Ares Capital Corporation
Q1 2021 Earnings Call Transcript

Published: 28 Apr 2021

[Operator:]

Good morning. Welcome to Ares Capital Corporation’s First Quarter Ended March 31, 2021 Earnings Conference Call. As a reminder, this conference is being recorded on Wednesday, April 28, 2021. I will now turn the call over to Mr. John Stilmar, Managing Director of Ares Investor Relations. Please go ahead.

[John Stilmar:]

Thank you. Let me start with some important reminders. Comments made during the course of this conference call and webcast as well as 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 the past performance or market information is not a guarantee of future results.

[Kipp DeVeer:]

Thanks, John. Hello, everyone, and thank you for joining us. I’m here with our Co-Presidents, Mitch Goldstein and Michael Smith; our Chief Financial Officer, Penni Roll; and several other members of the management team. I want to start by highlighting our strong first quarter results and then provide some thoughts on the current market and our positioning. This morning, we reported strong first quarter core earnings of $0.43 per share, up from $0.41 per share a year-ago. Our first quarter GAAP earnings of $0.87 per share reflects significant net unrealized gains as higher portfolio valuations drove our net asset value to a new record of $17.45 per share. We also had an active investing quarter, and the second quarter is set up for even more activity. The U.S. government delivered a powerful combination of significant fiscal and monetary stimulus, coupled with ambitious vaccine rollouts across the U.S., to provide a favorable backdrop for Ares Capital and our portfolio companies.

[Penelope Roll:]

Thanks, Kipp. Good morning, everyone. Our core earnings per share of $0.43 for the first quarter of 2021 were lower than the $0.54 for the fourth quarter of 2020 and higher than the $0.41 for the first quarter of 2020. Our first quarter core earnings were driven by strong recurring interest and dividend income and a solid level of capital structuring service fees from new originations and capital markets activities. Our GAAP earnings per share for the first quarter of 2021 were $0.87, which compares to $0.89 for the fourth quarter of 2020 and a GAAP loss per share of $1.42 for the first quarter of 2020. Our GAAP earnings per share for the first quarter of 2021 included net realized and unrealized gains on investments of $0.64 offset by a realized loss of $0.10 related to the early redemption of our 2047 notes.

[Mitchell Goldstein:]

Thanks, Penni. I would like to spend a few minutes providing more detail on our investments and portfolio performance for the first quarter of 2021. I will then provide an update on post-quarter end activity and our backlog and pipeline. During the first quarter, our team originated 1.75 billion of new investment commitments to a diverse set of high-quality companies across more than 20 distinct industries. The EBITDA of the companies refinanced during the quarter ranged from around 15 million to nearly 300 million, underscoring the breadth of our opportunity set and our ability to be a solutions provider to a wide array of companies. Our originations during the quarter also highlight our ability to invest actively while remaining defensive as approximately 80% of the commitments were first lien. The two largest industries to which we committed capital were healthcare services and commercial and professional services, consistent with our long-held focus on defensive high cash flow business model.

[Kipp DeVeer:]

Thanks a lot, Mitch. We believe we are off to a strong start to the year, and we are very pleased with our first quarter results, which included strong core and GAAP earnings, a recovery in our NAV per share to a level that is now above pre-pandemic levels and improving portfolio credit metrics. The company is hard at work delivering value for shareholders, and we believe we are again positioned for growth during what we believe will be a substantial economic recovery. The COVID-19 pandemic and all the uncertainty and challenges that brought are not over. However, we see a lot of it in the rearview mirror and have optimism for 2021 and beyond. While many aspects of the last 12-months have been unfortunate, we believe these difficult times have again demonstrated our strengths and reinforced our long track record of performance through varying market cycles. Coming out of this, our company is healthy and thriving. We believe a busier, and hopefully, a more normal year ahead provides a great backdrop for Ares Capital and the returns that we can deliver for our shareholders. That concludes our prepared remarks. We would be happy to open the line for questions.

[Operator:]

Thank you. And the first question today will come from Devin Ryan with JMP Securities.

[Devin Ryan:]

Great, good morning everyone and clearly, a lot of good stuff. Going on this quarter, I just want to look at I guess the quarter-to-date investment activity. The weighted average yield of debt and other income-producing securities at amortized cost was 7.4%, which is down a bit from recent quarters. And I just want to get a little more flavor around if that is just market conditions and current pricing, or if that is tied at all to maybe moving up the risk curve. And then just maybe ask differently, just talk a little bit more about the pricing and how that is evolved in the market recently.

[Kipp DeVeer:]

Yes. I think it is nothing necessarily by design to hit on the second point. Look, with the economic recovery, we have definitely seen spreads compress from where they had been over the last six to nine-months a little bit. The good news is we are not really seeing much of that continue. I feel like it is sort of plateaued at this level, and we are back to a steady state. But I think I would have to go back through specifically the backlog and pipeline versus the quarter. My guess is it is just a little bit more mix to first lien, and it is not us sort of directing that by design, right. We actually think there are still quite a lot of pretty interesting higher yield, higher risk with good risk/reward situations out there.

[Devin Ryan:]

Okay. Great. Very helpful and then I guess, a related question. So looking at the pipeline, you are very healthy here. Software and services is notably making up more than half of the pipeline. And so I’m just curious if that is kind of reflecting the mix of deal flow, so it is commensurate or is that an area that you are maybe leaning more in because of the attractiveness. So I just love some color there and then just any other industries that you are particularly interested in right now.

[Kipp DeVeer:]

Yes. Look, I mean, we kind of follow along with the general backlog and pipeline deal flow, right, particularly that of private equity firms, which still represents the majority of our financing opportunities. I would tell you that because of the attractive growth elements in the software and services space, there is just a lot of activity there, right. Tremendously high valuations on the equity side and just a lot of what we think is really high-quality credits and good deal flow in the software and services space. So we have continued to build out that effort, it has been a growing effort for us, and we think it is very attractive. I would add on top of that, we are seeing the same thing in healthcare, we are seeing the same thing generally in business services with – balance representing a really significant portion of our backlog and pipeline in terms of industry mix.

[Devin Ryan:]

Okay, great. I really appreciate it Kipp.

[Kipp DeVeer:]

Thanks, gentlemen, have a good one.

[Operator:]

And the next question will be from Finian O’Shea with Wells Fargo Securities. Please go ahead.

[Finian O’Shea:]

Hi, good morning. First question for Kipp on the higher level of investment income in Ivy Hill. I know that BDC invested more during COVID, but some back last quarter and the investment income still appears very robust. Is this an improved trajectory or more transitory for that vehicle?

[Kipp DeVeer:]

No. I mean we have continued to invest in Ivy Hill and with that obviously, we generate typically more funds under management, assets under management there that obviously increases the management fees of that company. As you know, we also invest securities in a lot of the funds and vehicles that they put together, which also just allows us to ramp up the investment income from Ivy Hill. So it is simply just an increased dividend this quarter that you should expect to see. As we invest more, obviously, we should be taking in more income from Ivy Hill. And obviously, a dividend increase just represents our continued belief that it is a very attractive investment vehicle and relationship with Ivy Hill, so just continuing upwards.

[Finian O’Shea:]

Great. And then just a follow-on on the origination this quarter. So the future without getting into issuer-specific items. Is this sort of an idiosyncratic situation that came to you from your network or are you peering into opportunities that you may see or may derive from the spec ecosystem out there?

[Kipp DeVeer:]

Yes. This one was a little idiosyncratic, came in through a banker, obviously, involved with a particular spec. We don’t have to bother with the nature there. It is not something that I would say we are seeing consistently, i.e., financing opportunities from specs.

[Finian O’Shea:]

Okay. That is all for me. Thank you.

[Kipp DeVeer:]

Thanks Fin.

[Operator:]

And the next question will come from Ryan Lynch with KBW. Please go ahead.

[Ryan Lynch:]

Hey, good morning. First one I just had was, if you look at term structure leverage in the broadly syndicated loan market, it is pretty much been on a straight path getting more and more borrower friendly. And obviously, that trickles down into the upper middle market and the middle market where you all invest in. I’m just curious, do those trends concern you based on just the trajectory that that is been on and have you seen those trends starting to kind of level out or flatten out or improve at all? And if not, what do you see in the future that can potentially kind of ease some of those pressures and kind of slow down that trajectory?

[Kipp DeVeer:]

Yes. I mean, look, with the, again, I think, rebounding economy, optimism from investors and a fresher year when folks were obviously frustrated with yields in non sub-investment grade, so other portions of the portfolio, we were seeing a lot of activity in credit spread tightening here in the early part of the year. And I think the middle market does follow that, everyone always answers it the same way, which is it lags a little bit, right. Look, I think the large-cap market has retreated a little bit in the last 30 to 60 days. So we don’t see dramatic kind of continued drops from here, right. Early part of this year, there was just not a lot of new issuance, refis were really heavy and that is sort of come down a little bit now with heavier new issuance on the calendar. So again, the concept of things were sort of plateauing here where they are as I think how we see things.

[Ryan Lynch:]

Okay. That is helpful. And then going back to kind of the backlog and pipeline question, you kind of discussed that earlier with the high concentration, kind of the software, healthcare. And you said that that is a little bit more of a reflection of kind of the private equity sponsors and what they are focusing on today, which those all seem to be largely kind of more recession-resistant businesses. Do you see that mix starting to shift maybe in the back half of 2021 as maybe some more COVID impacted or more cyclical businesses as private equity sponsors can start to transact with those more given kind of the increase in kind of the economic recovery?

[Kipp DeVeer:]

Yes, it is possible. I mean I think that when you go back to this time last year, a lot of the deal flow was around COVID rescue type stuff, which I’m thinking is, for the most part, behind us. I understand where your question is coming from, but don’t have my crystal ball today. You know I think a good solid economic recovery that is broad would have folks looking more to cyclical industries. But we have actually talked about this across our firm as a whole, whether it is credit, private equity and elsewhere. It seems to be that with purchase prices, particularly in private equity that are elevated, folks are willing to pay for growth in the sectors where they are expecting growth regardless of how uniform the economic recovery is. So I hate to answer with it, we will see. But your guests rise as good as mine maybe right now. It makes sense, but we are not seeing it yet.

[Ryan Lynch:]

Got you. I appreciate the comment. And if you can just give me a call back whenever you get your crystal ball, handy, I guess. Thanks.

[Kipp DeVeer:]

Come in handy. Thanks.

[Operator:]

And the next question will be from Melissa Wedel with JP Morgan. Please go ahead.

[Melissa Wedel:]

Good morning guys, thanks for taking my questions today. Actually, a lot of them have already been answered. But I thought I would switch over related to the activity questions that you have been getting. Certainly noticed that the April-to-date activity, the exits have lagged the new investments versus outpacing them sort of more broadly in the first quarter. Are you anticipating a change there for core net originations going forward or is it too early to tell?

[Kipp DeVeer:]

Well, I’m sorry, I missed a little bit of the lead-in to the question, and I got the second part. We don’t see any change in the activity levels, right, things sort of come and go. The backlog and pipeline is very healthy. Business is super active right now. But if I didn’t quite answer your question, feel free to jump back in.

[Melissa Wedel:]

Sure. Sorry about that. I was asking if you are anticipating a switch from sort of net exit mode to net origination mode given the size of the pipeline and the backlog.

[Kipp DeVeer:]

No, I think is the easy answer. We saw a couple of really large companies get refinanced as exits in this quarter, right, which is sort of the rationale for the next quarter. But no, I don’t expect any changes.

[Melissa Wedel:]

Thank you.

[Kipp DeVeer:]

Yes. Thank you.

[Operator:]

And the next question is from Casey Alexander of Compass Point. Please go ahead.

[Casey Alexander:]

Good morning Kipp, a couple of questions. One is hearing that you financed a company with $300 million of EBITDA; it used to be that the company thought in terms of larger companies as being second lien opportunities. Is that still true and when you are talking about companies of that size, has that impacted the hold sizes that you are willing to hold in the portfolio as well?

[Kipp DeVeer:]

Yes. I mean typically, a company that size will do a syndicated first lien deal more often than not and place junior capital privately more - that is more common, I guess it used to be, right, where you had smaller high-yield deals getting executed, et cetera. Now Ares, and obviously, a handful of our competitors have capital to privately place a lot of this junior capital directly, which they view as a win-win. And I think we do too. In the larger names, right, it is just math, right, that we typically will do. We will have larger final holds in some of these larger companies. I think I have said this in past calls, but we are actually seeing no real risk premium available in smaller companies, right the capital structures were largely the same. And I mentioned this in our prepared remarks a little bit, but we have moved up the company size spectrum because we think there is really good relative value in some of these larger companies, which inherently should be better credits, right, with better management teams, et cetera. So we like that, and we continue to see that as being a competitive advantage, a place that really plays into our strengths and one where we intend to remain active.

[Casey Alexander:]

Alright, great, thank you. My follow-up is I read some comments from Michael Arougheti about government stimulus has delayed sort of a default spike or a default cycle by two to three years. And I’m just curious, given the economic growth that we are seeing, why that would even be delayed two or three years, why wouldn’t we just be starting a whole new economic cycle? And what would lead into that two to three years?

[Kipp DeVeer:]

Yes. I didn’t see that. But I think the common wisdom out there these days is sort of that defaults have peaked, right, and that they are starting to come down. To me, that would play more into your thinking that we have gotten through this last 12-months, and there seems to be a pretty solid economic rebound which, to your point, may just start things over again. I think the asterisk is we really have some companies that are really impacted - really significantly impacted by COVID for the long haul, right. So I asterisk it by saying, I don’t think that the economic recovery is necessarily accruing to them the same way it is to others, right. But I think the stimulus pushed the pain out for some of these industries for a little while. And things like travel and hospitality and others we can all think of, I think there is still a lot of work to do for these companies to get back to where they were before COVID-19 presented itself. But I guess we will all see.

[Casey Alexander:]

Alright, thank you and I appreciate your thoughts.

[Kipp DeVeer:]

Yes, thank you.

[Operator:]

And the next question comes from Robert Dodd with Raymond James. Please go ahead.

[Robert Dodd:]

Good morning and congratulations on the quarter. First one, I’m kind of focusing on credit quality. It looks very robust right now. I mean the weighted average grade of the portfolio, no change at three. Mitch then gave seven to one upgrade to downgrade ratio in number of companies. So that tends to imply that a lot of small companies are getting upgraded or shift the weighted average grade. But at the same time, we are saying that the small companies are lagging fairly materially on EBITDA growth and kind of rebound. So can you give us any color on why it is that the small companies are getting upgraded in your rating system while lagging the broad portfolio by so much?

[Kipp DeVeer:]

That is a hard one. I think some of it is some composition just in the portfolio where we have got some smaller equity positions that are getting upgraded. So it is not necessarily representative, I think, if you make that generalization. Look, I mean, I think, Robert, the thing that we are most focused on as we have laid out for folks is being hard at work on kind of the ones and twos and just continue to show positive migration there. But to be honest, I would have to dig in a little bit more or have some folks digging a little bit more in terms of what I have in front of me right here but -.

[Robert Dodd:]

Got it. I appreciate it, it is a tricky one. Then just the follow-up kind of this quarter - I mean, a lot of discussion about dealing with bigger businesses, reviewing larger EBITDA businesses. I think you basically answered this question indirectly in response to Melissa. But your weighted average EBITDA shrank fairly materially for the first time in a long time this quarter. Is that an artifact of things like Athenahealth getting refied out or an artifact just more broadly, the how competitive the refi market is in the very large end of the BSL market?

[Kipp DeVeer:]

Yes, we did. We had two very large companies get refinanced out. Athena is one of them and was the other, both had north of $300 million of EBITDA. And I do think your point is right, you know some of these refinancings were occurring at the upper end EBITDA size of our portfolios because folks were finding a pretty attractive syndicated loan market to refinance per Ryan’s question as well so.

[Robert Dodd:]

Got it. Thank you.

[Kipp DeVeer:]

Yes. I mean, I would just say it is really not having any - and that we are winning quite a lot as you will see as we roll the year forward.

[Operator:]

And the next question comes from Christopher Marinac with Janney Montgomery Scott. Please go ahead.

[Christopher Marinac:]

Hi, good morning. I wanted to ask more details about the leverage you made. Is there a scenario where you would not be at the upper end of the leverage at the 1.2% that you cited?

[Kipp DeVeer:]

No. I mean I expect, and Penni can jump in too, if you would like to. I mean we sort of see it being ordinary course somewhere between one and 1.2. And as you know, the more active we are on a net originations basis, the more we have to draw the revolvers to fund that. That is typically just the way we do things. And if we see a more significant repayment quarter like we did this past quarter, the leverage tends to go down. But I think we will operate within that range based on active activity levels.

[Christopher Marinac:]

Great. I appreciate all the information this morning.

[Kipp DeVeer:]

You are welcome.

[Operator:]

Your next question comes from Kenneth Lee with RBC Capital Markets. Please go ahead.

[Kenneth Lee:]

Hey, thanks for taking my question. And this is going to be a follow-up to a previous question regarding the investment backlog. Should we expect to see more of a mix shift towards second lien investments over the near-term, especially as you start to gravitate emphasize more on investing in larger borrowers?

[Kipp DeVeer:]

Yes, I don’t think the mix has shifted too much, and I wouldn’t expect the mix to shift going forward right. I mean one of the hallmarks of the strategy is that we want to obviously go out to borrowers and counterparties with a complete set of products, right. So we are happy doing everything from first lien all the way through down to doing preferred and common equity investments. So it is really just going to be what presents itself in backlog and pipeline and what do we see as most attractive. But I think the mix will stay quite similar to where we are today. I think it is been consistent over the last year or so.

[Kenneth Lee:]

Great. That is very helpful and just one follow-up, if I may. Was there anything notable that was driving the portfolio dividend income that was reported in the quarter? Thanks.

[Kipp DeVeer:]

Penni, I might let you take that one. Is there anything that sticks out? I think we had a special dividend from one company in particular that we have been restructuring that we now own. But beyond that, I can’t think of anything other than that special dividend that came from one portfolio company that we are sort of in the midst of turning around and fixing.

[Kenneth Lee:]

Great, thank you very much.

[Kipp DeVeer:]

Alright Kenneth. Thanks.

[Operator:]

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Mr. Kipp DeVeer for any closing remarks.

[Kipp DeVeer:]

No, nothing beyond that, we appreciate everybody getting on the call to hear how the company is doing. We feel great about the positioning today and just wish everybody at least a happy spring here in the Northeast as the weather warms up. And I guess we will talk to you formally here again summertime. So thanks for attending.

[Operator:]

And thank you, sir. Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today’s call, an archived replay of the call will be available approximately one hour after the end of the call through May 12, 2021, at 5