Ares Management Corporation (NYSE:ARES) Q3 2023 Earnings Call Transcript

Ares Management Corporation (NYSE:ARES) Q3 2023 Earnings Call Transcript October 31, 2023

Operator: Welcome to Ares Management Corporation’s Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference call is being recorded on Tuesday, October 31st, 2023. I will now turn the call over to Carl Drake, Head of Public Market Investor Relations for Ares Management.

Carl Drake: Good morning, and thank you for joining us today for our third quarter conference call. I’m joined today by Michael Arougheti, our Chief Executive Officer; and Jarrod Phillips, our Chief Financial Officer. We also have a number of senior professionals with us today who will be available during the Q&A session. Before we begin, I want to remind you that comments made during this call contain forward-looking statements and are subject to risks and uncertainties, including those identified in our risk factors in our SEC filings. Our actual results could differ materially, and we undertake no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results and nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase an interest in any Ares Fund.

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During this call, we will refer to certain non-GAAP financial measures which should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles. Please refer to our third quarter earnings presentation available on the Investor Resources section of our website for reconciliations of the measures to the most directly comparable GAAP measures. Note that we plan to file our Form 10-Q in the first week of November. This morning, we announced that we declared our fourth quarter common dividend of $0.77 per share in the company’s Class A and non-voting common stock, representing an increase of 26% over our dividend for the same quarter a year ago. The dividend will be paid on December 29th, 2023, to holders of record on December 15th.

Of note, we plan to update investors about our new quarterly dividends for 2024 during our fourth quarter earnings call early next year. Now, I will turn the call over to Michael Arougheti.

Michael Arougheti: Thank you, Carl and good morning. Before we begin, I wanted to take a moment to acknowledge the horrific terrorist attacks that occurred in Israel and the subsequent loss of lives. Our hearts go out to all the innocent people and for the pain and suffering on both sides throughout the region. We are all holding on to hope for a peaceful resolution. Now, I’d like to begin with some market commentary and quarterly business and strategic highlights. During the third quarter, the markets adjusted to the expectation for rates to stay higher for longer while the underlying economy remained resilient, with robust GDP, a strong labor market, and continued modest growth in corporate profits. We’re seeing the lag effects from higher rates and the slow and uneven economic growth play out across the global markets that we invest in.

Transaction activity remains slower than usual due to the higher cost of capital and valuation disparities among buyers and sellers yet there’s significant pent-up demand and a large amount of aging private equity dry powder available to be invested. We’re seeing our private pipeline build generally with higher quality assets and strong growth characteristics coming to market. We’re also seeing a growing need for creative liquidity solutions, recapitalizations and rescue financings, and more interest in secondaries. With this economic backdrop, it remains a compelling time to invest across private market assets with defensive characteristics, particularly within private credit, as we see risk/reward characteristics that are as favorable as we’ve seen in many years.

Our quarterly results continue to demonstrate our strong growth and resiliency in these slower and more challenging market environments. We raised $21.9 billion in new commitments in the quarter, our second highest fundraising quarter in the history of our firm, and we’ve now raised $53.4 billion through the end of the third quarter. We continue to benefit from our existing institutional investors who re-up or cross over into new Ares Fund products, along with new investors who recognize our consistent fund performance and leadership in managing private assets. We also saw an increase in flows from our wealth management channel, supported by our newly launched non-traded BDC. Fund [ph] performance across our primary investment strategies also continues to be a highlight as approximately three quarters of those strategies performed well compared to their respective relative public indices or exceeded their annualized target returns in the third quarter.

We also incrementally increased our third quarter deployment, which supported growth in our management fees and fee-related earnings. For the first nine months, our management fees and fee-related earnings each grew by 20% or better compared to the same period last year. Now let me provide an update on our three private credit funds, which are all on track or have already closed at levels in excess of prior vintages. In the third quarter, we held the first close for our third US senior direct lending fund of nearly $6.5 billion in equity commitments plus nearly $2 billion in committed fund leverage. The first closing of LP commitments for this fund exceeded 80% of the total equity commitments for the predecessor fund. With additional closes expected into the first half of next year, we expect to meaningfully exceed the prior fund size of $8 billion in equity commitments and $15 billion in total investable capital.

Overall, our US direct lending business raised $11.6 billion in the third quarter which brought our total AUM in this strategy to nearly $118 billion. As a market leader, we believe that our global direct lending business continues to have significant white space as the private credit markets are meaningfully undersized compared to the $5 trillion of private equity AUM. We also raised an additional €750 million for our sixth European direct lending fund in the third quarter and almost €800 million more in October, bringing total commitments to €9.9 billion to date. We have line of sight to over €11 billion of equity commitments by year-end which would equal or exceed our prior fund vintage. We expect to surpass our prior vintage with additional closings from investors in our pipeline by early in the second quarter of 2024.

With over 85 investment professionals located in six offices across Europe, we believe that we have the largest and most tenured direct lending franchise on the continent, managing over $60 billion of AUM. With our leading alternative credit strategy, Pathfinder II closed approximately $2.2 billion in the third quarter, bringing total commitments to $5.8 billion at quarter end. And as we publicly announced yesterday, Pathfinder II held its final close at its hard cap of $6.6 billion, nearly double the size of the predecessor fund. We experienced significant investor demand hitting our hard cap in only seven months since the first closing. In addition to Pathfinder II, our open-end core alternative credit fund raised $750 million in the quarter, bringing total commitments to over $4.2 billion.

The strong investor demand for alternative credit strategies is driven in part by filling the gaps created by a pullback from traditional providers, along with the structural changes that we’re witnessing in the banking industry. With more than $32 billion in AUM, our alternative credit business is a leader in the private, non-rated and illiquid segment of the asset-backed market and is poised for growth in what we believe is at least a $4 trillion global addressable market. In Asia credit, we raised nearly $400 million in the quarter, including an approximate $200 million final close in Ares SSG Capital Partners VI, bringing final commitments to $2.4 billion, including a Sidecar fund. We’re seeing strong economic trends and robust corporate earnings growth in India and Australia, which account for 60% of our investments across the region, and we’re seeing a growing opportunity set for financing solutions for sponsor-led acquisitions in these markets.

Within Real Assets, we raised more than $500 million in a European real estate debt mandate, which now totals over $1 billion, and we anticipate that this strategy will continue to grow. Our real estate debt business now exceeds $11 billion, and we believe the team is well positioned for further growth due to investor demand and the current acute need for capital in the industry. Our second climate infrastructure fund raised another $200 million in the quarter, plus an additional $300 million in October, and this completed the funds closed with total equity commitments of nearly $1.1 billion or approximately 80% of the total equity commitments in the prior fund vintage. We currently have over 30 funds in the market, and by year-end, we expect to have first closes in our seventh corporate private equity fund, our inaugural credit secondaries fund and our third infrastructure secondaries fund, as well as additional closings in our larger funds, such as our fourth US opportunistic real estate equity fund, our second climate infrastructure fund and our sixth European Direct Lending fund, as just discussed.

Through the end of October, we have now raised nearly $58 billion, and we expect total fundraising for the year to exceed $65 billion, well ahead of the $57 billion we raised last year. Throughout next year, we have several of our largest fund series expected to hold first closings for successor funds, including our six infrastructure debt fund, our third special opportunities fund and our third US junior direct lending fund. While our core fundraising continues to be supported by expanding within the global institutional market, our strategically important insurance and wealth management channels are also poised for growth. Our affiliated insurance business, Aspida, continued its organic growth with new assets of more than $1 billion, bringing total AUM to $10.6 billion by quarter end.

We believe investors are attracted not only to Ares’ credit investing expertise, but also the technological advantages that Aspida is bringing to the annuity market. Our growth outlook is promising as we’re seeing demand for new annuities, reinsurance flow and opportunities for block trades, which we would expect to fund largely with third-party capital. We believe that we are on track to meet or exceed our goal of reaching $25 billion or more in AUM by the end of 2025. Within Wealth Management, our ongoing objective is to market a limited number of core semi-liquid institutional quality products through our global wealth management channel. We’re well on our way to accomplishing this over the next several years and today, we’re one of the largest alternative managers in the wealth industry with over 120 professionals, a footprint across North America, Europe and Asia, six products and relationships with nearly every major warehouse and private bank.

We expect to continue adding strategic partnerships and gain market share as we scale each one of these products. After launching our non-traded BDC, ASIF, primarily on one wire house in June, that has seen steady momentum with approximately $550 million raised in the first three months, including the September flows, which closed on October 1, bringing total AUM to over $2.7 billion. There are four additional global platforms that we expect will add ASIF in the first half of 2024. And despite a tough market for real estate fundraising, we continue to see net aggregate flows collectively across our two non-traded REITs, including the 1031 exchange programs. Turning to deployment. We invested $16.7 billion in the third quarter, which was up from the $15.2 billion in the second quarter, but down from $18.3 billion in the third quarter of 2022.

We’re beginning to see signs of large deal activity returning as Q3 was the third highest quarter for $1 billion plug tranche deals financed by the private credit markets. While still early and markets remain slower than we’d like, we’re encouraged by our fourth quarter-to-date investment activity and our pipeline. For 2024, we currently expect market activity to improve due to the aging private equity dry powder that is approaching the end of its investment period, growing pressure from LPs to return capital, stronger sentiment among middle market companies and further pressure on balance sheets and capital structures as rates stay higher for longer. We’re also seeing a growing opportunity to partner with the banking sector through our alternative credit business.

The bank market continues to be impacted by regulatory changes, asset liability mismatches and an inverted yield curve, all of which changed the way banks participate in certain segments of the market. Over the years, we’ve developed extensive bank partnerships where we have the opportunity to provide solutions to augment their existing businesses to improve risk weightings and reduce capital charges, while at the same time generate attractive returns for our investors. Our alternative credit team believes that we’re in the early innings of these types of transactions and we’re seeing an increase in our collaboration with our banking partners. Finally, we continue to explore inorganic growth opportunities to expand our business through both product and geographic expansion.

In October, we closed on the acquisition of Crescent Point, a leading Asia-focused private equity firm with $3.7 billion in assets under management. The Asia Pacific region is a key geographic target for us and we continue to look at various ways to expand each of our business lines into that region, either through organic team builds or strategic acquisitions. And as you may have seen, we also recently closed a strategic partnership and investment in Vinci Partners, a leading alternative asset manager in Latin America. We’ve known the Vinci team for over a decade and are excited to collaborate on distribution, product development and other business opportunities in Brazil and across Latin America. We believe that the Latin American markets are in the very early stages of shifting capital into the private markets, particularly within private credit.

This is similar to the trends that we saw in the early 2000s in Europe, and what we’re seeing now beginning to play out in the APAC region. We’ll continue to look for unique and attractive global growth opportunities for our business. And now, I’d like to turn the call over to Jarrod for comments on our financial results. Jarrod?

Jarrod Phillips: Thanks Mike. Hello, everyone, and thanks for joining us today. In the third quarter, we continue to see strong growth in our management fees, fee-related earnings, AUM and fee paying AUM compared to the third quarter of 2022. While realizations were light in the third quarter as we expected, we have a clear line of sight on stronger fourth quarter realizations, due to our European-style waterfall funds. We’re also on track to recognize a meaningful year-over-year increase in FRPR from our credit funds, as I will discuss. Starting with AUM. We ended the third quarter with $395 billion of AUM and we’re tracking well to meet or exceed our target of $500 million or more by the end of 2025. Our FPAUM grew to over $247 billion, up from over $218 billion this time last year, driven by deployment across our credit and special opportunities funds and new commitments to funds in our Real Assets group.

For the first time in our firm’s history, we have over $100 billion in dry powder, of which over $65 billion is AUM not yet paying fees and available for future deployment. Upon deployment, this would generate nearly $650 million in incremental management fees and position us for continued FRE growth and margin efficiencies. From a revenue perspective, our management fees totaled over $643 million in the quarter, an increase of 17% compared to the same period last year, primarily driven by deployment of our available capital in our credit group. Other fee income of approximately $20 million was down from the prior period as there were certain episodic transaction fees that contributed to our second quarter’s results. As it relates to FRPR in 2023, we continue to expect approximately 95% of our FRPR to be realized in the fourth quarter.

Currently, the potential FRPR from our credit funds is tracking well ahead of last year as we’re experiencing the benefits of a higher for longer interest rate environment, along with a modestly positive impact on loan pricing from tighter credit spreads. We are currently estimating FRPR from our credit funds of approximately $110 million to $120 million for the fourth quarter or $40 million to $44 million of FRE after compensation expense. I will caveat that, this is still subject to the total return performance of these credit strategies for the full year, including changes in market values in the fourth quarter. Regarding FRPR from our real estate group as of September 30, the two non-traded REITs had not accrued any incentive fees on their balance sheets.

Given the upward pressure on cap rates, we do not expect to recognize FRPR from these non-traded REITs in 2023 and earning FRPR in 2024 from these REITs may require an improvement in the current valuation environment. Fee-related earnings totaled $274 million, an increase of 18% from the third quarter of 2022, driven by higher management fees from deployment. For the year-to-date period, we’re tracking at over 20% growth in FRE. We remain confident in our ability to generate 20% or better FRE growth annually through 2025, excluding any FRPR from our non-traded REITs as we discussed on our call in February. Our FRE margin in the third quarter was 41.2%, a roughly 40 basis point improvement from the second quarter of 2023, and a 100 basis point improvement from the year ago period.

As we have said in the past, we expect to see a gradual expansion in margins that could accelerate in periods of higher deployment and corresponding growth in FPAUM. As a reminder, in the fourth quarter, we typically see a drag on our FRE margins related to FRPR, which are typically in the mid-30% range. Excluding this FRPR impact, we do expect continued modest FRE margin expansion in Q4, and we remain confident in our ability to reach a 45% run rate FRE margin by the end of 2025. Our realization activity was slower in the third quarter due to limited American style realizations in several of our equity strategies, coupled with the typically slow third quarter for European-style waterfall realizations as discussed on our last call. Given the early ages of many of our European waterfall style funds, we typically see tax-related distributions in the fourth quarter with a cleanup amount in the second quarter related to tax filing.

However, as our 2017 and 2018 vintage European waterfall style funds continue to season, we expect to see larger and more consistent European waterfall realizations likely beginning in 2025 and thereafter. For the fourth quarter, we currently expect approximately $45 million in European waterfall style net realized performance income. Looking forward, our potential net performance fee income from European style funds as increased from $2.5 billion earlier in the year to $3.5 billion. This potential amount has continued to grow as we raise additional European style funds, along with the compounding effect of higher interest rates in our credit like funds. At the same time, we’re seeing the duration of these expected cash flows extend out as there are fewer repayments and less overall transaction activity.

The extended fund duration has a positive compounding effect on the total realization value as the investments remain in our portfolio longer, but it impacts the timing of these realizations. Based on our updated estimates and including the fourth quarter guidance I provided, we currently expect approximately $80 million of net realized performance income in 2023 from our EU waterfall funds and about $160 million in 2024. Our initial view is that there’s more than $250 million in 2025. Our net accrued performance receivables stood at $969 million, up 9% from the year ago period despite nearly $150 million in distributed net realized performance income over the last 12 months. Notably, approximately $94 million of this increase comes from our credit funds where we’re seeing the benefits of higher interest rates above our fixed hurdle rates.

Unlike equity style funds, where increases in performance fees are based on capital appreciation driven by market multiples and EBITDA growth, our eligible credit funds can generate more predictable income from net returns after any credit losses above fixed hurdle rates with limited mark-to-market risk. For example, of the $969 million of net accrued performance receivables, $694 million or over 70% were in European style waterfall funds with over $500 million in private credit like funds. We now have nearly $125 billion or over 50% of our incentive eligible AUM in European-style waterfall funds, and we expect this balance will continue to grow. Realized income in the third quarter totaled $264 million and after-tax realized income per share of Class A common stock was $0.83, up 11% compared to the third quarter of 2022.

As Mike mentioned earlier, approximately three quarters of our primary investment strategies performed well compared to their respective relative public indices or exceeded their annualized target returns for the third quarter, with particular strength across US direct lending, alternative credit, Asia credit, infrastructure debt and special opportunities. In credit, all of our primary investment strategies have generated double-digit gross returns in the last 12 months as we continue to benefit from higher base rates, attractive spreads, low defaults and strong fundamental performance. Our credit metrics remain strong across our portfolios. As an example, in US direct lending, Ares Capital Corp’s non-accruals at cost declined to 1.2%, which remains well below our historical average and the industry averages.

And portfolio company EBITDA growth remains in the healthy mid- to high single-digits for our US and European direct lending portfolios. Loan-to-value ratios also remain attractive in the low 40% range in the US and mid-40% for our European portfolios. In private equity, both of our investment strategies performed well compared to the public equity markets in the third quarter. We continue to see double-digit EBITDA growth across our ACOF portfolios. Within real estate, higher cap rates are offsetting the relatively strong rent growth that we’re seeing in our portfolios, which are heavily weighted towards a more resilient industrial and multi-family sectors. This is leading to muted returns for the third quarter, yet due to our significant overweighting in these strongest performing sectors of industrial and multifamily, which account for more than 75% of our real estate gross value, our US and European real estate strategies have performed well relative to the respective public real estate markets over the past two years.

With that, I’ll turn the call back to Mike for closing remarks.

Michael Arougheti: Great. Thanks, Jarrod. In our view, the long-term secular drivers for our business remain very much intact. Both institutional and retail investors continue to seek higher risk adjusted returns in less volatile and uncorrelated alternative assets. At the same time, we’re seeing traditional capital providers and banks continue to retrench for a whole host of reasons, and Ares continues to play a key role in filling the gaps and providing solutions into these markets. As you saw with our performance to date, as well as past market cycles, we can generate strong growth even in tougher market environments. We continue to make investments for future growth by enhancing our product capabilities in adjacent areas, expanding into new geographies and deepening our distribution channels.

With a record amount of dry powder, we’re well-positioned to invest our capital opportunistically in highly attractive sectors. And because of the scaling of our private credit business over the past six years, we’re in a great position to realize a growing amount of performance income in the coming years from our European-style waterfall funds. All of this is to say that we have strong visibility on continued earnings growth, dividend growth and margin expansion. As always, I’m grateful for the hard work and dedication of our team around the globe and I’m appreciative of our investors’ continuing support for our company. And operator, I think we can now open up the line for questions.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from the line of Craig Siegenthaler with Bank of America. Please proceed with your question.

Craig Siegenthaler: Good morning Mike, Jared, I hope everyone is doing well. My first question is an update on the formation of bank partnership and how Ares is working much closer with banks now on asset acquisitions, especially in the ABF market. I think PacWest that purchase in June might have been the last big announcement. So since then, have you been forming new partnerships, are you seeing the flow of assets pick up from banks, and what are your expectations for the future with your bank partners?

Michael Arougheti: Hi Craig. Thanks for the question. PacWest yes, was the largest transaction that we announced, but I think the press picked up some recent activity too where we did a very significant strategic risk transfer, a couple of weeks back with a regional bank. There’s about $2 trillion of consumer loan assets sitting on bank balance sheets that are going to need to get addressed in some form or fashion, not to mention some of the challenges that we expect we’ll continue to see in the real estate books. So given that we just had our final close on the Pathfinder, funded $6.6 billion, and given that, that’s where the bulk of this activity is going to reside, we’re still pretty optimistic that the opportunity to partner with banks is still in the early innings and that we’re well positioned for.

Craig Siegenthaler: And just as my follow-up, a similar question but more on the investing side, focusing on asset-backed finance and the $7 billion Pathfinder fund and I know this vertical now is $32 billion and Ares which is very large. What verticals is Joe [ph] and team focusing on now? Are there any that they’re avoiding? And looking at Ares’ capabilities pay in the ABF [ph], are you broadly — do you broadly fill all the verticals? Are there still some white spaces where you could add investment professionals to sort of fill in, in the future?

Michael Arougheti: Without getting into too many specifics, Craig, I think the good news is we have probably one of the biggest and broadest teams in the space, particularly around the sub-investment grade part of the market which we think requires it [Audio Gap] we’re focused on now. We talked about resolution of some consumer loan portfolios and lender finance portfolios within the banking system. In a recent newsletter that, that team put out, there was a pretty good discussion, I thought on the opportunity in NAV lending, which is about a $100 billion opportunity. So I’d say broadly speaking, you want to be in a position to move between markets and geographies as the opportunity set develops. And there are very few people who can make those types of relative value decisions the way that our team can. But yeah, I think for the time being, we’re going to be focused on much of the core things that we’ve been talking about around bank partnerships and lender finance.

Craig Siegenthaler: Thank you, Mike.

Operator: Our next question comes from the line of Alex Blostein with Goldman Sachs. Please proceed with your question.

Alex Blostein: Hi. Good morning guys. My question for you outside of credit, maybe just a quick refresher on the opportunities you guys see for fundraising over the next call it, six to 12 months, in things like private equity and other verticals. So maybe we could start there.

Michael Arougheti: Sure. Thanks for the question. As we talked about on prior calls, I think the good news is, year-over-year, you’re going to see less dispersion in fundraising outcomes, largely because we have an increased number of larger flagship and core vehicles. Obviously, we’re building momentum in the wealth channel and the insurance channel and then the family of open-ended products that are on continuous offer are growing. So we’re going into any given year just with a much higher floor to jump off of with the large institutional flagships. As we talked about in the prepared remarks, we’ll clean up the large credit funds here towards the end of the year and into the first half of next year. And then we would expect to see first closes towards the end of this year into the beginning of next year for our seventh corporate private equity fund, our sixth infrastructure debt fund, our climate infrastructure funds, so on and so forth.

And then the big things on the horizon, I think, for next year are going to be our third special ops fund, our third junior debt fund are probably the two big ones. And then obviously, we’ll be growing into our six infrastructure debt fund. So it’s interesting, as the product set is growing and diversifying and then we’re showing that we can scale vintage over vintage, we’re no longer in this world where we’re just focusing on a handful of flagships. And you can see that just in terms of the quarter-over-quarter fundraising performance, and I’d expect that to continue into the first half as well.

Alex Blostein: Great. That helps. Thanks. The second question I had for you guys is zoning in on some of the retail initiatives. Helpful to hear that ASIF is going to be, I guess, on four additional platforms in the first half of next year. Any lessons learned, I guess, from the existing platform and how good of a re-across that could be to some of the other ones that you mentioned, given pretty robust momentum we’ve seen so far. And then I think you launched a European version of that as well. So maybe help us understand sort of how does the competitive market in Europe, vary versus the US and the opportunity there you see for the European version of this product relative to the early traction you see in the US.

Michael Arougheti: Sure. Just to frame it, so everybody is looking at the same numbers, we raised in our wealth products alone, they’re not looking at our traded product. Wealth product, we did about $1.7 billion in the third quarter, obviously, with good momentum on ASIF with only the one platform. I would expect, Alex, just given the attractiveness of the product at this moment in time in our BDC track record and leadership in private debt that adding those platforms is a pretty good read across. We’ll know it when we’re in those platforms, just how much they scale. But I think there’s a pretty significant amount of pent-up demand and respect for the brand in that channel. And so I think that’s a good starting point to expect that it would be a good read across.

Europe, it’s interesting because the European wealth market generally is less developed. So we just don’t have a great amount of precedent to know. But from a competitive standpoint, we have, by far, the leading private credit franchise in that market, both in terms of length of track record, scale of capital and size of team. So it’s an interesting, you have a less mature distribution channel, but we have a significantly better competitive positioning, I think, relative to others in that market. And so the two combined hopefully has us having similar experience with that product as we’re having with the US product.