Ares Capital Corp (ARCC) 2018 Q2 法說會逐字稿

Good afternoon. Welcome to the Ares Capital Corporation Second Quarter Ended June 30, 2018, Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded on Wednesday, August 1, 2018.

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

Great. Thank you, Brian, and good afternoon, everybody. 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 and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intend, 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 certain non-GAAP measures as defined by the SEC Regulation G, such as core earnings per share or core EPS. The company believes that core EPS provides useful information to investors regarding the financial performance because it is one method the company uses to measure its financial condition and results of operations.

A reconciliation of core EPS to the net per share increase or decrease in stockholders' equity resulting from operations, which is the most directly comparable GAAP financial measure, can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures may also be found in our earnings release filed this morning with the SEC on Form 8-K.

Certain information discussed in this presentation, including information related to portfolio companies, was derived from third-party sources and has not been independently verified and, according to the company, makes no representation or warranty in respect to this information.

The company's second quarter ended June 30, 2018, earnings presentation can be found on the company's website at www.arescapitalcorp.com by clicking on the Q2 '18 earnings presentation link on the homepage of the Investors Resources section. Ares Capital Corporation's earnings release and 10-Q are also available on the company's website.

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

Thanks, John. Good afternoon, and thanks to everyone for being with us today. I'm joined by members of our management team, including our Co-President, Mitch Goldstein; our Chief Financial Officer, Penni Roll; and other members of the Finance, Investment and Investor Relations teams. You will hear from Penni and Mitch later in the call.

I'll start by reviewing our second quarter results and providing an update on our current market conditions. I'll then discuss our plan to take advantage of the flexibility provided by the Small Business Credit Availability Act, which we detailed in a presentation posted to our website in late June. And finally, I'll leave you with some thoughts on our progress in the American Capital deal as the sale of non-core assets is now largely behind us.

This morning, we reported strong second quarter core earnings of $0.39 per share, an increase of 15% from the same period a year ago. The improved earnings were driven by higher portfolio yields as we benefited from continued portfolio rotation initiatives and increases in LIBOR. We also generated another quarter of strong GAAP earnings, which totaled $0.60 per share, reflecting significant portfolio appreciation, primarily from the remaining acquired American Capital portfolio.

Over the last 4 quarters, we've generated a GAAP return on equity of approximately 12%, above our long-term average since inception of roughly 11%. And we also ended the quarter in a conservative financial position, with a modest debt-to-equity ratio of only 0.57x. This is below our current target leverage range of 0.65 to 0.75x. We feel we're well positioned today and have significant near-term opportunity to deploy capital.

But it's a good transition as therein lies the challenge today. Overall market conditions remain highly competitive. We continue to differentiate ourselves from the competition with our large-scale commitment and hold capability, long-standing relationships, ability to take advantage of incumbency and the flexibility of our capital. We remain very selective on new deals, as evidenced by the fact that we closed less than 4% of the transactions that we review for new companies. And as Mitch will discuss later in more detail, the vast majority of our investments today are backing our strongest existing borrowers, where we believe we take the least risk deploying capital.

Despite these challenging conditions for investing, we did see evidence of increasing market volatility in the liquid credit markets begin in late June and it's continued. Under the weight of strong new supply and deal activity, investors began to push back on both pricing and terms in the liquid loan markets. As supply and demand dynamics in the market become more balanced, the syndicated loan market is seeing spread widening of approximately 25 to 50 basis points, marginally improved credit protections and tightening risk parameters from syndication desks for liquid loan executions.

This increased volatility from more capital market-oriented executions should be a positive for us since it provides additional opportunity for ARCC on the upper end of the market, with potentially improved pricing on larger transactions.

As these early signs of improved terms for investors develop, we remain patient as we know the middle market typically lags the liquid market, and in our opinion, it's a good time to take a wait-and-see approach in many situations. We feel good about having significant dry powder as we move forward.

I'd like to turn now to our previously announced plan regarding the adoption of certain provisions of the Small Business Credit Availability Act. Prior to our board approving the reduced asset coverage test under the SBCAA on June 21, 2018, we spent significant time engaged with our Board of Directors, lending partners, rating agencies and other key constituents in examining our options.

As we described in the presentation filed on June 25, we believe the adoption of the 150% asset coverage requirement and our corresponding plan will result in enhanced profitability for our company while maintaining our conservative investment grade profile. We also believe the greater flexibility offered by the Act allows us to operate with an increased cushion to the regulatory leverage threshold, which should benefit us in more volatile markets.

We have provided a clear and simple plan to gradually increase leverage to a range of 0.9x to 1.25x debt to equity over the 12 to 36 months following the effective date next June. We have no desire to change our investment strategy, which has proven to be very effective throughout credit cycles and through the last 14 years. We also have maintained our investment grade ratings with both Fitch and S&P, while Moody's placed our rating on watch for a possible upgrade.

All in all, we think our plan allows for the possibility of higher returns for shareholders while maintaining our conservative balance sheet and investment positioning. Our leverage of the company will remain modest, especially compared with other financial services companies or financial vehicles.

Finally, in connection with the plan, our investment adviser has reduced the base management fee from 1.5% to 1% on all assets financed using leverage over 1x debt to equity. This fee concession is meant as an additional benefit of our plan to shareholders in support of potentially higher future earnings.

Before I turn it over to Penni, I will finish with a brief update on the American Capital acquisition. I'm pleased to announce that we've completed the sale of the largest portfolio company that we acquired from American Capital, and we realized a sizable gain. Post-quarter-end in July, we sold our investment in Alcami, which was a controlled portfolio company and a leading outsourced drug development and manufacturing business.

With the sale, we recognized a $324 million realized gain, generating proceeds that were more than double the investment that we acquired. Since our initial acquisition of the $2.5 billion American Capital portfolio in January of 2017 and pro forma for the exit of Alcami, we've received more than $2.3 billion of proceeds from exits and repayments, including gains on a realized basis of $420 million.

We continue to hold approximately $900 million of ACAS investments using our June 30 fair value, and that does still include the Alcami investment. Of this remaining amount, approximately $400 million is in lower-yielding noncore assets. As of June 30 and pro forma for the Alcami sale, the gross realized asset level IRR on our acquisition of ACAS is in excess of 40%. We think it's a great reminder that our company has the ability to opportunistically make accretive acquisitions that can generate these very, very attractive returns.

Now let me turn the call over to Penni to provide more detail on the financials and to deliver some good news regarding our quarterly dividend.

Thank you, Kipp, and good afternoon. As Kipp stated, our basic and diluted core earnings per share were $0.39 for the second quarter of 2018 as compared to $0.39 for the first quarter of 2018 and $0.34 for the second quarter of 2017. Our basic and diluted GAAP earnings per share for the quarter -- second quarter of 2018 were $0.60 per share, including net gains for the quarter of $0.22 per share. This is compared to GAAP net income of $0.57 per share for the first quarter of 2018 and GAAP net income of $0.42 per share for the second quarter of 2017.

In total, we reported net realized and unrealized gains on investments and other transactions for the second quarter of 2018 of $92 million. This included net unrealized gains on our investments of $54 million, primarily supported by the further appreciation of our investment in Alcami that was driven by the exit value we ultimately realized in July.

As of June 30, our investment portfolio totaled $11.5 billion at fair value, and we had total assets of $12.3 billion. At the end of the second quarter, the weighted average yield on our debt and other income-producing securities at amortized cost increased to 10.4% and the weighted average yield on total investments on amortized cost increased to 9.1% as compared to 10.1% and 8.9%, respectively, at March 31, 2018. The total portfolio yield increased since the end of the first quarter, primarily due to the continued increase in LIBOR.

Due to the strong performance in the portfolio, the continued upward progression in our earnings and what we believe to be multiple drivers for future earnings growth, our Board of Directors approved an increase in the quarterly dividend to $0.39 per share from $0.38 per share. In addition, we currently estimate that undistributed taxable income carryforward from 2017 into 2018 will be approximately $346 million or $0.81 per share. The third quarter dividend of $0.39 per share is payable on September 28, 2018, to stockholders of record on September 14.

Moving to the right-hand side of the balance sheet, our stockholders' equity at June 30 was $7.3 billion, resulting in net asset value per share of $17.05, an increase compared to $16.84 a quarter ago and $16.54 a year ago. As of June 30, our debt-to-equity ratio was 0.64x and our debt-to-equity ratio, net of available cash of $475 million, was 0.57x compared to 0.73x and 0.69x, respectively, at March 31, 2018. Our total available liquidity at the end of the second quarter was approximately $3.5 billion.

Our balance sheet continues to be asset-sensitive and a further rise in LIBOR -- I'm sorry, in short-term rates should continue to benefit our earnings. For example, using our balance sheet at June 30 and assuming a 100 basis point increase in LIBOR, our annual earnings, after including the impact of income-based fees, are positioned to increase by up to approximately $0.17 per share.

And with that, I will turn the call over to Mitch.

Thanks, Penni. I would like to spend a few minutes reviewing our second quarter investment activity and portfolio performance. I will then provide a quick update on post-quarter-end activity and our backlog and pipeline. As Mike Smith and I often mention, we focus on originating a very broad set of middle market opportunities, with the goal of investing in the best credits where we find compelling risk-adjusted returns.

During the second quarter, we made 46 commitments totaling $1.6 billion, of which over 65% of these commitments were first lien and 90% were senior secured positions, reflecting our conservative approach in this market. The sheer size of our portfolio, along with the growing financing needs of our portfolio companies, offers us significant differentiated deal flow from our existing borrowers, which represented nearly 75% of our second quarter investment activity.

For example, in the second quarter, we led a $340 million incremental senior secured financing for our portfolio company, Community Brands, in support of a strategic acquisition. This transaction serves as a good example of how we evaluate software businesses. We seek software businesses with strong free cash flows and large embedded customer bases with high switching costs. Community Brands is a preeminent provider of integrated cloud-based software to over 100,000 faith-based institutions and not-for-profit organizations. Our first investment in this company was made in 2015, and over the past 3 years, we have raised a total of $2.0 billion through 7 transactions for the company.

Shifting to repayments. During the second quarter, we exited or were repaid on $2.2 billion of commitments as we used strong market conditions throughout most of the quarter to refine our portfolio. The strong repayments we experienced included exits of lower-performing credits and companies with investment terms where we were happy to be repaid at par or premiums to par. At quarter-end, our portfolio was $11.5 billion, consisting of 346 different portfolio companies, resulting in a highly diversified portfolio, where our average hold position per name at fair value was only about 0.3% of the portfolio.

Performance continues to be strong in our underlying portfolio companies. As of June 30, these companies continue to generate solid growth in their aggregate earnings as weighted average EBITDA grew over the past 12 months by approximately 7%, consistent with last quarter and up from 5% in the second quarter of 2017. We also saw a decrease in the number of companies on nonaccrual during the quarter, as 2 companies came off nonaccrual and there were no new nonaccruals during the quarter. At the end of the quarter, nonaccruals as a percent of the total portfolio at cost were stable quarter-over-quarter at 2.7%. Nonaccruals at fair value decreased to 0.8% in Q2 2018 from 1% in Q1 2018.

Looking forward, we remain defensive, with a continued focus on lending to franchise businesses with high free cash flows and strong margins. We continue to seek investments in industries such as business services, health care and software services, and we continue to be underweight in sectors where we see volatility or weakening trends, such as retail and media/communications. Underscoring the importance of industry selection, retail, media/communications and energy/oil and gas sectors accounted for nearly 9% of broadly syndicated leveraged loan defaults since the beginning of the second quarter 2017, all sectors that are either nonexistent or materially underweight in our portfolio.

We also made good progress this quarter in utilizing our availability under our 30% basket. Our SDLP joint venture made 5 new commitments totaling $500 million, bringing the aggregate capital funded in this program to $2.9 billion. ARCC invested $111 million in the subordinated certificates during the quarter, bringing ARCC's total investment in the SDLP to $589 million. The subordinate certificates of the program provide ARCC an attractive risk-adjusted return with a yield of 15% as of June 30, 2018.

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 July 1 through July 25, we made new investment commitments totaling $895 million and exited or were repaid on $629 million of investment commitments, generating approximately $326 million of net realized gains. The significant net realized gains primarily reflect the successful exit of Alcami.

Since ARCC's inception through June 30, 2018, and pro forma for the Alcami exit, we have generated over $950 million of net realized gains for an average annualized net realized gain of 1.2%. It is our belief that this metric compares favorably with most banks and other BDCs.

The Alcami transaction also demonstrates how our scale and position of incumbency supports attractive investment opportunities. As part of Madison Dearborn's acquisition of Alcami, we were selected to lead a $390 million first and second lien financing, allowing us to stay invested in the company. Our scale and knowledge allowed us to create a customized financing solution in what we continue to view as an attractive credit.

And finally, as of June -- July 25, our backlog and pipeline stood at roughly $710 million and $660 million, respectively. As always, these potential investments are subject to approvals and documentation, and we may sell or syndicate post-closing. Please note that there is no certainty that these transactions will close.

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

Thanks a lot, Mitch. So we're really pleased with our second quarter results and the continued execution against our goals for 2018. Our core earnings have increased significantly over the last 5 quarters. We believe our future earnings are positioned to further benefit from additional increases in LIBOR, releveraging back to our current target range of 0.65 to 0.75x debt to equity, and increased utilization of our 30% basket. The growth in earnings has allowed us to increase our quarterly dividend to $0.39 per share. We feel well positioned to deliver attractive returns for shareholders moving forward.

Looking longer term, we believe the flexibility we gained with the passage of the SBCAA and the plan we laid out will enable us to improve returns for shareholders going forward while maintaining our investment-grade profile and our conservative balance sheet. We intend to go slowly if the current market continues as it is. As we implement our plan, we'll be sure to keep all of our stakeholders updated. That concludes our prepared remarks.

Brian, would you open the line for questions, please?

(Operator Instructions) And our first question today comes from Rick Shane with JPMorgan.

Two questions this morning. First, Kipp, you talked about widening of spreads, and that's obviously a dynamic we have not seen in a very long time. I'd be curious, given that the portfolio has basically been bounded by par in terms of marks as spreads have tightened, if as spreads widen, there's substantial cushion, so we wouldn't expect NAV decreases -- or NAV compression associated with a little bit of movement in spread.

Thanks for the question, Rick. I mean, look, when spreads widen, generally, we see modest markdowns, is the way that the math works, just on the portfolio on a mark-to-market basis. But I think that we do have enough yield in the portfolio that, based on the way we think about valuation today, we didn't see anything material in Q2.

I'd just make the point, too, as it relates to valuation. This is sort of very late quarter-end and then continuing, I'd say, as much into July as it is anything else ongoing, but it's very dependent on supply of outstanding loan transactions. Some of the things that got a little choppy there in late June and early July seemed to have cleared with a slight tweak to pricing, and that supply/demand imbalance isn't quite as bad as it was maybe 6 weeks ago.

But it's something that we're monitoring. I think there's more caution on the sort of loan syndicate desks these days relative to underwriting large cap transactions vis-à-vis what's coming in the fall and beyond that.

Got it. And then I just wanted to follow up on a comment that Mitch had made. Am I correct? So in the slide, you note $326 million of net realized gains that are coming in the third quarter, and that was in the context, including, basically, the history of $900 million gains. Are you going to realize almost 1/3 of the gains, lifetime gains in the third quarter?

Yes.

The next question comes from Fin O'Shea with Wells Fargo Securities.

Congratulations on the strong quarter on all fronts. First, a question on Ivy Hill. You stated that, recently, you hope that keeps growing. Underneath, we saw investments come down a little bit, but are still above risk retention requirements. Is this still a lump based on the PacWest deal? Or should we see more underlying CLO investment exposure there?

I'm glad Mitch is here too, because he can probably answer. I want to make sure I'm clear on the questions, Fin, and we appreciate it.

So there was a modest write-down in Ivy Hill in the quarter simply as part of our regular valuation exercise I wouldn't call material in any way. The risk retention requirements don't really have any impact on Ivy Hill, right? I mean, we're an equity investor through Ares Capital. We have third-party investors. But there's no risk retention sort of element to it.

The only thing that really is material is obviously that we had increased ongoing dividend there to represent the larger size of the company post the transaction that we've talked about, that we called Project Jump but with Pacific West. Did I answer your question? I'm not -- I want to be sure I answered it or didn't answer it.

Yes. Just basically, it used to be more of an even split between the fee income and the investment income in that vehicle. So just seeing if there's going to be an increase in investment income going forward.

I don't think -- this is Mitch, and I appreciate the question. I don't think you'll see a material change in Ivy Hill going forward. Obviously, the PacWest transaction was a very large transaction that we closed in the beginning of this year. But I don't see a lot of changes in Ivy Hill going forward, certainly not in the short term.

And frankly, part of the write-down in Ivy Hill was the abundance of cash we have in some of the vehicles, given the slower deployment that we have, that we have to sop up before we can consider more Ivy Hill transactions.

Okay, and then that makes sense. And just for my follow-up, seeing Varagon a little more active in leading middle market deals, are you familiar as to -- if these are smaller market? Or are they able to build around the would-be SDLP funnel parameters?

I think they're mostly smaller deals, from what, at least, I've observed. Anybody here can chime in. Look, we're still happy with the partnership. We both originate for our joint venture. So to the extent they're growing and getting to be larger, it's probably a good thing for us. And we're happy for them on that front.

But I think a couple of the recently disclosed transactions that maybe I came across, that you did too, I think, were in some smaller companies.

The next question comes from Chris York with JMP Securities.

So as I assess the quarter, I think investors will try to make sense of the $0.01 dividend increase with the decline in the portfolio and leverage and then as we look out, combined with a few waivers that are set to expire in '19. So obviously, returning to target leverage will help expand net investment income.

So could you help us understand why the decision was made to declare this good news today as opposed to maybe waiting to rebuild the portfolio in 1 or 2 quarters to ensure [you'd dealt] with coverage?

Sure. Well, obviously, our -- we thought the timing was right. I think if we look back, I think, 6 quarters, we've been telling, what I hope people have observed, to be a pretty consistent story of using our existing capital to generate higher core and, certainly, it's been GAAP earnings with all the gains that we've realized, but higher core earnings that meet or exceed our dividend, which we've done now 2 quarters in a row and feel quite good. We'll reposition and continue to do that for the foreseeable future.

As we've evaluated the dividend policy, we've always said that we wanted to pursue a dividend increase. And we thought the earnings momentum of the company allowed for it, and we think that it does today.

So being modestly under-invested where we have dry powder and seeing earnings that meaningfully exceed the dividend is a little bit of a Goldilocks situation for us today. We feel very fortunate and feel very confident looking forward that whether it's a challenging investment environment, which we do see, or lower leverage on the company or even the rolling off of the fee waiver, we have a lot of confidence in the earnings power of the company. And we felt good about raising the dividend in this quarter.

Great, helpful color. And then as Mitch -- as Mitch pointed out, post-quarter-end activity, strong, again, provided -- I think I get about $0.75 per share on realized gains. And you have ample spillover to cover the core. So what inputs are going into your thoughts about distributing versus retaining this future income, or I guess it's already occurred, today?

Yes. So we've had -- obviously, we kind of disclose and test our spillover income on an annual basis, right? So as of the end of last year, it was about $0.81 a share. The significant gains that we've generated now, particularly through the end of July, will increase that.

But until we get to year-end, we're not going to have a firm view as to what the spillover income is because our GAAP and our tax positioning can vary a little bit. But it's safe to say that with the amount of spillover that we've had and what we assume will be an increase in that spillover income at the end of the year, everything is very much being discussed today with the board, whether it's special dividends, whether it's a modest tweak to the way that we think about paying out earnings in excess of the regular dividend, which I know a couple of the other BDCs in the space have done that have been well received.

So a lot of time being spent on that right now, but I think we'll have more to report probably as we progress through the year.

Awesome. Great color, again. Last one for me, and then I'll hop back in queue. So Mitch, you said exits were robust. I calculate a record this quarter, and some of it was strategic. So could you help me or us receive a little bit color -- more color on the level of exits repayments that were in your control versus maybe not and whether this level of portfolio churn may continue?

Yes. Mitch will chime in, too, if he -- certainly, if he wants to add something. I think that most of the exits that we're seeing probably fall into 3 camps. It's something like Alcami, where we're pursuing a sale at a reasonable or a pretty significant gain.

It is repayments that are coming in situations where we sort of regrettably lose one of our larger company transactions, typically to a syndicated deal, where a borrower can reduce their cost of capital with ratings in a syndication, which happens in an environment like this, definitely a little bit higher regrettable repayments.

But I think importantly, also, some opportunistic exits of debt position, situations that I would tell you I don't think we're all that excited about where companies were necessarily going, but they were still able to get pretty attractive refinancing packages that we probably wouldn't have come close to meeting.

So part of what you do late in a credit cycle, and we do think we're late in the credit cycle, is you try to get your portfolio to be as clean as possible. You use liquidity in the market to get your refinance out of situations that you're not thrilled about, and there were a couple of examples, for sure, in Q2 and, frankly, over the last 18 to 24 months where we've been doing that.

The next question comes from John Hecht with Jefferies.

Congratulations on the dividend increase. Actually, I had the same question as the last one with Chris. I guess maybe the only other thing I'd add to that is based on what you're seeing this quarter, do you expect that lumpiness of repayments to persist for the near term, basically -- and if you look at your pipeline and this and that, do you see further contraction of portfolio? Or do you think that will -- the tides will turn a little bit in this investing environment?

Yes. John, thanks for the question. I -- we don't see anything unusual in terms of inflows, outflows. I think Q2 to us felt a little bit unusual. We're just looking forward into Q3. It looks a bit more balanced.

I'm hoping with a target leverage ratio below where we'd like it to be, that we'd find ways to increase the leverage because it will obviously help us to even improve earnings from here. But I think we're going to, as I mentioned in the prepared remarks, continue to take a little bit of a wait-and-see approach, right?

I mean, it's August 1. We'll see what happens when backlog and pipeline gets rolled out in September, sort of how the first couple of weeks go, see if the markets are volatile, see if some of the transactions expected to launch in larger markets are well received, moderately received, poorly received, et cetera, and that'll kind of give guidance as to what we think September and the balance of the year looks like.

But I guess to get to it, I think Q2 is unusual in that we just saw that significant shrinkage in the portfolio. I think we're okay with that for the time being. We're pretty sure with the origination team and the relationships we have, et cetera, et cetera, that that'll recover.

Okay. And then a different question. I know we're only a couple quarters into Tax Reform, but I'm wondering, are you guys -- is there any behavioral change in the market, either from the borrowing customers or your private equity counterparts, that you guys have observed as a result of Tax Reform at this point?

Yes. I mean, I'd hate to give you a short answer, but not really. We haven't -- everybody's kind of shaking their heads around our board room here. So it's seems like the consensus in the room.

Next question comes from Allison Rudary with Oppenheimer.

Lot of my questions have been asked and answered. But I wanted to ask, one of your peers recently called out the direct lending space as an area and asset class that "is being primed for having real issues over the next couple of years."

And I think it's obvious that the opportunity for more like ACAS-like transactions seems pretty apparent in that, but would you guys agree with that? And how do you think about both the opportunities and the risks, especially in sectors that perhaps you didn't call out as ones that you avoid?

Yes. Thanks for the question. We have great respect for our friends based out on the left coast that while they say they continue to put quite a lot of energy into building their own direct lending business, I'm sure being opportunistic investors, as we are too, they look to the prospect of consolidation in the space.

We love the idea. Nothing's -- there are no changes at our company, right, and we've done 2 very large acquisitions of 2 troubled companies in our space. We certainly don't wish trouble on anyone. But we do expect that trouble will come at some point, and we're doing our best to stay out of trouble for the time being so that we're well positioned to potentially engage in those kinds of discussions, if and when they come.

So again, I think we're late in the cycle. I think there's a lot of not-so-great underwriting going on. I think there are a lot of mistakes being made. We're trying not to make them, but we'll see. I don't have my crystal ball here with me today to know, and then I'll comment if it does.

Great. And I guess for my follow-up, in -- with tariffs coming online in the United States and in our domestic economy and having -- starting to see some of the flow-through in larger company reportings, do you guys have pockets that were, I guess, sustained tariff or price increase situation with your companies could cause problems?

Yes. I think -- look, the good news is a lot of our investing is focused kind of in the services area, whether it's business services, health care, software, et cetera. The places that we've spent time starting to worry about are probably in the consumer and manufacturing sectors, where we think that some of the early pain points may get delivered from the tariffs.

But again, with what's really been rolled out, at least to my understanding, is a program that's pretty small scale relative to, obviously, the overall U.S. GDP and size of the economy and all that. So certainly doing work, our portfolio management team is spending time there, but I'm not particularly worried yet. Without not talking politics, though, I certainly don't view it as a positive for the U.S. economy, so.

Next question comes from Terry Ma with Barclays.

You guys had highlighted additional investment opportunities that could be available with expanded leverage. So can you just maybe talk about the types of investments you'll be able to do and how they differ from what you're doing right now?

Yes. We don't -- thanks for the question, Terry. I said this in the prepared remarks and we said it as well -- or we hoped to say it pretty clearly in the presentation that we posted in June, but we don't expect to see any change in our investment strategy at all.

I think there are other BDCs that have said, "We're going to make some changes to the way that we do things. We're going to orient ourselves more toward senior loans. We're going to increase our financial leverage and use leverage up to 1.5," or whatever folks have said.

We really don't intend to do anything differently. We have a long cycle-tested investment track record and a fantastic investment team as well as a whole lot of relationships in clients that come to us for flexible solutions to their capital needs. So I -- we don't really see any changes at all.

Okay, great. Thanks for being clear on that. My follow-up question: Can you just maybe give us a sense of how spread tightening has trended in the first half and whether or not you think the recent widening is more transitory? Or do you think that's just going to hold steady from here?

Spreads have been pretty consistent, maybe [grant] came in a little bit in the first quarter -- end of the first quarter and then back out again a little bit at the second quarter, such that they're about where they started the year. I do think it's transitory. I don't mean to -- based on our prepared remarks, say, we saw a big crack in the armor, so to speak, in June, and it's continuing. We're going to have all this opportunity.

But look, we saw the market's a little bit unsettled towards the -- of the back half of Q2 because despite flows into direct lending and flows into CLOs, there was just a huge, huge backlog of transactions trying to clear. And for the most part, they cleared. They just cleared a little bit wide, and I think we'll have the same type of situation to observe, which I mentioned in an earlier response in September. That's meant to be a busy month.

I think we'll have to see what the climate is, again, when everyone kind of is generally back from vacation and focused on doing new deals again. But I think the fall will be important for all of us to watch to see where we go from here.

The next question comes from David Miyazaki with Confluence.

Congratulations on a good quarter. And Kipp, we certainly do appreciate your efforts to stay out of trouble and your success in doing so.

Just a couple of questions. First one for -- actually for Penni. My recollection when you did the Allied acquisition that, obviously, you know pretty well, that there were instances when you realized gains above the acquisition price of certain assets, that they were below the tax basis of the original investment.

And so you could realize gains that wouldn't necessarily have to be distributed because, relative to the tax basis, they were losses. Is that the case with Alcami or any of the other realized gains that you might be having in the third quarter?

There was a tax difference in the way the 2 acquisitions were treated. With Allied, we did a tax rate exchange, which meant we had carryover basis of the Allied cost basis of deals, which resulted in us exiting things on a book basis that had a different tax basis. But what that did do was it did build up some capital losses that we could use and carryforward over time as we realized gains.

For the ACAS acquisition, it was a taxable transaction. So our tax cost basis for any deal is the same as our book cost basis. We don't have those timing differences occurring.

But we do have some tax planning that we can do, and there are some accumulated tax losses in the book that can shelter some of the realized gains that we have. And that's something that we'll be looking at as we move into the end of the year. That will determine the ultimate level of spillover that we have going into 2019.

To the extent we can use those losses, that does allow us to effectively retain those gains and not have to distribute them.

Okay, great. And then Kipp, this is kind of a follow-up to some commentary that I think you made in the past, that you didn't -- I think last year, when we talked, you didn't see any immediate need to raise equity. And I guess with having a higher leverage target range now, that, that would continue to be the case for the near term.

But as we think about ARCC more in the intermediate to longer term and growing and then presumably getting to your target leverage and raising more equity, not changing your investment philosophy, is there room in your existing business to grow and become a $20 billion asset BDC and still do the things that you're doing? Or do you anticipate adding different verticals or changing the nature of your focus because you have a larger asset base?

That's a great question. We talk a lot about things like that. It's a hard question to answer on an earnings call, frankly, because I could go on and on, and this is obviously the kind of stuff that we talk about at a very high level with our management team and with our board.

I mean, look, I think that we -- when we laid out our presentation vis-à-vis higher leverage, we laid out a more or less 3-year plan where we increase the assets of the company, continue to grow and continue to grow earnings all without relying on any equity issuance. I think for the foreseeable future, we don't really see that as part of the plan.

As we modestly increase leverage at the company, I think that question that you're asking, which is, again, David, great question, will be on us more in 2 or 3 years than it is today, right? So we've had a lot of changes vis-à-vis the SBCAA. We've been trying to evaluate those, and we've been working through, again, a challenging investment environment. It's easier to grow when investing is easy, right? And investing today is not that easy.

So what we've laid out in that presentation as our 3-year plan, which is a measured and slow-going plan to improve returns for shareholders, as we mentioned, is sort of as far as we've gotten. That being said, back to the point about -- I think it was Allison who mentioned things to buy, portfolios to buy, assets to buy, companies to buy, that can change reasonably quickly. And we participate in a very large market, where despite our market leadership, our market share is low. It's below 10% in terms of the available universe.

And we typically will consolidate market share and grow during -- again, easier times to invest, times when things are more opportunistic and, frankly, not as expensive as they are today. So I hope that gives you some thought as to -- you know, we could talk for a whole long time about that question, and we do around here. But hopefully that gives you some color.

Yes. No, that's helpful. I mean, I -- obviously thinking that far down the road, you can't have specifics. I was just kind of wondering what the thought process is around the intermediate and longer term.

Yes. I mean, that's -- look, we've got a big team here, and they're busy. I mean, we originated north of $10 billion in capital in this business last year. We continue to add people. We're always pursuing the idea of new verticals and new specialties and all of that and branching out. So for sure, that's all part of what we do here day to day.

Next question comes from Robert Dodd with Raymond James.

For Penni on tax planning, obviously -- I mean, Alcami is an LLC. So I presume it was held in a tax block, all right? So there's the question to the point of raising the potential for specials with much higher spillover, et cetera.

I mean, is it your intent to distribute or to upstream from the broker to the BDC and create a spillover event or to retain as much capital as you can, either in the broker or through some other vehicle and, i.e., minimize the spillover growth as a result of the Alcami gain? I mean, is that the plan? And if that's the case, obviously, the potential of the necessity of a special dividend would be significantly reduced.

I think just from a technical aspect, the Alcami exit is a taxable gain to us, just to be clear, from that exit at that position. So like with any year, when we look at our taxable income, because distributions ultimately are paid out of taxable earnings, we look at all of our book tax timing differences.

So when you put that all in a blender, effectively, we do have some losses we could take. But at the end of the day, the earnings of the company being in excess of our distributions and the significant net gains that we are realizing this year, we have some expectation that we would grow the spillover income vis-à-vis compared to what we did from 2017 to 2018 (inaudible).

So -- and then back to Kipp's earlier comment, we are continuing to look at how we could think about dividends in light of the earnings being in excess of our distributions, both from current income and capital gains. And that's something we would expect to continue to discuss internally and come back with a more -- a better view around that as we go through the end of this year.

Got it. I appreciate that, Penni. If I can, Kipp, a question for you. Obviously, we -- if we look back at the end of '15, beginning of '16, the BSL market was also very choppy. Obviously, a whole lot of different dynamics going on then with risk retention rules changing, et cetera, et cetera.

Now you indicated some choppiness. Maybe it's just supply/demand rather than something else. So for lack of a better term if I could ask what's your gut feel on whether -- obviously in '16, that choppiness got competed away very rapidly. Do you think that that's the same kind of scenario we're looking at given maybe no regulatory changes going on to elongate that choppiness? Or you feel that it's different now because rates are higher that the market's shifted?

I don't think it's different now. I think there's still a lot of interest in probably syndicated loans, and I think there's a lot of interest in U.S. middle market/direct-lending product. So my feel would be that nothing particularly funny happens in September, and that a lot of these transactions clear.

You've had a huge year of CLO issuance that's going to -- if this continues to be a record year. You continue to have inflows in the floating rate fund. That's largely at the expense of high yield. People are looking at a flatter yield curve, all of that.

But despite that, you've got a $40-plus billion forward calendar sitting on the desks at a lot of the banks, that when they get back from vacation, they're going to have to bank meetings for [themselves], right? So that doesn't mean that's not doable. It's just going to be a question of is there a little bit more price discovery, the investors put -- push back in terms little bit, which I think most investors have felt have swung too far perhaps the other way.

And I think there's some pushback, and I think it'll continue. I don't think there's anything too terrible, but just a little bit of a reset.

Okay. I appreciate that. One quick follow-on, if I can, or housekeeping one. Other income was $20 million from the non-affiliate side of the portfolio this quarter, pretty high.

I mean, is there -- is that a nonrecurring event? Or has something structurally changed in terms of more fees or things coming out of the non-affiliate side that that's going to run higher going forward?

Yes, there was actually -- there was an extraordinary item on top of what's usually $5 million to $10 million of other income in there. We put some disclosure in the 10-Q, if you wanted to give it a read. For the second -- it's on Page 117, by the way. But for the tax the second quarter, there's about a $0.5 million item.

But no, just part of our regular and kind of continuous review of all of our processes here, including allocation of fund expenses and reimbursement and all of that. Ares actually made a reimbursement to Ares Capital Corporation in the quarter, but there's disclosure on it in the Q.

So that reimbursement is in the other income line as income...

It's in the other income line. Yes.

Next question comes from Derek Hewett with Bank of America Merrill Lynch.

Kipp or Mitch, could you talk about growth in the SDLP, kind of given the accelerating trends? What's driving the optimism for this more liquid strategy when at least one kind of well-respected BDC competitor has been -- actually been shrinking their joint venture over the last year or so, including a preannouncement for this current quarter?

Yes, it's interesting. So if you look at our prior JV, that was, at its peak, an $11-plus billion program that we grew over a number of years.

So I'm not sure we agree that the acceleration of the investments in SDLP is an appropriate way to describe it. We are trying to find the best investments we can make in the unitranche product, and I think we've been pretty consistent over the last 3 or 4 years in growing that product. I expect that to continue to grow as we have in the last couple of quarters though.

It's a great product for our clients. They find a lot of value in it, but it's not for all of our investments given the market that we're in.

Next question comes from Christopher Testa with National Securities Corporation.

Kipp, you had mentioned about obviously the spread widening a little bit in the BSL market and some terms getting better. Obviously, the opposite of that trickle down through the upper and core middle market pretty quickly.

Do you expect the lag to be maybe longer than normal before these favorable trends hit the middle market, given that there is still a lot of money sloshing around and it's still a borrower's market? Or do you think that this is something that could pretty much manifest itself in a positive way as quick as it did in the negative?

Yes. I mean, I think it always takes a little bit of time. I mean, we were chatting before the call a little bit. But look, a middle market, sort of large capital market deal that actually had a rating was probably clearing 350, 375 a little while back, and now it's 400, 450. The unrated stuff would be a little bit wide at that.

So all we're really talking about here is, I'd call it, a modest 50 basis point fallback. Will it continue? I think it depends on, again, what happens in a broadly syndicated market in September vis-à-vis a recently large backlog of stuff needing to clear, investor enthusiasm for that or lack of enthusiasm for that, et cetera, et cetera. But I don't have a lot more to add on this one.

Okay. No, that's fair. And I'd be curious, there's -- obviously, scale is becoming increasingly important in this industry, and there's obviously been consolidation to reflect that.

Just wondering, you guys obviously have a large balance sheet, but there's not a lot of co-investment done, to my knowledge, at least, across other Ares funds. And there's been a lot of players in the market with not nearly as good of a track record as yourselves that have raised a significant amount of private AUM.

I'm just wondering what your thoughts are as Ares as a platform raising more private AUM to kind of reduce syndication risk -- reduce syndication and concentration risk and permit you guys to kind of take even larger bite size than you already do?

Sure. So we -- I think you might have that one a little off in that we've actually raised a fair amount of non-BDC-oriented capital here in the last 5 years, just to keep it broad.

So both in co-mingled funds and in separate accounts that are focused on what I'd call more traditional bank loan investing, LIBOR 400 kind of paper that for us hasn't been a particularly good fit in the BDC. And also focus on what I'd call larger transactions, covenant-light deals, private high-yield transactions, that sort of thing where we disclosed that we raised a fund there.

And the good news is that those funds can freely co-invest with the BDC, and they do. So we think that capital raising that we've done away from the public company has been a huge benefit to ARCC over the last 5 years.

Got it. And -- but out of those funds, I know you had mentioned a multitude of different ones with some strategies that might not be -- might not fit what the BDC does. How much of the AUM, just roughly speaking, do you think is really doing kind of almost exactly what ARCC itself is doing?

Well, the stuff that we're raising away from the BDC is focused on doing things that we frankly thought the BDC wasn't as good at. That's sort of the architecture for how we've done things.

But again, they do freely co-invest. We do have some LIBOR 400, LIBOR 500 bank loans that are at the BDC and that are elsewhere, and we do have like an air medical deal that we closed last quarter. We do have some very large covenant-light, junior capital financings that are at the BDC and that are elsewhere too in our -- and our -- on our platforms. So hopefully, that answers your question.

Next question comes from Casey Alexander with Compass Point.

This is just maintenance. I think we've pounded out every reasonable question that could be asked. The $325 million -- $326 million in realized gains that are being taken here in the third quarter, there is -- that was all within unrealized gains as of the end of the second quarter. Is that correct?

Yes.

Yes.

Yes, okay. Secondly, just to parse the language, you said you led the $390 million first and second lien package for Alcami. Did you retain all of it with the BDC?

No. But you'll see more about it in Q3. We talked about the deals that we closed. I think Mitch mentioned the $900-something million that we closed in July.

What we retained in Alcami is certainly in there. We love the company. We're a big supporter. It remains a reasonably sized position, but just very different, obviously, in its nature in that we used to own and control the business, now we're just merely a lender.

At this time, this will conclude today's question-and-answer session. I'd like to turn the conference back over to Mr. Kipp DeVeer for any closing remarks.

I think we're all set, and just appreciate everyone taking the time, all the great questions. Have a great finish to your summer.

Ladies and gentlemen, this concludes our conference call for today.

If you've 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 August 15, 2018, at 5 p.m. Eastern Time to domestic callers by dialing (877) 344-7529 and international callers by dialing 1 (412) 317-0088. For all replays, please reference conference number 10121377. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital's website.

At this time, you may now disconnect.