Ares Management Corp (ARES) 2016 Q2 法說會逐字稿

Welcome to Ares Management LP's second-quarter earnings conference call. At this time, all participants are in a listen-only mode.

As a reminder, this conference call is being recorded on Tuesday, August 9, 2016. I will now turn the call over to Carl Drake, Head of Ares Management Public Investor Relations.

Good afternoon, and thank you for joining us today for our second-quarter conference call. I am joined today by Michael Arougheti, our President; and Michael McFerran, our Chief Financial Officer. In addition, Bennett Rosenthal Co-Head of our Private Equity Group; and Greg Margolies, Co-Head of our Credit Group, 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 investment Ares Management LP. During this conference call, we will refer to certain non-GAAP financial measures, such as economic net income, fee-related earnings, performance-related earnings, and distributable earnings.

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 I fees. Please refer to our earnings release and Form 10-Q that we filed this morning for definitions and reconciliations of these measures to the most directly comparable GAAP measures. Our second-quarter earnings presentation has also been filed with the SEC, and is available under the Investor Resources section of our website, aresmanagement.com, and can be used as a reference for today's call.

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. Before I turn the call over to Michael Arougheti, I want to provide a quick recap of our second-quarter earnings. We reported GAAP net income of $0.46 per unit and economic net income after tax per unit of $0.44.

Our after-tax distributable earnings per common unit were $0.31 and we declared a distribution of $0.28 per common unitholders of record on August 23, and payable on September 6. With respect to our recently issued preferred units, we also declared a distribution of $0.54 per Series A Preferred unit, and set aside for payment on September 30 for record holders on September 15. I will now turn the call over to Michael.

Great. Thanks, Carl. Good afternoon, everyone.

Against the backdrop of sluggish economic growth and market volatility, the equity and tradable credit markets rallied in the second quarter, sending equity market indices to new highs and driving strong returns in liquid non-investment-grade credit assets. Many markets seemingly have shrugged off both Brexit and extraordinarily low global interest rates, as investors gained support from continued central-bank accommodation. The US markets are increasingly being viewed as a safe haven for global capital in search of higher returns as our economy with low growth and low interest rates offers better risk reward, compared to no growth and no rates in many foreign markets.

These capital flows into the US markets continue to bid up risk assets, some of which were at depressed levels as recently as the beginning of the year. But despite the volatility that followed Brexit at the end of the quarter, the financial impact on our portfolio values and earnings for the second quarter was very limited. Approximately 4.7% of our total AUM is invested in companies or properties in the UK, with about 2/3 of these assets in our EU direct lending strategy, where we have invested in first-lien senior secured corporate loans, at what we believe are conservative loans to value.

In addition, only about 2.5% of our funds are denominated in British sterling, and our funds continue to be well-hedged against currency fluctuations. While it's too early to determine the longer-term impact of Brexit, we do have significant dry powder dedicated to European investing in order to take advantage of potential opportunities. We also have a strong investment footprint across Europe in credit and real estate, and we believe that the challenges facing European banks should only continue to serve as attractive primary and secondary market opportunities for us.

From our vantage point, volatile markets play into our strength as a long-term opportunistic investor with locked-up flexible capital. Given our very patient and value-add approach to investing, we are in a better position to make opportunistic investments during times of volatility, and as the second quarter highlights, control outcomes by exiting positions during more advantageous periods in the market. Our significant self-origination capabilities become even more valuable and important in these types of markets.

Not only do volatile markets provide investment opportunities for us, but they also help us promote the attractiveness of our alternative assets, and our unique approach to our investors. Today, investors have fewer investment choices that meet their return thresholds, amidst negative or low-yielding fixed-income assets and elevated public equity valuations. Our asset platform, with higher and less correlated returns, offers a very attractive alternative.

We continued to see this play out during the second quarter and throughout the last year, as investors committed sizable amounts of new capital to us. To that specific point, we raised $4.4 billion during the second quarter, bringing our total gross fundraising over the last 12 months to approximately $24.7 billion.

During the second quarter, we announced the final closing of Ares Capital Europe III, our third commingled European direct lending fund, which reached its hard cap of EUR2.5 billion in equity commitments. One year after its launch, this fund was oversubscribed with roughly equal participation from new and existing investors. This fundraise supports our long-term view that the supply-demand imbalance in the European middle market continues to be attractive, as scaled, non-bank capital providers gain market share from the banking sector.

Of the $4.4 billion raised during the second quarter, $1.1 billion is attributable to ACE III. Also in credit, we raised more than $1.4 billion in new and add-on funds in our high-yield and structured credit strategies, and we also added $400 million in additional commitments to a US direct lending mandate. We continue to see significant interest in large, strategic mandates across a number of our credit strategies.

Capitalizing on our strength in the CLO sector, we priced a new $510 million CLO in our US syndicated loan strategy. As discussed in our last call, we also initiated a new public equity income strategy, investing in higher-dividend yielding public equities, where Ares has specific domain expertise. During the second quarter, we closed a new $300 million fund in this strategy.

We also added $400 million to our US and European real estate PE funds, including a final closing for our US development and redevelopment fund II, which brought the total raised across our US opportunistic real estate equity strategy over the past year to over $900 million. We're also closing out other successor funds and we are in the early stages of marketing new credit strategies that take advantage of the broad capabilities across our integrated global credit platform.

Across our firm, we continue to have success expanding the investment solutions that we offer to our client base. Existing investors consistently access multiple products on our platform. During the last quarter and the last 12 months, more than 80% of our direct institutional capital was actually raised from existing investors.

Importantly, over 42% of our investors are now invested in more than one fund with us, up from 23% five years ago. As a result of all these fundraising efforts, we now have more than $24 billion of dry powder, of which $17.7 billion is eligible for, but not yet earning management fees, and Mike McFerran will discuss the implications of this in more detail shortly.

Turning then to our investing activities, our investment teams are working hard to unlock value in a market with very low interest rates, strong capital flows, and generally elevated asset pricing. That said, we continued to find interesting relative value opportunities during the second quarter, with increased deployment in our drawdown funds compared to the same period a year ago. We deployed $4.4 billion compared to $4.1 billion for the same period last year, of which $2.4 billion was deployed from our drawdown funds in the second quarter, versus $1.6 billion in the second quarter of 2015.

The increased deployment was highly diversified across investments, but driven primarily by our European and US direct lending funds, and by our US and European real estate equity funds, focused on value added and opportunistic investing. As I mentioned across all strategies, competition is up, but transaction activity has also improved, allowing us to be highly selective and highly disciplined. Again, our broad origination capability has allowed us to source attractive opportunities in all market environments.

We generated significantly higher second-quarter earnings as our funds experienced strong market appreciation, particularly in corporate private equity in the US and in corporate credit. In addition, a number of exits across our three investment groups allowed us to generate a record amount of DE and distributions to unitholders for the second quarter. We experienced partial realizations in an information technology staffing company, and a healthcare staffing company in our corporate private equity funds, called a legacy CLO with embedded incentive fees, and had multiple monetizations in our US value-add real estate equity strategy.

Despite the volatility in the quarter, our fund performance was strong. In the aggregate, our corporate private equity funds generated a quarterly NAV return of 5.8%, led by a quarterly net return in ACOF IV of approximately 9%. Our loan in high-yield funds generated composite gross quarterly returns of 1.7% and 3.1%, and while these quarterly returns lagged our benchmarks, which were up 2.9% and 5.9%, as our commodity, and to a lesser extent, energy underweights didn't allow us to fully participate in a rally, we continued to outperform our benchmarks over the past 12 months.

In our direct lending strategy, our BDC, Ares Capital Corporation generated a 3% quarterly net asset value return, including dividends, and in our European strategy, ACE II generated a quarterly net return of 1.4%. In real estate, US VII generated a quarterly net return of approximately 3.8%, and our European fund, EU IV, gained 1.4% in net asset value for the second quarter.

In summary, we continue to perform well for our investors and this is validated by the expansion of our LP base and the increased allocation of capital from our existing investors. As we sit here today, I believe that we are well-positioned to grow our fees and our earnings. Over the past 12 months we have raised a record amount of gross capital, and we expect to invest this capital over time to deliver meaningful returns to our investors, and to deliver growth and management and incentive fees to our public unitholders.

Using the breadth of our platform, our deal sourcing, and diligence capabilities, are translating into strong investment performance, solid deployment, and nice monetizations. Now I'd like to turn the call over to Mike McFerran to give you his perspective on our financial results. Mike?

Thanks, Mike. As Mike stated, we are pleased with our results as we generated meaningful quarterly and year-over-year growth in E&I, as well as record distributable earnings as a public company, reflecting strong net portfolio appreciation.

While our fee-related earnings have continued to be the driver of our distributable earnings over time, it's nice to see our strong performance convert into higher distributable earnings and distributions for our unitholders this quarter. As we articulated in our call in May, as expected, our fee-related earnings held flat quarter over quarter, as we don't expect a meaningful step function increase in our fee-related earnings until we experience a lift from the beginning of the investment period for ACOF V or our deployment pace acceleration funds where we are paid on invested capital. In addition, we continue to make growth investments by developing new products where we incurred expense ahead of the associated revenues.

When looking at our recent fundraising momentum, and our record dry powder, and our shadow AUM, we believe there is a lot to be excited about, as the associated earnings have not yet shown up in our results. With those comments, let me turn to our second-quarter financial results.

In summary, we hit on more cylinders this past quarter, which drove a stronger distribution for our common unitholders of $0.28 per common unit. The distribution will be payable on September 6 to common unitholders of record, as of August 23. Let me now walk through some of our key metrics for the quarter.

Our AUM increased by about $7.7 billion to approximately $95.3 billion. A year-over-year net increase of approximately 9%. Our total current fee earning AUM increased by approximately $800 million or 1%. The modest increase is primarily due to the wind down of the SSLP within ARCC and runoff in US CLOs and doesn't yet include the $7.6 billion in fee-eligible AUM from ACOF V.

However, we introduced a new AUM measure this quarter, fee-paying AUM, which reflects AUM of those funds in which we directly earned management fees. We introduced this measure as we believe it will be useful in evaluating the periodic changes, using the basis of our direct fee paying assets under management. Our fee-paying AUM increased by $3.5 billion over the past year, or more than 6%, reaching $59.1 billion.

As Mike stated earlier, we had $24.3 billion in available capital at the end of the second quarter, of which $17.7 billion is in AUM not yet earning fees, which we also refer to as shadow AUM. This $17.7 billion is up 75% from the prior-year period.

Of that $17.7 billion, we consider about $15.7 billion available for future deployment. Our shadow AUM carries an expected management fee rate of approximately 1.2%, slightly higher than our current blended management fee rate, as our backlog continues to be weighted toward our higher average returning and higher fee generating strategies. Our shadow AUM, available for future deployment of $15.7 billion, equates to $186.3 million of incremental future management fees.

Note that over 55% of this gross amount relates to just ACOF V before the next step down of management fees for ACOF IV, with approximately 25% of this gross amount related to ACE III and our fourth special situations fund. Once we activate ACOF V, over half of our management fees tied to shadow AUM will start being earned. Of course, we expect to experience some runoff and step downs in fee rates as older funds, in addition to ACOF IV, and their investment periods.

Assuming ACOF IV is approximately 70% invested at the time we activate ACOF V, the associated step down in fee rates at ACOF IV would reduce the $186.3 million in potential management fees by approximately $43.7 million. Our incentive-eligible AUM increased 29% from the prior year to a record $49.4 billion, of which $14.7 billion is incentive generating, and another might $19.1 billion is to be invested. Of the $15.7 billion not generating incentive fees, approximately $10.1 billion is within 1% of reaching its respective hurdle rate.

Of the $10.1 billion, $8.7 billion is represented by ARCC's investment portfolio, where we are eligible for part II net capital gains fees, which have not have a material impact on performance-related earnings. As stated earlier, our second-quarter fee-related earnings of $39.6 million were up very modestly compared to the first quarter, as we continue to scale our distribution capabilities, infrastructure, and invest in new product development. Going forward, we continue to expect our FRE and FRE margins to move in a step function, with a relatively flat to modestly improving trend until ACOF V begins its investment period.

During the second quarter, we saw a rebound in our performance-related earnings, which increased 113% versus the second quarter of 2015, and reversed losses versus the first quarter of 2016, primarily driven by appreciation in our corporate private equity funds. Our balance sheet of approximately $637 million in diversified investments, provided higher second-quarter net investment income for us as well. Our second-quarter distributable earnings were $76.8 million, which translated into DE per common unit of $0.31, compared to $73 million a year ago, or $0.28 per common unit.

Despite the realized net performance fees of $30.6 million, our net accrued performance fees increased by about $16.2 million to $151.4 million, driven by portfolio appreciation. While it is still early, we currently expect additional realizations to aid our distributable earnings in the third quarter with the announced sale of a substantial portion of our investments in oil and gas E&P portfolio company in the Permian Basin, and the pending sale of one of our industrial portfolio companies. Of course, we can't provide any guarantees on the closing of this transaction.

We expect that activating management fees for ACOF V, net of the assumed step down of ACOF IV I spoke about earlier, will generate approximately $60 million of net growth and management fees, which would translate into approximately $0.06 per quarter of after-tax distributable earnings per unit as of June 30. While the investment environment and our corresponding deployment will dictate when the investment period starts when we activate ACOF V, we're currently targeting the end of the fourth quarter of this year from a timing perspective.

Let me now address our financial support for our externally managed business development company, ARCC, and its pending acquisition of American Capital. In May, ARCC announced a merger agreement to acquire American Capital for an aggregate cash and stock consideration of $3.43 billion. To support this transaction, we agreed to provide $275 million of cash to American Capital shareholders to be paid at closing and waived up to $100 million in ARCC part I fees for 10 calendar quarters, beginning the first full quarter after closing.

To finance our support, we issued $12.4 million Series A Preferred units in June, for a total offering price of $310 million. The units are entitled to a 7% dividend, payable beginning on September 30 of this year. We believe the transaction will enhance Ares Management's already leading position in direct lending.

Additionally, since the transaction is expected to result in an increase in ARCC's gross assets of approximately $3 billion, increasing management fees and potential part I fees on the acquired assets, we expect the transaction will be accretive to earnings and beneficial to our unitholders. Now, I'll turn the call back to Mike for closing remarks.

Great. Thanks, Mike. I know we just covered a lot in a lot of detail, so let me just try to distill things down to a few simple closing thoughts before we take your questions.

First, with persistently low interest rates and volatile global equity markets, our flexible alternative asset capabilities provide a compelling value proposition to institutional and retail investors. Our investment performance continues to be strong across the platform, and our existing clients and new investors are validating our performance by committing new capital to us in both existing and new strategies, and across multiple products.

We're expanding our platform by introducing new or adjacent products where we can leverage our existing expertise and track records. We have a record level of dry powder and shadow AUM, which is very long-dated, and which we expect will drive FRE growth and FRE margins over time.

As Mike highlighted, we believe that the combination of our shadow AUM deployment, including ACOF V, and the expected accretion from the ACAS transaction will catalyze earnings growth for the next year and into subsequent periods. We also have a record level of incentive eligible AUM, providing upside potential for growth in future performance fees.

And most importantly, every day we're leveraging the power of our platform across all of our activities and our investment in operational teams in order to execute for our fund investors and our unitholders. So with that, I just wanted to thank our team for their continued hard work in these ever-changing markets, and thanks to everyone on the phone for their time today and for our investors for their continued support. Operator, with that, we'll open up the line for questions.

(Operator Instructions)

The first question is from Craig Siegenthaler, Credit Suisse.

Thanks. Good morning.

Morning.

First, just on the $11 billion private equity dry powder, and I know this is mostly ACOF V, but can you just comment on your ability to invest it today, given current public equity valuations are getting even more stretched here?

And ACOF V has not started its investment period yet. Just was wondering if you could remind us when we should expect that, and also how long is the investment period with this fund?

We are going to hand it over to Bennett Rosenthal who is here with us just to talk through it specifically.

Yes, so we will start our investment in ACOF V as soon as we're finished with ACOF IV. We would expect that we would be done investing ACOF IV, or at least, and ready to invest ACOF V. We are targeting in the end of the fourth quarter.

Although we can't give any assurances, obviously, with the public equity markets and the private equity markets at very high multiples, we are being cautious in this environment. We are seeing some opportunities for rescue capital as well as some growth equity investments on our platform that give us confidence we'll get to that -- we will be able to keep that calendar, but you're right, the markets are very frothy right at the moment, but we are targeting end of the fourth quarter.

One thing I would add, Craig, specifically, because, as we have talked about on prior calls, the private equity strategy here we think is quite unique, as Bennett mentioned, with the ability to do both growth equity investing and rescue or distress re-control transactions, which we think smoothes out both deployment and harvesting relative to more traditional LBO-only oriented buyout firms. I think a good example of our ability to be creative and flexible in this type of market is our recently-announced Clayton Williams transaction, which is in the public domain.

Just to add to what Mike is saying, we funded in March a rescue capital loan to give the Company some breathing room and just recently, as you may have seen, we announced an equity investment into Clayton Williams.

Got it. Very helpful.

I heard the aggregate number in your prepared remarks for ACOF IV in terms of the C impact, but can you remind us what the imagined fee of ACOF IV is? Where it's going to step down to, and also what is the fee rates or the imagined fee rate on ACOF V?

ACOF IV on a blended basis is currently running at 1.4% average fee rate, and I believe that once we turn on ACOF V that steps down to a point.

0.75%.

0.75%. From 1.4% to 0.75%.

And then ACOF V?

ACOF V is similar and the investment period is six years.

I think that was one of the questions you asked in your first round of questions. Six-year commitment period from the time we turn on the fund.

Perfect. Thanks for taking all my questions.

Thanks, Craig.

The next question is from Mike Carrier from Bank of America Merrill Lynch.

Thanks, guys. Just a question on the incentive income in the quarter, Mike, you mentioned some of the performance and I think across strategies it's pretty variable in the quarter. Just wanted to get some color, because ACOF IV went back into carry, if there was any acceleration that may be benefiting the incentive income during the quarter?

I think as you highlighted, the good thing about performance across the quarter was in each of our businesses. The good and the bad news about the environment we're in is valuations are up, which is helping not only our realizations actual, but also the unrealized valuation around the portfolios, and that's true in our US and European businesses across private equity credit and real estate. As we mentioned in the prepared remarks, the benefit of that backdrop is persisting into the third quarter as we continue to have both realized investment performance coming through our PE portfolios, and also a favorable valuation backdrop.

Okay, just so we're clear, on ACOF IV, was there any acceleration of like the performance fees?

Yes, as far as acceleration, if you recall, last quarter we said ACOF IV's IRR dropped slightly below the hurdle rate, which took it out of carry. This quarter, with the market appreciation, it did cross back into it, so there is a GP catch-up element to that, which helped benefit performance fees this quarter.

Okay. Got it. And then just on the realization outlook, I know you mentioned two things that are pending in the third quarter, and I know until they are completed it is tough to give the information, but just wanted to see if you had any color on what the equity investments are or what the multiple on invested capital, just to get some sense on the outlook for the realization activity and then obviously the distribution in addition to FRE, because FRE we have a pretty good eye on.

You know, for Q3, I think we mentioned in the prepared remarks, we do have visibility on a few realizations, recognizing we're just a little over a month into the quarter, there is still a way's to go, so we didn't want to give any more specifics at this point. On the specifics of those portfolio company investments, we usually don't give out those details, but again, you could tell from our remarks, we believe that there will be realization activity that should be additive to distributable earnings above FRE for Q3.

How much? It's just too early to tell.

Okay. Thanks a lot.

Okay.

The next question is from Ken Worthington of JPMorgan.

Hi. Afternoon. Wanted to get a little more details on the performance in the various asset classes. You gave us some details already, but it looks like ACOF IV having such a good quarter, as you mentioned, maybe what went so well there?

It seems like the IRRs really picked up, and then on the other side you mentioned some real estate. It looks like, to me, maybe I got this completely wrong, but real estate seemed to struggle a little bit in the quarter, so if so, what happened there?

And then lastly, on credit, you mentioned that the lower energy exposure didn't help you this quarter. Is that what may be weighed on performance or was there something else on the credit side? Thanks.

Why don't we handle each of those separately? Bennett can talk a little bit about PE, Greg and I can chime in on credit, and then I will give you a little bit of color on real estate, if that is helpful.

Great.

In PE, it was pretty broad-based with most of the portfolios seeing valuation appreciation. There was some particular value increases in our -- in both our energy and our healthcare investments, but I would say it was pretty broad-based across the portfolio.

Okay. Great.

With regard to the specific question on being underway energy in commodities, that did primarily impact performance in our loan funds, given the positioning of those funds, which again, if we are going to get penalized for performance, we would always like it to be when we are being on the conservative side in a volatile market than being on the other side of that, but maybe generally, Greg, on credit, broadly?

I would agree. Our performance in the first quarter was predominantly driven by being a little more conservative and being underweight in commodities both in fee and metals and mining. That's certainly been the most aggressively priced sector in the second quarter, being up substantially off of the lows.

We were more conservative, both in terms of being underweight those commodity driven sectors, as well as being a little higher up in the credit spectrum, being a little bit more conservative in the risk (inaudible) was taken throughout the portfolios, and that has worked against us a little bit in terms of the extreme risk on nature of the market today. We continue to position ourselves to be looking for the best credit [side] in the marketplace, also some event-driven credits. We believe Ares is quickly being able to enter our market for creating alpha, be under-weighting a little bit of the beta risk in the market, especially on the commodities side.

Okay. Great. And lastly, on real estate?

Yes, real estate, I don't know what you were referring to. As you look at our real estate funds, generally the valuation environment for real estate was constructive. If you look at some of our European funds, in particular EU III, and some of our older vintage funds, they were slightly down, but across the board, performance for the quarter in terms of appreciation and net value was generally up and kind of the low single digits.

Okay. Great. Thank you very much.

The next question is from Chris Harris at Wells Fargo.

Thanks. Hey, guys.

You do a good job here in the presentation laying out shadow AUM, laying out things that might be coming in terms of perhaps incentive-generating AUM and growth in AUM in general, but one thing is a little less clear is, what could potentially be rolling off. And I know in private equity we sort of have somewhat of a line of sight, but I think credit is a little bit harder for us to kind of get our arms around that. Maybe wondering if you guys could share some thoughts about how we should be thinking about sort of that offset of the potential significant increase in AUM you guys are onboarding here?

One thing, we look at our AUM and it is a key reason why we introduced a new metric this quarter, the fee-paid AUM, is included in both AUM, and the fee-earning AUM, are the commitments related to the FSLP program for ARCC, and while that is in AUM and fee-earning AUM, as you know, it does not directly translate in the management fees for Ares Management.

So, we have seen runoff of that, and we expect that will continue as that program continues to amortize down, but that's been a bit of what I would call a headline offset to the capital we have been raising and that actually is fee-generating. In the credit world, we do have amortization of CLOs, past the reinvestment period, however, as we continue to issue new CLOs, the majority of that capital is still in reinvestment. We think that is going to be modest for the foreseeable future.

One other thing I did just want to highlight just to clarify the point on around ACOF is, I know we were talking about the impact of ACOF IV versus ACOF V, ACOF IV is a rate of 1.5% on $14.5 billion of fee paying commitments. That does step down by half to 75 basis points on invested capital when ACOF V turns on.

One other thing I would highlight, again, it's difficult to know, because some of the runoff just comes from redemptions, not of investor capital, but actual realizations. I think when we talk about the trend line, it's important to see that in our global credit business, where we are raising commingled funds, the trend has very much been to raise meaningfully larger funds from the predecessor funds.

So, ACE III being a good example of a $2.5 million Euro fund on the heels of a $1 billion euro fund, or SSF 4 being a $1.5 billion special situations fund, on top of a $750 million fund three. So, the net AUM growth and trend is being supported by our success in raising significantly larger successor funds in our co-mingled strategies, and then as I highlighted in our prepared remarks, a lot of the fundraising momentum that we're seeing in global credits are what we would call strategic managed accounts from larger institutional LPs, who are looking to get broad access in a diversified way across the global credit platform.

Thank you. That's helpful, and a quick one on ACOF IV, how far above the hurdle rate are you guys now with that fund?

Let me take a quick look at what the IRR is. We are at -- the IRR is running just over 9.5% against an 8% hurdle.

Thank you.

The next question is from Michael Cyprys at Morgan Stanley.

Hi. Good afternoon.

Hi.

Just wanted to follow up on your comment earlier on competition. You mentioned that you are seeing some increased competition. Wondering if you could elaborate a bit on that, just in terms of which product areas or geographic regions that you are seeing more competition. And then also, are you seeing any sort of irrational behavior in any sense or any early signs on that?

Sure. So as I said, when we talked about competition, maybe a better choice of words would've just been flows and/or liquidity, and hopefully not lost on people given all of the central bank accommodation that we're seeing around the globe, there is a significant amount of liquidity that is finding its way into the markets writ large, so in each of our businesses, we are seeing incremental capital coming in.

When you see that, I think the more important question is, is the capital coming into a capacity constrained market? Is it affecting the return opportunity of your point? Are we seeing irrational behavior? I think most importantly, do we, Ares, have competitive advantages in those markets to defend against some of the more fluid capital that comes in and out of the markets?

I think the good news is, whether you're talking about private equity, credit, or real estate, we believe that through the nature of the capital that we've raised, through the size of our origination networks that we've built, through the amount of dry powder that we have, through the research and information advantages that we've created, that even in markets where we are seeing increased or heightened liquidity, we're still able to find what we believe are very attractive risk-adjusted returns, and we talked about that in the prepared remarks, in the context of the deployment environment. In terms of irrationality, I think rational investment behavior is always in the eyes of the beholder.

I think generally, I wouldn't call it irrational, because given the global rate environment and given the access to capital, I would actually say that the behavior is quite rational. But as Bennett mentioned, and as Greg mentioned, valuations are elevated, spreads have tightened, and that's just the reality of the markets that we're operating in. But I don't consider that to be irrational, because I think that capital flows tend to be agnostic and it's our job as an alternative manager to do the best we can to drive relative value in those markets when we see the capital coming in and out.

Okay. Thanks. That's helpful.

And just a follow-up on your outlook for realization activity. Just curious how you think about this quarter's results on realizations in the context of, I suppose what you've done historically and where you see the firm going forward.

Is the second-quarter realization activity in operation? I know you mentioned third quarter you have some activity shaping up, and then just how you're thinking about that, say, over the next 12 months and what sort of market environment do you need for this level of activity that we've seen in the second quarter to continue?

Sure. Let me just contextualize it, because we talk about it a lot, but not necessarily in the context of this quarter's earnings. I think it's important for people to appreciate that our business model is different than some of our more PE or distressed-centric peers, public and private, and the business model that we've tried to articulate and execute well against is rooted in a lot of fund diversity, and a very significant percentage of our distributable earnings coming in the form of fee-related earnings and predictable management fee. So, quarter to quarter, while naturally, you're going to see some volatility and inconsistency in the amount of distributions and realizations, I think it's important that even in a quarter like the one we're in now, with 55% or so of our distributable earnings coming from FRE, that's down from a historical average of somewhere between 70% to 75%. Even in a quarter like the one we're in now, where we're seeing a significant percentage of DE from FRE, we're still through the high end of the peer range for that metric, so we are as focused as ever on sustainability and stability of our earnings as we are on realizations. With regard to the realizations, even though they do represent a fairly small percentage of our earnings, the realization environment is very constructive and favorable. Q2 was a great quarter, as we mentioned, early days, but we are continuing to see a favorable environment to exit positions into the third quarter, and all else being equal, I would expect that to continue through the end of the year.

Great. Thank you.

The next question comes from Erin Doyle at KBW.

Hi. Good morning. Thanks for taking my question. I am filling in for Rob Lee.

The first question, Mike, earlier you spoke about being in the early stages of marketing some new credit strategies. Could you elaborate on some of those?

Sure. As you know, we don't talk about specific funds in the marketing phase, but I will give a general sense for the types of strategies where we are seeing significant investor demand, but also significant market opportunity.

First is what I just referred to as diversified credit. Appreciating the comments earlier about low interest rates and correlated asset classes. We are seeing a significant amount of global appetite in the form of either commingled funds or strategic managed accounts that have the ability to dynamically allocate across the entirety of our global credit franchise.

So, if you go back 10 years, the products and solutions that were on offer to a typical institutional investor would be a direct lending fund or a high-yield managed accounts. There has been a significant amount of development of new product that just much more dynamic in the way that the capital is getting allocated, and I see that as a meaningful trend in credit. The second is building off of our global direct lending franchise, we see a big opportunity at the upper end of the middle market to provide larger underwritten solutions, and also what I would call middle of the balance sheet capital solutions in the form of mezzanine and second lien.

What is accelerating that opportunity for us is, as we have talked about on prior calls, there is a longer-term trend in direct lending for assets to leave the banking system and find their way into the alternative credit system. What we are seeing now is many of the banks either due to regulatory or just economic reasons, are actually reducing the investments that they have made in the distribution of certain products in the leveraged finance market. So, the opportunity to either underwrite and distribute loans is a big growth area for us, and also as a buyer of those loans as the banks look to continue to de-risk and get more certainty of executions. I think you'll see us rolling out funds that are going after that thematic trend as well.

Appreciate the color. Also, a question just on ARCC buying ACAS, I don't know how much you can say about it, but just in terms of what you have been seeing since the transaction was announced, are you guys still expecting some accretion in early years, even including the fee waivers?

Yes, Ann, unfortunately we are in the early days of a proxy solicitation process, so we really can't comment other than what we've already said. If you go back and look at the already made public commentaries, as well as what we've said today, yes, we do believe that the transaction will be accretive to both Ares Management and Ares Capital.

Thank you.

The next question is from Doug Mayweather at SunTrust.

Hi. Good afternoon, good morning. Two questions. First, I noticed your expense were flat to down, sequentially. Was there some seasonality in there or is it just sort of your leveling off the big buildup you had in expenses over the past couple of quarters?

There is no real seasonality. There is some timing with when we make investments potentially around some fund launches, but overall, I think we said a couple of quarters ago, that we were aiming to keep expenses in the $29 million to under $30 million range quarterly. And [at the extent] we could do better than that we are pleased with the discipline in doing so, and I think this quarter was reflective of that.

Okay. Thanks for that. And the second question is actually a follow-up to Ken Worthington's question about real estate. I think what he might have seen and what I saw too, and I'm curious to hear the answer is, on real estate, the net investment income for your balance sheet on balance sheet investments in real estate was actually negative in the quarter, which seemed to belie the nice trends you've been seeing in real estate in general. I just didn't know if there was one particular fund or one particular investment that --

Yes, that's actually a quirky line item. We made the acquisition of area property partners years ago, we had two things that we inherited. One was a real estate joint venture in India and the other was actually an entity that housed historical promotes within those real estate funds. We have deemphasized our activities in the Indian joint venture, and as we have actually had positive realization activity as reflected in the funds themselves, the income coming off of that carried interest vehicle has reduced.

Okay. That makes sense.

Thanks. That's all my questions.

The next question comes from Patrick Davitt at Autonomous.

Hi. Thanks for taking the question.

You mentioned a lot of the opportunity being around disintermediation in the leverage lending world. Obviously there has been a lot of chatter about players like yourself increasingly filling a void left by banking institutions. Are you seeing that trickle into any change in regulatory scrutiny on your business and what you're doing, or is the business still kind of a status quo that's always heavily regulatory scrutinized?

We've actually seen no evidence of that. I think it is still the status quo, and again, when you think about that trend, we are not supplanting the banks. I think we are actually just supplementing their capabilities, but when you look at the amount of capital in the banking system versus outside of it, I think we're a long way away from a conversation about our markets. We haven't seen anything to that affect.

And then just a follow-up on your prepared remarks, the 4.7% of UK exposure, is that total AUM or inground AUM?

That is total.

Okay. Thank you.

The next question is from Eric Berg at RBC Capital Markets.

Thanks. Mike, do you consider, with respect to -- taking a step back and thinking about the macro environment, which you have discussed, let's call it record low level of interest rates and the record level of the stock market, both of these factors, it seems to me cut both ways for you for reasons that should be apparent.

You're a buyer and a seller, so with the stock market is high as it is, you are paying more for properties than would otherwise be the case, but you're selling for more than what otherwise be the case, and similarly, it seems to me on the interest rate side, the low interest rates result in, I would say, higher volumes on deployment, higher cost of acquisitions, but also reduce your cost of debt financing. My question, on a net basis if in -- were to ask you, which I would like to do now, on balance do these extremely low interest rates or high equity values favor you, hurt you, or is it a neutral? What would your answer to that question be?

I would say it would be generally neutral, but I think higher rates should be a net positive for the platform. I'm glad you brought up the question, because as I highlighted earlier, I think the value in the platform resides in some of those competitive advantages I talked about earlier in origination and deployment, but part of the other value proposition that I articulated is the fund diversity and the ability to make money in any kind of market environment. That is a function of the long lived locked up nature of our capital.

It is a function of how we structure our funds with flexible investment mandates. So generally, and this may be hard to fully appreciate if you're not in the alternative asset management business, I think good alternative asset management firms feel that they have funds and strategies that generally can perform across market environments, and this environment is no different. When you are in a market environment like the one we're in now, you have to be laser-focused on risk-adjusted return and relative value, which we are. The reason I said generally interest rates going up, I think that could be a welcome change here.

If you look at the character of the investments in many of our underlying funds, the preponderance of our credit assets are floating rate shorter duration assets that should benefit from rising interest rates. Number two, where we have used leverage, we have typically match funded or created a favorable mismatch and asset sensitivity from the way that we are leveraging some of these funds. And three, generally speaking, when rates are going up and if they're going up for the right reasons, it is constructive for credit, and is an indication that fundamentals are actually improving and constructive.

I think the good news is the business is performing extremely well in this environment. I don't think that people are worked up about the nature of the opportunity now, but on balance, I think a rise in rates would probably benefit the platform modestly.

Thank you.

Our final question comes from Michael Cyprys at Morgan Stanley.

Hey. Thanks for taking the follow-up. Just had a question on CLOs, obviously, a growing business for you. Just curious if you could talk a little bit about the upcoming risk retention rules that will be going into effect and how you see that impacting your business, I guess, first from an opportunity perspective, but then also how much I guess incremental capital do you see yourself needing and how you kind of plan to fund that.

This is Greg. I'll take the first half of the question. There's been a significant alteration in the landscape of CLO managers given the risk retention rules that have been implemented in both Europe and the US.

To give you a sense, US is running at about a 50% of their issue rate, relative to last year, and Europe has also materially changed. We have continued to raise capital in both venues that are risk compliant, and or structured such that it gives us flexibility to do risk-retention complying going forward. We will utilize what we think is acceptable from a regulatory perspective, structures that meet the risk retention rules, both in the US and in Europe, and we are either have in place or will surely have in place the necessary setups to take advantage of all of those, and will be issuing in the future to [continue issued] funds that are risk-retention compliant plan.

I think it helps folks like us to just given the capital that is required to do the and/or the sophistication necessary to set up those vehicles benefits the smaller group of larger CLO managers. I think that does benefit us.

I also think you'll start to see -- well, we've already started to see at the beginning of this year, and we think will continue if not accelerate consolidation in CLO managers, in terms of the small approach, you just can't to raise the capital or have the sophistication to create these vehicles to be risk-retention compliant, so you will continue to see a consolidation out there, in terms of number of managers, we're looking at all those, of course. But I don't think it will change our ability to access the market to raise CLOs. We're actually more focused just on raising the rate risk-adjusted return for our investors and making sure that the arbitrage is correct.

I would make one quick follow-on comment, because CLOs is obviously where we think we will see the bulk of the opportunity get created for us, but risk retention implementation should also have a positive impact on our commercial real estate lending businesses, as well as it will change the face of the CMBS market, and I think it will be a net positive for alternative lenders who are coming into a pretty meaningful wall of maturity right now.

Do you see yourselves needing more funding in order to take advantage of those opportunities, or even to do existing business that you have on a go-forward basis?

No, I think we're very well-positioned, both with balance sheet capital, and as Greg mentioned, certain third-party vehicles that will allow us to continue to grow.

Great. Super.

Just one last quickie here. I know there was a recent SEC proposal on incentive compensation for investment advisors, and there has been some concern out there that CLO managers could be included in the incentive comp restrictions, just curious how you're thinking about that proposal and to what extent it could impact your business on the CLO side or even outside of that.

Yes. We're watching that.

We're not convinced that it is going to have a meaningful impact on us. Still early days, but if I had to pick a side, I would actually say that I don't think that is going to have an effect on our business.

Great. Thank you very much.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Arougheti for closing remarks.

Great. We don't have any. Again, I just wanted to thank everybody for all the time today.

Really good questions, and we look forward to a conversation next quarter. Thank you.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archive replay of this conference call will be available through September 7, 2016, by dialing 1-877-344-7529. International callers by dialing 1-412-317-0088.

For all replays, please reference conference number 10088374. An archived replay will also be available on a webcast link, located on the homepage of the Investor Resources section of our website.

Thank you. You may now disconnect.