Ares Capital Corp (ARCC) 2018 Q1 法說會逐字稿

Good afternoon. Welcome to Ares Capital Corporation's First Quarter Ended March 31, 2018, Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded on Wednesday, May 2, 2018.

I will now turn the call over to Mr. John Stilmar of Investor Relations.

Thank you, Austin, and good afternoon, everybody. Welcome to Ares Capital Corporation's First Quarter Ended March 31, 2018, Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Wednesday, May 2, 2018.

I will now turn the call -- thank you very much. Let me start with some important reminders. Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements that are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of such words as anticipates, believes, expects, intends, will, should, may and similar such expressions. 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 core earnings per share, or core EPS, which is a non-GAAP financial measure as defined by the SEC Regulation G. Core EPS is the net per share increase or decrease in stockholders' equity, resulting from operations less professional fees and other costs related to the acquisition of American Capital; realized and unrealized gains and losses; and any capital gains incentive fee attributable to such realized and unrealized gains and losses as well as any income taxes related to such realized gains or losses.

The reconciliation of core EPS to net per share increase or decrease in stockholder's equity, resulting from operations to most directly comparable to GAAP financial measure, can be found in the accompanying slide presentation of this call by going to the company's website. 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 operations. Certain information discussed in the 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 warranty to -- with respect to this information.

As a reminder, the company's first quarter ending March 31 earnings presentation is available on the company's website at www.arescapitalcorp.com by clicking on the Q1 2018 earnings presentation link on the homepage of the Investor Resources section of the website. Ares Capital Corporation's earnings release and 10-Q are also available on the company's website.

I will now turn the call over to Mr. Kipp DeVeer, Ares Capital Corporation's Chief Executive Officer.

Thanks a lot, John. Good afternoon, and thanks, everyone, for being with us today. I'm joined by members of our management team, including our Co-President, Michael Smith; our Chief Financial Officer, Penni Roll; and other members of the finance, investment, and Investor Relations teams. You'll hear from Penni and Michael later in the call.

Let me start by reviewing our first quarter results. And afterwards, I'll provide some thoughts on the current investing environment and a brief update on the American Capital transaction.

This morning, we reported strong first quarter core earnings of $0.39 per share, which is our fourth consecutive quarter of sequential core earnings improvement since the first quarter of 2017, when we closed the American Capital acquisition. Our core earnings exceeded our quarterly dividend and represented an increase of more than 20% from the same period a year ago. The improved sequential earnings were driven by higher yield on the investment portfolio as we benefited from continued portfolio rotation initiatives and from increases in LIBOR.

We're also able to generate another quarter of great GAAP earnings, which totaled $0.57 per share as a result of the strong net appreciation in our investment portfolio, which increased net asset value. We believe our continued ability to generate these incremental earnings from strong investment performance further distinguishes us from other BDCs in the marketplace.

Let me change course and provide an update on the current market conditions. Market terms continue to be challenging, with many aggressive participants willing to provide high leverage to companies, along with looser documentation and structures. We're not immune to this. However, we do believe we see a much broader opportunity set than our competitors and as a result, are able to selectively invest in what we believe are more attractive situations with better risk-adjusted returns. We use our long-standing relationships, the flexibility of our capital and large commitment sizes and final hold capabilities to differentiate ourselves in the more competitive situations.

We currently are only closing on about 3% to 4% of the transactions we review for new companies, and we continue to stress backing our strongest incumbent borrowers. For example, in the first quarter, we reviewed more than 330 new portfolio company transactions, and we closed 12.

We continue to use our platform's significant informational advantages to lend to leading noncyclical businesses with attractive growth prospects and strong sponsorship. Michael will provide more color on our recent investment activity later in the call, but we remain vigilant in an admittedly tough market, with a focus on companies with the strongest fundamentals, while maintaining the integrity of our loan structures and documentations through our investment process. This is not our first time managing through these types of markets. As a reminder, we have a very experienced, long-tenured team that's been together a long, long time. Every member of our 8-person Investment Committee has spent more than a decade investing together here at Ares.

Before I turn it over to Penni, I'd like to provide an update on American Capital. Since our initial acquisition of the $2.5 billion portfolio that we closed in January 2017, we received more than $1.5 billion of principal proceeds from exits and repayments, including cumulative net realized gains of $91 million. And we've generated an asset-level gross realized IRR in these exits of more than 20%. The remaining ACAS portfolio was $1.6 billion at fair value at March 31, 2018, which includes $271 million of net unrealized appreciation. The remaining portfolio also includes $1 billion at fair value in lower nonyielding, non-core assets, which provides us more opportunity going forward.

Now let me turn the call over to Penni to provide some more detail on the financials and the balance sheet.

Thank you, Kipp, and good afternoon. As Kipp stated, our basic and diluted core earnings per share were $0.39 for the first quarter of 2018 as compared to $0.38 for the fourth quarter of 2017 and $0.32 for the first quarter of 2017.

Our basic and diluted GAAP earnings per share for the first quarter of 2018 were $0.57, including net gains for the quarter of $0.23 per share. This compared to GAAP net income of $0.54 per share for the fourth quarter of 2017 and GAAP net income of $0.28 per share for the first quarter of 2017, which was reduced by American Capital-related expenses of $0.06 per share.

As of March 31, our investment portfolio totaled $12.2 billion at fair value, and we had total assets of $12.7 billion. At the end of the first quarter, the weighted average yield on our debt and other income-producing securities at amortized costs increased to 10.1%, and the weighted average yield on total investments at amortized cost increased to 8.9% as compared to 9.7% and 8.7%, respectively, at December 31, 2017. The total yield increased since the end of the fourth quarter, primarily due to the increase in LIBOR.

We experienced net unrealized appreciation on our portfolio of $84 million in the first quarter, supported by the fair value increase in our investment in Alcami, which was driven by the company's strong performance.

In total, we reported net realized and unrealized gains on investments and other transactions for the first quarter of $98 million.

Our current dividend remains well supported by our core earnings and our spillover income. We currently estimate that undistributed taxable income carryforward from 2017 into 2018 will be approximately $346 million or $0.81 per share. The second quarter dividend of $0.38 per share is payable on June 29, 2018, to stockholders of record on June 15.

Moving to the right-hand side of the balance sheet. Our stockholders' equity at March 31 was $7.2 billion, resulting in net asset value per share of $16.84, an increase compared to $16.65 a quarter ago and $16.50 per share a year ago.

During the first quarter, we've remained proactive in managing our liabilities. And in particular, we issued our longest-dated institutional investment-grade notes in a $600 million transaction priced at a 4.25% coupon and maturing in 7 years. Given the continued increase in interest rates, we are pleased to have opportunistically completed this longer-date issuance at very attractive pricing.

In addition, during the first quarter, we repaid $270 million of 4 3/4% convertible notes at their maturity in January. For the remainder of 2018, we have $750 million maturing later in the year. Given the significant unused capacity under our revolving credit facilities after having issued a significant amount of term debt over the past 9 months, we have plenty of liquidity to repay this maturity without needing to access the term debt market.

At the end of the first quarter, we also amended our revolving credit facility to increase the facility size by $25 million to a total of $2.13 billion, extend the maturity and reinvestment period by 1 year, and reduce the borrowing base-driven interest spread grid from 1.75% or 2% to 1.75% or 1.875%. Note that the reduction in the grid pricing doesn't impact our current spread as we were already borrowing at the low end of the range at 1.75%.

As of March 31, our debt-to-equity ratio was 0.73x, and our debt-to-equity ratio, net of available cash of $254 million, was 0.69x compared to 0.7x and 0.66x, respectively, at December 31, 2017. Our total available liquidity at the end of the first quarter was approximately $2.8 billion.

Our balance sheet continues to be asset-sensitive. Any further rise in short-term rates should benefit our earnings. For example, using our balance sheet at March 31 and assuming an up to 100 basis point increase in LIBOR, our annual earnings, excluding the impact of income-based fees, are positioned to increase by up to approximately $0.21 per share.

And now with that, I'd like to turn the call over to Michael.

Thanks, Penni. I would like to spend a few minutes reviewing our first quarter investment activity and portfolio performance, and then we'll provide a quick update on post-quarter-end activity and our backlog and pipeline.

During the first quarter, we used our scale, relationships and extensive market coverage to originate $1.8 billion of new investment commitments, while remaining highly selective and consistent in our investment approach.

Excluding the $263 million investment in Ivy Hill, which I will discuss momentarily, we made 33 new commitments, with initial fundings of $1.2 billion. Approximately 60% of these new investments were to incumbent borrowers, and more than half of these investments were in first lien secured positions.

At quarter end, our portfolio reached $12.2 billion, consisting of more than 350 different borrowers. The size of our portfolio provides us with a significant advantage as our incumbency often enables us to support the additional capital needs of our best borrowers as they seek to grow.

Providing capital in these types of situations, we believe, has been important contributor to our long-term investment outperformance. For example, during the first quarter, we committed to a $355 million first lien loan in support of Starr Investment's acquisition of ACA Compliance. ACA provides risk management and technology solutions, focused on regulatory compliance, performance, financial crime and cybersecurity to over 2,800 clients. ACA was a portfolio company of Ivy Hill. Based on a relationship with the company as well as our ability to commit to the full transaction, we are awarded this investment opportunity in a franchise business in a noncyclical industry. This example underscores part of the strategic value that Ivy Hill brings to ARCC in allowing ARCC to have broader positions of incumbency to support future origination opportunities.

That brings me to our investment in Ivy Hill that we made during this quarter. As Mitch mentioned on last quarter's call, in Q1, we closed on the purchase of a roughly $1.4 billion portfolio of senior secured loans from Pacific Western Bancorp, as the bank decided to exit middle-market lending during the first quarter. The transaction was consummated predominantly at Ivy Hill, with the support of a $263 million debt and equity investment from ARCC. Given Ivy Hill's strong market presence and firm market conditions, Ivy Hill successfully priced a $1 billion middle-market CLO, which included most of the acquired loans on favorable terms. With this execution, we expect our additional equity investment in Ivy Hill will generate a comparable level of dividends compared to our existing equity investment, while also providing further incumbent positions to support future investment opportunities at ARCC.

Shifting to the portfolio. Performance continues to be strong in our underlying companies. As of March 31, ARCC's portfolio companies continued to generate solid growth in their aggregate earnings as the weighted average EBITDA growth over the past 12 months increased to approximately 7% compared to the approximate 6% LTM growth rate last quarter.

We also saw a reduction in the number of companies on nonaccrual. During the first quarter, we had 3 companies come off of nonaccrual compared to one new nonaccrual investment. At the end of the quarter, nonaccruals as a percentage of the total portfolio at cost decreased to 2.7% as compared to the fourth quarter 2017 at 3.1%. Nonaccruals at fair value also declined to 1% in Q1 2018 from 1.4% in Q4 2017.

Before I turn the call back over to Kipp, I would like to provide some brief comments on our post-quarter end investment activity. From April 1 through April 26, we made new investment commitments totaling $736 million and exited or were repaid on $362 million of investment commitments, while generating approximately $2 million of net realized gains.

Finally, as of April 26, our total backlog and pipeline stood at roughly $755 million and $105 million, respectively. As always, these potential investment opportunities are subject to approvals and documentations, and we may actively sell or syndicate, post closing. Please note that there are -- is no certainty that these transactions will close.

I will now turn the call back over to Kipp for some closing remarks.

Thanks, Michael. In closing, we're really pleased with our first quarter earnings. We're well aware that many investors have been waiting for our core earnings to revert to a level where it exceeds our dividend. We're pleased to have crossed that bridge this quarter.

In addition, strong realizations continue to help us build net asset value, and the total return proposition from the ACAS acquisition is providing a nice tailwind. We continue to manage the company in what we believe to be a prudent fashion and in the same manner that we've operated over the last 14 years. And we believe that should serve us well, even if the environment becomes more difficult.

I almost forgot, one last item before we turn this over to Q&A. As most of you know, the Small Business Credit Availability Act was signed into law in March. The law includes a provision that allows a BDC to achieve significant regulatory relief by increasing the asset coverage ratio required of BDCs from 200% to 150%. Or said another way, it increases the debt-to-equity limitation from 1 to 1 to 2 to 1.

As we stated in the press release that we issued last month, we believe this regulatory relief is a significant positive for the industry, as widening the leverage limitation improves the risk profile of our company. Very simply, if no other action is taken by a BDC other than adopting the change in the asset coverage ratio, the probability of default for all of our lenders decreases. In addition, we believe this relief may allow for added flexibility in the asset side by expanding the portfolio into lower-risk senior debt investments.

As for the new law's impact on ARCC specifically, we're carefully considering the next steps. We've begun to engage with banks, rating agencies and other key constituents. I want to emphasize that we're considering a range of options, and we've made no decisions about where we are headed nor do we have any formal action in front of our Board of Directors regarding the new legislation. We will be happy to answer some questions on this call, but please understand that there will be many topics related to this new legislation that we're still evaluating and therefore, not in the position to comment on at this time.

Thanks for your understanding and your continued support of Ares Capital. That concludes our prepared remarks. Operator, would you open the line for questions?

(Operator Instructions) And our first question today comes from Jonathan Bock with Wells Fargo Securities.

Kipp, my first question will just center on the investment environment. In particular, in the more senior, lower-risk book that you kind of outlined as a forthcoming opportunity, would you be able to give us a sense of what the all-in spread returns are in that market right now and just what you and Mike and the team are seeing across on a return basis? That's just the first part of the question. The second part of the question would be, what's the financing costs generally on those types of assets?

Sure, Jonathan. Thanks for the question. Appreciate it. Look, through middle-market, call it, $50 million of EBITDA, bank debt, LIBOR 400 would probably be the middle of the range. There's some nuances to whether it's rated or it's unrated, it's a club deal, et cetera. But with LIBOR, at wherever it is now, 2 and change percent, the all-in return on assets is about, call it, 6.5%. It depends on how you book fees or think about fees, too, which would obviously increase that number. We tend to originate a lot of our deals, as you know, and that number goes up with higher origination fees.

So cost of financing is an interesting one, for sure. And then you know where outstanding debt has been issued, both secured or unsecured. So I think if we did more of that, we'd do it by drawing down under our bank facilities, which is generally, rough numbers, 4% money today. The cost of most of our recent fixed-debt issuances have been 4% or below to use a rough number. But what is interesting is, in the expanded leverage context, we really don't know if we went there what the cost of our borrowings would be, would they change, would they not. We're substantially overcollateralized, relative to our existing senior debt today. I'd make an argument that we should have a lower cost of financing based on the amount of assets that we pledged against that.

The only other data point that might be useful for you is thinking about some of the recent CLO issuance. I did have a chance to listen to your call, whenever it was, a couple of weeks back, where you laid out a couple CLOs and Ivy Hill, Antares. Some others have done some middle-market CLOs of scale, where the cost of financing there has been lower than all of that. You're talking about blended LIBOR plus 160 type numbers, so, call it, 3.5-ish percent. So hopefully, that gives you some context.

And our next question comes from John Hecht with Jefferies.

Maybe just dive in a little bit in the portfolio. I saw you had a pretty big increase in the number of portfolio companies from 314 to 360. I'm wondering, was there -- were there some movement around in kind of definitions there? Or would you guys -- you managed to have a successful quarter of bringing in new borrowers?

Yes, John, it's actually related to the jump transaction. A lot of it's associated revolvers.

Okay. And then similarly, though -- and Mike talked about the pickup in EBITDA in the quarter. I wonder, your average company EBITDA saw a pretty good pickup in that item. Is that organic? Is that mix shift? I'm wondering if you could talk about the trends you're seeing within the portfolio of companies.

Yes. Nothing new and different. We closed the transaction with a very large company called Air Medical, but it's a business we've known for a long time here at Ares. Very, very large, $500-plus million of EBITDA, public company, et cetera. So that skewed the number up. If you exclude that for Q1, the average EBITDA number is about $64 million, which relative to Q4 '17 of $62 million doesn't represent much of a change. So it's literally a single name.

Okay, that's helpful. And finally, Kipp, I'm wondering if you could just give us some color. I mean, you talked about a fairly competitive market. Where do you -- have the terms changed? Have covenants changed? I realize spreads could change with the benchmark rates and so forth, but any commentary on what you're seeing on the margin of deal at this point?

Yes. I mean, I would say that more than spreads coming in, which we really haven't seen -- and again, we've seen yields expand largely because of the increase in LIBOR. We've seen just all-around weaker underwritings. So more covenant-light, lower-quality earnings being financed, i.e., lots of adjustments being financed to high multiples, structural loosening of all sorts of provisions and documentations, provisions for restricted payments that we haven't seen before, capital structures that allow for layering of debt, covenants that actually don't decline if they exist. So people say, I'll give you a 9x leverage covenant forever, which is a new invention in today's market. So just all sorts of things that we don't think represent particularly sound underwriting metrics.

And our next question comes from Rick Shane with JPMorgan.

Penni, you made the point that you have the capacity to fund the 2018 maturities in November -- '18 maturity off the revolver. That's absolutely true. But when we look at what you just executed your 7-year deal at and think about what the forward LIBOR curve looks like, it strikes me that terming out more of your financing should be pretty compelling. I'm also wondering, in light of the potential of increasing leverage over time, whether it makes sense to sort of get ahead of that, given how attractive the financing is currently.

All right. Thanks, Rick. I think, yes, you make a good observation. If you think about my comments, I was really commenting in the context of our resolution of maturities for this year is basically done. So we have no risk of repayment. But as we always do, we constantly look at the markets. We look at the interest rate environment, and we look to see where we can opportunistically issue new debt into the capital markets, and that's something you will continue to see us assess and do as we move forward. So I don't think it's a statement of saying we won't do something if we have the right market. It's really just a statement of saying we don't need to do anything.

Yes. It was funny when you made the comment, as one parent to another, I thought of the difference between nice to have and need to have in that conversation.

Exactly. So we always like to go to the markets when it's really a nice time to go, where we have good positive dynamics to effectively and efficiently issue capital. And that's been our history, and that's what we'll continue to strive to do.

And our next question comes from Allison Taylor Rudary with Oppenheimer.

So 2 questions. I noticed that the Ivy Hill dividends stepped up from $10 million to $13 million, and I wondered to ask how we might think about that going forward. Is that kind of a new steady state? Is there opportunity for that to go up as new things might come on there? And then, my follow-up would be, the -- there are still a few million dollars of costs related to ACAS going to the portfolio. And I'm wondering -- or going to the P&L. And I'm wondering if those are kind of -- are those still -- how do we think about those rolling off? Are they sort of related to the portfolio transition? Or might those stick around for the next few quarters?

Yes. Well, maybe I'll take the ACAS question first.

Yes, go ahead. Thanks, Allison.

And then for that, we continue to see, I would call it, a trickling of just ACAS-related expenses that are primarily portfolio-related. So certain expenses are coming through related to certain portfolio companies. We are presenting that expense through this line item. So there may continue to be a modest amount of related expenses as we go forward that we've broken out, but the more significant, like operational expenses and things that we were incurring last year, are behind us.

Yes. And on Ivy Hill, Allison, I think we increased the quarterly $10 million to $13 million this quarter. It's likely, I'd say, to go up from there and that we're waiting until the closing of this CLO at Ivy Hill, which enhances the economics of our investment in that transaction. So I'd say, we are conservative for Q1 on the $13 million number. I don't think we've completely settled on where we're headed from a perspective number. I expect it to be a little bit higher. But if you'd give us the second quarter, we'll come out and lay a number out for you, [all that's] more representative of what to expect going forward.

And our next question comes from Ryan Lynch with KBW.

If I look at your guys' -- commitments you guys made in this quarter of $1.8 billion as well as what you guys had done quarter-to-date, about $700 million, you have a pretty good backlog of about $800 million. If I compare that to your comments talking about a very competitive environment, can you just get investors, I guess, comfortable with the amount of deals and of originations you guys are putting on the books today in contrast to what you guys speak of as a very competitive environment?

I don't know if I can get you guys comfortable, but we're comfortable. It's a tough question to answer. I think we've been incredibly selective. We think that we've got a long history of being able to pick the right credits. We're focusing on doing deals that we think have very little business risk is the most important thing. It's really a market where being right on credit is going to be exceptionally important. So a continued emphasis on incumbent borrowers or new deals; something like an Air Medical, I'd hold out as a -- it's a very large public company that has $500-plus million of EBITDA. We're excited about opportunistic deals like that, where we're able to write big checks. But I don't know how to get you comfortable or others comfortable other than to say, we feel comfortable with what we're doing despite the market conditions.

Okay, that's fair enough. One question on the SDLP. It looks like your guys' investment commitment shrunk a little bit this quarter. Can you guys just talk about what is the growth potential outlook for the SDLP? And then also, related to the 2 to 1 leverage, I would assume that if you guys do eventually end up passing that, a lot of the loans that could fit in the SDLP could potentially now fit on your guys' balance sheet with additional leverage. So I guess, how are you guys thinking about potentially growing that if you guys do start to put some more lower-risk loans on your balance sheet with the 2 to 1?

Yes. Again, I don't know if that falls into the question we're not going to answer, so to speak, today. But I'd just say that the SDLP remains a very important strategic partnership and program for the company today, as does Ivy Hill. As of this moment, we have no interest or desire or intent to change the way that we're deploying in that program. Beyond that, I really don't have a whole lot to add.

Our next question comes from Robert Dodd with Raymond James.

So obviously here, the double leverage issue. Given that you guys were one of the strongest voices lobbying for the double leverage provision over the last, I guess, like 6-plus years, so that's been ongoing, is it a foregone conclusion you're going to ask for it? And the question then is, how long is it going to be before, do you think -- before the review of your options is complete and the board is presented with a recommendation one way or the other?

Sure. I mean, I think we're -- thanks for your question, by the way, Robert. So I think we're moving along at what we think is a patient and sort of judicious pace. I don't think we're going to provide anybody on this call a timeline for if and when we chose to make any changes to the way that we operate the business. But certainly, if we do that, we'll let you know. I don't think it's a foregone conclusion.

I'll just make a few observations. Because while we're believers that putting additional leverage on these assets actually wouldn't put undue financial risk on our company, and when we look at other financial institutions that invest in these types of assets, almost all of them have substantially higher leverage than we do, at 0.7 to 1. So the reason that we've been supportive is that we thought it would increase operational flexibility of the company, widen the fairway, so to speak, in terms of our ability to invest in -- we feel are safer, albeit lower-return first lien assets.

Some of the things that have happened since the passage of the legislation have surprised us. I think, as you're aware, we have an investment-grade rating at our company that we feel fortunate to have, would like to maintain and use, we feel, as a competitive advantage to drive low-cost financing against the assets. And some of the considerations there are -- some of the observations there, perhaps, are different than what we might have expected. We would have expected that the relaxing of the debt covenant and loosening, so to speak, of the regulatory regime that we're under would have actually created a safer, better credit profile for a lot of our lenders. Certain folks in the ratings community have viewed it differently, perhaps differently than we might have. And we've had some conversations, as you'd expect, with them.

So -- but we are in the process of taking in all of these variables today to think about where we'd go from here, and we've got a lot of options. And we don't take the decision lightly and certainly want to think about our shareholders' best interests and have a good, solid, in-depth conversation with our board. So I definitely would not call it a foregone conclusion. And again, we'll report back to you guys when we have more comfort in getting to a conclusion.

Okay, great. I really appreciate all that color. If I can, just a second question. On the nonqualified bucket, you're at 13% right now. So it's underutilized already today, right, relatively speaking. So normally, a question of if you do double leverage, so obviously, the nonqualified bucket group is even greater relative to the size of your equity base because it's a percentage of assets. And when we look at the SDLP and some of the nonqualified-type assets, the return on assets can obviously be considerably above the 6.5% that we see in middle-market lending. So just general question about -- are you reviewing how to utilize the nonqualified asset bucket right now? And secondly, what if -- big caveat on the if -- double -- you do go forward with double leverage, would that further alter how you would utilize the nonqualified bucket?

I think your observation is the right one. One of the things that is nice about the non-qualifying 30% numbers, that we can use it in ways that we've obviously used it in the past to enhance the return on equity of the company. So I think we'll continue to do that. If the balance sheet was larger, and we had a larger basket, I think we'd continue moving towards the goal of increasing utilization there. So I think it continues to tick up. We're always trying to find, as we talked about on past calls, interesting new things that we can bring to the benefit of the shareholders at Ares Capital Corporation, with particular focus on other things that we're doing here at Ares that ARCC may not be getting the benefit of. So we've highlighted some examples of that in the past, and those sorts of things as well as many others are definitely in the lap.

And our next question is from Chris York with JMP Securities.

So the first question is a clarifying question. What do you think the ROE potential is at Ivy Hill after the close of the CLO? And then maybe, Michael, are your comments that the run rate will be comparable to dividend run rate will be comparable to previous period a function of yield? Or is it another metric?

I think we've always -- Ivy Hill, we've always targeted sort of the low to mid-teens return on, and I think we're moving back, even with the substantial increased investment there. So kind of the same territory back to Allison's question as to when we cover off the Q2 dividend and sort of what it looks like on a run rate basis.

The question directly for Michael, I guess, I'll let him answer.

Yes, no, it's on a yield basis based on the equity investment that we made into Ivy Hill. And given the execution of the CLO, which were on very favorable terms, we think we can generate with the yields that Kipp just mentioned in that low teens rate and hopefully, as Kipp mentioned earlier, increase that dividend back to ARCC from Ivy Hill.

Got it. Low teens, so $13 million, $15 million is kind of what I was thinking, okay. And then next question is on portfolio management. The appreciation in Alcami has obviously been a very welcome event to investors, but it has created the situation where it's a top 2 investment at 4.4%. And then I think the first and third are two diversified portfolios. So I'm curious whether you are comfortable with the concentration to this single investment. And then are there any other steps that you could be taking to reduce the concentration?

Yes. I mean, look, I mean, Alcami has been just a really, really strong performer. Just a real sort of pleasant surprise, right? It's a company that we acquired, obviously, with the American Capital portfolio. And look, it's -- I reminded somebody of this the other -- it's been a while, right? When we first started working on that transaction, it was kind of Christmas 2015, which seems like a long time ago. So the company was in a very different place in terms of its profitability and its operating metrics and all of that. And we don't talk all that often about single portfolio companies, but I'd [salute] really, really clearly based on the numbers. Strong management team there that continues to do just a fabulous job at that company. So it's resulted in a lot of unrealized appreciation to date.

While there's a debt component there, the unrealized appreciation is, of course, largely due to the fact that we control the business today. And I think as you're aware, we're not really a BDC that likes to operate as a control owner of portfolio companies. So I'd think to mitigate that concentration in time, you'd likely see us be a seller. But the performance there has been so strong that we felt that it's been the right thing to do for shareholders to hold onto it here over the last couple of years. Let the management team do their thing.

Our next question comes from Terry Ma with Barclays.

Just want to touch on the lending environment a little bit more. We're now more than a full quarter after Tax Cuts. Just wondering if you've seen any change in appetite from borrowers or your portfolio companies for debt capital?

I mean, I'm looking around the room, I don't think so. It would be the simple answer.

Okay. And then on any additional portfolio purchases, like the PacWest deal out there, how many more are out there? And how competitive are the situations?

I'm certainly not the only person who works here, so I'm not aware of anything that we're particularly interested or sort of working through right now. But look, I think we're always seeing examples like PacWest pop up, right? We continue to believe that it's just such a typical transaction these days where a bank acquires a middle-market lending franchise, tries it out for a little while and then decides it doesn't want to do it anymore, which was the situation with PacWest and of course, the CapSource transaction that they did in the past.

Look, there's certainly other things going on, right? I mean, you saw the transaction that got done with Triangle. We thought it was interesting. BlackRock acquiring Tennenbaum Capital. So there are loads of things out there. We get a lot of calls from bankers on a lot of things, but there's nothing to comment on, I think, that we're engaged in right now or that we see as near term.

And our next question comes from Doug Mewhirter with SunTrust.

Regarding the competitive environment and your portfolio activity, I'm not sure if this was a mix issue or is distorted by the Ivy Hill transaction. But it seemed like you had originated -- you have been originating an increasing number of subordinated loans, which just strikes me a little odd, given that if things are just getting tighter and underwriting [synergies] are dropping, the logical conclusion would be to go higher in the capital structure. But maybe it's a cause and effect, where everyone's going higher in the capital structure, and that's what's screwing everything up. I just wondered if you could, I don't know, just maybe break it down a little bit, in a little bit more detail, your reasoning and how you're looking at the portfolio.

Sure. I don't think we're doing anything differently. Frankly, obviously, things can move a little bit quarter-to-quarter. But there were kind of 2 transactions, Air Medical being one, another deal last quarter that influenced that a little bit. There's actually a name in there called Gehl Foods that we actually underwrote the junior piece of and actually have since exited. So I think there's a little more noise in the number rather than there is sort of any shift in philosophy. And generally speaking, I'd agree with your comments. So we've been continuing to try to position ourselves up the balance sheet as best we can. But we do find some good situations to do junior capital and will stick to it where we've got conviction.

Okay. And my second and final question, now that LIBOR has obviously gone up considerably and you are busy sort of trying to fix out as much as you can at attractive rates on the liability side of your balance sheet, are you seeing any demand on the asset side of your balance sheet from borrowers or their sponsors wanting to try fixed-rate loans? Or is there sort of some structural part of the industry which really would prevent that -- a wholesale shift towards fixed in this environment?

Yes. I think it's a good question. It's a good observation. I -- we haven't seen it. There've been a couple of asks, I think, that we've seen, and that probably is a good idea for companies, obviously, to try to be fixing their debt. But not really, which, perhaps, is a little bit of a surprise. Remember that, even if they're borrowing floating, they actually do have hedging agreements in place that require them to swap some of their floating rate debt into fixed, as some of the companies already have kind of fixed some of their exposure just in terms of the way leverage credit agreements work. But again, not to be too simplistic, the answer to your question is not really.

Our next question comes from Casey Alexander with Compass Point.

In relation to the Ivy Hill acquisition, how did you determine -- I mean, if I read the release right, which portions of the acquisition to pull on to your balance sheet as opposed to leaving with Ivy Hill?

Yes, it's a good question. So when -- you probably appreciate this. Or most people do, but if you don't, I'll give you a little color. So obviously, CLOs require certain diversification standards. So to the extent we had assets on our balance sheet, one of the reasons that we may have held onto something was size of position, right? So diversity of the portfolio that we eventually securitized as of the other day was part of it.

The second piece of it is there are a couple of loans in there that I would categorize as just less traditional to frankly get financed on a CLO. Some media-oriented stuff, just some things that don't fit as well. We left that in what I think of as kind of the remainder financing, which we're calling Ivy Hill 13, which, again, is a pool of assets that's meaningfully less diverse, financed with a warehouse line from one of the investment banks. And it's our intention to effectively exit those assets, either quickly or in natural course, and we think that will lead to a repayment of some of our capital in terms of what we invested in that deal. Does that make sense?

Yes, it does. And my follow-up is, you made an allusion in last quarter to the SSLP assets, which, during the Investor Day, they were identified as things that come on the balance sheet that you'd like to redeploy. And then in the last quarter, it was -- well, in case of the leverage bill, you might just want to hang on to those assets. Are you delaying redeployment of those assets until you make a determination with the board as to which -- the way you want to go?

No, we're not.

Because I noticed that you did mention those, that (multiple speakers)

Yes, yes, yes. Most of it [do not look fair] at all.

Our next question is a follow-up from Jonathan Bock with Wells Fargo Securities.

The one item that we've always debated and discussed, Kipp, was kind of a mix between senior and junior debt. And clearly, the returns have parsed that out over the period of 2 or 3 years. The question that I think folks will ask in this environment, just as -- you mentioned about moving up the balance sheet and at times, the second liens being a bit more situational. And happy to ask this both to Mike and yourself at the same time.

Can you give us a sense of the types, if you could describe some themes of opportunities, where second lien can, and it does make sense in this environment? We've heard folks talk about bridge financing. Or even if -- pick a number, large EBITDA company that's never going to lose money. Whatever the theme is but parse out where you believe kind of the opportunistic second lien investment really does make sense in an environment when folks are now being conditioned to focus a bit more on the senior part of the stack.

Yes, sure. Thanks for the follow-on, Jonathan. It's a good question. We definitely, again, emphasize existing borrowers, companies that we know, that we think offer sort of less risk than a potential new deal. So look, I mean, some of the second lien investment we did in Q1, junior deals just to give you a flavor, invested again in a company called Mavis, tire company, which I bet a lot of people know. It's our bet that a very diversified retailer of car repair and tires is probably unlikely to have very substantial changes in their business model any time soon. It's a great company, founder-owned, been around a long time, now with a new sponsor. So that's an example.

Another incumbent name that we added some capital to is a great business that we've been invested in for, I think, 11 or 12 years called OTG. They run restaurants in airports. As long as people keep flying, my guess is they're going to order food and beverages while they sit and wait for their flights. That company has done exceedingly well. We're very close to the CEO; also a founder-owned business that I've been involved in, along with many others here, for a long period of time and just have a lot of confidence in.

Another one's a company called Dent Wizard that we've been invested in for a long period of time. Not necessarily like a collision repair center. But literally, if you get a dent in your car, and you need to go in and not have a dent in your car anymore, you drive into their store, and you get the dent worked out. I guess there's a dynamic to that business -- don't change a whole lot any time soon. So these are the types of just reliable services where we think there's pretty inelastic demand, the types of things that are large companies. They're established. We've known them a long time, et cetera.

And the new example this quarter is, again, a company called Air Medical, which we take a lot of comfort in, the fact that it's obviously a very large public company. It provides airlift health care services all over the country. It's a business that multiple people, myself included, at Ares -- and I'd include our tradeable credit business, our health care analysts there, our PE team, et cetera -- have known the management team there for literally 10 to 15 years, maybe more. It's controlled by KKR, a very strong sponsorship, very resilient financial performance over the years.

So those are a couple of examples where we just have a lot of conviction that being down the balance sheet doesn't put us in a terrible risk position, so to speak, and we're able to generate really, really strong returns. So...

Your next question is from Christopher Testa with National Securities Corp.

Just curious, guys, if you could just provide some color on your discussions with banks, specifically with regards to increasing leverage. In your opinion, have the banks sort of treated this much differently from the rating agencies and seem to be more amenable to you guys making -- having potentially more leverage on safer credits? Or are the banks pretty much more kind of bent on driving up your borrowing cost, even if you're making safer loans that have less likelihood to default? Just curious any detail you could provide there.

Yes. I mean, all of our lenders probably view it a little bit differently. I think your comment around are the banks more amenable potentially than the rating agencies, I think the simple answer to that is yes. The banks have always financed these types of assets, not in BDCs at substantially higher leverage ratios. So they're comfortable with an advanced rate methodology against these assets that would allow for more borrowing, i.e., our borrowing base today is substantially in excess of our current drawn secured debt.

The convention at the banks has always been simply to rely -- I think if I spoke for them; I don't want to -- but I think it's just been to rely on the regulatory leverage constraint of 1 to 1 being the covenant. I'm hopeful that as we continue to advance, if we choose to go there, that they would relax the covenant if we asked them to. And we took the company in that direction. But I do think, based on at least some of our early conversations, that they're a bit easier and amenable, and all that, to answer the question.

Okay, great. And do you think it ever becomes economical to effectively wind down the SDLP and put all these loans on balance sheet with higher leverage to reduce any frictional cost between them?

Probably not. And then again, if we're looking at an expanded leverage model, which obviously we've got a lot of them floating around here, and you're looking at increased leverage on assets that pay you 6.5%, and you're financing those assets at 4%, you can do the math as to even if you max the leverage ratio out to some number that I don't think we're remotely close to talking about here, it doesn't generate an ROE that's even remotely in the same ZIP Code as SDLP or Ivy Hill, right? So I think, again, those are 2 important programs and partnerships for us, and we intend to continue to support them both, and we hope they'll both keep growing.

And our next question comes from Henry Coffey with Wedbush.

Really, 2 questions. I'll get the first one out quick and then go to the second. Yes, it's a very competitive environment, but are you seeing the tone of your ability to [harvet] either companies that you would prefer to be out of or companies where you have significant gains? Is this becoming a better environment for creating liquidity there?

And then my second question is really just going all the way back to what Robert was speaking about. When you think of increasing internal leverage, is that going to go into its own special product bucket that you'll add leverage, but they'll be to loans with, say, very senior characteristics or some other dynamic?

Yes, it's fair. So thanks for your questions, too, by the way. But -- yes. So look, there's one real benefit of the tremendous amount of liquidity that exists both in the credit markets and the PE markets in that it's an excellent time to sell. I think we've said this for the last, I don't know how many years now, but we continue to kind of generate record gains at this company. We think that we're reasonably intelligent to know what we're doing, but we're also taking advantage of what's a very good market to sell things, right? So we had lots to sell over the last couple of years, which is one of the reasons that we purchased American Capital. And when you buy a very large portfolio at a discount to NAV, and you hold it through a rising multiple environment, you find yourself in a good position to exit and generate gains, which is what we've done.

But I think your second question -- or part of the first question is actually more interesting, and I've made this point in the past as have others on calls. But it's a great time for us to exit companies that we don't think are actually on the right path. We want to set up companies that we're leveraged, and deleverage over the first couple of years. That's how we ensure that we actually get paid back. So if we underwrite a business that's levered 6x, and 3 years later, it's levered 6x, it's not performing, right? So if other lenders come in and say, "Oh, we'd love to pitch on that business. That looks like a great 6x levered credit," there have been a whole host of examples of exits that we've made from companies that, frankly, we weren't thrilled with performance in.

So we talk about backing our incumbent winners a lot, the companies that we see show up in other people's portfolios that used to be our portfolio of companies. We typically have an ability to keep those in the portfolio if we want to. So if we're exiting them, you can assume that we're exiting them for a reason, unless we're simply being outcompeted, I think we've avoided some future problems as a result of the liquid market and the amount of competition that is out there. I think that's an important point that people don't pick up on, and I appreciate that question.

In terms of the increased leverage, I'm not quite sure what you mean by the special product bucket. So if you wanted to clarify that, you can. But I'm not quite sure how to answer that second question.

Well, I mean, if you added -- let's just use numbers. If you went from having $100 million worth of debt to $50 million -- $150 million worth of debt, would those incremental investments just look like what you're doing today? Or would you say -- or would you then say, "No, we're going to go into a different bucket, different type of investment, a more senior investment, a small business investment." I'm not -- I'm just thinking of examples where you'd be more comfortable with adding the leverage, et cetera.

Sure. I think it's safe to say that if we did choose to increase leverage on the portfolio, we'd do it to, again, expand the fairway and invest in more kind of first lien assets that add lower returns, and we're safer. But again, we're early days in terms of this discussion. You can model it a whole host of different ways, but that's probably, if we took it there, where we'd take it.

And our next question comes from Chris York with JMP Securities.

Yes. Guys, a quick follow-up on the rules. I don't know if Mr. Arougheti is on the call, but we already discussed that Ares was instrumental in advocating for the modernization of BDC operations. So I'm curious if you guys have any thoughts on whether either legislators or regulators, the SEC, may be more supportive to modernizing shareholder obstacles like AFFE for public BDC investors.

Sure. I don't think Mike is on the call. I know he's in Los Angeles, but I don't think he joined us today. I've been involved in everything from the legislation as well as the AFFE discussions as has Penni, Mike, Mitch. Josh Bloomstein, our General Counsel, is here with us today. So look, I think that there is a better tone, I guess is what I would say, in this SEC than there was in the prior SEC. And we've had some more productive dialogue that I'm hopeful will lead us to, again, what I think would be the next most important regulatory relief that we could see from D.C. So I think it's particularly impactful on us as a large company in the space because I've had enough meetings with folks who have just said, "We love what you're doing at the company, but we just can't own it. And our mutual funds -- or we're maxed out in our mutual funds. Or the 3% position that I have is the max I can be in." And look, this is a firm that's very comfortable and very appreciative of the institutional support that we get for all of the investment vehicles that we run, ARCC being first and foremost. There's a -- we'd love nothing more than regulatory relief that does seems obvious that would increase institutional ownership in the space.

And our last question today will come from Derek Hewett with Bank of America Merrill Lynch.

All of my questions have been addressed, so I'll -- maybe just a housekeeping issue. Kipp, you had mentioned that there was about $1 billion of lower-yielding American Capital assets on the books that could eventually rotate out of the portfolio. What was the average yield on those assets?

What is it, Penni?

6.8%.

6.8%, I'm hearing. And just look, when you cut through it, about half of it's Alcami. So just to make that clear in case people hadn't figured that one out.

Ladies and -- oh, excuse me, this concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Kipp DeVeer for any closing remarks.

No, I don't have any. But I'll just thank everybody for their time, and hope you have a great day.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately 1 hour after the end of the call through May 16, 2018, at 5:00 p.m. to domestic callers by dialing (877) 344-7529 and to international callers by dialing 1 (412) 317-0088. For all replays, please reference conference number 10118465. An archived replay will also be available on our webcast link located on the homepage of the Investor Resources section of our website. Thank you for attending today's presentation. You may now disconnect.