Ares Capital Corporation (NASDAQ:ARCC) Q3 2023 Earnings Call Transcript

Ares Capital Corporation (NASDAQ:ARCC) Q3 2023 Earnings Call Transcript October 24, 2023

Ares Capital Corporation beats earnings expectations. Reported EPS is $0.59, expectations were $0.58.

Operator: Good afternoon. Welcome to the Ares capital Corporation’s Third Quarter, September 30, 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Tuesday, October 24th, 2023. I will now turn the call over to your host Mr. John Stilmar, Managing Director of Ares Investor Relations. Thank you, you may begin.

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 the 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 or core EPS.

The company believes that quarter EPS provides useful information to investors regarding financial performance because it is one method the company uses to measure its financial condition and results of operations. A reconciliation of GAAP net income per share to the most directly comparable GAAP financial measure to core EPS can be found on 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 companies was derived from third-party sources and has not been independently verified and accordingly the company makes no representations or warranties with respect to this information.

The company’s third quarter September 30th, 2023 earnings presentation can be found on the company’s website at www.arescapitalcorp.com by clicking on the third quarter of 2023 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 it over to Mr. Kipp DeVeer, Ares Capital Corporation’s Chief Executive Officer.

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 Financial Officer, Penni Roll; our Chief Operating Officer, Jana Markowicz, and other members of the management team. Before it began my prepared remarks on the company. I’d like to express our deepest sympathies to those who have been affected by the recent horrific terrorist attacks in Israel and the subsequent loss of innocent lives. It’s truly a tragedy, and we hope that a peaceful resolution is achieved as soon as possible. Turning to our results, I’ll start with some highlights from our third quarter, and then add some thoughts on the economic environment and the current market.

This morning, we reported strong third quarter results. Our core earnings per share of $0.59 increased 18% year-over-year, primarily reflecting higher net interest and dividend income, largely a result of higher base interest rates. Our GAAP earnings per share for the third quarter were $0.89, driven by our strong core earnings and an increase in the overall value of our investment portfolio. These results lead to another quarter of sequential growth in our net asset value per share to $18.99, which has increased 3% since the beginning of the year, we remain one of the few BDCs that’s been able to deliver a consistent or growing regular dividend while building NAV over long periods of time. We’re pleased with these results and we think it’s important to put them in the context of what we’re seeing in the broader credit markets.

For much of the quarter, the credit markets remain constructive and saw some lift as the soft lending narrative for the U.S. economy led to enhance liquidity and modestly higher transaction activity. However, with expectation that higher for longer interest rates will be required to tame inflation, volatility is returned to the capital markets. There is no doubt the unsettled international landscape in Ukraine and Israel in particular, are adding to this volatility. As a result, the leveraged finance market is less constructive to new transactions, particularly smaller ones. And companies that sought the bank and liquid credit markets for their financing needs are turning to the private credit markets looking for worthy partners that can deliver a higher certainty of closing Underscoring the market opportunity for direct lenders, this was the third most active quarter in history for $1 billion-plus unit tranche transactions and the private credit markets demonstrated the ability unitranche transactions, and the private credit markets demonstrated the ability to provide a $5 billion financing solution in the Finastra transaction.

Driven by the scale and capabilities of managers like Ares, private credit is continuing to gain market share over bank and syndicated capital market solutions. During the third quarter market pricing and terms continued to be highly attractive for new transactions. Credit spreads on new loans are well above historical averages, leverage levels are lower, and equity contributions are at historical highs. Looking forward, we’re optimistic about the outlook for new investment opportunities and we expect an uptick in M&A and additional sponsor-to-sponsor portfolio company sales to accelerate in 2024. Given the robust level of private equity drypowder that has largely gone unspent growing pressure from private equity LPs seeking returns of their capital, and stronger sentiment amongst middle market companies to invest in the growth of their businesses, we expect stronger transaction volume in 2024.

The simple turning of the calendar year will also help. We would expect the fourth quarter will be moderately better than the third quarter in terms of volume but likely below fourth quarters in past years. We believe that our experience, scale and capabilities position as well to benefit from these market dynamics. Ares’ management has continued to invest in the quality and growth of its direct lending platform and we continue to focus on both sponsored and non-sponsored companies and the expansion of our specialty industry coverage. Leveraging what we believe is the largest and most tenured U.S. direct lending team in the market with 180 professionals across the U.S., we feel that our broad sourcing capabilities provide significant and differentiated deal flow.

As an example, in the third quarter, we reviewed more transactions that were reported in both the leveraged loan and the middle market combined. We believe these sourcing advantages allow us to maintain a highly selective approach, which in turn drives strong long-term investment performance. The sourcing capabilities have been a key driver to what we believe is a high-quality diversified portfolio. Our companies are continuing to perform well, despite the increase in borrowing costs. Our portfolio interest coverage ratio, measured using current market interest rates at the end of the quarter was stable quarter-over-quarter, and substantially all of our companies are consistently making their interest payments despite the higher base rates.

We’d also note that the weighted average portfolio grade is flat quarter-over-quarter and remains better than our 15-year average. Our non-accruals at cost are just over 1% and continues to be well below our own and BDC averages for the past 15 years. In addition, amendment activity and modifications remained stable at historical levels. The credit strength in our portfolio is supported by healthy levels of EBITDA growth across our portfolio companies, which we believe are demonstrating comparatively stronger growth in the broader market, due to the industries that we tend to overweight and our defensive positioning. Our simple strategy of avoiding cyclical sectors more prone to default continues to pay dividends for the company. We estimate that the weighted average LTV in our loan portfolio is around 43%.

Although we acknowledge the valuation environment is changing in response to higher rates, but regardless of these shifting valuations, we have covenants there’s significant value beneath us and most capital structures, a lot of it supplied by large and well-established private equity firms with whom we have strong relationships, and do repeat business. In situations where we have asked sponsors to step up and support their portfolio companies, we’ve been pleased with sponsors willingness and ability to provide capital. Despite this constructive view on the portfolio and the economy generally as credit investors, we are laser focused on ensuring we are well prepared in the event of a more protracted economic downturn. In addition to the benefits of our diversified and defensive portfolio, we have a large portfolio management and valuation team, which supports our investment teams, and is proactive in identifying problems early and developing strategies to maximize our outcomes.

Our balance sheet remains strong with net debt-to-equity levels of around one times. We have ample access to capital to invest in this attractive vintage. Importantly we also have access to capital to deal with more challenging situations as they arise. In tougher situations, we believe we have the appropriate resources to execute on our demonstrated playbook for managing the portfolio. We believe these risk management workout capabilities are central to our ability to continue to look to continue to deliver on our industry leading track record for credit performance. Given these dynamics and the company’s overall positioning, we feel good about our third quarter results and our position looking forward. And with that, let me turn the call over to Penni to provide some more details on our financial results and our balance sheet position.

Penni Roll: Thanks, Kipp. We reported GAAP net income per share of $0.89 for the third quarter of 2023, compared to $0.61 in the prior quarter, and $0.21 in the third quarter of 2022. Our higher GAAP net income per share in the third quarter of 2023 benefited from strong core earnings and higher portfolio values during the quarter, driven largely by tightening market spreads. On a core basis, we reported core earnings per share of $0.59 for the third quarter of 2023, compared to $0.58 in the prior quarter, and $0.50 in the third quarter of 2022. We continue to see the benefits of higher rates on our predominantly floating rate portfolio in the third quarter of 2023, as our interest and dividend income increased from both the prior quarter, and the third quarter of the prior year.

Our stockholders’ equity ended the quarter at nearly $10.8 billion, or $18.99 per share, which is an approximate 2% increase per share over the prior quarter. Our year-to-date annualized return on equity using GAAP EPS and core EPS was 14.5% and 12.5% respectively. This strong level of profitability further builds upon our long-term track record of a 12% GAAP-based annual return on NAV since inception. Our total portfolio at fair value at the end of the quarter was $21.9 billion, up from $21.5 billion at the end of the second quarter, reflecting a combination of net fundings and net unrealized gains from the portfolio for the quarter. The weighted average yield on our debt and other income producing securities at amortized cost was 12.4% at September 30, 2023, which increased from 12.2% at June 30, 2023 and 10.7% at September 30, 2022.

The weighted average yield on total investments at amortized cost was 11.2%, which increased from 11% at June 30, 2023 and 9.6% at September 30, 2022. The yields on our portfolio largely reflect the continued increases in interest rates. Now, let’s shift to our capitalization and liquidity. During the quarter, we returned to the investment grade debt markets for the first time in over 18 months. This $600 million debt issuance was our first sub-five-year term issuance in this market. This shorter three and a half year duration benefited our maturity ladder, as it allowed us to slot into 2027 where we after this issuance still only have $1.1 billion maturing in that year. Overall, our liquidity position remains strong with approximately $5.3 billion of total available liquidity, including available cash, and we ended the third quarter with a debt-to-equity ratio net of the available cash of 1.03 times as compared to 1.07 times a quarter ago.

We believe our significant amount of drypowder positions as well to continue to support our existing portfolio company commitments to remain active in the current investing environment, and to have no refinancing risk with respect to next year’s term debt maturities. We declared a fourth quarter 2023 dividend of $0.48 per share. This dividend is payable on December 28, 2023 to stockholders of record on December 15th, 2023 and is consistent with our third quarter 2023 dividend. As Kipp stated, we have a longstanding dividend track record. We’re one of a select few BDCs that have paid a stable or growing regular dividend over the past 14-plus years. And with that, I would like to turn the call over to Mitch to walk through our investment activities for the fourth quarter.

Mitch Goldstein: Thanks Penni. I’m going to spend a few minutes providing more detail on our investment activity, our portfolio performance and our positioning for the third quarter. I will then conclude with an update on our post quarter and activity, backlog and pipeline. In the third quarter, we originated $1.6 billion of new investments, which increased from $1.2 billion in the prior quarter, as we saw a slight uptick in M&A activity. Underscoring the breadth of our market coverage, the EBITDA in the companies we financed during the quarter range from below $20 million to over $800 million of EBITDA. Approximately 50% of our new commitments were to existing borrowers, which is consistent with our historical practice. With this quarter’s activity, our portfolio now includes 490 companies.

This is an increase from 354 companies pre-COVID and represents a growth rate of 38%. I point this out to highlight the meaningful benefits that come from incumbency. We believe incumbency drives future origination. Additionally, we believe incumbency enables us to support our strongest portfolio companies, reduces underwriting risks on new commitments, and achieves better documentation and terms. And finally, incumbency enhances our relationship with financial sponsors. This quarter, over 85% of our sponsored transactions, were with repeat sponsors. Now, as we have all year we continue to find compelling value in today’s market. This is demonstrated by the first lien investments we originated in the quarter, which had a weighted average yield in excess of 12%, but a leverage ratio of only 4.6 times.

This is a full turn of leverage lower than the industry senior leverage track by PitchBook LCD over the past 10 years. Underscoring its earlier point about the historically attractive relative value, we’re able to achieve in the current market, the weighted average LTV of all our new investments this quarter was below 40%. In addition to adding accretive investments in the current market, our existing portfolio continues to perform well. And we are seeing stability within our credit metrics. We believe this is largely due to our defensively positioned portfolio and market leading companies in resilient industries. In the third quarter, the weighted average LTM EBITDA growth rate of our portfolio was a healthy 6%. This compares to an estimated flat EBITDA growth rate for the S&P 500 over the last 12 months.

With respect to our portfolio grades, the weighted average portfolio grade of our borrowers at cost was stable with last quarters at 3.1. Our non-accrual rate at fair value declined from 1.1% last quarter to 0.6% this quarter, which continues to be well below historical levels. Non-accruals at costs decreased from 2.1% last quarter to 1.2% this quarter, and remain well below our 3% 15-year historical average, and the KBW BDC average of 3.8% for the most recent 15-year period available. Looking forward, we remain confident about the performance of our portfolio in part due to our disciplined approach to risk management and portfolio diversification. Our $21.9 billion portfolio at fair value is diversified across 490 different companies and 25 different industries.

This means that any single investment accounts for just 0.2% of the portfolio on average, and our largest investment in any single company, excluding SDLP and Ivy Hill is just 2% of the portfolio. We believe we have the greatest level of portfolio diversification of any publicly traded BDC. Finally, I will provide a brief update on our post quarter end investment activity and pipeline. From October 1 through October 18, 2023, we made new investment commitments totaling $410 million of which $287 million were funded. We exited or were repaid on $158 million of investment commitment. As of October 18, our backlog and pipeline stood at roughly $820 million. Our backlog and pipeline contain certain 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, Mitch. In closing, we’re pleased with the quarter. Our portfolio continues to perform well and our sourcing, underwriting, portfolio management and capital advantages are driving strong financial results. We feel that we’re well positioned to navigate any potential future economic challenges and to capitalize on today’s attractive environment for new investing. As always, we appreciate you joining our call today, and we’d be happy to open the line for questions. Operator?

Operator: Thank you. [Operator Instructions]. Our first question comes from Melissa Wedel with JPMorgan. Please proceed with your question.

Melissa Wedel: Good morning. Thanks for taking my questions, today. Kipp, I want to start with some of the commentary you provided around expecting some rebounded activity in 2024. It sounds like some of that is based on drypowder and expected pressure from private equity investors to reengage a little bit. But do you think there’s risk to that recovery and activity should rates remain even higher than expected as implied by the forward curve right now?

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Q&A Session

Kipp DeVeer: I mean it’s probably just — thanks for the question, Melissa. It’s probably just my own view. But I mean, I think this has been a difficult year to buy and sell things, as I’ve said in some other places. If you haven’t been in a need to sell mode, this is probably a pretty difficult year to think about selling. And then buyers, obviously, are exploring, we think, materially lower purchase prices for a lot of assets, not just corporates. And I think that translates similarly into real estate and infrastructure assets, et cetera, everything is just worth less in a higher rate environment. My optimism around next year is that if we see a leveling out of rates, which I think we’re seeing, generally, maybe there’s another increase or two.

But generally, you’re seeing a leveling of rates that price exploration that’s been going on between buyers and sellers just gets to be a bit easier, right? But while you’re seeing rates, I think unexpectedly increase as quickly as they did. And as materially as they did, it just makes those conversations more difficult. So that’s kind of number one. And number two, yeah, my belief is that there are a lot of limited partners out there that have money in the ground, particularly in private equity, where they’re looking to 24 a year where they need more material repayments to come back, right? When they think about managing their cash flows, whether it’s a pension or any other investor. So I’m hopeful that the combination of those two things should lead to better activity levels.

I think our deal flow today, Mitch talked a little bit about the backlog and pipeline is better than it’s been. So I’m cautiously optimistic, but I guess we’ll wait and see.

Melissa Wedel : That’s really helpful. Thanks, Kipp. And then a question for Penni. Penni, did you have an update for us on any lower income as of quarter end? Thanks so much.

Penni Roll: Thanks for the question. We have been continuing to accrue — well, I may go back to — we did finalize last year’s tax returns. And the final spillover was about $1.18 per share or $643 million as we finalize that number, and that’s what’s reflected in the earnings presentation. As we look into 2023, we continue to accrue excise tax to come to a similar level of spillover to last year. We’re still obviously going through the year and tax is never done until we get through a full year. But we are continuing to accrue excise tax at a similar level, if you annualize where we are this year-to-date versus the final expense for last year.

Melissa Wedel : Thanks, Penni.

Operator: Our next question is from Finian O’Shea with Wells Fargo. Please proceed with your question.

Finian O’Shea : Hi, everyone. Sorry, I was on mute. On the repeat borrower financing statistic you gave 50% this quarter, which is helpful that you give that, that appears to have come down from pretty elevated levels in the first half. So I’m seeing if there’s anything to see there in terms of a completion, say, refinancings of your portfolio companies or maybe some of the exits are rolling off out into the market. I’ll stop there. And I guess if you can add as well year-to-date, what percent of your — directionally of your commitments to REPEAT borrowers are for refis versus M&A? Thanks.

Kort Schnabel : Yeah. Hey, Finian, it’s Kort Schnabel. I think on the first part of the question around the 50% to existing borrowers, that’s actually consistent with our historical experience, if you look back over a normal period at 50% to existing borrowers. So I think what you’re just seeing is a pickup in activity for new borrowers relative to the prior few quarters where, obviously, that volume was a little more muted. And that’s what resulted in us returning to that 50% level to existing borrowers. So I don’t think there’s anything more to see there other than that. And then on the second part of the question, actually, I’m sorry, I don’t —

Kipp DeVeer: Now was the — is there a change in use of proceeds? I don’t think then we have kind of that analysis run, frankly, we can go back and dig a little bit in the numbers. But let us take a look at that, and we’ll come back to you offline.

Finian O’Shea : Okay. Thank you. And a follow-up on Ivy Hill, do you have a breakdown of, say, the weighted average duration for the CLO reinvestment periods? Are those materially shortening like as we’re seeing in the CLO market. Thank you.

Kipp DeVeer: Yeah. No, not really. I mean we continue to actually be able to raise capital there. I could go back and dig with the team and look at it, if it’s not something I spend a lot of time thinking about. It’s pretty diversified. It’s a combination of loan mandates and CLOs, but Mitch waving at me that he’s—

Mitch Goldstein : I would say it’s not all CLOs and idle anyway, right? There’s a lot of bespoke, they call it the loan mandate, bank loans where we are able to adjust those maturities year after year and have a consistent basis within ideal. There’s not a shortening of that, and we’ve been having lots of success refinancing when we needed to, but they’re not all CLOs would be important for.

Finian O’Shea : Thanks so much.

Mitch Goldstein : Yeah, thanks.

Operator: Our next question comes from Arren Cyganovich with Citi. Please proceed with your question.

Arren Cyganovich : With ’24 looking like it might be a better year for — or at least an increase in activity for investing, are you expecting exits to be of a similar amount? And what are you thinking about in terms of potentially increasing some of the leverage you have in the portfolio?

Kipp DeVeer: Yeah. I mean they tend to be reasonably reciprocal Arren. Thanks for the question. I would think that new deal activity and repayments are likely to pick up next year relative to this year, which has been slower on all those fronts.

Arren Cyganovich : Okay. And it was good to see your nonaccrual activity, ratios came down again. What’s your outlook for next year for expectations with non-accruals? I would imagine in the industry, expect to see a bit of an increase from here?

Kipp DeVeer: Yeah, I think you’re probably right. I mean this quarter where we actually realized a couple of restructurings and situations where we took ownership of a company where we continue to be a lender. We actually exited two situations that we were not feeling great about and realized two charge-offs but charge-offs sort of at the mark. So I think we carried them well. Yeah, I think you’re probably right. I mean, with higher rates, being in place now for a while and the general slowdown in the economy, that would tell you the general expectation, I think, not just at this company, but most of our competitors in the market broadly is the defaults will continue to go up next year.

Arren Cyganovich : Thanks.

Kipp DeVeer: Yeah.

Operator: Our next question comes from Casey Alexander with Compass Point. Please proceed with your question.

Casey Alexander : Hi, good afternoon. On kind of a cross purposes question, but noticing that you swapped out the new debt maturity into a floater, it sort of feels like a call that it’s your expectation that rates will come down and that your cost on that will get cheaper. Otherwise, I’m not sure why you would swap it out. But suggesting that ’24 is a better year for deals and originations actually argues that you think that the economy is going to be okay and deal activity is going to pick up. And that kind of argues that rates stay higher for longer. I’m curious at sort of the cross currents from those two items.

Kipp DeVeer: I’m going to turn to Penni on the hedging comment because we had quite a lot of debate about that. It was atypical from our past practice. But Penni, do you want to jump into some thinking there maybe and then we can come back and talk about this on ’24 and how we see things. And Casey, your guess is as good as mine around rates, but I’ll let Penni comment on the hedging range.