Ares Management Corp (ARES) 2017 Q1 法說會逐字稿

Good day, everyone, and welcome to Ares Management, L.P.'s First Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded on Monday, May 8, 2017.

I would now like to turn the conference call over to Carl Drake, Head of Ares Management, Public Investor Relations. Sir, please go ahead.

Thank you, Jamie. Good afternoon, and thank you for joining us today for our first quarter 2017 conference call. I'm joined today by Michael Arougheti, our President; and Michael McFerran, our Chief Financial Officer. In addition, David Kaplan, Co-Head of our Private Equity Group; and Kipp deVeer, Head of our Credit Group, will be also be available for the Q&A session.

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, L.P.

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 first quarter 2017 earnings presentation we filed this morning for definitions and reconciliations of the measures to the most directly comparable GAAP measures. This presentation is also available under the Investor Resources section of our website at www.aresmgmt.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.

Now I'll turn the call over to Michael.

Great. Thanks, Carl. Good afternoon, everyone. Before I begin with the discussion of our first quarter financial results, I'd like to take a moment to reflect upon our growth as a firm as we just crossed our 3-year anniversary as a public company this past week.

Looking back, there've been several industry trends that have supported our growth, namely: the growing global investor demand for alternative investments; and the consolidation of assets into larger and more diversified global asset managers as investors search for economies of scale, unique investment solutions and more consistent performance. The increasing investor demand for alternative strategies is illustrated by the growth in the number of our investors, our assets under management and the increasing diversity of our revenues. 3 years ago, we went public with approximately $77 billion in AUM and approximately 525 direct institutional investors across 146 funds. Today, we're at approximately $100 billion of AUM and have approximately 720 investors in over 200 funds. The trend of consolidating investor assets into fewer, broader alternative asset managers has also supported our growth. First, we've developed new or expanded product offerings that leverage our core strategies within areas such as structured credit, asset-based lending and power and energy infrastructure, and we've expanded the geographic reach of our existing products as exemplified by the growth of our direct lending strategy in Europe.

At the end of the first quarter, over 40% of our institutional investors are invested in more than one product on our platform. Secondly, over the past 3 years, more than 80% of our total capital raise has come from existing investors. At the same time, the composition of our AUM has shifted toward larger, institutional investors as direct investors now account for 65% of total AUM compared to 55% 3 years ago, with the most growth coming from large institutional investors or consolidating managers, particularly within the pension fund community.

The average direct investor now commits $89 million to us versus $79 million just 3 years ago. This has allowed us to scale many of our most important commingled funds into larger successor funds, such as ACOF V, ACE III and U.S. real estate VIII. We've achieved this growth while also improving the quality and diversity of our revenue streams.

Management fees continue to remain north of 80% of our total fee income. Our growth is also visible in our financial results given the over 25% growth in our comparative LTM fee income, fee-related earnings and economic net income compared to the same period 3 years ago. And as we've grown our AUM, we provided a foundation for future growth as well. Today, our incentive eligible AUMs stands at over $55 billion compared to approximately $36 billion 3 years ago. We also have more than $24 billion of available capital compared to just $18 billion 3 years ago. So as we look forward, many of these macro factors remain, yet I would highlight that there are additional trends that are supporting our growth. The asset manager sector itself is consolidating in order to meet this changing investor demand, gain efficiencies and to broaden products and distribution. With the rise of passive investing, active managers without distinguished performance are losing share. However, active managers that can truly add value are becoming more and more relevant. We believe that our consistent generation of attractive returns puts us in a solid position to be a consolidator in this changing landscape. As we talked about before, consolidation brings scale, providing important information on sourcing advantages that can result in improved investment returns. For example, we believe that our direct lending franchise's broad origination scale and ability to commit and hold large capital amounts is differentiated and improves our ability to review a wider set of investment opportunities.

Second, investors continue to be significantly under allocated to alternative assets. In particular, insurance companies are seeking higher current risk-adjusted returns in today's persistently low-rate environment, and pension funds continue the need to solve for higher returns to meet liability gaps. With the shift from defined benefit to defined contribution plans, we're also seeing a growing appetite from retail investors. We remain focused on developing new products and new channels of distribution to meet this emerging demand.

Lastly, the changing political landscape in the U.S. is likely to provide more opportunity for us. The current administration's pro-business agenda, desire for significant infrastructure spend, possible BDC legislative reform and tax reform all present potential growth catalysts. With significant dry powder and flexible fund strategies, we believe that we're poised to benefit from any opportunities that may surface.

Now I'll turn to a quick review of our first quarter's results and our core business areas. Generally speaking, our addressable markets remain very healthy, with both strong asset level fundamentals and market technicals. While this environment is constructed for fundraising, fund performance, asset valuations and realizations, deployment can be more challenging given the significant amount of liquidity in the markets. Our ability to generate consistent returns in this environment is a testament to the competitive advantages of our platform and our balanced business model. The first quarter saw a favorable credit and equity market performance on expectations of potential tax and regulatory reforms and solid corporate earnings. Against this backdrop, we generated quality results, which were highlighted by strong fundraising, solid growth in AUM and double-digit year-over-year growth in our core fee-related earnings.

So maybe to start with fundraising, during the first quarter, we raised $3.1 billion in gross new commitments, including equity commitments from 50 direct investors, with more than half coming from existing investors, a common theme for us as our existing investors continue to show a willingness to commit more capital and extend into new strategies within Ares. Over the past year, we've raised $14 billion in new capital commitments, including equity commitments from 136 direct investors, with about half, again, coming from existing investors. These new capital commitments have helped drive our AUM growth, approaching an important milestone of $100 billion in AUM. Our fee paying AUM has also climbed to nearly $70 billion, a growth rate of 19% year-over-year.

Our current fundraising outlook remains very promising. In credit, we're very active raising U.S. and European Direct Lending SMAs, seeking noncorrelated current returns, generally with target returns in the 6% to 12% range. We're particularly active with pension funds, sovereign wealth funds and insurance companies in this area. We closed approximately $1 billion in Direct Lending SMAs in the first quarter, and our pipeline of future funds is robust.

And as we discussed in our last call, we also held the first closing for our first junior capital private direct fund where we focus on larger companies searching for private high yield and mezzanine solutions. Our first closing on this fund in the first quarter was more than $1.1 billion, and we continue to raise capital toward our target of $2.5 billion.

Deployment within ACE III, our third European Direct Lending fund, has been stronger than anticipated due to favorable market conditions and strong execution, and we're now approaching 50% deployment. As a result, we have a clear line of sight to begin considering our fourth fund in this strategy later this year or early next year. We continue to have strong flows across our liquid credit funds where we can toggle for relative value between asset classes, and we're off to a strong start in the CLO market, pricing and closing of $409 million U.S. CLO in the first quarter and just pricing our second U.S. CLO over the year in April at over $800 million, bringing total raised this year to over $1.2 billion. And last month, we held a final closing for our third structured credit fund, ACOF III, bringing total fund commitments to over $400 million. We continue to seek SMAs around our third-party structured credit and private asset-backed investment strategies as well.

In real estate, we're nearing the next progression of successor funds for our 2 largest fund strategies, targeting U.S. value add and European opportunistic real estate investments. Last Friday, we held our first closing of more than $400 million for our ninth U.S. value add fund, and we expect that this fund will ultimately exceed its predecessor fund in size. Based upon strong deployment and stronger performance in EU IV, our fourth European real estate fund, our natural progression would be to begin the process of raising a successor fund as early as Q4.

And lastly, within private equity, we expect to close out our fifth power and energy infrastructure fund during the second quarter and since acquiring EIF in January of 2015, we've raised more than $800 million in this strategy, including co-invests.

As we stated on our last earnings call, we didn't have much visibility into significant first quarter realizations, and this is indeed reflected in our lower first quarter distributable earnings. However, the realization environment continues to be excellent, and we currently expect that we'll have many opportunities to lock in attractive values on realizations throughout the year.

As an update on our Clayton Williams transaction, the acquisition by Noble Energy closed on April 25 and our funds received just over $1 billion in cash and Noble Energy's stock on the date of closing. Based upon the cash portion received, we'd expect the realization event to result at approximately $0.06 of DE per common unit. And using Friday's closing price of Noble Energy, the value of the stock would translate into approximately $0.10 per common unit in additional DE if we were to sell our holdings, but of course, we won't recognize any realizations until our holdings are ultimately monetized.

Secondly, we're very pleased with the recent highly successful IPO on the New York Stock Exchange of our private equity portfolio company, Floor & Decor. Floor & Decor is a leading specialty retailer in the hard surface flooring market and an Ares fund ACOF III acquired a controlling interest in the company in 2010. The offering priced at $21 per share above the initial range of $16 to $18, and it closed its first day of trading at $32 per share, up more than 52%. We elected not to sell any shares in the IPO, and we agreed to 180-day lockup provision. Using last Friday's closing price of $36.73, the value of our holdings equates to a multiple of invested capital of 10.5x our money for ACOF III, including debt repayments and dividends and a potential profit of approximately $1.9 billion. This translates into approximately $100 million of DE for Ares Management, assuming we monetized our position at Friday's price. For the second quarter thus far, Floor & Decor's market value as of last Friday would add incremental net performance fees and net investment income of approximately $80 million. And similar to Clayton Williams, of course, these amounts are using last Friday's closing price, the price may fluctuate, and we won't realize any value until the portion of our holdings are monetized.

Fortunately, our investment performance was very consistent across our platform for the first quarter and particularly strong over the last 12 months. Fundamental portfolio company performance remains really strong across the portfolio and credit defaults continue to be relatively benign.

Starting with our direct lending strategy in credit. Ares Capital Corporation generated a quarterly net return of 2.5%, and our European strategy, represented by ACE II, generated a gross return of 2.7%. In our liquid credit strategies, the high yield and loan markets continued their strong run early in the first quarter, but performance stalled toward the end of the quarter, given some weakness in energy. Our high-yield and leveraged loan composites generated positive first quarter gross returns of 2% and 1%, respectively. Our corporate PE funds have performed well, with ACOF I through IV generating gross returns of 27% over the past 12 months, including 2.2% on a gross basis in the first quarter. Our performance has been mostly supported by strong EBITDA growth. Strong real estate fundamentals and careful investment selection have driven good performance in our U.S. real estate strategies. Our U.S. VIII value add fund generated a gross return of 4% for the quarter, after a gross return of 19% in 2016. Our largest real estate fund in Europe, EU IV, also continues to perform well, crossing into carry during the fourth quarter. And first quarter gross returns for EU IV were 5% after generating a 20% gross return in 2016.

As I hinted at earlier, the current investment environment requires a high degree of selectivity. We're using the breadth of our global platform and sourcing advantages to find compelling opportunities, but at the same time, remain disciplined with our deployment. One benefit of having a diverse global platform is that we can identify investment opportunities across different markets, assets and regions.

During the first quarter, we deployed $3.6 billion compared to $1.4 billion a year ago, and in our drawdown funds, we invested $2.6 billion in the first quarter of 2017 versus $1.1 billion a year ago. We were most active in U.S. and European Direct Lending, where we continue to use our size, scale and broad direct origination as important competitive advantages to source and underwrite quality assets at attractive risk returns. Our direct lending investment team is cautious on the current environment as spreads are tight and the markets are full of liquidity, but we remain active in search of the best credits. With our market leadership and approximately 160 investment professionals in the U.S. and Europe, we continue to find quality investment opportunities where we believe that we construct our attractive returns.

The corporate private equity markets are challenging, given the elevated valuations in most segments, and we are likely a net seller within our flexible private equity strategy in the current environment. That said, we found specific well-valued opportunities and deployed $1 billion during the first quarter. As discussed on our last call, we've made some attractive PE investments using our structuring expertise and creativity in the energy sector, including our recent investments in publicly-traded Gastar Exploration and in development capital resources, which seeks to partner with E&P operators seeking flexible growth capital to expand in strategic basins.

In other sectors, we focused on taking advantage of secular trends, where we can partner with dedicated management teams, backing franchise businesses with solid value propositions, barriers to entry and strong brands. Within our power and energy infrastructure strategy, we continue to see significant opportunities to deploy into new investments with attractive risk-return parameters. Most recently, we partnered to commence construction on a new 500-megawatt nat gas power plant in Southeastern Pennsylvania. This project is emblematic of the substantial capital needs in the industry to replace our nation's retiring and uneconomic coal plants. This trend, as well as the continued deployment of renewable energy and new advanced technology, is redefining the opportunity set for us. These market forces combined with the current administration's efforts to reduce regulation, boost infrastructure spending and leverage domestic natural resources, amplifies an already compelling investment environment.

And finally, in real estate, we continue to see a healthy backdrop for commercial real estate equity and debt, investing with most activity in the U.S. market during the first quarter. Both U.S. and European real estate demand drivers remain favorable, given the tight labor market, rising rents and steady population growth in select markets. We're continuing to pick our spots in segments carefully, and we're finding interesting investments that meet our returns in both value add and opportunistic strategies. We believe that new supply remains relatively rational in our markets.

During the first quarter, we continued our emphasis on value add multifamily investments and attractive growth markets in the U.S. as well as our strategy of buying quality assets out of distressed ownership structures in Europe.

And now with that, I'm going to turn the call over to Mike McFerran to give you more detail on our Q1 financial results and future outlook.

Thanks, Mike. Let me start by highlighting a few themes about our financial results, then I'll walk you through our results in more detail.

Over the last 12 months, our AUM increased by about $6.3 billion to approximately $100 billion, a year-over-year net increase of approximately 7%, and our fee-paying AUM increased by 19% to $69.2 billion, which includes the ACOF V fee activation and ARCC's acquisition of ACAS. Overall, we're -- we generated respectable first quarter core earnings, with management fees and other income increasing 11% year-over-year and fee-related earnings increasing 20% year-over-year to $46.7 million. Performance-related earnings totaled $29.1 million for the quarter as compared to our prior year loss of $14.9 million. Our economic net income more than doubled from the weak first quarter in 2016, supported by the fee-related earnings growth and a healthy rebound in performance-related earnings. For the first quarter, we reported economic net income of $75.9 million, which translated into $0.30 on an after-tax per unit basis after preferred distributions.

With that overview, I'll take you through our results in greater detail, starting with revenue. The management and other fee income for the first quarter totaled $181.6 million. This reflected approximately 1 month of revenue from ACOF V, net of the step down of ACOF IV management fees, which, on a net basis, contributed just over $5 million to management fees for the quarter. Accordingly, on a full quarter basis, based on ACOF IV's invested capital at quarter end, the quarterly run rate will be over $15 million versus the $5 million for the first quarter. The first quarter's management fees also reflect the closing of the ACAS acquisition by ARCC from which we earned 50% of a full quarter's incremental base management fees on the acquired assets or approximately $5 million. In addition of ACE management fees, we earned $33.3 million of ARCC Part I fees in the aggregate for the first quarter compared to $28.6 million for the same period a year ago. I do want to remind everyone that the fee waiver of up to $10 million per quarter of ARCC Part I fees that was part of our transaction support for the ARCC-ACAS merger went into effect beginning in the second quarter and will continue for 10 consecutive quarters. It is our expectation that this fee waiver will reduce a portion of the ARCC Part I fees that we expect to earn until our team can efficiently rotate the acquired portfolio and approve the yields on those assets. We expect the fee-related earnings contribution from this acquisition to increase gradually throughout 2017 and beyond. Our AUM not yet earning fees, or shadow AUM, declined from $18 billion to $13 billion as ACOF V began to pay management fees on $7.6 billion, while ACOF IV transitioned to paying management fees on invested capital. Of the $13 billion, $10.3 billion was available for future deployments, with corresponding management fees totaling approximately $108 million.

Next, I'll turn to expenses. Compensation and general and administrative expenses were $100.6 million and $34.3 million, respectively, for the first quarter, representing year-over-year increases of 5% and 20%, respectively.

For compensation, this quarter's results include costs related to permanent and transitional employees from ACAS, and we expect this number to grow modestly in the coming quarters as we continue to grow our business.

With respect to G&A, this quarter included a $2.5 million onetime tax-related expense. Excluding this, our G&A would've been just under $32 million, which is in line with the fourth quarter of 2016.

With respect to performance-related earnings, we saw a significant rebound for the first quarter, with $29.1 million of performance-related earnings as compared to a loss of $14.9 million for the same period a year ago. The improvement was broad-based and reflected positive fund appreciation in all 3 investment groups during the first quarter.

Our balance sheet is approximately $653 million of diversified investments, mostly in our funds, generated income of $12 million, up $17 million from this time last year, reflecting appreciation in our private equity funds, particularly in ACOF Asia and in our CLO holdings. As of March 31, we had accrued performance fees totaling $185.3 million, of which approximately 2/3 relates to our private equity business. I do want to emphasize the importance of our incentive eligible AUM, which totaled $55.9 billion at quarter end, representing a 17% increase from prior year. Of this amount, $20.2 billion is incentive generating and a $20.2 billion amount is still to be invested. Of the $20.2 billion of uninvested capital, approximately 73% or $14.7 billion is to be invested in funds already above their respective hurdle rates.

Our fourth quarter distributable earnings were $40.9 million, slightly down from $41.3 million a year ago. Our after-tax distributable earnings, net of the $5.4 million preferred equity distribution, was $0.14 per common unit versus $0.15 per common unit a year ago. As Mike stated, we expect a meaningful pickup in our distributable earnings over the next 2 quarters as a result of the closing of the Clayton Williams transaction and several other monetization opportunities during the period.

Another factor determining the potential distributable earnings from realizations lies in our net accrued performance fees, which have increased 37% or $50.2 million compared to the same period a year ago and now total $185.3 million. Of the $185.3 million, approximately 73% relates to funds with annual incentive fees or American-style carry waterfalls.

Next, I'd like to provide an update on the potential tax and GAAP accounting treatment of the financial support of $275.2 million that we provided for ARCC's acquisition of ACAS. As we mentioned in our last call, the tax treatment is subject to final determination from the IRS and could range from treating the $275 million as an immediate deduction or amortizing that over a set period of time, typically 15 years on our tax guidance. At this point, we have not yet received confirmation from the IRS regarding this matter. However, for GAAP purposes, it was determined that the $275.2 million paid in transaction support should be accounted for as a onetime expense, which contributed to a GAAP net loss of $41.1 million for the quarter. As a reminder, we strongly believe that significant value will be created from this acquisition as it brought Ares $2.8 billion of fee-paying AUM at closing in a permanent capital vehicle.

In summary, as we look out further in 2017, we expect to achieve a meaningful step-up in both revenue and fee-related earnings through ACOF V, the ACAS transaction as well as deployment and fundraising activities. We are very well positioned with the strong and growing management fee base, which we believe is relatively insulated from risks of asset price volatility and redemptions, and we have a record level of incentive-eligible AUM that we believe can generate meaningful performance-related earnings and, in turn, distributions in the quarters and years ahead.

Now I will turn it back to Mike for closing remarks.

Great. Thanks, Mike. So in closing, we feel really good about our business performance over the past 3 years and are enthusiastic about the firm's strong industry positioning, the supportive macro trends and the opportunities for value creation going forward. We're focused on continuing our disciplined investing, expanding products and distribution opportunistically and pursuing inorganic strategic opportunities when they fit our criteria. Mike mentioned, we have significant dry powder, flexible fund mandates and long-dated capital poised to take advantage of opportunities as we navigate through these changing market conditions.

Thanks to everybody for taking the time today, and with that, operator, if you could open up the line for questions.

(Operator Instructions) Our first question today comes from Craig Siegenthaler from Crédit Suisse.

Just coming right back to the $275 million of financial support that you provided with the ACAS acquisition. What is the difference between how you could potentially account for this benefit on an ENI and DE basis? I just wasn't sure if ENI was roughly the same as the GAAP, which you just actually provided us.

Sure. For purposes of ENI, Craig, we exclude acquisition costs to the $275 million to be reflected in GAAP income or loss or actually loss for the quarter, but it's not included in ENI. And if you take a look, you'll see that in the reconciliation of GAAP to ENI in the earnings presentation.

Got it. And then, with the fees turning on with ACOF V and stepping down with ACOF IV, I know we had a month of that in 1Q, is the 2Q step-up in management fees on a net basis in the neighbor of $14 million that we should be looking for in the second quarter?

No. We said it would be -- would've been $15 million -- a little over $15 million if it was on for a full quarter on Q1, of which we earned just over $5 million. So the incremental will be closer to $10 million.

Our next question comes from Mike Carrier from Bank of America Merrill Lynch.

This is actually Mike Needham in for Mike Carrier. The first one fee-related earnings. You covered some of it on the prepared remarks. I guess, I was just hoping if you could give us a sense for the timing of that FRE trajectory you're talking about from the ACAS deal, how long it takes to make changes to that portfolio, the fee waiver is coming on? And then expenses, I think there may be some temporary expenses that were in there for 1Q that you expect to come down.

I'll take the first part on expenses, then I will hand it over to Kipp on ACAS. So our expenses for G&A for the quarter were $34 million. I think we mentioned in our prepared remarks that I included $2.5 million of a onetime tax expense. So if you back that out, you would've seen G&A for the quarter of about $31.8 million, which I think was in line with what you saw -- or it's slightly under what we reported for the fourth quarter last year.

This is Kipp deVeer. I think what we laid out for folks on the ARCC call last week was we structured in a 10-quarter fee waiver to give us cushion. We are well ahead of sort of that 10-quarter expectation. We've been actively selling assets acquired during the ACAS transaction and repositioning them on the call last week. We'd identified roughly $1.1 billion of assets remaining, which were either low yielding or equity oriented that we continue to reposition out of. So our best guess is maybe 18 to 24 months, but less than the 10 quarters.

Okay. And then, just a second, it sounds like the consolidation of managers continues to happen. I guess, how much more of a trend -- how much more you think there is to go? And then on fees, as your clients are getting better or consolidating their managers, are you seeing any changes in fee discussions or any fee pressure?

Sure. So the consolidation trend is ongoing. And I think you've seen transaction announcements in the market in and around the alt space that are good indications of the continuation of that trend. Obviously, in the traditional space, some of the catalysts for the consolidation are different than we see in the alt space, right? Traditional space, it's a move towards passive investing, significant fee pressure and weak capital flows. In the alt space, we're actually not seeing dramatic fee pressure. We're seeing positive flows, so the consolidation story is a little bit different, but it's real, and it's continuing. And it all centers around some of the themes that we highlighted in the prepared remarks that most of the large global investors are trying to reduce the number of GP relationships that they have. And I think they're trying to do it first and foremost to make their businesses more efficient and less complicated. I think they're also realizing that large global managers, like us, who have broad geography, multiasset class capabilities that they can access different markets much quicker with much less friction, particularly in markets where volatility is popping up more frequently.

And so I do believe that a lot of that is being driven by people's views that risk-adjusted returns are actually better for the larger managers in many cases, in particular, as you navigate changing markets. And then lastly, the fees. Clearly, if you are coming to a platform like ours with significant amounts of strategic capital in the form of SMAs, to get at some of these synergies, there is always a conversation around fees and economics for that relationship. I will say, if you look at our fee rate blended across the platform, you'll actually see that it's been going up pretty consistently based on mix, number one. And then, when you look at the marginal profit on those types of relationships, it's very, very high. So the consolidation of LPs putting more money with pure GPs obviously translates into an opportunity for us to continue to consolidate on the asset manager side, to be able to offer those products in a very cost-effective way. But fee pressure is really not a big part of the conversation. As we've talked about in the past, we have seen some fee pressure in the more liquid parts of our credit business historically. I would say, the bulk of that pressure is behind us and the markets now settled out at a fee level where it makes sense for the market. But in the true, what we'd call, 2-and-20-type structures, commingled funds, asset classes that require significant origination infrastructure and investments and sourcing and research and portfolio management, fee pressure is a very small part of that conversation.

Our next question comes from Alex Blostein from Goldman Sachs.

Question on outlook for management fee growth and I guess, just broader investment environment. So I guess, given that the latest private equity fund is generally in the run rate, the bulk of the growth in management fees is likely to be, I guess, coming from deployment of some of the kind of shadow AUM that you guys highlighted over $100 million of management fees. When you take that with, looking through the lens that you highlighted on Direct Lending team, essentially it's fairly cautious on the investment environment. Help us understand, I guess, where you guys finding incremental opportunities, the pace of that capital deployment? And ultimately, how are you sizing new money that's coming in right now, just potentially given some of the capacity constraints given valuations?

I'll make one high level comment and then I'll let David or Greg chime in specific to private equity and the credit market. I think it's important that people reorient around why these asset management businesses are attractive. And one of the reasons is they are cycle durable and they can actually make money throughout the cycle because of the balanced approach to the business. And as I talked about in the prepared remarks, when you're in a market where you have significant liquidity, that may manifest itself in slower or more cautious deployment, but the total value proposition then reorients itself towards harvesting gains. And so whether you're talking about direct lending, where you saw modest reduction in deployment, you're also seeing harvesting of gains in order to drive attractive returns to the investors. And similarly, in private equity, where we're probably being a little bit more selective and targeted in what we're looking at, as we highlighted in the prepared remarks, the opportunity to monetize existing assets is quite good right now. So the balanced approach of being able to monetize investments when there is a lot of liquidity to offset potential reduction and deployment, I think, is a key hallmark to how these businesses work. And obviously, when you have long-lived locked up fund structures with flexible asset mandates, you can do that. And I think you're seeing that across the board that we do have levers to pull to drive deployment, but generally, when deployment is low, you should see it made up for in net gains. I don't know if you have anything specific on PE with regard to the deployment environment?

I think -- this is David. Environment is very competitive right now. Or as you've heard us use the word a few times in this call, of being selective. So being very selective is obviously important from a individual asset standpoint where we're deploying. That's true across all the assets that we manage at Ares Management. That being said, I think our strategy of flexible capital within our corporate private equity business allows us to try to find idiosyncratically favorable risk reward. I think if you look at the $0.5 billion commitment we made out of Fund V, in Gastar recently, which is a public company, you'll see at the highly structured investment where we feel really good about downside protection as well as having traditional private equity upside associated with it. So we just need to remain flexible. I'd like to say, in this environment, we have to work harder to find good investments and we're certainly doing that.

Okay. And my second question was back to Mike's earlier point around you guys being a potentially consolidator in the space. Any indication of kind of where you're still finding gaps in your offering, whether on the product side or the distribution side, where you might be a little bit more active on the M&A side of things?

Yes. It's -- there's nothing really in front of us that I would say is actionable, but as you can imagine, we look at a number of opportunities. Our real estate business continues to see a meaningful amount of opportunity to build out our strategies as well as to look at parts of the market that we're not currently in and around core and core plus real estate and the permanent capital space in and around direct lending. Obviously, the ACAS acquisition is still fresh in our minds, but there have been a number of opportunities to look at in that space. PE, a little bit harder. Obviously, as you've seen us do with EIF to the extent that we can bring on what we believe is a unique investment capability onto the platform. We'll do it, but I'm not seeing a ton of opportunity in, what I would call, regular way PE. And then, broadly-defined liquid credit, along the spectrum from below investment grade to high grade, there is a number of things that we've looked at that we have found interesting. As we've talked about before, anytime we're looking at fees, we have to approach them with a view that we can make the business better by bringing it to Ares and supporting it with resources. And we have to have a view that they can make us better, i.e. bring something differentiated and unique to the table that we don't currently have. Obviously, the economics of the deal need to make sense and the cultural fit needs to work. And we've said this before, it's hard to check all 3 of those boxes. Particularly in this environment, where valuations are elevated across the board, the financial pieces is a little bit harder. So we are seeing, I'd say, more opportunities for consolidation we've seen before, but making all 3 of those things work together is probably a little bit more difficult, particularly around valuation. But I'm encouraged by the pipeline and the amount of conversations we've been able to have over the last 12 months, and I'd expect it to continue.

Our next question comes from Robert Lee from KBW.

Mike, I apologize. I know you went through it somewhat on the call. I missed some of it. But I'm just trying to get, I guess, a better handle on the next generation funds you're currently raising. I know you mentioned the power, and I think the U.S. value add. But could you maybe just also go through that again quickly? I think there was also the 1 year large credit funds, your -- I think you mentioned you're in the market right now kind of with the next generation raised?

Yes. So in the earnings presentation, you'll see a summary of the capital that's raised and some of the funds listed there, you'll see all the funds that we referenced are still in process. But in terms of the large commingled funds that were in the market, when we talked about our first junior capital private debt fund in the U.S. that had raised about $1.1 billion capital in the quarter against the $2.5 billion target, that's obviously going very well. The strategy is being met with enthusiasm from the market and, obviously, is a testament to the Direct Lending franchise we've developed here. We are, as I said, raising our ninth value add U.S. real estate fund. We highlighted that post quarter end last Friday, we closed $400 million into that fund, and we would expect that fund, when all is said and done, to be larger than its prior fund. We talked about having visibility based on deployment and execution to being in the market with our next European Direct Lending or private credit fund towards the back half of this year and to early 2018. And similarly, for our European real estate private equity fund, again, based on deployment and execution there, we'd expect to be in the market towards the back half of the year, if not early 2018 as well. As we highlighted, we would expect to finish up fundraising likely for our fifth power and energy infrastructure fund in the second quarter. And as we highlighted, since we acquired EIF, we've raised about $800 million into that strategy. And then lastly, which is hard to really quantify for you guys is the real, I think, story for fundraising going forward is the importance of the strategic managed account relationships that we've been able to develop, given the breadth of the products that we have on the platform. And if you actually look at the assets that we've raised over the last 12 months, about 50% of those direct funds that actually been raised through SMA structures. And so speaking to this consolidation theme of LPs reducing number of GPs, we're actually seeing more SMAs coming on to the platform than we have before, which is a nice complement to the success for commingled fund raises.

Great. That's helpful. And then maybe just a follow-up, not to meet the acquisition M&A, of course, too much, with the ARCC absorbing ACAS and pretty busy with that and revamping their portfolio. Does that kind of impact, at least, over the near to intermediate term you're thinking about the types of M&A you'd be interested in, additive to Ares in terms of new strategies or versus a, what I'd call, a more pure consolidating transaction?

Sure. So Kipp can chime in if he feels differently. I think as we talked about on the ARCC call, the good news is the ACAS integration could not be going better. We have brought on some people, but not a significant amount of people, pretty straightforward systems integration and as Kipp just highlighted earlier in the call, given the nature of the markets, we're probably ahead of schedule on the rotation of that portfolio and the repositioning of that portfolio. And I think all early indications are that, that's going better than we could have hoped for. But to your point, there is limited bandwidth here. So I think that the bar to make an acquisition in direct lending is probably higher than in other parts of our business, both because of bandwidth constraints, but frankly, when we have an origination machine that can originate assets at $0.96 or $0.97 from the dollar, paying par or par plus to acquire assets is not a great way for us to create return for our investors. So there is always a balance between where can we manufacture our own product versus where can we buy it in the market and given what we have in direct lending in particular on the heels of the ACAS trade, the bar is probably pretty high there. That said, as you know, the platform infrastructure here to evaluate and integrate M&A opportunities is quite substantial. And so in all parts of our business, as we see opportunities, obviously, our strategy group and corporate finance teams help the business heads think through potential acquisitions within their groups. And as I said, the pipeline has been quite active.

And our next question comes from Ken Worthing from JPMorgan.

I guess, maybe just modeling questions. On the ACAS acquisition, are the kind of credit groups revenue and expense is at the right run rate? Or are there parts of the income statement that flex as we migrate to 2Q in the second half of the year? I think you mentioned that the fee waivers 1 and 1Q, so that would be one. In G&A, the 2.5 tax benefit, that would be 2. Are there other variations we'd expect as we migrate to the end of the year?

That's the big one. Why don't we -- might be helpful to go back to the slide we mentioned in our prepared remarks, which was, if you look at the management fees related to ACAS, we said we only received a half quarter's management fees in Q1. So I think the way we look at it is, when you think about the ARCC with respect to how it's impacted by ACAS, there's really 3 moving pieces. You've got the management fees, which we said -- if this was a half quarter, we earned about $5 million from the acquisition this quarter, so assume it would be $10 million next quarter incremental from ACAS. The Part I fee that we earn is the second lever. And the third is the waiver of up to $10 million. When you look at our Part I fees, the average we earned on a quarterly basis in 2016 was about $30 million in the quarter. In Q1, we earned a little over $33 million. So you're going to have the $10 million waiver coming into effect. What's going to be offsetting that is, to the extent the portfolio is transitioning, so we'd expect, I'm just going to use round numbers, let's say, the Part I fee pre-waiver was, call it, $35 million, then you would earn $25 million next quarter, net of the waiver. So I think all in all, second quarter's income from ARCC would be slightly lighter than Q1, but then probably, as you see Q3 and 4 progress, kind of hitting that breakeven and then being additive to what you saw this number -- this quarter's numbers, I mean.

Okay. Great. And sorry, I'm going to keep digging here. On the $10 million waiver, are there anything that can drive that waiver lower in any given quarter? You mentioned a couple of times the repositioning of the portfolio. Does that somehow impact the fee waiver? Or is it really going to be $10 million a quarter for more or less the next 10 quarters?

Yes. So it's just a straight waiver $10 million a quarter. But as Mike highlighted, when you think about the economic value coming off of ARCC, there is a management fee, and then there is a Part I income-based fee. And ARCC right now, as Kipp talked about on ARCC's call last week, is running lower leverage and harvesting gains. And so as ARCC re-levers and the book increases in size, you'll actually see both management fee and likely that income-based Part I fee increasing. So the brunt of the fee waiver in this quarter, particularly because it was the first quarter out of the gate, probably feels more impactful than it will, to Mike's point, as we get into the back half of the year and into 2018. But there is nothing variable about it, just a straight $10 million waiver.

Okay. Great. Much more clear to me now. And then, Michael, I think you brought up potential for BDC reform. Anything new to report there? Or I mean, what's the reference, just we've got political change and it's always possible that new regulators will kind of rekindle the reform process with regard to these rules?

Well, again, I've long been out of the political prediction game. But I will -- we're encouraged just based on the tone in Washington, around job creation and the search for bipartisan financial services regulation that everybody can get behind. And I think that the BDC legislation checks that box. What encourages us even further is, I don't know if folks saw, but the financial choice act actually passed the House Financial Services Committee about 1.5 weeks ago and embedded within that piece of legislation is the proposed BDC legislation. So that bill is starting to make its way through the house and the BDC legislation, at least for the time being, is attached to that. So that is a step in the legislative process that we view as a meaningful positive as we continue to watch what's going on with BDC regs.

Our next question comes from Chris Harris from Wells Fargo.

I believe a derivation of this question came up on the ARCC call, but I was hoping to get a little bit more clarity out of you guys. Valuations in direct lending remain pretty elevated, and ARCC had some difficulty finding attractive investment opportunities. Could there be a scenario where there potentially might be further fee waivers out of Ares to help ARCC support the dividend?

So I think there was a discussion. There was a question that came up on the call, and my recollection of the answer was, as managers, clearly, anything is always on the table. But there is a very emphatic response that, given the environment that we're in, given the games that are getting generated and given the growth in that book, that the dividend is stable, if not, positioned to grow over time as we continue to execute on the ACAS strategy. So I would say, no, not because we would never consider it. I would say, no, emphatically because we just don't see any rationale for that, given what we think is very strong fundamental performance at that company. And as we highlighted and came up on the ARCC call, and I just mentioned it around the fee waiver, it will take a little bit of time to transition that book, re-lever it and have the games roll through, but we feel, again, that everything is on track post the acquisition to realize on the value that we told people that we'd realize on.

Okay. Great. And then, just one question on the AUM growth you guys have been experiencing. I mean, you're getting close to this $100 billion milestone. You highlighted that. As you continue to grow, how do you feel about the scalability of the platform at this point?

In terms of investment functions, noninvestment functions or both?

All of the above.

I think we're just getting started. We've talked a lot about the noninvestment groups, and I'll let Mike highlight that. But when you look at what we bring to our investors in terms of investment solutions and access to noncorrelated risk-adjusted returns around the globe, we're still really, really bullish about the prospects for growth, both on our existing businesses and new businesses that we're not in yet. And the reason for that optimism is driven by a lot of things that we talked about in the prepared remarks. But first and foremost, we operate in very, very significant addressable markets. Our addressable markets are large and they're growing. And we, as a market leader or one of the handful of market leaders, while we continue to take share, still have very, very small share. And so as students of financial markets, when we see markets that are consolidating in large addressable markets where we have competitive advantages, we just view that as a natural opportunity for organic growth. The flows, as we've talked about, are significant and they're broad-based and they're coming from all corners of the world and all types of investors, both institutional and retail, and we don't expect that to stop. And then, importantly, there are whole sections of the globe that either have not come online yet for investment by folks like us, like China, like India, like parts of Latin America. And similarly, there are large regions that haven't come online yet as meaningful allocators to alternative asset classes, places like China and Japan, to name a few. So when we look at the macro tailwinds, it's hard not to see consistent organic growth. And what we are seeing, you'll see this in the fundraising numbers, you'll also see it in the deployment numbers, the larger platforms are taking a disproportionate share of the AUM and a disproportionate share of the deployment, and I think that speaks a little bit to this underlying trend that we keep referring to. And again, I don't see anything that would take us off course on that.

Our next question comes from Doug Mewhirter from SunTrust.

First question, looking at the real estate segment, looks like you're raising some funds and you're -- you may be having your eye on a successor fund, although one of your bigger funds, looks like it's starting to wind down. How do you feel about actually being able to grow, on a net basis, either the AUM or the fee-paying AUM this year for that segment overall?

Very, very good, actually. Our real estate business is, what I would call, an inflection point, both in terms of where we are in the fundraising cycle and the deployment cycle. As we highlighted, we're in the market now with our ninth value add fund that will be larger than our eighth fund. Our expectation is that we'll be in the market with our fifth opportunistic fund in Europe, that should be larger than its predecessor fund. We believe that we have made some very meaningful adjustments to our real estate lending business that should position that part of our real estate capability for meaningful growth. And we've done a lot to restructure and continue to further integrate and consolidate that business from a process standpoint, both investment and noninvestment. So I actually look at that as a real bright spot for us. I think that given the increasing size of our funds in some of the things I mentioned that we're actually poised to see margins continue to expand and not to see a net reduction.

My second and final question, it's, again, more of a big picture question. Obviously, there is sort of cause-and-effect issue, especially on the credit side and, to a lesser extent -- and also on the private equity side, really with spreads or valuations, how you're going to characterize it, are really being driven by these flows, which are benefiting you so much. But obviously, the -- with the rising valuations that impacts your ability to deploy, I guess, what I am more curious about is your view on how that would actually provide feedback to the allocators. Are the allocator's starting to take a second look and say, "Well, why do we want to dump another $100 million into private credit when spreads are sort of tight, for example?" Or they're just more like, "Okay, we'll give you the money now and if you have to sit on it for a while, that's fine, but we're not going to cut our budget. You just figure out when the best time is to deploy."

It's really the latter. If you get back to the structure of our funds, the typical commingled fund, putting aside the SMA conversation, which is probably even pushing us more towards it, but in the commingled fund structure, typical fund will have somewhere between a 3- and 4-year investment period against the 7- to 12-year fund life. And the conversations with our investors is less about them anxious around deployment and more around them feeling like they actually have measured and level set deployment throughout that fund investment period. And just as an example, and David can comment on this, if you look at ACOF V, we had a fairly light deployment year in 2016. The capital that we raised there, I think, was raised with a view, on the part of our investors, obviously, based on feedback from us, that a distressed opportunity would present itself to us. And better to be well capitalized with the right type of capital and the right amount of capital going into that environment rather than scrambling to play catch-up.

So I actually think it's the opposite. Most of the sophisticated institutional investors who can accept illiquidity and recognize that the way that they get paid outsized returns over cycle is to capture a liquidity premium are looking more for us to help them understand when they should be deploying and where they should be deploying, but not how quickly per se they should be deploying. So I think what we have to do, obviously, is, both on the front end when we're raising capital and as we continue to manage capital is we have to be very transparent with our investors about what the return opportunity is, what the expected deployment is, and then continue to be transparent much as the same way we are with the folks on this phone about where the markets are and how we're navigating. But David, maybe you want to just quickly comment on the PE dynamics? I think it's pretty telling.

Sure. I'd like to say that cash and dry powder give you resilience and optionality. And I think that given the sized markets, which Mike just commented on that we address in everything that we do across the Ares Management platform and, of course, within private equity, specifically across market cycles where we're able to find interesting risk reward. But having this flexible capital approach where we can in a distressed or discounted debt market environment, find attractive opportunities to deploy capital and private equity is not that we're waiting to deploy capital, but it is a distinct possibility over the course of the investment period of ACOF V, specifically, there will be some form of correction, which will be in a position to take advantage of.

And ladies and gentlemen, our final question today comes from Michael Cyprys from Morgan Stanley.

Just wanted to circle back to the fee-related earnings margin. As the management fees ramp over the next couple of quarters, I just wanted to get a sense of the incremental margin on that revenue coming in the door. And then, just on the fee-related earning to margin itself, what sort of FRE margin is realistic would you say later this year into next year versus the longer term in terms of what you think you can get to over time?

Sure. We have said before that we believed, during the course of 2017, achieving a 30% run rate, go forward FRE margin was achievable. We still believe that. As I do think we'll see that, especially as we talked about some of the timing around the Part I fee related to the ACAS transaction, as that trends up in the second half of this year, we think that we'll probably cross over that 30% inflection point. Looking ahead, as Mike said earlier because we use some scalability in the firm, I think in years to come, if we achieve that 30% run rate over the course of this year, we'd expect that we can improve upon that going into 2018 and beyond.

And ladies and gentlemen, at this time, we'll conclude today's question-and-answer session. I'd now like to turn the conference call back over to Mike Arougheti for any closing remarks.

Great. Thanks so much. I think we covered a lot, so only thing left to say is thank you for all of your time today, and we look forward to speaking again next quarter. Have a great day.

Ladies and gentlemen, that does conclude today's conference call. If you missed any part of today's call, an archived replay of this conference call will be available through June 6, 2017, by dialing (877) 344-7529, and to international callers, by dialing 1 (412) 317-0088. For all replays, please reference conference number 10104758. An archived replay will be available on a webcast link located on the homepage of the Investors -- Investor Resources section of our website. Once again, we do thank you for attending. You may now disconnect your lines.