Ares Management Corp (ARES) 2015 Q3 法說會逐字稿

Welcome to Ares Management LP's third-quarter earnings conference call.

(Operator Instructions)

As a reminder, this conference call is being recorded on Tuesday, November 10, 2015. I will now turn the call over to Carl Drake, Head of Ares Management Public Investor Relations. Please go ahead.

Good morning and thank you for joining us today for our third-quarter earnings conference call. I'm joined today by Michael Arougheti, our President, and Michael McFerran, our Chief Financial Officer. In addition, Greg Margolies, our Head of Tradable Credit, will also be available for questions.

Before we begin, I want to remind you that comments made during the course of this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ materially from those expressed in such forward-looking statements for any reason including those listed in our SEC filings. We assume no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results. Moreover, please note that performance of and investment in our funds is discrete from performance of and investment in Ares Management LP.

During this conference call, we will refer to certain non-GAAP financial measures. We use these as measures of operating performance, not as measures of liquidity.

These measures should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles. These measures may not be comparable to like titled measures used by other companies.

In addition, please note that our management fees include ARCC Part 1 fees. Please refer to our earnings release and form 10-Q for definitions and reconciliations of these measures to the most directly comparable GAAP measures.

I would like to remind you that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase an interest in any securities of Ares or any other person including any interest in any fund.

We've also posted a new third-quarter earnings presentation under the Investor Resources section of our website at www.AresMgmt.com, which can be used as a reference for today's call. I will now turn the call over to Michael Arougheti.

Great, thanks Carl. Good morning everyone. I'd like to start off with a business performance update and then put our third-quarter results into context given the current market environment. I will then update you on several important business drivers for us before turning the call back over to Mike McFerran, who will provide an update on our third-quarter financial results in greater detail.

During the third quarter, fears of slowing global economic growth, declining commodity prices and uncertain Federal Reserve policy all contributed to increased volatility for risk assets. These market fluctuations not surprisingly had an impact on our performance-related earnings in certain business segments as the unrealized lower marks on our assets impacted our balance sheet investments and our net performance fees.

Importantly, we don't believe that these fluctuations had much to do with the fundamental performance of our funds and portfolio investments during the third quarter as the underlying aggregate performance of these investments continues to be very strong. While the contribution of our performance-related earnings to our ENI is important, the short-term unrealized impact is less relevant until investment outcomes are ultimately realized. Instead, we believe that our more stable fee-related earnings are a better metric to evaluate the core strength of our business.

As we've talked about in the past, our focus continues to be on growing our fee-related earnings, which were up 28% for the first nine months of this year compared to the same period in 2014. This past quarter, our fee-related earnings were slightly lower quarter over quarter as we continue to make infrastructure investments in personnel and technology in advance of the commensurate step up in management fees that we expect from our current fundraising cycle. However, we do expect a meaningful improvement in our fee-related earnings and margins during 2016 as we deploy funds where fees are paid on invested capital and as we raise several large successor commingled funds on which the substantial majority of capital raised pays fees based on committed capital and each with targets larger than their predecessor funds.

Now just a few highlights on the key business drivers for us starting with our fundraising. For the third quarter, we had significant success with $6.5 billion in gross new capital raised. There were three strategies in particular that drove these results.

First, we raised $3.6 billion in direct lending funds, including $2.4 billion in our third European direct lending commingled fund, which was comprised of $1.5 billion in equity and $900 million in debt commitments, $400 million in other European direct lending mandates and another approximately $400 million in the new US separately managed account. As may if you recall, the sale of GE's middle-market private debt assets earlier this year created a lot of institutional investor interest in direct lending, and as a market leader, we are now benefiting directly through new separately managed accounts.

Second, our tradable credit group continues to be a leading market player in the CLO sector, and during the quarter, we closed two new US CLOs and priced a third, totaling $1.9 billion in the aggregate. Finally, our real estate group closed approximately $700 million in real estate private equity funds, primarily through first closings on our two new equity funds in our US opportunistic and European value add strategies.

We continue to have success attracting funds directly from existing and new institutional investors. This past quarter, 75% of direct new funds raised came from existing investors, and 25% was from new institutional investors. Approximately 45% of the investors were European, about a third were North America, with the remainder from the Middle East, Asia and Australia.

So looking back over the past 12 months, we've raised approximately $15.5 billion in gross capital with two thirds coming from existing investors and one third coming from investors new to the Ares platform. The two largest investor types are pension investors and insurance companies followed by our continuing penetration of the private bank wealth management channel.

We believe that the high percentage of existing investors adding capital to our platform validates our strong performance and our ability to serve our clients' needs with an expanding array of investment strategies. However, it's important to point out that more than half of this $15.5 billion of capital is not yet earning management fee. There are two main reasons for this.

First, about 20% of this capital was primarily in the form of long-term fund-level leverage and is not eligible for fees. And secondly, about 37% of the capital is comprised primarily of drawdowns, direct lending and special situations fund where fees are paid on invested capital rather than commitments and that capital has not yet been deployed.

Let me now provide a further update on our prospective fundraising in progress, which we expect will meaningfully enhance our 2016 FRE. Most importantly, we're experiencing strong demand for our fifth US and European private equity fund with a target of $6.5 billion compared to our fourth fund of $4.7 billion. We expect a substantial first closing in the fourth quarter with the final closing expected during the first half of next year and initial investing to begin later in the year.

We are also raising our fifth power private equity fund with a target of $2 billion. We continue to expect a first closing during the fourth quarter in this fund strategy as well. Once we begin investing these two funds, we will begin earning fees on committee capital.

Within direct lending, we are also experiencing significant demand having held two closings already for our third European commingled fund that we launched this summer. Our first closing was comprised of EUR1.4 billion in equity in the third quarter, and during the fourth quarter, we just held another closing on EUR400 million of equity commitments, bringing total equity commitments to EUR1.8 billion.

We expect a final closing of equity commitments for this fund above our EUR2 billion target early next year. We've also added long-term fund level leverage of [EUR800 million] associated with this direct lending fund.

Also during the third quarter, we held a first closing of approximately EUR300 million in our second European value add real estate private equity fund, well on its way to a target of EUR600 million and a first closing of approximately $200 million for our US opportunistic real estate PE fund with a target of $500 million. We've raised additional capital during the fourth quarter, and we expect final closings for two of these funds early next year. Importantly, in addition to the over $12 billion in commingled fundraising plans that I just described, we continue to make progress on additional separate account mandates, commingled fundraisers for new strategies and additional commitments to existing accounts.

Now turning to our investing activities, we continue to find attractive investment opportunities across our diverse global platform with relatively consistent deployment. We remain focused on leveraging the power of our platform to invest in high-quality assets where we have a sourcing advantage and where we can add our expertise to create meaningful value. In the aggregate, we deployed $5 billion in gross capital during the third quarter, balanced across our various strategies, with a focus on US and European direct lending, liquid securities in tradable credit as well as a few private equity platform investments in both the power and corporate sectors.

Looking forward, we believe continued volatile markets should create attractive new investment opportunities. Driven in part by energy and commodity related securities, the distress ratio in the high-yield market is elevated, recently reaching levels last seen in the fall of 2011. In addition, liquidity has declined as banks are hampered in their ability to commit capital and maintain liquid markets in many of these lower-rated issues.

While technical factors have absolutely contributed to volatility and wider investment spreads in both the high-yield and leveraged loan markets, we believe the corporate performance remains generally sound although we are seeing a few cracks in certain non-energy and commodity-related sectors. As the cycle evolves, we expect individual security selection will become ever more critical, playing into our strength as an in-depth research-intensive and flexible investor.

These market dynamics haven't materially impacted other less liquid asset classes in which we invest, but we are encouraged that volatility may eventually lead to an improved investment environment for firms like us that can deploy capital flexibly in a wide range of opportunities. We feel well-positioned with significant dry powder to invest.

From an investment performance standpoint, our intermediate to long-term performance remains strong. In our liquid credit strategies, we continue to outperform for both the third quarter and year-to-date periods.

While our loan and high-yield composite third-quarter returns were negative 0.8% and 3.6% respectively, we did outperform our benchmarks by 40 and 130 basis points respectively. As one might expect, certain of our special situation strategies experienced unrealized depreciation and negative third-quarter returns, but our new commingled fund takes a very long-term investment approach and remains largely uninvested.

Our direct lending strategies generated 2% or better quarterly returns on net asset value and were largely unaffected by volatility during the third quarter. Both of our largest US and European direct lending funds have generated net asset value and dividend returns of approximately 10% and 12% over the last 12 months.

Similarly, our real estate private equity funds have also not been adversely impacted to date. For example, our two latest US real estate value add funds both increased over 5% during the third quarter.

Within corporate private equity, our fund investors tend to look at much longer-term IRRs, which remain strong. For the third quarter, our corporate private equity funds outperformed the public equity markets by a wide margin, with a net asset value return of approximately negative 1% during a quarter in which the S&P 500 declined 6.4%.

Lastly, before I turn the call over to Mike, I thought it would be appropriate to close the loop on our mutual decision to terminate our merger with our friends at Kayne Anderson. As we disclosed in our press release, our two firms had different views on how to proceed with the merger in light of the heightened volatility in the energy markets.

After carefully considering various alternatives, we both determined that not moving forward with the transaction was in the best interest of our respective stakeholders. We are pleased that we are continuing to collaborate on certain opportunities with Kayne, and we look forward to investing in certain of their energy investment funds. And now with that, I will turn the call over to Michael McFerran, our CFO.

I will start with a quick summary of our results and key metrics and follow up with a review of our upcoming distribution. As Mike stated, we believe our third-quarter earnings performance may not be the best reflection of our actual underlying business performance due to the March market impact and our performance-related earnings or PRE. Measuring performance-related earnings is a useful gauge, but price movements up or down, driven primarily by technical market factors, don't necessarily reflect the outcome of that investment.

We are patient and disciplined investors, and ultimately, outcomes are driven by realizations. Bearing this in mind, we have more opportunities for value creation during periods of increased market volatility even though such volatility may adversely impact our short-term performance-related earnings. We benefit from managing bond-based capital that is well matched to investment strategies across our businesses and affords us the ability to focus on long-term value creation and not to be overly focused on short-term market value fluctuations.

So with those opening comments, let's dig into the numbers. For the third quarter, our AUM increased by about $4 billion to approximately $92 billion, a year-over-year increase of approximately 15%. Our total fee-earning AUM also increased to about $67 billion, up 11% year over year.

For the third quarter, we generated modestly higher management fees of $162.2 million and fee-related earnings of $43.1 million, a growth rate of 6% and 5% over the prior-year period in each case including ARCC Part 1 fees. The growth is primarily attributable to deployment and new capital in our direct lending group as well as the contribution from EIF within private equity. Compared to the second quarter of 2015, the third quarter's fee-related earnings were lower by a few million dollars, reflecting some ramp up in expenses and other timing differences.

Our year-to-date growth in fee-related earnings continues to be strong at approximately 28% compared to the same period in 2014. Of our total $21.7 billion in available capital at the end of the third quarter, we had $13.3 billion in shadow AUM not yet earnings fees. We expect to receive incremental fees paid on these funds as we invest capital.

In addition, we expect a meaningful contribution next year from our current fundraising cycle as Mike discussed, as these funds are weighted toward our higher average returning and higher fee generating strategies. When we combined the expected fees from new fundraising and the deployment of our available capital, we anticipate achieving higher fee-related earnings margins of over 30% on a run rate basis during the course of 2016.

Moving to our performance-related earnings, we incurred an unrealized loss of $37.1 million compared to an unrealized gain of $30.8 million for the same period a year ago, primarily due to unrealized depreciation from our balance sheet investments and private equity and tradable credit funds, and to a lesser extent, reversals of net performance fees for funds in these groups. The two primary contributors to the unrealized losses were first, a reversal of previous unrealized gains in our Asian private equity portfolio and second, unrealized depreciation in certain alternative credit funds. Our third-quarter pretax economic net income of $6 million was substantially lower quarter over quarter due to the volatile asset pricing environment.

Our third-quarter distributable earnings declined to $39.6 million compared to $65.3 million a year ago. We had a very light realizations during the quarter, and accordingly, our fee-related earnings comprised essentially all of our distributable earnings. Our current view is that fourth-quarter realizations may also be modest based upon current planned exit activity across our funds.

As disclosed in our press release, we agreed to reimburse Kayne Anderson for their estimated out-of-pocket merger expenses of $30 million. Consistent with past practice, we expect these and other one-time merger-related expenses will be accounted for as unusual items and therefore not deducted from our fourth-quarter non-GAAP measures like economic net income or distributable earnings.

Moving to distributions, third-quarter distributable earnings attributable to common unit holders were $0.14 per common unit net of tax. This morning, we announced a distribution of $0.13 per common unit for the third quarter. The distribution will be payable on December 8 to common unit holders of record as of November 24.

Our distributions have generally been fairly stable and growing due to the high composition of fee-related earnings. However, they can be lumpy. This past quarter's distribution will be low by historical standards, and the fourth quarter's distributable earnings are currently tracking to a similar level. For the reasons we described, we anticipate that improving our fee-related earnings will contribute to a higher base level for our distributions as we progress throughout 2016.

Next, turning to our balance sheet, on November 5, we used cash on hand to redeem our $325 million of 5.25% notes at [101] of par, which were required to be repaid as part of the termination of the merger with Kayne Anderson. In addition to our $250 million 4% notes currently outstanding, we have a nominal amount of our $1.03 billion revolving credit facility currently drawn. Now I will turn it back to Mike for closing thoughts.

Thanks, Mike. In certain quarters or market environments, our business can be lumpy and at worst appear complicated. But from where I sit, I think in fact it's quite simple. We raise capital from a global investor base, we invest money well on behalf of our clients, and when we perform well for our investors, our Company grows along the long-term trend line.

So to simplify it, alternative asset allocations are growing globally as investors continue to be frustrated with low interest rates and with the volatility in global equity markets. At Ares, we are getting more than our fair share of these alternative allocations across our platform based on our product breadth, our capabilities and our track record of performance.

This is evidenced by the significant fundraising success we are having and which we believe should provide meaningful growth in our 2016 FRE and FRE margins. Finally, markets are inherently volatile, particularly today, and while this shows up in PRE, net-net volatility is a big opportunity for us given our down market expertise, our flexible strategies and our significant dry powder available to invest into these markets.

That concludes our prepared remarks. I like to thank everyone again for your time and support, and operator, we would now like to open up the line for Q&A.

(Operator Instructions)

Our first question is from Ken Worthington at JPMorgan.

Good morning. Maybe first, BDCs are generally trading below NAV, preying them for raising new capital. But we understand the private BDC market, they are raising capital more freely to take advantage of the opportunities in the marketplace.

In your opinion, what are the issues here for the publicly traded BDCs, and is it a near-term issue or is there a longer-term problem? Thanks.

Sure. I'm not a perfect predictor of the future. It feels to me like it is a near-term issue, not a secular long-term challenge for the BDCs. There are specific issues that are challenging specific publicly traded companies within the BDC sector either related to energy market exposure, structured product and CLO exposure, over leverage, poor performance, et cetera.

You have to first weed out some of the company-specific issues when you look at the sector. And when you pull some of those out, what you have is a BDC sector that is trading somewhere in the 90% of NAV range.

We've been running as I think people know what is now the largest BDC for over 11 years, and we have had periods just like this where based on macro factors and volatile markets, stocks traded below NAV, but we have had the opportunity to access the equity markets about 20 times at a weighted average multiple of 1.1 times book.

We've seen it before. We don't read that much into it.

Understand, and it's maybe a good segue into the question about private markets, yield stocks in general -- it's not just limited to BDCs -- but we see it in mortgage REITs, we see it in closed-end credit funds. We saw it firsthand in the MLP space.

For whatever reason, yield stocks are out of favor, and as I think most people know, yield stocks are predominantly held by retail investors. Retail investors can be a little bit more fickle particularly as we go into year end and people are managing their tax positions.

I don't read into fundamentals here because to your point, when we look in the private market and we even saw it here at Ares in our direct lending strategies where we raised $2.4 billion in direct lending assets in the private markets during the quarter, the fundamental opportunity in private credit is very strong. We're seeing it coming from pension funds, insurance companies, endowments, sovereigns. And yes, we are also seeing a certain class of retail investors still have a willingness to invest equity into the BDC market in the private nontraded space -- public nontraded space.

We will keep an eye on it. It hasn't hindered our business. I think as people saw in our ARCC earnings call, we continue to grow the core earnings of the BDC even without having access to the equity capital markets over the last 18 months, and private demand for private credit is as good as we've seen it.

Great. Just given the break up with Kayne Anderson, how are you thinking about your own capabilities in energy today? How attractive is that asset class today? Are you finding investment ideas, or is it generally still too early in the asset class? Thanks.

Sure. Maybe putting Kayne Anderson aside just to talk about energy, we have very good energy capabilities here in our private equity tradable credit and private debt businesses. Kayne was an opportunity for us to supplement and augment those capabilities.

With the termination of the Kayne Anderson transaction, we are absolutely still in the business of evaluating opportunities that are presenting themselves in the energy sector. We have made a very small handful of investments in the direct lending space as banks are readjusting their reserve base revolvers. We have been active investors in the energy space in some of our tradable credit and in special situations funds, so we are active.

We are picking our spots, but I would say this man's opinion is if it is not too early, we believe this opportunity will be presenting itself for quite some time. So we're being measured in the way we are accessing the market. I will turn it over to Greg Margolies to give some perspectives on tradable credit.

I completely agree with that, Mike. I think this opportunity is going to be with us for a while to take advantage of.

I think the key here, like so many other times you see distressed or stressed opportunities across sectors is being a credit picker within those segments. So you can't look at it as a buying opportunity across the whole sector, but rather picking the right opportunities within the sector.

And let's keep in mind that energy has structured very differently depending upon where you are, whether you're an exploration company or a midstream company. All of that goes into the credit selection process.

We do see opportunities today. We are playing them in our special situations and credit opportunity funds, but very selectively.

Okay, thank you very much.

Our next question is from Craig Sigenthaler of Credit Suisse. Please go ahead.

Thanks, good morning. First on the $22 billion in dry powder, if we look at the composition of the available capital with almost $10 billion direct lending and $5 billion in tradable credit, can you provide some commentary on your ability to deploy this dry powder, how long it may take if the macro environment remains more or less consistent with today?

Sure. Starting with the second part of that, I think we said on our last earnings call and the answer is consistent. When we think about undeployed capital based on the strategy, we say on average 18 to 24 months.

However, as we potentially are heading into periods of increased volatility where the opportunity set widens at an accelerated pace, we think that could happen more quickly. When you think about the composition of our dry powder, there is a mix between a fair amount of stuff that's been ratably deployed over some of our committed capital funds and recent fundraising, most notably the $2.5 billion Mike made reference to for our new European direct lending fund.

Bear in mind, Craig, as you think about that number while it has grown quarter over quarter as we told people it would, and obviously given the fundraising backlog I described in our prepared remarks, I would expect that number will continue to grow. Understand this number is recycling itself, so we are deploying, raising new capital and seeing that capital run off. But when you look at the deployment numbers in Q3 alone with $5 billion of gross capital deployed in what was a fairly choppy market, again, I think it gives you a pretty good sense for what the deployment capability is in our credit businesses where the bulk of that uninvested capital is.

Got it, and as my follow-up, on the product front, what are the keyholes in your product offering today, and what are your plans in terms of filling the spaces between bolt-ons and M&A?

Sure. I don't know if we have keyholes. I think the nice thing about the Ares platform, we've got very broad product capabilities in the liquid and illiquid markets in the US and in Europe.

So as we've talked about M&A in the past, you've heard me talk about the filter we've used to think about M&A in terms of cultural fit, strategic fit and financial impact. But if you also look at the history of M&A for us, it's been a wide array of team acquisition, product acquisition, company acquisition and distribution channel acquisition.

But every time we've done it, it has come off a core competency of ours. So as an example, being one of the largest CLO managers, we moved into the CLO structured credit space in a meaningful way and now manage about $3.5 billion in structured credit in our direct lending business.

We had a market-leading US direct lending franchise, we moved that franchise into Europe and now you can see the success we are having growing there. The easiest and most achievable growth for us is to take a core competency that we have, add a team or a new product alongside it and grow them by using our global distribution and information advantages to help them.

I don't really perceive a lot of key product pulls, but I do see some adjacencies that I think we could be more aggressive in. In direct lending, we are investing heavily in the growth of our commercial finance platform. In tradable credit, we are investing heavily in our structured credit business.

In our global credit business, we are beginning to invest heavily in some larger market illiquid credit product. In our real estate business, you are seeing us start to fill in some of the gaps on the direct lending side as we aggregate capital in the private -markets.

I would say we do have a gap in core real estate given the amount of product that we manufacture to core in our value added strategies, so that is something we spend a fair amount of time thinking about. But as we sit here, I wouldn't perceive any key gaps. I think they're all easily attainable adjacencies to what we already do very well.

Thank you.

Our next question is from Mike Carrier from Bank of America. Please go ahead.

Thanks guys. I just wanted to do -- two comments on the outlook for the fourth quarter and for 2016. I think for 2016, I just wanted to get a sense -- you mentioned the fee-rated margin above 30%.

I just wanted to get a sense, is that mostly on the fundraising on the commitments? And then if you deploy capital faster, like there would be a benefit to the FRE? I just want to get a sense of how much is deployment versus just a commitment that you are looking at in terms of projecting there?

For the fourth quarter, anything related to Kayne on the notes or the $30 million cost. Just wanted to see if that will all hit in the fourth quarter and then 2016 will be pretty clean in terms of anything related to that transaction?

Sure. Starting with next year, a significant amount -- we mentioned the 30%, that is a combination of fundraising, both fundraising that happened to date, so the deployment of that capital as well as funds that are currently being raised where we have a lot of conviction about the timing, at least around ranges where we think they will end up.

As we look to 2016, it's going to be a function of deploying capital, at what we will call a modest pace. I think to the point you alluded to in the question, if the opportunity sets there to deploy capital more rapidly, I think seeing that 30% will come more quickly. But it really is from a function on the revenue side without any significant assumptions on the expense side.

Maybe before Mike jumps to Q4, just to reiterate, when you look at the fundraising pipeline, the bulk of those funds are coming in higher return, higher fee, higher-margin products in corporate private equity, power private equity and real estate. And the bulk of those funds actually pay on committed capital in a much higher percentage than the current book. The level of confidence we have going into 2016 is rooted in those facts about the fundraising pipeline.

On the merger costs, we are expecting the majority of expenses to be recorded in Q4. When I say the majority, it's the $30 million plus any other expenses we had related to terminated transaction including the redemption of the bonds will all be in the fourth quarter.

I think we mentioned the comments in our prepared remarks that as these are unusual items, consistent with how we have dealt with merger costs in the past, we're not going to include them in some of our key non-GAAP metrics so there won't be an impact on FRE and ENI and won't be directly part of distributable earnings. However, they will impact our GAAP results as expenses. But they will all be completed in the four quarter, and none of that will go into 2016.

That's helpful. Just as a follow-up, you said the realization outlook, the distributable earnings and distribution into 2016. I think because of the outlook on the FRE, we can gauge that in terms of what that means for the distribution.

But when you look at maybe the overall portfolio and you look at an environment where maybe it's not as volatile as the fourth or the third quarter but we get a little bit more normalization, is there any way to set a range when you're thinking about the quarterly distribution you hit in the third quarter versus what has been more typical as a quarterly run rate? I know it is a tough thing and a volatile environment, but I want to get a sense of -- the third quarter, is that more of an anomaly or should we be expecting something at this lower rate ex a pickup in realizations?

When you think about our distribution, we said it was $0.14 this quarter, and that effectively all came from our core earnings which we call fee-related earnings. To our comments on this call, if you look at our capital raising, the pace of deployment, I think the message we are sending is pretty clear.

We expect that number to increase next year by a meaningful amount. And we expect to see significant FRE expansion and as a result margin expansion.

With that, that core base level of distributable earnings will move higher just off that core, and we think that is real important. As we've talked about in the past, one thing that is really important to this model is that we have a fairly predictable amount of decent and growing distributable earnings.

If you look at our core contribution, for example the last couple of quarters, it was around 60%. This quarter, the core contribution is nearly 100%.

And as the business continues to expand its core earnings base, that is what we will call minimum level of earnings really is going to increase. We think that's -- we're going to see that as we go through the course of 2016.

To the second point on realizations, frankly it is hard to predict. Mike made the comment earlier about the crystal ball. We have over $150 million of accrued net performance fees at quarter end.

It is going to be somewhat a function of the markets, and it's going to be a function of when it makes sense to exit things. The nature of our capital affords us the flexibility to be thoughtful and opportunistic and not rush to realizations for the sake of generating short-term outcomes, but we're very long-term focused.

There will be times when certain opportunities will be there for higher realizations and they won't. When we think about this business and looking ahead to 2016, the most important thing is going to be that core earnings expansion.

Thanks a lot.

Our next question is from Chris Harris from Wells Fargo. Please go ahead.

Thanks guys. Can you give us a little bit of detail on what drove the investment write-downs in ACOF Asia? I know the markets generally were weak there and you guys hinted most of the write-downs were technically driven. I just wanted to make sure that was the case in that fund or whether there was any fundamental issues that have propped up there.

One thing as a backdrop you should appreciate, Chris, and this sometimes goes back to the dichotomy between fundamental performance and technical performance, but also short-term versus long-term. If you actually look at ACOF Asia which is our primarily investment vehicle for growth equity in China, that fund is currently running about 1.3 times cost.

Obviously when you look at it in any given quarter, you may see significant volatility, but I think it's important that people get anchored that when you look at that from the private market perspective through the lens of the investors in that fund, the fund is actually performing quite well. And I think it's important we always remind ourselves of that baseline performance even when we are in volatile public markets. 8% IRR since inception for that fund despite everything that's going on in the market.

When you look at what has been happening this quarter, it is really the reversal of prior gains, particularly in two companies. One is a dairy producer, and the other is a purified water company. Our strategy in China tends to be investing in consumer-facing growth equity businesses.

The fundamental performance of that company continues to be very good, but obviously there has been a significant amount of volatility in the Hong Kong market and we have seen dramatic reversals of previously realized gains. That said, when you look at those two companies in particular, YST Dairy and Ozner Water, we've seen a pretty significant rebound again highlighting the volatility in Q4 in both of those companies.

Okay, got it. That makes sense. Just a quick follow-up on credit quality more broadly across the Ares enterprise, and you guys have a great line of sight into that.

And Mike, you did mention you're seeing a little bit of cracks in some non-energy sectors. Can you expand on that a little bit? What sectors are you seeing a little bit of weakness in and what is Ares' exposure there?

I will let Greg kick us off with the tradable perspective and then I can provide a little color from the private side.

Thanks Mike. We are definitely seeing the weakness in the commodity-related sectors, oil and gas as well as metal and mining. As I mentioned earlier, we are selectively playing those opportunities especially in the special situations funds.

We are beginning to see cracks within the rest of the industries. Some of that is very company specific whereby we are seeing some healthcare names and trade significantly lower and very company specific news, but we are also seeing it in some of the retail and consumer names.

And most importantly, I think to give you a sense, in August of last year the distress ratio in the high yield market which is measuring credits that trade at 1000 basis points over treasuries was around 6%. Today that ratio is 18% to 19%.

About half of that is in commodity-related sectors. The other half is widely dispersed across all other industries. So there is no specific industry that is beginning to see it, but you are beginning to see earnings misses in a number of industries as is evident of trading levels across this industries.

And how do we take advantage of it? Again, it is very credit specific. In our non-revolving funds, obviously we look to avoid those situations and look to take advantage of the volatility in those numbers for good companies that have stumbled in either special situations or credit opportunity funds.

I would echo I think we're seeing similar types of outcomes in the direct lending space, obviously less indexed and more esoteric business models. I would say there are early signs that some of the traditional manufacturing businesses may be slowing if not recessing, and certain parts of the retail market are probably underperforming as well.

When you look at our direct lending portfolio specifically, and we talked about this on the ARCC earnings call, when you look across those portfolios, we are still seeing cash flow growth in excess of 10% year over year. Again, what we are trying to do in how we play it is reconcile what we see as good fundamental performance in our portfolios against what we know is technical challenges in the market that should create certain opportunity but then looking at certain pure portfolios recognizing we are at that point in the cycle where people are starting to see non-accruals grow up, credit marks go up, et cetera.

Thank you.

Our next question is from Ann Dai from KBW. Please go ahead.

Good morning. I want to touch back on realizations really quickly. I understood the markets have been volatile and might not be a fantastic realization environment, but I would think there is some aspect of realization that should be tied to a more recurring interest income or contractual repayments that we might see in any given period. I'm just wondering if there's anything unusual around that and the dynamic you are seeing that would lead to very light realization in third and fourth quarter.

Maybe I would just give a little bit of qualitative comment and then we can talk about the composition of our PRE a little bit more specifically. And Mike can chime in.

One of the challenges I think of understanding the alternative asset managers is that historically they as a peer set that have been PE centric. I think the market is conditioned to think about the timing for realization and harvesting if you will as they think about value.

I think for this sector as a whole, that is probably an oversimplification of the business model and doesn't really give full benefit for some of the secular trends I talked about earlier where we are seeing just a meaningful growth in alternative asset allocations globally into both PE centric strategies but also alternative credit strategies. I think we are in the midst of a shift in the sector where you are seeing Ares and others change the composition of their business to be aligned as much to recurring revenue and credit-oriented strategies as PE strategies.

With that said, what we've always said as long as we've been a public company is we do believe Ares is differentiated among this peer set given the percentage of our earnings that come from FRE and recurring management fee and to your specific question, Ann, the percentage of our PRE that is coming from non-private equity strategies. And again, it is lumpy because of some of the mark to market volatility we can see in our tradable credit strategies. If you look over the last four or five quarters, 40% to 50% of our incentive fees are actually in credit-oriented strategies.

Even when we are in volatile markets, yes, I would agree with you would probably see a smoother realization pattern in some of our heavily PE centric or distress centric peers, but that's mitigated by inherent volatility in those markets that could constrain realization as well. I can't give you a specific number, but I think your point is well taken.

Great, thank you. A quick question on the expenses. I know you mentioned the ramping up as you invest in the business and get ready to deploy a lot of the capital that you've been raising, but is any aspect of those higher expenses related to the fundraising itself and maybe something that we could see abate?

We are adding significant resources as we have been for the last number of years in our front facing business development and marketing group. Part of it is adding people around the globe to help raise capital and also adding people internally in our Investor Relations functions to manage those relationships as they come in.

Just add on to Mike's comments, as you've seen us make acquisitions and integrate other businesses over the past year which we have done, we are also including both non-compensation and compensation expenses of those people that come to work. On a year-over-year basis, you can see for example EIF is included in the results from that team and their operating costs as well as the things we've done like commercial financing.

Makes sense. One more just very high-level question. There's been a lot of talk. I know you guys have mentioned feeling like you're in the later innings of a credit cycle and there potentially being an opportunity to snap up assets in more distressed or dislocated environments and maybe not knowing where that's going to happen but feeling like it might.

I guess I'm just curious how that plays into your current investment decisions. You are definitely still putting money to work, but are you feeling like there are certain scenarios where certain fund or strategy, it is tougher to do a deal that looks like a deal maybe you might have done a year or two ago but now you're thinking should we retain capital? Is there any change in the thinking around those investments?

Again, I will give some qualitative stuff and Greg can chime in here too because of the focus we have on special sits investing. First of all, as an alternative manager, not lost on everybody on this call hopefully, is that we are designed as a business to be able to benefit and encourage in periods of volatility.

And it is as simple as if you are a high-yield mutual fund and you get retail flows, when you get inflows, you put the money in the market, and when you get outflow, you pull the money out of the market. And it leaves a lot less discretion, if you will, to the portfolio manager to have a view on where they are and where they are going.

The nature of our funds given the long-term nature of our capital and the flexibility of a lot of the strategies is regardless of where we are in the credit cycle, we are asking ourselves -- are we seeing good relative value in a given market relative to other markets, and do we believe that the opportunity today is better than the opportunity that we expect to see one month, six months or year from now. Obviously when we make portfolio allocation decisions, that is the lens we think about investing through.

What you will hear everybody at Ares talk about, I think even Greg mentioned it earlier, our private equity guys would tell you that right now they are in a stock pickers market given where valuations are, given how much cash is sitting with strategic buyers, and you have to be laser focused on picking the best franchise businesses that you can add value to. I think Greg and his team -- and the same is true in direct lending -- is they will call this a credit pickers market where you have to leverage all of the information and all the sourcing advantages that we have to find the best investments in this market environment.

There are a certain funds, therefore, where we are actually slowing deployment because we believe that spreads are widening and we may have a better deployment opportunity six months from now. And there are other funds that are structured to be deploying more consistently that doesn't really fly in the face of the view that the markets are actually improving from a spread widening perspective.

Again, not to complicate it, it depends on the nature of the fund. If we have a loan only credit fund, we may behave one way. If we have a special situations fund, we may behave differently.

But generally speaking across all of our products, very focused on credit and equity selection. Our close rates are probably lower now than they have been in quite some time across the board, which really supports the view that we are late in the credit cycle.

I think the only thing to add is the credit cycle comment is also being exacerbated by the regulatory changes going on and how it affects the banks. That volatility in the marketplace on the tradable side is heightened because of the lack of the capital the banks are committing to actually making markets.

So whether it be on the stressed or distressed end of things, on the special situations side or even on the performing side, we see pockets of opportunity to pick up high-quality credits just because of the volatility in the marketplace because you're just not seeing orderly markets. It really depends on the day and the week where you can just reiterate what Mike said, pick up very high-quality credits which is the focus on both the performing and nonperforming side because of what the market is offering you.

Thanks so much.

Our final question today is from Michael Cyprys from Morgan Stanley. Please go ahead.

Good morning. You mentioned earlier you are seeing a rebound so far in the fourth quarter and some of the ACOF Asia funded investments. Just curious if you marked your book say as of yesterday, how much of the investment income would come back?

Most of our portfolio both to carry as well as our balance sheet to Level III, we are not marking it daily. I would say to Mike's point for some of the observable equity traded positions we have in those portfolios, the two companies Mike referred to in Asia, prices are up.

I think one is up 5% and one is up 12.7%. And I think generally our liquid credit strategies have rebounded nicely through the month of October.

If you think about the influx to what we will call Level III valuations, significant ones where credit prices have gone and things that are correlated to the equity markets which clearly are up, but we don't have an exact number to share with you. But directionally themes have gone up since we closed the quarter.

Got it, okay. As a follow-up, can you talk to some of the trends you are seeing from allocation changes by sovereign wealth funds and how you are thinking about the risk of these firms setting up internal asset management capabilities, insourcing some of that, and also some of the risks that these entities that are geared more towards oil prices may look to bring some money back home over time?

Sure, there's a couple questions in there. First, one of the benefits of the platform is we have a very well diversified investor base in the public markets and the private markets, geographically diverse and diversified by investor type.

We do have very, very strong relationships with most of the global sovereigns. However, that only represents about 10% of our assets under management today.

In terms of insourcing, insourcing has been something the largest institutional investors have been doing for quite some time, both some of the large pension funds and some of the sovereigns. We have not seen that change their behaviors vis-a-vis our relationship, and we haven't seen them emerge as competitors or that the insourcing has changed the way they are allocating to third-party managers.

Maybe down the road, that could impede the growth of that segment of the business for us, but it's actually been the benefit as they've gotten better direct, they've actually grown more comfortable with a lot of the alternative assets that we manage. And with that education, we've seen larger flows. So it has actually been a net positive for the most part.

In terms of oil prices, we actually haven't seen a change in investor behavior with volatility in oil. One could expect to see that if oil prices are low for longer, but we actually haven't seen that yet. It's something that we've asked ourselves the same question, but hasn't shown up in the way capital is getting allocated.

Great, thank you.

This concludes our question and answer session. I'd like to turn the conference back over to management for closing remarks.

We really have nothing else. We really appreciate everybody's time today and the great questions, and we look forward to speaking to everybody again next quarter. Thank you.

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 through December 9, 2015 by dialing (877) 344-7529 and to international callers by dialing 1(412)317-0088. For all replays, please reference conference number 10074377.

An archived replay will also be available on our webcast link located on the home page of the Investor Resources section of our website. Thank you for attending today's presentation. You may now disconnect.