Ares Capital Corporation (NASDAQ:ARCC) Q1 2024 Earnings Call Transcript

Ares Capital Corporation (NASDAQ:ARCC) Q1 2024 Earnings Call Transcript May 1, 2024

Ares Capital Corporation reports earnings inline with expectations. Reported EPS is $0.59 EPS, expectations were $0.59. ARCC isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning. Welcome to Ares Capital Corporation’s First Quarter March 31st, 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Wednesday, May 1st, 2024. I will now turn the call over to Mr. John Stilmar, Partner of Ares Public Markets Investor Relations.

John Stilmar: Thank you. Let me start with some important reminders. Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. The company’s actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in its SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results. During this conference call, the company may discuss certain non-GAAP measures as defined by SEC Regulation G, such as core earnings per share.

The company believes that core EPS provides useful information to investors regarding financial performance because it’s one method the company uses to measure its financial condition and results of operation. A reconciliation of GAAP net income per share to the most directly comparable GAAP financial measure to core EPS can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures may also be found in our earnings release filed this morning with the SEC on Form 8-K. Certain information discussed in this conference call and the accompanying slide presentation, including information related to portfolio of companies is derived from third-party sources and has not been independently verified and accordingly, the company makes no representation or warranty with respect to this information.

The company’s first quarter ended March 31st, 2024 earnings presentation can be found on the company’s website at www.arescapitalcorp.com by clicking on first quarter 2024 earnings presentation link on the homepage of the Investor Resources section. Ares Capital Corporation’s earnings release and Form 10-Q are also available on the company’s website. I’ll now turn the call over to Kipp DeVeer, Ares Capital Corporation’s Chief Executive Officer. Kipp?

Kipp DeVeer: Thanks John. Hello, everyone, and thanks for joining our earnings call today. I’m here with our Co-Presidents, Mitch Goldstein and Kort Schnabel; our Chief Operating Officer, Jana Markowicz; our Chief Financial Officer, Scott Lem, and other members of the management team. I’d like to start by welcoming Scott to his first earnings call with me in his new role as Chief Financial Officer. Scott has been with us for quite a while as a key business leader within our finance and accounting team. He’s been at Ares for more than 20 years. So, having him join us as our newly appointed CFO is great. We look forward to his continued contributions to Ares Capital. Scott and his promotion is just another example of our culture of continuing to promote our strongest players and shows the depth of the talent that exists at Ares.

We still believe this differentiates us from other companies in the market. Now, we’ll move on to our results. This morning, we reported another quarter of strong core earnings of $0.59 per share. Our core earnings per share increased 3.5% from the prior year and were well above or $0.48 per share first quarter regular dividend. These results were driven by continued strong attractive investment environment and the beneficial impact of higher base rates and attractive credit spreads. The strength of our earnings and the positive valuation momentum in our portfolio has also supported solid growth in our net asset value per share after paying a healthy level of regular dividends. Our NAV, which increased 6% year-over-year, reached another record of $19.53 per share.

In the first quarter of 2024, while merger and acquisition activity levels remain relatively low, our share in the business continues to remain very strong. The banks are more active again and this is generally good for all market participants as the increased availability of capital typically brings out more M&A and adds confidence to companies seeking financing for transactions. The firming of the credit markets, the aging of significant amounts of private equity dry powder, and the continued pressures from LPs to return capital are all factors that support higher levels of activity. We’re seeing signs of a pickup in transaction activity as evidenced by the $1.2 billion of commitments we’ve closed in the second quarter to date. While current market conditions are more competitive, this is not a new phenomenon for us.

We have navigated in many competitive markets over the past two decades, 2021 was the most recent that was similar. In these environments, we believe that our expansive direct origination capabilities that span the entirety of the middle market from the low, middle, and upper segments become even more valuable. And having a very large portfolio also helps to drive new investment activity. We continue to find attractive investments with compelling returns at historically lower levels of relative risk. And specifically for our originations in the first quarter, the weighted average LTV was below 40%, all-in yields were nearly 11%, and leverage is nearly 0.5 turn, below our weighted average over the past two years. Furthermore, the originated yield per unit of leverage, which we view as one measure of the risk-adjusted return in the current rate environment was 10% and above the recent two-year average.

Our credit fundamentals across our portfolio are also indicating health and strength. Our portfolio companies showed organic EBITDA growth over the last 12 months of 10%, which is remarkable in today’s economic environment. Interest coverage levels remained stable to slightly improve and leverage levels tick down. The annual EBITDA growth of our portfolio companies is more than double the annual growth of the companies in the S&P 500, which we source through data provided by S&P. On a final point, and as Scott will discuss further, current market environment does enable us to raise capital more efficiently. So, far this year, we’ve been active as an issuer in the unsecured notes market and the secured bank and CLO markets. We’ve issued in all these markets in what we believe are the tightest pricing levels amongst the BDCs. With that, let me turn the call over to Scott to provide more details on our financial results and some further thoughts on our balance sheet.

Scott Lem: Thanks Kipp. I’m excited for the opportunity to serve as Ares Capital’s CFO. This morning, we reported GAAP net income per share of $0.76 for the first quarter of 2024 compared to $0.72 in the prior quarter and $0.52 in the first quarter of 2023. As Kipp stated, we also reported core earnings per share of $0.59 for the first quarter of 2024 compared to $0.63 in the prior quarter and $0.57 in the first quarter of 2023. Our investment income in the quarter was primarily driven by the continued benefits of higher base rates and structuring fees due to an improving investing environment. Our restructuring fees decreased from the fourth quarter of 2023 given the usual seasonality in our business. They increased meaningfully from the first quarter of last year.

Our stockholders’ equity ended the quarter at $11.9 billion or $19.52 per share, a new record high for us, which is a 1.5% increase per share over the prior quarter and nearly a 6% increase per share from a year ago. Our total portfolio at fair value at the end of the quarter was $23.1 billion, up from $22.9 billion at the end of the fourth quarter, largely driven by net unrealized gains in portfolio for the quarter. The weighted average yield on our debt and other in completion securities at amortized cost was 12.4% at March 31st, 2024, which was down slightly from 12.5% at December 31st, 2023, but higher than the 12% at March 31st, 2023. In terms of our capitalization and liquidity, we have had a fairly active start to the year, making sure we are able to continue supporting our investment opportunities.

So, far this year, we have amended, extended, or raised over $7 billion of financing for ARCC. More specifically, in the first quarter, we issued $1 billion of unsecured notes at market-leading spreads and successfully settled our maturing $400 million of convertible notes in almost all newly issued shares, allowing us to retain the capital and further bolster our permanent equity capital base. In March, we also extended each of the revolving period and maturity date for our SMBC funding facility by three years. Post quarter end, we renewed our largest revolving credit facility for another year, pushing it to a full five-year maturity with the same pricing and terms. We also lowered the pricing on our BNP funding facility to SOFR plus 250 basis points.

Finally, just last week, we priced our first on-balance sheet CLO in nearly 18 years. The blended pricing for the AA tranche on the $476 million of notes was SOFR plus 186 basis points, which we believe is one of the tightest executions amongst issuers in this part of the market. Closing is expected in the next few weeks, subject to customary closing conditions. This transaction allows us to further diversify our sources of committed debt financing at pricing levels currently below other forms of secured funding available in the market. Our overall liquidity position remains strong with approximately $6.3 billion of total available liquidity, including available cash and pro forma for all of post-quarter end transactions previously mentioned.

We also ended the first quarter with a debt-to-equity ratio net of available cash of 0.95 times as compared to 1.02 times a quarter ago and our lowest net leverage ratio since the end of 2019. We believe our significant amount of dry powder positions us well to continue supporting our portfolio company commitments, remain active in the current investment environment, and eliminate any refinancing risk with respect to the this year’s remaining term debt maturities. Moving on to the dividend. We declared a second quarter 2024 dividend of $0.48 per share. This dividend is payable on June 28th, 2024, to stockholders of record on June 14th, 2024, and is consistent with our first quarter 2024 dividend. In terms of our taxable income spillover, we currently estimate that we ended 2023 with approximately $635 million or $1.05 per share for distribution to stockholders in 2024.

This estimated spillover level is more than 2 times our current regular quarterly dividend, which we believe helps bring stability to our dividend. I will now turn the call over to Mitch to walk through our investment activities.

Mitch Goldstein: Thanks Scott. I’m going to spend a few minutes providing more details on our investment activity, our portfolio performance, and our positioning for the first quarter. I will then conclude with an update on our post-quarter end activity, backlog, and pipeline. In the first quarter, our team originated approximately $3.6 billion of new investment commitments across 61 transactions. We continue to find compelling investments with attractive risk-adjusted returns, despite some more competitive market conditions. We are generating double-digit yields with a weighted average LTV on our senior loan commitments at levels below 5 times debt-to-EBITDA. Excluding the $1.6 billion of loans on transactions we originated and distributed as agent, our commitments nearly tripled from the first quarter of 2023.

The breadth of our sourcing capabilities allow us to find value in companies with EBITDA from less than $15 million to over $600 million. Our extensive market coverage of companies of all sizes across the market enables us to source transactions in segments where we are seeing less competition or where we believe that we have a strong competitive advantage. Shifting to the portfolio. We ended the first quarter with a $23.1 billion portfolio at fair value, which grew 1% from the prior quarter and 9% from the prior year. The median EBITDA of our portfolio is $79 million, which reflects our presence in both the core middle market and the upper middle market. The weighted average LTM EBITDA growth of our portfolio of 10%, that Kipp mentioned, is also broad based.

Importantly, in our portfolio, the size of a company has not been a driver of performance. Companies in our portfolio with $25 million to $50 million of EBITDA have similar to or even higher growth rates as compared to companies with over $100 million of EBITDA. We believe company and industry selection as well as our underwriting process drive these types of positive results. In fact, our view is based on a study done by the Ares quantitative research group that found that industry selection could account for approximately 500 basis points of difference in total for senior U.S. loan returns over more than a decade of investing. With respect to our credit performance, our weighted average portfolio grade of 3.1 remained unchanged from the prior quarter’s level.

Our non-accruals at cost ended the quarter at 1.7%, up slightly from the prior quarter but lower than the same quarter a year ago. Our current non-accrual levels remains well below our 2.9% historical average since the Great Financial Crisis and the KBW BDC average of 3.8% for the same period. Our non-accrual rate at fair value remained consistent with last quarter at 0.6%, which continues to be well below historical levels for our company. Another indicator of stable credit performance is the fact that our portfolio companies with a risk rate of 1 or 2 declined quarter-over-quarter. And finally, our portfolio quality is also reinforced by the substantial amount of equity invested in our company, primarily by large and well-established private equity firms.

At the end of the first quarter, the weighted average loan-to-value in the portfolio was 43%, which we believe gives us strong downside protection in our loans. As the market is starting to see more dispersion results among managers, we believe our outperformance and credit position, including our significant diversification, differentiates us from our competition. Our strong and growing portfolio is well-diversified across 510 different companies that span the market. The number of companies in our portfolio has increased 9% over the past year and 48% over the past five years and the average hold size is only 0.2% at fair value. Excluding our investments in Ivy Hill and the SDLP, which we believe are well-diversified on their own, no single investment accounts for more than 2% of the portfolio at fair value.

And our top 10 largest investments totaled just 11% of the portfolio at fair value. We believe this degree of diversification further adds to the credit strength of our portfolio as it reduces the impact to the overall portfolio from any single negative credited event at an individual company. And finally, we have had an active start to the second quarter. From April 1st through April 24th, 2024, we made new investment commitments totaling $1.2 billion, of which $1.1 billion were funded. We exited or were repaid on $249 million of investment commitments, which resulted in us earning $1 million of net realized gains. As of April 24th, our backlog and pipeline stood at roughly $1.3 billion. Our backlog contains investments that are subject to approvals and documentation and may not close or we may sell a portion of these investments post-closing.

I will now turn the call back over to Kipp for some closing remarks.

Kipp DeVeer: Thanks a lot Mitch. In conclusion, we believe that the company is well positioned to navigate the opportunities ahead of us. At Ares Capital, we’ve navigated a variety of market environments, credit cycles, and interest rate cycles over our 20-year history with a cumulative average return on equity in the double-digits. In our opinion, this is a very good time to be invested in a high-quality company focused on private credit. Our portfolio is performing well and we believe that the potential returns on our investment remain compelling by historical standards. While we remain mindful of the potential for increased credit risks, delivered with a higher for longer rate environment, we are highly diversified in defensively positioned companies and our companies are demonstrating healthy and differentiated levels of growth.

Our balance sheet and liquidity position remains strong, which we believe allows us to take advantage of this compelling new investment environment. Overall, we are confident that the factors that have driven our historical outperformance remain firmly in place and as a result, we remain optimistic about our future prospects. As always, we appreciate you joining us today. We look forward to speaking with you next quarter. With that, operator, we can open the line for questions.

Operator: Thank you. [Operator Instructions] And we’ll take our first question today from John Hecht with Jefferies.

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Q&A Session

John Hecht: Morning guys. Thanks for taking my questions. Thinking about a lot of activity in the quarter, both on the deployment and repayment side, I’m wondering, Kipp, can you give us kind of an update on the syndicated and liquid of owned markets and how they’re influencing activity with you guys and elsewhere in the market?

Kipp DeVeer: Sure John. I mean I think it’s not a huge driver, frankly, of what we’re doing. There’s been a lot of press, I’d say, about the bank’s returning to the market and perhaps a more risk on way to try to arrange and underwrite to syndicate more traditional leveraged finance transaction. So, that certainly picked up. I think if you look specifically at our activity, I think it was about 70% of our new deals were coming from the existing portfolio, a little bit slower on the kind of new platform side, which was a little bit surprising for us. But as I mentioned in the prepared remarks, we’re pretty optimistic that a handful of factors remain in play that should compel pretty good transaction activity this year.

John Hecht: Okay. And then you had obviously a lot of, again, deployment and repayment activity and the capital structuring fees as a percentage that were a little lower, is there anything to read on that side or is that just a function of the mix of originations?

Kipp DeVeer: It’s more mix than anything, although I will say we’ve noticed a little bit of pressure on upfront fees on new deals in the market simply because there aren’t as many of them. So, it’s one of the levers that a borrower can pull to a certain degree to try to achieve more attractive financing, but it’s more mix than anything else.

Scott Lem: I’d also add there real quick, the numbers are probably a little bit inflated just because we also as an enrolled agent, we did front some deals, so the true origination was probably closer to the $2 billion.

Kipp DeVeer: You sort of have to back that number out.

Scott Lem: Yes, exactly.

John Hecht: So, the true — what was that — the true origination was what?

Scott Lem: About $2 billion because about $1.5 billion was us as our role of agent fronting for some deals.

John Hecht: Got you. Okay.

Kipp DeVeer: This happens from time-to-time. Yes, it happens from time-to-time just depending on what syndicate composition looks like, who can fund it closing, who can that sort of the technical point, but when you evaluate it, just make sure you look at the math in that light.

John Hecht: Okay, perfect. Thanks.

Kipp DeVeer: Thanks John.

Operator: Our next question will come from Finian O’Shea with Wells Fargo.

Finian O’Shea: Hey everyone. Good morning. Hi Kipp. How are you? Can you talk about the environment for second lien if the reduced exposure there is more market related or your portfolio positioning? And if that should continue or if applicable, your ability to replace that with other forms of junior in structured equity, there’s a lot of that at the portfolio, but wondering if there are sort of adequate volumes there if second lien meaningfully recedes? Thanks.

Kipp DeVeer: Yes, I’m going to have Kort follow-on a couple of thoughts. On my side, I would say, look, when last year came around and kind of the private credit players that’s included, really, were representing new deals in the market. Almost everything that we’re doing is getting done as a unitranche regardless of size. And that second lien, which has been a larger part of our investing effort, is just frankly not as prevalent in the market in terms of the mix of new deals. Does that come back if some large deals actually get done as first lien in the syndicated market where we can provide junior capital? Maybe, I guess, we’ll wait and see. As you know, our second lien investing tends to emphasize much, much larger companies and is very often in line with the syndicated first lien.

And that transaction just really hasn’t been prevalent in the market, I’d say, for the last, call it, three, six, nine months and we’ll see where we go from here. The only other thing I’d add, and I’ll kick it to Kort if he wants to add on is, we are seeing a lot of really good companies, to your point, about junior capital investing and structured equity and all of that, that are performing well, but simply don’t have the amount of cash flow they expected. So, you see some senior lenders that are probably saying, well, with higher rates, I’m not really deleveraging the way I was hoping to, and frankly, on the other side, the equity is looking for an extension of duration to accomplish what they want to achieve from an IRR perspective. So, there is we think, a pretty interesting opportunistic credit pipeline and funnel to do some of these deleveraging junior capital deals.

But hopefully, that answers the question. Kort, if you have anything to add to it.

Kort Schnabel: No, Kipp, I think you covered it all. Obviously, we’re — the return opportunities in the first lien market are super attractive. So, regardless of the fact that there aren’t as many second lien opportunities right now, we’re not too bothered by that given the other opportunities that the market is showing us. But certainly, more a function of what the market is giving rather than a purposeful change on our part.

Finian O’Shea: Awesome. Thanks. And I guess a small follow-up, maybe sort of related. We noticed the special opportunities or ASOF Group was moved over to credit, presumably under your domain, Kipp. Is that — is there any anticipated change there? Like maybe if you can go over your historical collaboration or co-investment with that unit and how might that change going forward? Thanks.

Kipp DeVeer: Yes, I mean it plays into the comment that I made about opportunistic credit. And I guess all I’d say is there’s been a lot of collaboration over the years and frankly, because that business was changing, I’d say, a little bit missed opportunity to look more credit facing and less like it should be attached to our private equity efforts. It was just a pretty simple move for us that we made kind of around year-end that became formal here at the end of the first quarter.

Finian O’Shea: Thanks so much.

Kipp DeVeer: Thanks.

Operator: Our next question will come from Melissa Wedel with JPMorgan.

Melissa Wedel: Good morning. Appreciate you taking my questions. I noticed that dividend income was substantially higher quarter-over-quarter. As we think about the dividend income stream going forward, should we think about that as being aligned with the direction and change in interest rates and really consider that as much a floating rate piece of the portfolio?

Kipp DeVeer: Yes, hey Melissa thanks for the question. So, it’s two things, right. So, Ivy Hill, obviously, represents the lion’s share of that dividend income. But I’d say for this quarter, it’s higher because we actually took on kind of one-time dividend from one of our equity investments. So, that’s probably why you see it tick up. I don’t think there’s a big change there away from maybe that one-time event, but we obviously benefit from having a diversified equity portfolio that can deliver dividends from time-to-time.