better efficiency ratio than any other structure in the market. So this idea that the asset class hasn't been cycle-tested is wrong. And the idea that there's risk in the private credit market that doesn't exist elsewhere, I also think, is wrong. Because what it comes down to for me is a loan to a private company is a loan to a private company, a loan to a consumer is a loan to a consumer. And the argument needs to be made like where is it best held. And when you want to talk about systemic risk or structural risk at the end of the day, if you're managing a 10 to 15x levered balance sheet as a bank or insurance company, credit underperformance has a much more material impact than if you're doing it in an unlevered long-duration institutionally held private fund. That's not to say one is better than the other. They're just fundamentally different. So based on everything I see and some of the comments I made earlier just about where these loans are positioned, who they're made to, how much equity is in the system supporting these loans, I do not think that there is undue risk in that part of the market relative to other parts of the market. With regard to bad actors or bad apples, look, the reality is we had some poorly managed banks that have been quite visible in their mismanagement over the last couple of years. That doesn't mean that every bank is bad, the same way that you will see dispersion results in the private credit market like we've seen in every prior cycle. But I don't think that those bad -- I don't -- I wouldn't even call them bad actors, just bad investors are not going to spoil the bunch. And the reason they're not going to spoil the bunch, the private credit markets are still very concentrated in terms of how the capital is getting raised and deployed because scale drives performance in private markets investing. So if you look at the top 25 private credit managers over the last 5 years, 60% of the capital is raised by them. So if you say then 40% of the capital has been raised by the other 975 managers that raised their hand and say they're in private credit, you may have some bad performance there, either because of a lack of experience or the quality of the companies. But when you look at it indexed to the whole private market, I just don't -- I don't see it.

You keep coming back to the equity subordination, and I think it's a totally fair point. And all of your competitors say the same thing. So as we think about risk, slowing economies, sticky rates, are you saying basically that maybe private equity might have more of an issue or that the IRR are going to be a lot lower there?

Yes, not to pontificate about private versus public markets, but it's very hard if you're a public market practitioner to kind of understand the way the private markets function, right? And so even when you make comments and I know that came out in some of the earlier panels that mark-to-market versus non-mark-to-market, the mark-to-market is a function of technicals, right? So if you have an asset that is liquid and you have one person that wants to sell at a price, price goes down even if that's not reflective of the intrinsic value of the asset. In the private markets, you have willing buyers and willing sellers, but most people are coming into these capital structures with a long-term view around intrinsic value and value creation. And so it promotes stability at the end of the day, and the equity is not forced to sell. So what's happening in private equity now is even though the valuations are lower in theory, there's no forcing mechanism for anybody to take a loss. So what winds up happening is if someone bought a company for 15x cash flow that's now worth 12 and their cost of capital just doubled, they go to their loan provider and say, "How do we actually get this company back to a place where we can reinvest in growth?" Because collective value creation is for the benefit of everybody. And that conversation looks something like rather than pay you 10%, we'll pay you 14%, but we want to pay you 7% cash, not 10% cash or maybe we're going to go raise a preferred and we're going to pay down your debt and we're going to reduce the cost of capital on the debt and we're going to free up growth. So they are going to this vintage, they will theoretically make lower IRRs than were underwritten but they will get higher MOICs because they're just going to hold these companies longer. And I think people need to get their heads around that because they're staring at these big installed bases of capital, and everyone is wondering like why isn't everybody's hair on fire because it's [indiscernible]. And the reason is there's really not a -- there's not a forcing mechanism and back to why I'm so confident in private credit performance. We're more than happy to support our private equity clients by giving them runway to maximize return, right? That's a win-win. The liquid markets don't give you that luxury because if you have an underperforming company, your bonds trade to 70, 60, 50, 40, someone comes into your [Audio Gap] I think you'll see lower returns, but not realized loss.

On that point, a lot of public BDCs actually make the point that some incremental stress, credit stress and the workout process is actually positive for earnings. Could you walk us through kind of the drivers of that?

Kind of what I just said, I mean, the way that I think about it and this goes back to what works on a bank balance sheet versus what doesn't, any enterprise asset or company has an unlevered cash flow yield, and people are just going to decide where they want to attach to it. Bank regulatory framework forces you to stop investing in a certain risk level. The private markets allow you to capture more of that free cash flow yield, and the private markets have gotten very good at knowing where the risk-return cutoffs are going to be. And so when you get into a period of distress, what winds up happening is you go to the table with the equity owner. They give you equity upside, right, in that enterprise at the top of the capital structure. And so again, if you look at the loss rate that I quoted earlier, the reason that, that happens is even in periods of volatility or distress, everyone's aligned to par. And you have an opportunity to actually get a transfer of value from the equity to the debt in the form of warrants or incremental coupon or fees or whatever it is to give somebody runway to ultimately realize value. And so our experience has been -- not in every case. But if you have patient capital and you can actually -- you have the capability to work out these loans, you can actually accrete beyond par.

One more and then we can move to Ares specifically. I'm hearing increasing concern as the broadly syndicated market has reopened, that there could be like a quality drift in direct lending portfolios as higher-quality companies refi into BSL. Maybe lower quality companies can only get financing from private. So does that mean that the weighted average portfolios are trending riskier, that trade-off? Or how...

No, I don't think so. Again, there's a lot of what I would call misinformation about private credit. Private credit is not there to fund risk that other parts of the market don't want to. It's there to provide some level of flexibility or creativity or structure that isn't available in the public markets, right? In order for the liquid markets to function the way that we all want them to, they have to be quite rigid in the types of risks and structures that work because you need ratings and you need consistency. And once you get into the private market, you have more degrees of freedom to structure and price risk. So people go there not because they can't get financed elsewhere. They go there because of the value proposition of being private. In this moment in time, it's interesting, the pipeline of opportunities that we're seeing is probably higher quality than we've seen historically because the folks that are liquidity constrained are the ones that probably got the most leverage, that are dealing with the most liquidity stress even though their fundamental operating performance is good. And two, they're also the ones that can actually transact at a valuation that works for buyer and seller, right? So both public and private credit right now, I think, are seeing a very high-quality pipeline in terms of the companies that are coming.

Good to hear. So you had a big Investor Day last week. So I want to ask a few questions on that. The big takeaway I heard, from investors at least, was that your 5-year FRE growth CAGR target of 16% to 20% appeared to be at least meaningfully below where consensus is for the next few years. But then you look through all the underlying content, and I think it certainly suggests the growth algorithm is a lot better than that. So how conservative do you think that target is? And I guess, in other words, should we consider it a baseline, that you can be -- like the last Investor Day?

Sure. I can't really answer that other than to say our guidance is our guidance. Obviously, it's interesting when you say I don't -- consensus or not, the guidance that we tried to focus people on is our RI and dividend expectation is to grow 20% to 25% per year for the next 5 years. And there's a lot that goes into the makeup of the guidance in terms of your AUM growth, the trajectory of that growth, the nature of the assets, what your fee rates are. So there's a lot that goes into the mix to come up with that guidance. And I guess we're the victims of our own success. The last time we put out guidance 4 years ago, we said 20% plus, and we did 33%. So people have gotten accustomed to that outperformance. That's not to say that we can't outperform in the future. But I remind people, I can't think of an industry other than ours that actually has the conviction to be able to put out 5-year guidance, right? I mean, you have companies in other industries that are putting out quarter-over-quarter guidance, and they can't hit it. And we're putting out 5-year guidance with a high level of predictability and precision and meeting or exceeding that guidance. So whenever I get into a conversation with you and others about is it conservative or not, 20%- to 25%-plus dividend growth for 5 years, that's high conviction guidance. And if we do better, that would be great. But I think people need to take a step back and understand what that's really saying about the quality of the underlying business, the cash flow and our ability to actually understand it and predict it because I think that's quite unique.

Yes, that's totally fair. Staying on the theme, the underlying AUM target. Underlying that is $750 billion plus. I think we have a pretty clear picture of the strategies in the market this year and next. But I think it'd be helpful maybe if you could frame how you see the mix of your AUM and flows evolving in the more medium to long term? In other words, do you see the mix shifting more balanced away from private credit? Or does the still significant growth remain private credit keep it fairly steady?

I think you'll see some mix shifts. Obviously, private credit is a big component of what we do. And what we tried to articulate at the Investor Day was obviously when we talk about private credit, it's not just middle market corporate direct lending, right? It's infrastructure lending and real estate lending and asset-backed finance and commercial finance and all of those things. And so when you look at the diversification of strategies in private credit, you get a little bit of a different picture in terms of the concentration. It's 75% of what we do. So even as we ramp other parts of our business, it's going to be hard to move away from that. And I would suggest that we don't want to because it's a really, really good business to be in. Two places where we had highlighted growth that will at least shift the mix through the eyes of the public market. One was insurance. And we had articulated that our expectation was going to be that we would grow our affiliated insurance assets to $50 billion by 2028. And we had also articulated that we expected our wealth management business to grow to about $100 billion. So if you said 150 on $750 billion, that's about 20% in those 2 parts of the business, which are -- that will show you a slight skewing of the asset mix versus where it is today.

That makes sense. In that vein, you highlighted the build to kind of a $40 trillion addressable market just for private credit. It's the same number a couple of others have put out there. So I guess it's right. How much of that -- I get this question a lot, how much of that do you think is truly addressable in other words, like will transition from a traditional channel?

Yes. So you have to be very careful, like this is the challenge of being a public company in a market like this or even going back to your questions about Jamie Dimon's comments, news travel is very fast in these markets. People love headlines. So it's like, when are you getting to $1 trillion? Or how big is the market? So when you put out $40 trillion, it's an eye-poppingly large number relative to the size of the market. And no one is articulating that, that all is going to transition. I think what we're all trying to articulate is just the breadth and depth of the addressable market that's available to us off of what is currently a very low market share. The biggest chunk of that market is what we would call the securitization adjacent market or the asset-based finance market. That's probably over half of it. And some of that will become increasingly available through people's insurance businesses. Some of it will be increasingly available through the growth in alternative credit in the private securitization market. But you don't need to see huge portions of this TAM go into the private market, right? If you just say the private credit market today, as people define it, is somewhere between $1 trillion and $2 trillion, right? So if you wanted to sustain the type of growth that we're all putting forward in our guidance, you don't need a big market share gain in that $40 trillion to get the results that we're all hoping to get. So I think it's a very accurate number. It just -- it's a question of how much is going to transfer versus not, but you don't need a lot to come out.

To your point, asset-backed finance, I think, represents a little over half of that number, and you and your competitors are all pointing to this as kind of the next big hockey stick growth opportunity within the broad private credit label. But I sense a little bit more caution from you guys last week, maybe versus others. You expect -- I mean, you're still expecting the AUM to double, but that's only $70 billion through to 2028. So what's driving that more cautious stance on what seems like a -- it seems like maybe that you expect to be a little bit slower.

No. Not quite the opposite. I mean, I actually think we were early in this market. We've been building this business for well over a decade. I think that business was $5 billion Ares in 2018. And so we've grown that business at a 30% CAGR since then, and we put out numbers that would indicate that it will continue to grow at that high rate. So that's not conservative, right? When you're putting out 30% growth rates, that's not conservative. But what's not there is this whole conversation that we're having with the market in terms of what we're calling quality AUM and where you reside in the ratings spectrum. So in most levered capital structures in ABF, you're -- you look at the securitization market, you're going to be taking on anywhere between 3 and 10 turns of leverage. A big portion of that capital stack would be in the high-grade equivalent part of the market at a lower risk-adjusted return and a lower fee. In the non-rated part of the market, which is where we spend most of our time, you're buying the bottom half of the capital stack at a higher risk-adjusted return and a higher fee to your investor. So when we're going from 35 to 70 and doubling that business in the guidance, that's not accounting for all that kind of growth above it, supporting the equity returns that we want to generate. So we could easily go out and say we're going to add $200 billion of high-grade equivalent assets in ABF at 25 basis points, and we do a fair amount of that. But I think you have to, again, think about the AUM growth, where it sits in the capital structure, how it gets feed and what rate of return we're trying to generate. So it's anything but conservative. And I do think that we've established a pretty meaningful leadership position in that market with the depth of our capability, the size of our team. But we are -- think of it as the unlevered piece.

Right. Helpful. I was going to deployment, which is more meaningful for you, given the way your fund structures work. The 1Q call, you talked about deployment trends being a little bit obscured by this refinancing activity, but also that the pipeline is looking much stronger into 2Q. So why don't you update us on how that give-and-take is tracking and when you think, maybe more medium to long term, we could see more tangible impact of that deployment on your FP -- your fee-paying AUM growth?

Sure. Yes, Q1 was an interesting moment in time because you probably had a little bit of a technical imbalance where you had more money wanting to come into the market than there were deals, and so that was definitely peculiar. Q1 is usually a seasonally slow quarter where you see spikes in Q2 and Q4 in normal markets. As an example, at ARCC, which is a good proxy for deployment, we said in April, we did $1.2 billion gross and $900 million net. So the gross to net was more akin to what we're used to seeing and that we had a backlog behind that of about $1.3 billion. What I will say qualitatively is that we are seeing significant momentum building in the pipelines. The deal machine is falling. I think the stability in rates, even though we're not seeing rate cuts, is allowing buyers and sellers to come together more productively around transactions. And so we're seeing that in corporates. We're also seeing it on the real estate side of the business as well. So our thesis coming into the back half of the year, which we talked about in Q1, was that we would expect transaction activity to be meaningful.