Ares Capital Corp (ARCC) 2013 Q2 法說會逐字稿

Good day, and welcome to the Ares Capital Corporation Second Quarter 2013 Conference Call and Webcast. All participants will be in listen-only mode.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Mr. Michael Arougheti, CEO. Mr. Arougheti, the floor is yours, sir.

Great. Thank you operator, and good morning everyone, and thanks for joining us.

For today's call, I will briefly highlight our second-quarter results and touch on marketing conditions, before turning the call over to Penni Roll, our CFO, to take us through the financial results in more detail. Our President, Kipp deVeer, will then discuss our investment activity and portfolio performance, and I'll conclude the call and open it up for Q&A.

We reported strong results for the second quarter. Our core earnings per share of $0.38 continued to fully cover our dividend. Our GAAP earnings of $0.50 per share benefited from both net realized and unrealized gains, driven primarily by healthy market conditions and strong investment performance. Our net asset value increased 1.4% quarter over quarter, and 4.5% year over year to $16.21.

Our portfolio companies continue to perform well. Non-accrual ratios further improved during the second quarter, reaching the lowest quarterly level since the end of the first quarter of 2008, measured on an amortized cost basis. Weighted average EBITDA growth for the underlying corporate portfolio companies remained strong, at 9% when measured over the last 12 months for the most recently available period, compared to the same prior 12 months.

While this was an active quarter of new investments for us, we ended the second quarter with modest leverage and approximately $1.2 billion in available debt capacity for new investments. Our balance sheet continued to be well-positioned at quarter end, given our largely floating-rate assets, combined with a long-dated, predominantly fixed rate, and well-laddered liability structure.

From a market standpoint, beginning in late May the credit markets began to experience volatility, caused by the Federal Reserve's communication around tapering. Credit spreads widened moderately, and flex activity on syndications picked up in June. However, this volatility was fleeting, and had no real lasting impact on the leveraged loan market for the quarter. To that point, the S&P Leveraged Loan Index was down only 0.8% during the second quarter, while the Thomson Reuters middle-market loan index increased 0.7%. High-yield bonds, which carried fixed-rates coupons and are more sensitive to interest rates, were more adversely impacted by the Fed discourse, with bid prices down 3.6% for the second quarter.

Since quarter end, credit market volatility has declined, as market participants have become more comfortable with the prospect of a gradual reduction in monetary stimulus. Weekly in-flows are trending positive in both the leveraged loan and high-yield markets, and credit spreads are firming once again in both the broadly syndicated and middle markets for leverage loans. However, while the markets have recovered rather quickly, we are seeing a little more credit discipline in the markets than before this period of volatility.

From an activity standpoint, while the broadly syndicated loan market cooled off in the second quarter, with loan volumes down 14% compared to the first quarter, overall middle-market loan volume was stronger, up about 19% quarter over quarter. Middle-market loan volume for private-equity-sponsored transactions was also more robust, up 31% quarter over quarter. This trend was clearly reflected in our quarterly investment activity.

As Kipp will discuss later in the call, the strong sponsored finance market environment during the second quarter provided us with the opportunity to make several larger investments in new portfolio companies. In the aggregate, we made over $1.2 billion of gross commitments, while repayments were comparatively slower, resulting in net new commitments for the quarter of $809 million.

Lower capital markets volatility after quarter end allowed us to be opportunistic on the right-hand side of our balance sheet. In July, we took advantage of improved market conditions and issued $300 million of 5.5-year senior unsecured convertible notes, with a coupon of 4 3/8%, and an initial conversion price of $20.16. This issuance lowered our overall funding costs on our fixed-rate debt, and enabled us to term out some revolving debt for 5.5 years.

Now Penni, if you would lead us through the second-quarter financial results in more detail?

Sure, thanks Mike.

For those of you viewing the earnings presentation posted on our website, you can start by turning to slide 2, which highlights our financial and portfolio performance information. As Mike said, our basic and diluted core earnings were $0.38 per share for the second quarter of 2013, which was in line with the $0.38 per share for the first quarter of 2013, just slightly down from the $0.40 per share in the second quarter of 2012. The $0.02 decrease in our second-quarter core earnings per share versus the second quarter of 2012 was primarily driven by the impact of higher leverage a year ago, compared to the second quarter of 2013.

GAAP net income for the second quarter of 2013 was $0.50 per share, an increase compared to $0.32 per share for the first quarter of 2013, and $0.41 per share for the second quarter of 2012. Total investment income for the second quarter of 2013 was $206.1 million, a 5.7% increase over total investment income of $195.1 million for the first quarter of 2013. As compared to the first quarter, the second quarter saw an increase in interest income due to the impact of the higher net origination activity, and an increase in structuring fees.

Dividend income for the second quarter of 2013 was lower than for the first quarter of 2013, as Q1 dividend income included an additional dividend of $17.4 million from our portfolio company, Ivy Hill Asset Management, which was paid out of accumulated earnings previously retained by IHAM. The regular quarterly dividend paid by IHAM for both the first and second quarters of 2013 was approximately $10 million.

Our net investment income, which includes accruals for capital gains incentive fees, decreased to $0.35 per share for the second quarter, compared to $0.40 per share in both the first quarter of 2013 and the second quarter of 2012. The lower second quarter 2013 net investment income per share was primarily due to the accrual of $0.03 per share of capital gains incentive fees, attributable to net realized and unrealized gains, as compared to a reduction in the capital gains incentive fee accrual of $0.02 per share in the first quarter of 2013, and a de minimus per share accrual in the second quarter of 2012.

By comparison, net realized and unrealized gains for the second quarter of 2013 were $0.15 per share, compared to net realized and unrealized losses of $0.08 per share in the first quarter of 2013, and net realized and unrealized gains of $0.01 per share for the second quarter of 2012.

As Mike highlighted, our origination pace was strong, especially as compared to the seasonally slower first quarter, as we made gross investment commitments totaling $1.2 billion, compared to gross investment commitments of $410 million during the first quarter of 2013, and $728 million during the second quarter of 2012. We exited commitments of $395 million in the second quarter of 2013, resulting in net commitments for the quarter of $809 million. Net fundings for the second quarter of 2013 were $747 million, as compared to $129 million and $248 million for the first quarter of 2013 and second quarter of 2012, respectively.

As of June 30, 2013 we had total assets of $7.1 billion, and total stockholders equity was $4.3 billion. As you can see on slide four, as of June 30, our portfolio totaled $6.8 billion at fair value, and consisted of 164 portfolio companies. At fair value, 62% of the portfolio was in senior secured debt investments, 21% was in subordinated certificates of the senior secured loan program, which as of June 30, had 41 separate borrowers. 4% was in senior subordinated debt, 4% was in preferred equity, and 9% was in equity and other securities.

We continue to emphasize floating-rate loans. You'll see floating-rate assets were 79.3% of our portfolio at fair value at the end of the second quarter of 2013, up from 75.3% as of the end of the first quarter of 2013. From a yield standpoint, the weighted average yield on our debt and other income-producing securities at amortized cost declined 30 basis points quarter over quarter, and 90 basis points year over year, to 10.8%. This decline reflects a continued focus on investing in lower-yielding senior secured debt, lower yields on new debt investments in general, and the re-pricing of some loans as a result of market conditions, and the exit or repayment of some higher-yielding investments.

The weighted average yield on our total portfolio at amortized cost has shown a more moderate decline of 10 basis points quarter over quarter, and 60 basis points year over year to 9.8%, as we have reduced our portfolio weighting in non-yielding equity investments. Having said that, when income generated from our assets is measured against our interest costs, we have been able to maintain our net interest and dividend margin, which we look at as net interest and dividend income over our average portfolio at amortized cost over the last 12 months. This margin remained flat quarter over quarter at 8.7%, and was slightly above the 8.5% margin for the second quarter of 2012.

Let's turn to slide 7, and I will highlight the components of our net realized and unrealized gains for the second quarter, which totaled $39.9 million, or $0.15 per share. During the quarter, we realized $8.6 million in net realized gains, in addition to $33.7 million of net unrealized gains, and $2.4 million of reversals of prior net unrealized appreciation related to net realized gains. The $33.7 million of net unrealized gains were primarily related to the net appreciation of a number of our equity securities.

Now let's turn to slide 9 for a discussion of our debt capital. As of June 30, we had approximately $3.9 billion in committed debt facilities, and approximately $2.7 billion aggregate principal amount of indebtedness outstanding. Over 50% of our total committed debt capital, and approximately 75% of our outstanding debt at quarter end, was in fixed-rate term debt with immediate- to longer-term maturities. In our view, the long weighted average maturity of our debt of nearly nine years provides us with significant stability, and contributes to the overall strength of our balance sheet. In addition, we enjoy operating flexibility by not having any debt maturities until 2016.

During the second quarter, we completed an amendment to our largest revolving credit facility, reducing the spread on the facility from 225 basis points to 200 basis points over LIBOR, extending the revolving period and the state of maturity by two years each to 2017 and 2018, respectively; which brings us to a five-year tenor versus the previous four year tenor, and increasing commitments to the facility by $30 million, bringing the total commitments to $930 million. Additionally, subsequent to quarter end, we further increase commitments to the facility by $25 million, bringing the total commitments to $955 million.

The weighted average stated interest rate on our outstanding debt at quarter end decreased to 5%, as compared to 5.5% at the end of the first quarter of 2013. This decline reflected an increase in borrowings on our lower-cost secured revolving facilities. The weighted average stated interest rate on our outstanding debt is calculated based on the mix of our actual borrowings at period end. On a fully funded basis, our weighted average stated interest rate declined from 4.3% for the second quarter of 2012 to 4.1% for the second quarter of 2013. In total, at the end of the second quarter, we had approximately $1.2 billion in available debt capacity, subject to borrowing base and leverage restrictions, and $80 million in available cash. As of June 30, our debt-to-equity ratio was 0.59 times, and our debt to equity ratio net of available cash was 0.57 times.

Since quarter end, we have continued to focus on our liquidity and cost of capital. As Mike mentioned, in July we completed a $300-million unsecured convertible notes offering. These notes mature in 2019, and have a stated interest rate of 4.38%, and a conversion premium of 15%, resulting in an initial conversion price of $20.16 per share. We were excited to receive our lowest coupon and our highest conversion price compared to any of our prior convertible notes issued. The net proceeds of the offering were used to re-pay outstanding indebtedness under our revolving credit facilities, as well as for other general corporate purposes. Pro forma for this transaction, our available debt capacity, subject to borrowing base and leverage restrictions, as of June 30 was approximately $1.5 billion.

Finally, this morning we declared our third-quarter dividend of $0.38 per share, which is payable on September 30 to stockholders of record on September 16. As a reminder, we still estimate that we will carry over undistributed taxable income of approximately $0.97 per share into tax year 2013.

With that, now Kipp, I'll turn it back over to you.

Thanks, Penni.

I'm happy to discuss our recent investment activity and portfolio performance in more detail. I'll also update you on post-quarter-end investment activity, and discuss our backlog and pipeline. Please turn to slide 12. In the second quarter, we may 22 new commitments, totaling $1.2 billion. Eight of these commitments were made to new portfolio companies, eight were made to existing portfolio companies, and six commitments were made through the senior secured loan program. We're pleased this quarter's activities was led more by new deal flow than the last, which was dominated by refinancings and recapitalizations.

During the second quarter, 58% of our new commitments were in first-lien senior debt, 25% were in second-lien debt, and 17% were in sub-certificates of the senior secured loan program. The weighting of new investments toward secured debt reflects our continued emphasis on conservative structuring and capital preservation in the current environment.

We continue to feel that our ability to write large commitments to our borrowers is a meaningful competitive advantage in sourcing. We utilized these large commitment and hold capabilities to our advantage this quarter, making eight new commitments in excess of $75 million. Our largest new investments were in defensively positioned companies, and in industries where we remained very comfortable.

Turning to slide 13, notwithstanding the fact that the weighted average total net leverage for the corporate companies in our portfolio increased very modestly, and that the weighted average interest coverage for these companies declined slightly, we believe the credit quality in the existing portfolio remains strong. This view is supported by the stability in the weighted average grade of our investments, our positive non-accrual trends, which I will get to on slide 18, and the year-over-year EBITDA growth for our corporate portfolio company, which Mike mentioned earlier.

Slides 14 to 17 provide other notable summary highlights of the portfolio at quarter end. There are several points to make here. On slide 14, you will notice the new investments we completed this quarter in the corporate portfolio companies had a weighted average EBITDA of $98 million. This is larger than the norm compared to recent quarters, primarily as a result of investments that were made in two companies, with significantly higher EBITDA than the current portfolio average EBITDA. We're pleased with the investments in these companies, as they were deals that we view as somewhat opportunistic in nature. However it is more likely that our investment focus going forward will continue to be on portfolio companies of EBITDA levels closer to our overall weighted average, which was about $49 million at the end of the quarter.

On slide 15 and 16, you'll see that our portfolio continues to be well diversified. We typically like to manage single-name exposures to less than 5% of the portfolio from a risk management perspective. The only exception here, of course, is the senior secured loan program, which at quarter end represented approximately 21% of the portfolio at fair value. But as a reminder, the SSLP had 41 separate underlying borrowers as of quarter end, and continues to grow its own diversification within the joint venture.

Excluding SSLP, the next-largest 14 investments in aggregate represent only 31% of the portfolio at fair value as of June 30. Slide 18 demonstrates the positive non-accrual trends that I mentioned earlier. As you can see, non-accruals as a percentage of our portfolio at amortized cost declined from 2.3% at the end of the first quarter to 1.9% at the end of the second quarter. On a fair-value basis, the non-accrual ratio remained constant at 0.6%. We continue to be pleased by the performance of our portfolio companies as they emerge from a difficult economic period, and perform well on a slow but steady growth environment.

Now let's skip to slides 19 and 20 for an update on our recent investment activity since quarter end. I can provide some details on the current backlog and pipeline. Since July 1, and through August 2, we've made new investment commitments of $313 million, of which $301 million were funded. In terms of mix, 44% were in first-lien senior secured loans, 31% were in subordinated certificates of the SSLP, and 25% were in second-lien senior loans. Of the $313 million of new investment commitments, 95% were floating rate. Only 5% were fixed rate, and the weighted average yield on the debt and other income-producing securities that we funded during this period at amortized cost was 10.2%.

Also from July 1 through August 2, we exited $40 million of investment commitments. Of the $40 million of exits, 53% were floating rate, 46% were fixed rate, and 1% were on non-accrual status. The weighted average yield of debt and other income-producing securities exited or repaid during the period at amortized cost was 11.1%. On the $40 million that we exited, we recognized total net realized gains of approximately $36 million, driven by favorable realizations on two of our successful equity investments.

if you flip to slide 20, I will provide more color on what we are working on today. We're pleased to report new deal flow remains strong, despite what is typically a slower time of year for us as the summer holidays factor in. As of August 2, our total investment backlog and pipeline stood at approximately $750 million and $230 million, respectively. With this roughly $1 billion in total potential investment opportunities at these stages, we feel that we are well-positioned in the current market. We are also pleased that Ares Capital continues to be viewed as a go-to provider for flexible financing solutions. Thanks for your time.

I'll turn it back over to Mike for some closing thoughts.

Great, thanks Kipp.

As you know, we will always look to be opportunistic on both sides of the balance sheet to take advantage of changes in market conditions. Consistent with that stated strategy, we will continue to remain thoughtful and highly selective on new investment activity, while also standing ready to issue capital during periods of low volatility and high liquidity. We're pleased that our hard work in this regard over the past year has allowed us to maintain a strong net interest and dividend margin, realized net gains, and to deliver attractive returns on equity despite tightening spreads. With an asset-sensitive balance sheet, modest leverage, and a long date of liability structure, we believe we're well-positioned to continue to execute on our strategy.

In the long term, we continue to believe that the outlook is bright for scaled non-bank capital providers like us that can provide flexible capital with larger commitment and hold amounts to support the growth needs of the middle market. We have taken advantage of this growing non-bank opportunity by broadening our investment platform into project and venture finance, which we believe provides attractive investment diversification across markets. We do hope to continue to find other niche opportunities where we can take advantage of these secular trends. That concludes our prepared remarks for today. As always, we thank you for your time and continued support.

Operator, I think we would now like to open up the line for Q&A.

Yes, sir. We will now begin the question-and-answer session.

(Operator Instructions)

John Hecht, Stephens.

First question is regarding the second quarter, the pace of investments. Were they balanced throughout the quarter, or were they front- or back-ended?

John, hi, it's Kipp. In terms of when the closings actually on new deals occurred?

Yes, I'm trying to just get a sense, was it evenly balanced throughout the quarter, or was there any particular concentration where you were closing investments?

Yes, it was pretty balanced, John.

Okay, thanks very much. Second question is related to -- Mike, you mentioned there was some volatility during the quarter in the credit markets, which allowed spreads to widen, but that was a fleeting moment. In your opinion, are we -- you think, stable spreads now, or is there still pressure -- and if there is pressure, where is it coming from?

As I mentioned, I think there are a couple positive trends. Number one, we are seeing spread stability over the last couple of weeks despite continuing in-flows, the pace of deal activities absorbing the supply of capital. So we've seen spread and fee stability.

Then the other positive trend, which Kipp highlighted, we are seeing a growing percentage of our closed deals, as well as our backlog and pipeline, in new M&A financings, as opposed to recaps and refis, which I think bodes well for the supply/demand balance in the market. We're not seeing further tightening, and it feels pretty good out there right now.

As a little bit of a follow-up to that, you mentioned that you're seeing credit disciplines emerge in the market. How is that manifesting itself?

Why don't I take that? I think, John, what we are trying to suggest is that that period where the market came off a lot, in particular the high-yield market, I think it gave investors a chance to recalibrate a little bit. For -- call it a three- or four-week period there, there was a real nice time to go out and commit capital, and that definitely helped us grow the portfolio this quarter.

But I think what Mike was alluding to is -- during those periods, the recovery from those periods, even as the market technicals come back, people have learned a short-term lesson, and at least apply it in the near term. Without any stats to back it up, necessarily, I would say that we just felt that investors had more strength pushing back in that market after a bit of tightening.

Great. I appreciate the color, guys. Thanks a lot.

Thanks.

Doug Mewhirter, SunTrust.

Hi, good afternoon. Had one big-picture question. Mike, you were talking about there was obviously a pick-up in your pipeline, pick-up in activity. You also noted that -- positively -- that there was -- a lot of these were new deals, new M&A deals, and a general increase in sponsor activity. Could you go into maybe the reasons why, if you talk to a private-equity sponsor, they say -- okay, we're in the market now because of XYZ. What's sort of that XYZ? Is it because the equity markets in general are good, still going to get financing, they have more optimistic outlook of the economy?

Yes, I think it is all of the above. Everything is somewhat circular and feeds on itself. On our prior quarterly calls, I think we expressed a little bit of surprise that we had not seen M&A pick up or sponsor activity pick up, given the underlying strength in the economy and the strength in the capital markets. I think now that we have seen so many successive quarters of positive earnings momentum, we've seen significant momentum in the capital markets.

I think it's a combination of solid fundamentals, a really healthy capital markets backdrop, and then you see a pick-up in activity. The way the market psychology works is, obliviously, that activity feeds on itself and continues to fuel new activity. We are seeing those trends continue now into the third quarter, as well, heading into then what will be typically our seasonally strongest quarter in the fourth quarter.

Thanks, that's all the questions I had.

Thank you.

Robert Dodd, Raymond James.

Hi, guys. You talked about, again, some credit disciplines returning to the market. If we look at the middle-market numbers, we've seen that leverage pulling back a little bit. Can you give us any additional color on -- if you've got any -- on what's driving that? Is it just only funding higher-quality companies now, is that the source of discipline? Or is there anything you can add to that?

Let me try -- this is Kipp. Let me try to answer it a little bit differently. I think when you look at the market stats, the obvious things that you pick up are -- what are the spreads, what are the leverage levels? But in underwriting, there are actually a lot of other things that go into it. It's number of covenants, for instance, it's quality of loan documentation. These are pretty detailed credit agreements that we negotiate as the lead investors. Unfortunately when the larger-market tendencies creep into the middle market, a lot of those things fall by the wayside.

I think, again, around being more disciplined on underwriting, it is everything from insisting on better security provisions to collateral provisions and loan documents. It's talking about covenants and setbacks to base cases -- just being more realistic, I think, in other underwriting metrics that may not show up just in the off-the-shelf numbers that you will see from some of the publications. Perhaps that's helpful -- (multiple speakers)

Yes, that is. If I can follow-up on that, obviously you pointed out your weighted average portfolio leverage picked up just a notch, and the coverage down just a touch. But at the same time, you said you are very, very comfortable with where that's at. Is that indicative that, though they've moved, you're actually layering more covenants onto new deals, or -- ?

No, I wouldn't put it that way. Look, we have 164 portfolio companies that are obviously all slightly different underwritings. That move in the weighted average leverage or in the weighted average interest coverage stuff is, frankly, immaterial. It just comes and goes quarter to quarter.

I think all that we're trying to reinforce was I think that there was a perception that the market meaningfully backed up over the course of maybe late May and June. All we were trying to make clear to folks is that by the end of the quarter, most of that had really come out. For us, the real key is driving our strengths, which we feel is a best-in-class underwriting culture, but also a very, very deep originations team that is across the country. As always, we're just focused on credit selection, making sure that we are investing in the best companies with the best management teams.

I'll just add two quick things, Kipp. I think when you look at the leverage and cover statistics, one thing that we didn't report but I think is worth mentioning is that our first dollar of leverage actually declined in the quarter. We're moving up the balance sheet to a higher attachment point, as opposed to down only.

The second thing I would also highlight is that our loan to value within the portfolio and the corporate portfolio remained stable at around 57%, which was pretty consistent with most of the quarters within the year. I think that's a reflection, to some of Kipp's comments in the prepared remarks, around the larger borrower concentration within our most recent closings. Those larger, higher-quality borrowers do command slightly higher leverage.

The only other phenomenon, which we have discussed in prior quarters, is also our intent focus on making sure that we're protecting the best borrowers within our existing portfolio. Some of that natural move quarter to quarter in the leverage is really a reflection of the fact that we are re-leveraging and re-capitalizing a lot of our better-performing borrowers, as opposed to simply a reflection of the new market environment.

I appreciate it.

Greg Mason of KBW.

Great, thank you, guys. You guys have talked quite a bit on the asset side and the opportunities there. What about additional changes to the liability side? A lot of BDCs have been issuing securitization that -- what do you think about that market? Do you have the assets to fit inside of a new securitization? Just your general thoughts on the opportunities there?

Sure. I will let Penni answer some of this as well, but I will take a first crack at it, Greg. We did a securitization, if you'll remember, back in '06. We're pretty experienced relative to the public company doing that; and I'll also mention, obviously, that Ares is a substantial issuer of CLO paper broadly across our institution, both in the US and in Europe. It's a market that we know well.

I would say that our current liabilities provide us quite a lot of un-drawn debt capacity today, at rates that we view as favorable, that have substantially more flexibility than what you would see in a traditional CLO, which obviously has [WIRF] requirements and diversity score requirements, and all sorts of other things that are, frankly, complicated in terms of managing those portfolios.

We do have the assets, obviously. We have lots of first-lien assets. I'm sure it wouldn't be difficult for us to carve a pool off, and sell a securitization against it. It's something that we have thought about, and obviously not done yet, or you would have heard of it from us.

Penni, I don't know if you have any other thoughts on that?

I think it's definitely something we watch, and as Kipp said, we have the right asset mix to do it. It's really a more relative trade-off value to what we can get under our existing revolvers from flexibility and pricing, vis-a-vis, what we could get there. If there's a point where the pricing becomes enough lower from where we borrow on our revolvers, where it makes sense to give up some of that flexibility, is something we would definitely explore further.

Could you talk just a little bit about your revolver utilization then? I think in the past you've mentioned that you really want to utilize the revolver to do new deals, but ultimately then term that out into longer-dated liabilities, like you have been doing with the convertibles and the baby bonds. Given that you view this -- the revolving liabilities -- as a more flexible source than a securitization, is there thoughts of utilizing more of the revolving facilities for a longer-term investment purpose?

I think, one thing that we have done is we have further increased the amount of revolving capacity available to us over the last few years. And today it's just under $2 billion of capacity. I think, we haven't changed our view on how we use the revolvers in the context of using those to build a portfolio, to then ultimately take out those revolvers with long-term debt and equity to keep the leverage ratios in line. I think as long as we have continued capacity there, we will use them.

If you look at where we were at the end of the quarter, we had drawn about $660 million. I would guess we are probably historically using those between 30% and 60%. Clearly, you don't want to use them to their full capacity. You want to make sure you're taking them out with term debt appropriately; and also to give you timing opportunities to take down increments of term debt so that you have properly and well-laddered maturities, as well.

The one thing about a securitization is it probably is a little more permanent financing, vis-a-vis, the revolvers that we use, which is one thing that does make them attractive. But there's nothing to say that we wouldn't consider having more floating-rate, lower-cost debt available to us as it makes sense in the capital stack.

Great. And then one final question on the net interest and dividend margin on the portfolio. As you talked about, it's flat to actually slightly up over the last couple quarters. As you think back to where that was running a couple years ago, or even prior to the crisis -- I don't have those numbers available. How do you view your overall net interest and dividend margin today, relative to where it stood a couple years ago, or even pre-crisis?

Yes, we are comparing notes here, quickly. We have the numbers, obviously, and we have laid them out here in this presentation back to June of 2012 -- the end of Q2 2012, Greg. So they've been pretty stable. We'd actually probably have to go back and look.

I'd say a few things. We feel great about the credit quality in the portfolio. We feel that the ability to deliver an 8.7% net interest and dividend margin in a company that obviously typically utilizes a leverage ratio at kind of 0.6% to 1 or less, is pretty extraordinary.

We have obviously termed out our liabilities, both the secured revolvers -- I was going to make the point on Penni's last point. We all did this back 8, 9, 10 years ago. Most of what you saw on the liability side was a one-year warehouse to take out, and the two-ish-year revolving credit facility. Our revolvers now have three-year, four-year maturities; and obviously, we have termed out all of our debt.

I think we feel great about the assets today. We feel like the net interest margin is very solid, and that the balance sheet is in significantly better position than it was seven or eight years ago. I'm not sure that they are directly comparable, but we're pretty happy with where we are today.

I'll make a general comment, Kipp, and we can follow up with people if they want the specifics on a historical basis. But just to put it in context, when you look at the ROA on the portfolio, from prior to the cycle, through the cycle, up to today, you'll actually see a surprising amount of consistency. We have typically generated ROAs between 10% and 13% across the cycle.

If you go back to Kipp's point, and look at how we were funding ourselves economically going into the downturn, we had one year senior secured revolvers at roughly LIBOR 2.25%, with LIBOR probably averaging over that period about 500 basis points. You had a cost of funds that was probably approaching 7%-plus, against 12% assets.

Using just that as a benchmark, going into the dislocation, we were probably running at a lower net interest margin than we are now. And as Kipp mentioned, we not only believe that the right-hand side of our balance sheet is much stronger and better positioned, but I actually believe that the quality of the portfolio, despite our extraordinary performance through the downturn, is actually stronger now than it has ever been.

I appreciate the comments.

Jon Bock of Wells Fargo Securities.

Good afternoon, and thank you for taking my question. Mike, maybe continuing with that topic, just a little bit here in terms of NIMs. If we look at the new investments today, parsing through it, we see a rather low weighted average yield. Largely, that's because of loans that -- some of which -- I will take a $60-million ISS number-two LLC at 6.5%. You have a rather low, about 8%, weigh on -- I would think we have already got about $800 million of assets that you put out, just looking at it.

In light of that, right, if we're looking at lower-weighted average yields, because you are focused on higher-quality companies, walk us through how NOI can increase in light of the fact that your cost of debt is at 5% -- you fixed it, that's great. Your cost of equity, there's your dividend yield; but then more importantly, the cost of actually running the business -- fees and G&A as a percentage of total assets -- is about 330 basis points plus. We understand your existing portfolio's providing you current NIMs that are attractive, but a lot of those assets are being refinanced -- American Broadband, for example. Maybe give us a few more constructive terms on where we can see this going, if you're going to continue to focus on higher quality, which right now, looking at 5% yields that were made in this quarter, high quality is coming at a low yield or price?

There's a lot in there. I will try to start at a high level, and then give you some specifics. But as we have always said, this business is about risk-adjusted return and not absolute return. When you are in benign credit environments, particularly benign credit environments with tightening spreads, it is not always obvious to the market what the quality of the underlying yield is. We, as a management team and a Company, have always been focused on stability, predictability, and quality of earnings first, and earnings growth second.

As it relates to earnings growth, I will highlight a couple things. Kipp mentioned in his prepared remarks that the weighted average yield on new investments that we have been making -- that we made through August 2 on $313 million of new commitments was about 10.2%. If you look at our backlog and pipeline, those types of returns are continuing. Those yields exclude the impact of fee income, which I think people are aware generally is 2% to 3%.

If you use the market convention of a three-year discount margin, and you amortize those fees over three years, we are booking assets at an ROA of 10% to 12% today in very high-quality borrowers in defensive industries. When you look at that type of ROA relative to other credit product available in the corporate credit space or otherwise, I think you would see that, relative to the risk we are taking, that is significant excess return.

Number two, as Penni mentioned, we are actually bringing down our weighted average cost of debt over time. It does not show up perfectly every quarter because of the timing of investments. But if you look at the cost of our liabilities today on a fully funded basis, they've actually come down from 4.3% to 4.1% in the quarter, as a result of the work that we're doing on the right-hand side of our balance sheet. So the continuation of high ROAs against a declining cost of liabilities will provide the stability and predictability in the earnings that we are looking for.

The two biggest drivers of NOI growth going forward are going to be, obviously, increased leverage -- we have been operating at leverage levels in the 0.57 to 0.59 range. As we have communicated before, we have significant comfort given the quality of our assets operating at higher leverage levels. That creates a pretty meaningful catalyst to earnings growth.

Number two, what you will continue to see is us rotating the portfolio, and generating portfolio velocity, as we have done through syndications to Ivy Hill and to the market, which drives earnings growth. When you look at the picture today, obviously given our size and given the complexion of the balance sheet, people should not expect significant earnings growth, but I do think that the levers are in place through lower cost of funds and velocity, as well as increased ROA.

The only other thing I'll mention -- we keep highlighting it, but when you think about the construction of the portfolio, we are predominantly floating-rate asset portfolio against a predominantly fixed-rate liability structure. As interest rates do go up -- and we are already beginning to see that, you should see a pretty significant pick-up in earnings, and that's yet another catalyst.

I appreciate that, Mike. You did mention, from July 1 to August 2, the $313 million in new commitments awarded 10.2% yield. I'm curious, what does that look like if we exclude the SSLP, which could be considered -- as well as maybe the second-lien loans, which are likely considered -- I would say, a little bit more leverage, some would assume a little bit higher risk. I understand that the asset level of the SSLP is completely different. But just curious, what are you getting on that 44% of first-lien senior secured that you're looking at quarter to date?

I don't want to give you a specific answer, Jon, because, again, as Kipp mentioned, how you price a loan is a function of so many Company-specific and structurally specific issues, it is hard to pin a number on the entire portfolio. Generally speaking, when you look at traditional first-lien loans in this market, you're going to see us pricing them anywhere between 5% and 8% excluding fees, depending on the attachment point and the structural protections that we get in the loan.

Okay, great. Jumping to one -- second-lien investment made this quarter, I believe to SpinCo -- and I am unsure if this is a loan that was part of the refi bucket -- but I noticed there was about, in the press release, I think $200 million committed, yet on the balance sheet I see roughly just $140 million show up. What's the delta $60 million between the $140 million and the $200 million? Was that syndicated?

Yes.

It was, Jon.

Okay, great. What is the market for that syndication in this environment, and is that increasing, should we say, over the next few months as banks are relatively hungry to put spread assets on the books?

Sure, look, we originate a lot of paper, obviously. When you're doing billing-plus for originations a quarter, it allows us to be the lead on deals; and sometimes we choose to optimize whole sizes, or take other considerations into account. But I would say, generally, do we find the loans that we underwrite easy to syndicate? The answer typically is yes, because in most of those transactions, there are three or four other people that are trying to win that deal, and they are losing to us. Our ability to turn around and syndicate a portion of those loans to the market is, frankly, not that difficult. There are a lot of buyers out there.

Okay. And then in terms of disclosure, will -- does this take on a similar type of syndication financing, as some of the others that have been earmarked as, I would say, back-end-levered transactions? I think there's like five or six deals. Will we end up seeing a footnote for that as it materializes, or was it sold somehow differently than the previous ones that we have seen in your statement of investments?

Jonathan, it's Penni. Fortunately, with respect to what everyone else is doing, it is just hard to know their details and specifics around how their transactions are structured, and how they are accounting for it. To the extent that we have information that needs to be disclosed around loans that are sold, we will disclose those. With respect to just the accounting, you see how ours are accounted for, and I really can't speak to how other people are accounting for their transactions.

Just other loans, Penni, not relative to other BDCs. Will this loan on SpinCo end up having a footnote, just as the others that are on the balance sheet today?

It will not, Jonathan. We sold the security (inaudible) with the security that we are holding.

Okay, great. One last question, Mike, related to Ivy Hill. Obviously, this is a meaningful contributor to dividend income. Moving past the substantial income you got dividending up more just last quarter, a few questions about the entity. Does IHAM itself hold a position, or hold a portion of the CLO equity, that it perhaps sells or originates? Obviously, they sell a portion of the AAAs, et cetera, down. Do they retain a portion of that equity at that asset-manager level?

Sometimes.

Okay. The question is -- if you look at that dividend going forward, if they do hold a position in CLO equity, and they were -- growth at that entity and new issuance in CLOs has been rather strong, yet spreads have tightened, what is the likelihood of volatility in that dividend stream, in the event that CLO returns decline as a result of limited spread on assets, yet a fixed liability structure?

It could theoretically have some impact. If you look at what the equity return requirement is, generally speaking, for a middle-market securitization today, it's probably in the 10% to 12% range, which is running slightly lower than the steady-stream dividend yield coming off of the IHAM fee stream.

That said, it typically isn't a requirement; so, when Ivy Hill was looking at launching a new CLO vehicle, they are typically syndicating the bulk of the capital structure, and then making an evaluation as to whether or not they want to hold the equity. When you look at the size of Ivy Hill's balance sheet, and you look at the margin that they are generating on the fees, I just don't think that the returns on new equity investments is going to be a meaningful downward driver on IHAM's earnings capability.

Okay.

Jon, I will make one other comment there, too, which is obviously, we have an ongoing dividend policy coming up from Ivy Hill. We saw a deviation from that last quarter, where there was actually an excess dividend up-streamed, out of the portfolio company to Ares Capital. That you should take as a reflection that we feel that the dividend level that we have in place, that obviously is recurring quarterly, is very conservative. We're experienced looking at both the way operating profits coming off the management contracts that they have work, but also in terms, certainly, of the securities that they own. I don't think any market changes in those securities would have a meaningful impact on our ability to take dividend income from Ivy Hill.

I appreciate that. Last question is for you, Kipp. As you are very active in the origination part of the franchise, give us a sense where covenant cushions are today in terms of structure, as well as equity cures, and how they compare to perhaps the same covenant cushions and equity cures that you were doing 12 to 18 months ago.

Look, that is all over the map. It really depends on who is leading the deal, right? It depends; if they -- if you're buying something from a bank, obviously that they are underwriting and structuring to sell to accounts, I would tell you that the loan documentation, all the things that you mentioned, are meaningfully worse than the things that we are writing in our own loan documentation as an arranger and as a lead underwriter. It is too difficult to just say broadly that it's this much better or this much worse. But I would say convention in the market is that loan covenants are written at 20% to 25% discount to base cases laid out, either by a sponsor, a company, or a management team.

Okay. I guess a last question on the weighted average EBITDA. You mentioned it was up -- obviously up significantly at $98 million as a result of two deals that you were involved with. Were you the sole underwriter and structurer of that transaction, or both of those transactions that moved up that EBITDA number significantly?

In one of them, we were the lead, but there were some other partners in the deal. The second one, we were not a lead. It was actually one of the companies that we underwrote back in '08, I think, that we originally got involved with. This is a company called Performance Food Group that did a refinancing where we got involved with a significantly larger company in '08, because there was really no high-yield market, and did a private-notes deal on that company. They refinanced recently, and we were part of the club, effectively, that refinanced, but weren't a lead in that deal.

Kipp, would it be fair to say that the covenant packages on larger EBITDA-type companies that are obviously hunted for by the banks, that it's possible there's a little bit more latitude in terms of covenant and cures that might be, perhaps, a bit more aggressive in this market than maybe 12 to 18 months ago?

To be honest, Jonathan, I'm not sure off-hand. I would have to go back and look at each of those loan documents in particular. I just haven't done it lately.

Okay, guys, thank you so much for taking my questions.

Rick Shane, JPMorgan.

Good morning. Thanks for taking my question. Just want to talk a little bit about the relationship between the backlog and the pipeline. Obviously that's the leading indicator for future originations. This quarter there was a little bit of an anomaly, which is the backlog itself is at sort of a peak level, and the pipeline is at more of a trough level. We have never really seen that before. Does that suggest strong near-term originations, but some need to rebuild that pipeline headed into the fourth quarter?

I think, yes, probably it does. As you know, Rick, it sort of comes and goes month to month, so it's just unpredictable over the course of a quarter or over a year. I actually would highlight a lot of that backlog as being things that we have been working towards closing. I'd categorize the pipeline, frankly, as being a little bit thinner because it's the beginning of August, and a lot of people are at the beach. Can't really think of any other reasons. There's nothing else that is really indicative there, other than probably coincidence and some summer factoring in.

Got it. It's interesting, because ordinarily I wouldn't read too much into this. The relationship sort of gravitates towards 1 to 1. Right now -- and it's never been over 2 to 1 backlog versus pipeline. Now it's almost approaching 3.5 to 1. That's why the issue comes up.

I think it's just seasonal, Rick. If you talk to people on the street, I think you'll hear a generally consistent theme that this has been a very busy summer, probably one of the busiest summers that people have seen. I think the backlog is an indication of how busy the summer has been. The pipeline -- I wouldn't read too much into that. You're not going to really get a good sense for how the pipeline is developing until after Labor Day.

Mike, do you think that's a function of issuers trying to get out before there's any movement in rate? Is that what's driving the behavior, do you think?

No, I think it's some of the things we talked about earlier. You've got a very good market environment, you've got good fundamentals, lots of liquidity in the market. I don't think that there's that much thought going into trying to rush because people think the market is going to fall apart in the fourth quarter. My expectation is that Q4 will be equally as busy, and once people come back from the summer vacation, you'll start to see some meaningful activity pick up.

Mike, let me add one thing, Rick, maybe for your benefit. When we calculate that pipeline number for these purposes, we obviously probability weight the things that are in our deals-under-review list to say -- what's the chances this actually closes? I guess the August issue is -- if you're not getting a lot of return phone calls pressing, pressing, pressing, it doesn't mean that you don't have a deal in review, and that you're not working on a lot of things that aren't included in the pipeline.

We probably just have lower probability weightings around some of those deals under review because we are just less sure in a month like August. But to Mike's point, I think, as everybody gets back after it, perhaps, a little bit more in September, we will feel better about firming that pipeline up. There's a lot of -- we are pretty busy here. We have a ton of deals that we are working on right now. I think it's just probably how we calculate and probability weight that backlog and pipeline that's skewing the number.

Got it. Because it is interesting, because the last two Augusts, the relationship has been more normal. It really is somewhat a function of August 2013, for whatever reason.

Yes.

Thank you, guys.

Great, thanks, Rick.

Thanks a lot, Rick.

That concludes our question-and-answer session. I would now like to turn the conference back over to management for any closing remarks. Ladies and gentlemen?

Great. We have nothing further. Again, thanks for spending so much time with us today. We are thrilled with the quarterly performance, and look forward to talking to you guys again next quarter. Thanks so much.

We thank you, sir, and to the rest of the management team, for your time. The conference call is now concluded. We thank you all for attending today's presentation. At this time, you may disconnect your lines. Thank you, and have a great day.