Patrick Davitt: Hey, good morning, everyone. How are you? My first question is on kind of first quarter trends. The ARCC call highlighted current refinancing boom could be a headwind for net deployment in the quarter as M&A deal volumes are still picking back up. What are you guys seeing in terms of that give and take between new deal volume and refinancing outflows as the broadly syndicated and how yield market opens back up. And in that vein, are you seeing borrower interest and direct lending the ship at all yet? Thank you.
Michael Arougheti: Sure. I want to clarify some of the comments that were made on the ARCC call, because that is not how I would interpret the commentary. There is a give and take in the market generally that when the markets are accelerating in activity, the banks will get more active, syndicated loan and high-yield market will open up and the CLO machine will turn on. That’s not necessarily a bad thing because that means that transaction activity is picking up, and there’s an opportunity to drive higher volumes and higher fees. I think it’s important that people appreciate at least from the Ares [ph] and ARCC perceive is that we continue to have a very, very strong focus on the traditional middle market. It’s a very big part of what we do across the globe.
And I think there’s a little bit of a misunderstanding that a lot of the growth has come from share gains from the syndicated loan and high-yield market. And as long as we’ve been doing this, yes, there are moments in time when the loan market is closed. And at the higher end of the middle market, private credit providers can take share and then obviously, when the markets heal, activity levels pick up. But unlike some of our larger peers, we are not dependent on a transfer of market share from the liquid markets in order to continue to drive the growth and performance that we’ve seen. So to clarify, I think, the commentary, I would say the enhanced levels of activity and turning back on of the deal market writ large, I think, right now is significantly more of a positive than a negative.
There are significant, what I would call mitigants to refinancing in the private markets unlike the liquid markets that tend to just be price-driven. A lot of that is just relationships. So if you look at our deployment, for example, in 2023, 57% of our deployment in 2023 was to incumbent borrowers. That relationship is critically important and is actually protective of the portfolio. And then when you look at the amount of upfront fees, call protection, et cetera, that exist in these private credit instruments, even as spreads are tightening and capital is flowing into the liquid market, the economics of refinancing take a while to find their way into the market. So, I think as we’re sitting here today, I would say it’s actually a net positive.
We’re seeing increased transaction activity, more liquidity in the market. And I think that’s generally a good thing. So, I heard some of the commentary on the call yesterday. I don’t think that we’re looking at a return to normal in the liquid markets is bad for the Ares Credit business. I’d also highlight that we are one of the largest liquid credit managers and CLO managers as well. So from the Ares management perspective, as that market opens up, we’re a big beneficiary as well.
Patrick Davitt: Great. Thanks. And then a quick follow-up. Obviously, we get a ton of detailed data on U.S. direct lending portfolios. But could you give us a little bit more detail on how the European portfolios are tracking versus the U.S.? Are you seeing any signs that these portfolios could diverge versus the strong outcomes we’ve been seeing in the U.S. portfolios? Thanks.
Michael Arougheti: Yes. It is remarkably similar. If you look at the EBITDA numbers that were quoted for the ARCC portfolio is about an 8% year-over-year EBITDA growth that had accelerated from 6% in the prior quarter. If you look at the European direct funding, which is actually pretty amazing, year-over-year EBITDA growth was 18%. LTVs are a little bit higher. They’re kind of in the 48% range in Europe versus 42%, 43% in Europe. Interest coverage is a little bit higher in Europe, 1.8% versus 1.6%. But if you just take all of the different ways to articulate credit exposure, they’re largely similar. But we’re seeing a surprising amount of momentum and resilience within the fundamental revenue and EBITDA portfolio in Europe right now.
Operator: Our next question comes from Ben Budish from Barclays.
Nick Benoit: Hey, good morning. This is Nick Benoit on the line for Ben this morning. So in the prepared remarks, the nonaccruals continue to remain low. I believe Kipp noted on the ARCC earnings call yesterday, the nonaccrual rate – historical nonaccrual rate is about 3%. So how do we kind of think about the macro backdrop for nonaccruals to return back to historic average about 3%? And do you kind of think there’s been almost a reset in the direct line portfolio where normalized nonaccruals will stay lower for longer?
Michael Arougheti: It’s a good question. I think Kipp articulated it well, which is just by definition, given the rate backdrop and the assumption that rates will stay higher for longer, I think you will see an uptick in defaults, but that’s not necessarily a bad thing. And what we keep trying to focus people on is the structural improvement in the leverage lending market, particularly the private credit market in terms of the amount of equity subordination in a lot of these capital structures. And so if you look at loans to value of 42% or 48%, when you look at the structure of the private equity market, there’s about $3.5 trillion of private equity sitting at the bottom of a lot of these capital structures with $1 trillion of dry powder to protect value.
And so I think part of what you are seeing is that even if there’s a nonaccrual, many of these are unlike prior cycles where you have fundamental underperformance at the company level. They’re being driven by higher rates for some of the better performing companies that were able to access more leverage. And those are a lot easier to resolve, both in terms of modification and amendment. But they’re also the first places that capital coming in from the private equity sponsors to protect the value below you. I would say the industry is obviously running higher than we are. I think that we continue to outperform from a credit standpoint. But we’re at peak rates. The economy continues to be strong. So if rates stay at this level, I would expect that to tick up a little bit, but I don’t think that we’re going to return to historical levels.
Nick Benoit: Great, thank you.
Operator: Our next question comes from Alex Blostein with Goldman Sachs.
Luke Bianculli: Hi all, thanks for taking the question. This is Luke on for Alex. I wanted to get a sense for how you’re thinking about the growth trajectory of the business outside of credit. And if we can dig into secondaries in particular, you alluded to the state of LP liquidity across the industry. How does that factor in? And outside of that, what do you view as key drivers of growth for the business? Thanks.
Michael Arougheti: Sure. Obviously, we have been diversifying the business for a very long time now, both in terms of asset class, fund structure, distribution channel, geography. And a lot of those investments, as I highlighted in my concluding remarks are now bearing fruit and have significant momentum. Credit as well is not one thing here, right. So when you look at our credit business. It’s a host of strategies, liquid and illiquid around the globe at various parts of the capital structure. And while many people feel like those businesses are maturing, if you look at the way that these funds are structured and the way that the performance is stacking, we still think that we have significant growth across the credit spectrum.
It’s an interesting comment on secondaries because right now, if you look at the balance sheet of all of these assets, whether it’s a buyout or a piece of real estate or an infrastructure asset, everyone is dealing with the same challenge, which is fundamentally strong performance, over-levered balance sheet and a liquidity challenge. And so for the first time in a very long time when we’re going through the market transition, the problem or the use case is the same in every market that we’re in. It’s how do you bring capital into these companies and assets in a way that minimizes dilution, expands duration and runway for the asset owner and a lot of these businesses to not just kind of get to the other side of the rate hiking cycle but to accelerate out of it.
And that’s taking any number of forms. It could be through direct lending, where we’re making a first or second lien loan. It could come through our opportunistic credit business, where we’re doing debt restructured equity investing. It could be P/E, where we’re coming in with some kind of minority equity, and then it could be secondaries. So I think the investment thesis for growth in secondaries, again, secular and cyclical. Secular growth is being just driven by the growth in the primary markets on a global basis. And the cyclical opportunity is this need for creative solutions to resolve the installed base. And we are seeing volumes pick up pretty dramatically across the secondaries landscape. And I think we are uniquely positioned given the fact that we have funds in real estate, infrastructure, private equity and credit that could come into these situations at various cost of capital and be a really good solution provider.
