Ares Capital Corporation (NASDAQ:ARCC) Q4 2022 Earnings Call Transcript

Ares Capital Corporation (NASDAQ:ARCC) Q4 2022 Earnings Call Transcript February 7, 2023

Operator: Good afternoon, and welcome to Ares Capital Corporation’s Fourth Quarter and Year Ended December 31, 2022 Earnings Conference Call. . As a reminder, this conference is being recorded on Tuesday, February 7, 2023. I will now hand the call over to Mr. John Stilmar, Managing Director of Ares Investor Relations. Please go ahead.

John Stilmar: Good afternoon, everybody. 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 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, core EPS.

The company believes that core 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 operation. A reconciliation of core EPS to basic and diluted net income per share, the most directly comparable financial measures can be found in the accompanying slide presentation for this call. In addition, the 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 representation or warranty in respect of this information. The company’s fourth quarter and year-end December 31, 2022 earnings presentation can be found on the company’s website at www.arescapitalcorp.com by clicking on the fourth quarter 2022 earnings presentation link on the home page of the Investor Resources section. Ares Capital Corporation’s earnings release and Form 10-K are also available on the company’s website. I’ll now turn the call over to Kipp DeVeer, Ares Capital Corporation’s Chief Executive Officer.

Kipp DeVeer: Thanks, John. Hello, everyone, and thanks for joining our earnings call today. I’m here with our Co-President, Mitch Goldstein and Kort Schnabel; our Chief Financial Officer, Penni Roll; our newly appointed Chief Operating Officer, Jana Markowicz and other members of the management team. For those of you who don’t know ready know, Jana has been an important member of the Ares direct lending team for over 18 years, and we’re delighted to have joined the executive team at Ares Capital. Jana currently serves as a Chief Operating Officer, Head of Product Management and Investor Relations for our U.S. Direct Lending strategy. Our newly pointed President, Kort Schnabel will speak later in the call, but I’d like to formally welcome him as well.

Kort has been instrumental in helping us grow and manage the U.S. Direct Lending business over the last 19 years, and we’re thrilled to have him on board. A warm welcome to both of them. This morning, we reported strong results for the fourth quarter and the full year. We generated record quarterly core earnings per share, $0.63. This 26% quarterly increase in core earnings was largely driven by the benefit of rising market interest rates and our net interest income, but also from strong capital structure and fee income on the fourth quarter transactions. For the year, our core EPS of $2.02 matched from a prior record in 2021. On a GAAP basis, our fourth quarter and full year earnings of $0.34 per share and $1.21 per share, respectively, were below our core earnings and has been recognised $0.03 per share and $1.08 per share, respectively, of net unrealized depreciation due largely to widening market yields.

Despite these markdowns, which we’ve taken stride with the transitioning market, we generated net realized gains from the full year 2022 as we continue to deliver positive realized gains in excess of our losses. The realized gains and losses is the more important metric in grading our performance than the unrealized gains and losses, which has substantially less impact on our long-term results. In our view, our track record of strong credit performance compared with other BDCs demonstrates the merits of our long-tenured proven investment process as we work to deliver differentiated results to our shareholders. I’d now like to shift and provide some thoughts on the market and the economic environment. 2022, as a year of transition for the U.S. economy and one that brought significant volatility to the capital markets.

As overall capital formation slowed in both the liquid and private credit markets, we believe the competitive dynamics and the risk-reward environment for Ares Capital shifted positively can be as attractive as we’ve seen in quite some time. Market spreads on new deals are at least 100 to 150 basis points higher than at year-end 2021, and we believe that the total return opportunity afforded by the higher base rate in addition to the spread expansion is very compelling. These enhanced economics are being achieved in transactions that also have reduced leverage and meaningfully better documentation. We think this is an exciting development for our new investment business, and we remain active in the market. To dig in a bit deeper, the senior loans that we originated in the fourth quarter had a weighted average yield of more than 10.5%, with weighted average leverage less than 5x debt-to-EBITDA.

Many of these investments focused on larger businesses. We provided loans to companies with a weighted average EBITDA of more than $500 million in the fourth quarter. We believe the volatility of 2022 also continues to widen the fairway for us and to expand the market in direct lending generally. Larger companies continue to shift their focus to private capital alternatives as a preferred and more reliable source of financing for their businesses. And with challenges faced by the banks due to risk capital constraints and the lack of liquidity in the syndicated market, we believe private lenders have steadily gained share throughout 2022. This has led to our involvement with larger companies. At year-end 2022, the weighted average EBITDA of our portfolio companies reached $275 million, an increase from $162 million at the end of 2021 and meaningfully above the weighted average from 5 years ago of $62 million.

We believe this offers significant benefits to Ares Capital as we grow as larger companies generally have stronger credit profiles as a result of more diverse revenue streams, broader customer bases and more experienced management teams. As demand for our capital solutions has grown, we’ve responded by continuing to augment our direct origination capabilities through continued hiring and the addition of new capabilities. Today, we believe we employ the largest direct lending team in the United States with approximately 170 dedicated investment professionals. We believe that the scale of our team enables us to have complete market coverage by industry and by geography and to drive compelling opportunities in every channel that we target. For example, despite a 22% drop in U.S. M&A volumes, and a 45% decline in broadly syndicated transaction volumes in 2022, we reviewed more than $500 billion in transactions.

This volume is comparable with or even slightly higher than the amount we reviewed in 2021, which was the busiest year in the company’s history. Despite this, during periods of volatility, our inclination is to become incrementally more selective on new deals and utilize the experience of our large and tenured portfolio management team to focus on risk management efforts. We do have an expectation that a slower U.S. economy and the higher rate environment will create more stress in the portfolio, and we’re focused on getting ahead of it as we have in past economic and market cycles. Led by partners with an average of over 15 years tenure at Ares, we believe we have the largest and most experienced portfolio management team when compared with other direct lenders.

And this team works in collaboration with our core investment teams to actively monitor and engage with our borrowers and sponsors. Our goal is to identify problems early and develop strategies to maximize our outcomes in companies that are underperforming to plan or having more difficulty in the higher interest rate environment. The economic benefits from our credit and portfolio management process have led to a strong culture focused on downside protection and risk mitigation in our lending activities. Since inception, Ares Capital has generated a cumulative 1% net realized gain rate on our investments. This means that along with generating gains on many investments, we have also successfully minimized losses in the portfolio in more difficult times.

One statistic to call out here, we’ve actually achieved about 0.9x multiple on invested capital on all the loans that have been placed on nonaccrual over the years. Despite the more challenging backdrop and the higher prevailing interest rates, we feel the portfolio is defensively positioned today due to our long-standing underwriting strategy of focusing on market-leading companies with high free cash flows and what we believe to be resilient industries. Using market interest rate levels at year-end, our overall interest coverage for the total portfolio was 1.8x. These strong coverage metrics allowed us to receive 99% of contractual interest in our portfolio during the fourth quarter. The health of the portfolio is also demonstrated by stable weighted average portfolio grade and nonaccrual rates to remain quite low relative to historical averages.

Finally, the strength of our portfolio continues to benefit from the substantial amount of equity invested in our companies. Most often from large and well-established private equity firms. At year-end 2022, we calculated the weighted average loan-to-value in the portfolio to be approximately 45%, which we believe gives us strong cushion to the downside in these loans. These metrics, along with our positive view of the company’s earnings power, support of our decision to increase our regular quarterly dividend 3x during 2022, moving from $0.41 per share in the fourth quarter of 2021 to $0.48 per share in the fourth quarter of 2022 which builds on our long-term track record of delivering consistent dividend growth. 2022 represents our 13th consecutive year of stable or increasing regular dividends to our shareholders.

Supplementing this growing regular dividend, we paid $0.12 per share of additional dividends in 2022, resulting in $1.87 per share of dividends for the year, which represented a 15% increase in total dividends versus 2021. With that, let me turn the call over to Penni to provide more details on our financial results and some further thoughts on our balance sheet.

Penelope Roll: Thanks, Kipp. For the fourth quarter of 2022, we had a record level of core earnings of $0.63 per share compared to $0.50 per share in the prior quarter and $0.58 per share in the fourth quarter of 2021. For the full year 2022, our core earnings per share was $2.02, matching the core earnings per share for 2021. Our 2022 earnings significantly benefited from the increase in market interest rates driving a 17% increase in net interest and dividend income per share as compared to 2021. The growth in these recurring earnings roughly offset the decline in capital structuring fees in 2022 relative to the higher fees earned during the more active 2021. On a GAAP basis, we reported GAAP net income per share of $0.34 for the fourth quarter of 2022 compared to $0.21 in the prior quarter and $0.83 in the fourth quarter of 2021.

For the year, we reported GAAP net income per share of $1.21 compared to $3.51 per share for 2021. Our core earnings for 2022 as compared to 2021 and was stable year-over-year, where our GAAP net income for 2022 was reduced by the net unrealized depreciation taken on the portfolio throughout the year, driven primarily by market volatility. Conversely, our GAAP net income for 2021 benefited from the net unrealized appreciation seen on the portfolio throughout that year as we saw a rebound from valuation declines incurred in 2020 as a result of COVID. While we have seen volatility in asset values over the past few years, our underlying portfolio continues to perform well through this volatility, as Kipp mentioned earlier. Our stockholders’ equity ended the year at $9.6 billion or $18.40 per share compared to $9.4 billion or $18.56 per share at the end of the third quarter 2022 and $8.9 billion or $18.96 per share at the end of 2021.

Our portfolio at fair value at the end of the year grew to $21.8 billion, up modestly from $21.3 billion at the end of the third quarter and more meaningfully from $20 billion at the end of 2021. The weighted average yield on our debt and other income-producing securities at amortized cost was 11.6% at December 31, 2022, as compared to 10.7% at September 30, 2022, and 8.7% at December 31, 2021. The weighted average yield on total investments at amortized cost was 10.5%, which increased from 9.6% at September 30, 2022, and 7.9% at December 31, 2021. The yields on our portfolio reflect rates given our predominantly floating rate loan portfolio. Shifting to our capitalization and liquidity. We ended the fourth quarter with a debt-to-equity ratio net of available cash of 1.26x.

Pro forma for the $223 million equity offering that we closed in January of 2023, our debt-to-equity ratio, net of the available cash declined to 1.21x. Our liquidity position remained strong with approximately $3.9 billion of total available liquidity, including available cash, pro forma for our financing activities in the beginning of this year. After accounting for the $750 million of unsecured notes that come due this month, our next nearest debt maturity is not until March of next year. With this level of dry powder, we believe that we remain well positioned to take advantage of the current investing environment. As Kipp stated earlier, we declared a first quarter 2023 dividend of $0.48 per share. This dividend is payable on March 31, 2023, to stockholders of record on March 15, 2023, and is consistent with our fourth quarter 2022 dividend.

We continue to consider our taxable income and the amount of spillover when setting our overall dividend. We recognized that we had a strong level of core earnings for the year, which far outpaced the total dividends we paid. When looking at our taxable income for the year, our current estimate of undistributed taxable income sometimes referred to as our spillover at year-end 2022 is $675 million or approximately $1.27 per share after considering the shares issued in our January equity raise. This spillover reflects the realization of a tax deduction related to a legacy Allied Capital investment which reduced our total taxable income for the year and thus reduced our spillover. After considering this deduction, our estimated spillover for 2022 is generally in line with the $678 million that we carried over last year.

Importantly, this 2022 spillover level is more than 2.5x greater than our current regular quarterly dividend rate. We continue to believe that having a healthy level of spillover income is beneficial to the stability of our dividend. We will continue to monitor our undistributed earnings and balance these levels against prudent capital management considerations. With that, I would like to welcome Kort to his first Earnings Call and will now turn it over to him to walk through our investment activities.

Kort Schnabel: Thanks, Penni, and hello, everyone. Before I get started, I just want to say, after 21 years at Ares I could not be more excited to serve as new Co-President of Ares Capital Corporation and for the opportunity to help lead our company into the future. I look forward to spending more time with all of you on the phone here in the months and years ahead. Okay. Let’s move it forward, and I can provide more detail on our investment activity and portfolio performance for the fourth quarter. I will then conclude with an update on post quarter end activity, backlog and pipeline. Over the course of 2022, we completed over 180 investments across 23 distinct industries. In line with the overall loan portfolio, the top 3 industries where we made new financing commitments in 2022 were software and services, health care services and commercial and professional services.

Our new investments were made into what we believe are high-quality companies, which present opportunities for attractive risk-adjusted returns, driven by lower leverage levels, tighter credit documents and higher spreads. As we’ve seen in the past, periods of volatility amplify the secular shift towards private capital. This dynamic is clearly illustrated by LCD’s recent report which shows that 98% of the new LBO issuance in the fourth quarter of 2022 was completed by private capital providers, a market traditionally supported by the broadly syndicated channel. We believe that our scale, competitive position and flexible capital have enabled us to take advantage of these opportunities. Importantly, we were a lead arranger on 85% of our investment during 2022 and 95% of our investments in the fourth quarter.

The ability to lead transactions is an important benefit we derive from our trusted relationships, our scale and the attractiveness of the capital solutions we provide. We strongly believe our approach provides us greater control over capital structures, pricing and documents, and longer term, better tools to drive successful credit outcomes. We also believe the size and quality of our incumbent portfolio drives differentiated access to attractive investments. In 2022, over 50% of our new commitments were to existing borrowers, which is consistent with our history. Incumbency enables us to support our strong performing portfolio companies that we know well, which we believe limits underwriting risk on new commitments. Shifting to our portfolio.

As of year-end 2022, our portfolio remained well diversified across 466 different borrowers, with an average hold size of only 0.2% at fair value. Excluding our investment in Ivy Hill and the SDLP, which we believe are diversified on their own, no single investment accounts for more than 2% of the portfolio at fair value, and our top 10 largest investments totaled just 11.8%. We believe the diversification of our portfolio differentiates us from our competitors as it reduces the impact to the overall portfolio from any single negative credit event at an individual portfolio company. We also believe this diversification plays a significant role in ensuring that we have predictable revenue, which gives us confidence in the level of dividend we have declared.

Kipp discussed this a bit earlier as well, but we do believe the fundamentals and overall credit performance of our portfolio remain healthy. The weighted average EBITDA of our underlying portfolio companies demonstrated solid growth in the fourth quarter, expanding 11% year-over-year. This overall healthy EBITDA growth is skewed to our larger industry concentrations, which, in aggregate, are growing at a faster rate than our smaller industry concentrations in the overall portfolio. This underscores what we believe are one of the many merits of not being a benchmark style investor as we are able to be selective, not only in regard to the companies we are financing, but also the industries we target more generally. The weighted average grade of our portfolio companies of 3.2 was consistent with last quarter and improved slightly from 3.1 in the fourth quarter of 2021.

Also, our portfolio management team believes that the share of companies that were highly impacted by inflationary pressures, supply chain disruptions and staffing shortages remained at stable and manageable levels. By our measures, those impacted represent less than 10% of the total loan portfolio. Our nonaccrual rate during the fourth quarter increased slightly as we added 1 net new company to nonaccrual, resulting in nonaccruals at cost of 1.7% as compared to 1.6% in the third quarter of 2022. Our nonaccrual rate is currently below our average during 2021 and well below our 10-year average of 2.4%. Amendment activity continues to represent a small number of companies relative to the size of our portfolio, although it has picked up since prior quarter.

We do expect that amendment activity is likely to increase in future periods as well, but remain manageable. It is important to note that the amendments we enter into often come with positive to us as the lender in the form of fees, incremental spread, tighter documents and sponsor equity injections. Finally, I’ll provide a brief update on our post quarter end investment activity and pipeline. From January 1 through February 1, 2023, we made new investment commitments totaling $226 million, of which $158 million were funded. We exited or repaid on $372 million of investment commitments. As of February 1, our backlog and pipeline stood at roughly $265 million. Our backlog contains investments that are subject to approvals and documentation and may not close or we may sell a portion of these investments post closing.

So while it’s been a pretty slow start to the year, even for the typically seasonally slow first quarter, we do expect things should pick up here in regular course. And I will now turn the call back over to Kipp for some closing remarks.

Kipp DeVeer: Thanks a lot, Kort. We’re thrilled to formally have you on board here at the company, and I know you’ll add a ton of value here and Co-President with Mitch. In closing, 2022 was a year of strong performance for the company, and we believe that we’re well positioned to navigate through any uncertainty that lies ahead. Our long track record of successfully managing the company throughout economic and market cycles, provides us with confidence as we enter a different environment in 2023 and likely beyond. Over the past 10 years through September 30, 2022, which is the latest full reporting quarter for all the BDCs, Ares Capital has differentiated itself versus the competition in almost every relevant performance metric.

The company has delivered the highest regular base dividend per share growth rate, the highest NAV per share growth rate, the highest total return on its NAV and the best equity return on our stock. In each case, when compared with every other externally managed BDC with a market capitalization of over $700 million that’s been publicly traded for the last 10 years. Let me close by saying that we’re deeply grateful to our investors for the trust and confidence they’ve demonstrated in areas and their support to the company. I’d also like to thank our team for their hard work and their dedication throughout 2022. With that, operator, I think we can open the line for questions.

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Q&A Session

Operator: . Our first question today comes from the line of Melissa Wedel from JPMorgan.

Melissa Wedel: To start, I thought maybe we could just touch on the dividend policy. I know that you’ve talked about how you’ve approached that both today, but also in the past. I guess compared to where you were last year in paying out a small supplemental dividend per quarter, is there anything that we should read into the fact that you didn’t establish something similar headed into ’23, especially with the level of earnings power currently embedded in the portfolio?

Kipp DeVeer: Melissa, it’s Kipp. No, I don’t think there’s anything to read into it. We obviously chose to increase the dividend pretty materially. The regular dividend last quarter from $0.43 to $0.48 to obviously acknowledge the increased earnings power. We said we were going to reevaluate the spillover, which when we trued up from a tax perspective is kind of the same as it was at year-end last year. So we really tried to pursue the increase through a regular increase rather than a special. But I don’t think there’s anything to read into. And obviously, we have opportunities going forward to do other things, whether it’s a regular increase or a special in the future. But I wouldn’t read anything into it.

Melissa Wedel: Okay. And then a follow-up to your comments about sort of nonaccrual rates and how they compare to sort of the historical average portfolio. You did say that you expect stress to increase from incredibly low levels currently. In that context, are you expecting sort of a reversion to mean for this portfolio? Or are you expecting that to take a bit higher than the long-term average?

Kipp DeVeer: Yes. I mean it’s hard to tell. We obviously tried to lay out in the prepared remarks. I did, and I think Kort did as well. look, our expectation that it’s probably going to be a more volatile year than we would expect the increase in amendment activity and all of that to lead to increases in nonaccruals and defaults, not only for us, but we expect for our competitors and focus in the business in general. Based on how we see the portfolio and the economy as a whole though, I think more of a reversion to average is likely. We get asked the question a little bit differently than you asked at most of, but I’ll ask the question that we had asked instead of the one you asked, which is we don’t expect the current environment is going to create an extraordinary amount of defaults that flow through historical averages.

We see this as a pretty regular credit cycle where defaults are likely to go up and not exceed the averages. I think is how we’re seeing things today.

Operator: The next question today comes from the line of Ryan Lynch from KBW.

Ryan Lynch: First question I just had was, if I look at your capital restructuring fees, they basically doubled this quarter versus the prior quarter on kind of a modest level of increasing commitments in the quarter. Was there anything kind of onetime going on in the numbers this quarter? Or is that just kind of more indicative of the current lender-friendly environment allowing you to kind of generate more economics from the deals you guys are joining?

Kipp DeVeer: Yes. I mean nothing extraordinary. I mean I think we’re — fees generally for new deals are higher. Is the simple answer, Ryan.

Ryan Lynch: Okay. Okay. So just the particular ones you guys had this quarter were higher fee deals.

Kipp DeVeer: Yes. I mean the average fee rate on new commitments is higher relative to the average and relative to prior quarters.