Ares Management Corp (ARES) 2018 Q3 法說會逐字稿

Welcome to Ares Management L.P.'s Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference call is being recorded on Thursday, November 1, 2018. I will now turn the call over to Carl Drake, Head of Public Investor Relations for Ares Management. Please go ahead.

Thank you, Laura. Good afternoon and thank you for joining us today for our third quarter 2018 conference call. I'm joined today by Michael Arougheti, our Chief Executive Officer and Mike McFerran, our Chief Operating Officer and Chief Financial Officer. In addition, Bennett Rosenthal, Co-Head of our Private Equity Group and Kipp deVeer, Head of our Credit Group are also available for questions.

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

During this conference call, we will refer to certain non-GAAP financial measures such as fee-related earnings, realized income, performance-related earnings and economic net income. 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 our 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 third quarter earnings presentation that 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.

Please note that we plan to file our quarterly report on Form 10-Q early next week. 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.

This morning, we declared our fourth quarter common dividend of $0.28 per share, which will be paid on December 31, 2018 to holders of record on December 17. This represents a 5.7% annualized yield based on yesterday's closing price. We also declared our quarterly preferred dividend of $0.4375 for Series A Preferred Share which is payable on December 31, 2018 to holders of record on December 17.

Now I will turn the call over to Michael Arougheti. He will start with some financial and business highlights.

Great. Thanks, Carl. Good afternoon, everyone. Hope everyone had a nice Halloween for those who celebrated. Q3 was another strong quarter with continued double-digit growth in our core management fee revenue and record fee-related earnings. For the third quarter, we posted another core fee-related earnings record with $64.4 million, up 11% year-over-year, marking our sixth consecutive quarterly increase. For the 9-month period, our fee-related earnings have increased 18% compared to the same period last year. In addition, with nearly $7 billion in gross fundraising in the third quarter, our AUM exceeded $125 billion up more than 18% year-over-year.

On a year-to-date basis, gross new capital commitments raised of approximately $26 billion is already a full year record for us. For context with approximately $26 billion of gross capital raised through the first 9 months alone, we're already 1.5x the capital raised in all of 2017, which at nearly $17 billion, was a pretty good year in its own reign.

Our third quarter realized income was also strong at more than $91 million as we monetized a portion of recent gains and supplemented our growing underlying core fee-related earnings. I think as many know, economic fundamentals, as we're seeing come through in corporate earnings and consumer confidence remains strong. However as demonstrated by October's volatile equity market performance, there were increased geopolitical risks and growing concerns about a range of issues that could change the outlook and trajectory. The impact from new tariffs, increased inflation, rising interest rates and slowing global growth are all potential risks to the cycle. In addition as central bank liquidity is slowly withdrawn from global markets, volatility is likely to increase.

I'd like to remind everyone and emphasize that in our view, increased volatility is absolutely good for our business. Quite simply, choppier markets make it easier for us to invest at attractive risk-adjusted returns with less competition. Importantly, at this stage of the business and credit cycle, our portfolios are defensively positioned. With credit assets accounting for over 70% of our AUM, we're conservatively positioned with most of our investments, senior and the capital structure and mostly in floating rate investments.

We believe that generally investing in the top half of the capital structure with attractive returns, particularly in the current elevated pricing environment, offers attractive risk-reward with greater downside protection. And naturally, this should also result in our returns improving as rates drift higher. As we sit here today, we have over $34 billion of long-term and flexible capital available to invest, totaling 28% of our AUM across a broad range of flexible strategies and mandates. This should allow us to take advantage of stresses and dislocations in the marketplace as they develop. And from a business model standpoint, we operate a management-fee-centric and balance-sheet-light business model, which means that our earnings stream is less sensitive to changes in investment performance. The attractiveness of credit as a defensive asset class and our market leadership in private credit continue to result in significant inflows into the firm. With rising interest rates and elevated private equity multiples making regular way private equity buyouts more challenging in today's market, investors are increasingly recognizing the value of lower yet less-volatile expected returns and floating rate credit strategies. To that end, for the third quarter, we raised another $5 billion across our global direct lending strategies. We've also upsized our expected fundraising for our senior direct lending strategy in the U.S. with the new year-end target of approximately $4.7 billion, including anticipated leverage, which is up from our earlier target of approximately $3.5 billion.

During the fourth quarter to date, we've already closed additional LP commitments of $600 million, bringing total LP commitments to $2.2 billion in that fund. To support this growth, we also continue to invest in origination and portfolio management talent with over 125 investment professionals in the U.S., and more than 40 in Europe, we believe that we have the largest teams in these direct lending markets. And as we've always said in the private credit businesses, scale can create unique competitive advantages in origination and market intelligence that ultimately benefit performance.

On prior calls, we've discussed several growth initiatives across our 3 groups, namely our team and product expansions and real estate debt, private equity sub-strategies and in structured credit. Recently, we've launched commingled funds within our U.S. real estate debt strategy, energy and special opportunity strategies within our PE group, with expected first closings in a few of these strategies as early as Q4. Also, within structured credit, during the third quarter, we formed a new joint venture with a major insurance company to invest in private asset-backed securities, with total third-party capital available of $3 billion and we've already closed several investments into the new JV. We expect to continue to expand our non-corporate asset-backed investing strategies even further in 2019, capitalizing on the continuing de-banking trend that we're seeing in different segments of these markets.

We're also in the early stages of developing a climate infrastructure strategy which would focus on the growth in clean energy and technology that promotes the efficient use of our natural resources. Our continued fundraising momentum illustrates our strong performance over time, the valuable partnerships that we've built with our existing LPs, the expansion of our marketing infrastructure into new markets, and our proven ability to offer multiple investment strategies across our platform.

During the third quarter, over 70% of our capital raised directly from institutional investors, came from existing Ares clients. This highlights an important continuing trend in the industry, where LPs are consolidating funds with larger and more diverse asset managers that can offer broader alternatives for strategic portfolio construction. We continue to see growth opportunities in all major investor categories, particularly with global pension funds, insurance companies, sovereign wealth funds and private banks. Our total number of direct investors has now increased to over 860, up more than threefold from 5 years ago. And over the past 12 months alone, we have added 124 new investors to the platform with 58% of all money raised coming from investors outside of North America, illustrating our increasing global footprint.

On the investing side, we had an active quarter, deploying $3.8 billion in our drawdown funds, mostly in European and U.S. direct lending strategies, followed by selective deployment in our special opportunities, infrastructure and power and U.S. and European real estate PE strategies. The current environment requires additional scrutiny, caution, patience and a very flexible approach to investing to preserve attractive risk-reward. We continue to find our best opportunities when we're leveraging a prior incumbent relationship, proprietary knowledge or information advantage or to use our flexibility and scale of capital. As an example of this, greater than 50% of our European and U.S. direct lending teams transactions during Q3 were sourced from incumbent portfolio companies.

I'll now turn the call over to Mike McFerran, our CFO, who will walk through our Q3 results in more detail and describe our expected growth into future earnings. Mike?

Thanks, Mike. I'll start with the review of our quarterly results followed by an update on our process of converting our legal structure to a state law corporation.

As Mike stated earlier, Ares is benefiting from its strongest fundraising cycle yet with approximately $26 billion of gross capital raised during the first 9 months of this year. We view the growth of our AUM not yet earning fees or otherwise referred to as shadow AUM, as a leading indicator for future growth in our fee-paying AUM, management fees and both fee-related and performance-related earnings as we deploy this capital. Our AUM growth accelerated to 18.4% year-over-year, reaching $125.1 billion on the heels of strong third quarter fundraising. Our nearly $7 billion of third quarter gross commitments were fairly broad-based within our credit group, highlighted by a $1.6 billion first closing for our first commingled fund and senior direct lending which has subsequently increased to over $2.2 billion thus far as Mike pointed out. The final closing of ACE IV with LP commitments in the quarter of $1.1 billion, $1.2 billion in other U.S. direct lending SMAs and funds, approximately $1 billion in European direct lending SMAs, $1.1 billion across U.S. and European CLOs and over $225 million in structured credit funds.

The future pipeline continues to be promising with the launches of new funds and real estate debt, a new private equity energy opportunities fund, a new special opportunities fund, and other strategies in credit and private equity to be launched in the near future. Our fee-paying AUM increased almost 10% year-over-year, driven by deployment as most of our AUM converts to fee-paying AUM once it is invested. Management fees and fee-related earnings increased 13% and 11% from the third quarter of 2017 respectively or up 11% and 18% for the first 9 months of the year compared to the same period in 2017.

As Mike stated, our third quarter realized income totaled $91.4 million, which translated into after-tax realized income per common share of $0.34. Over the first 9 months of the year, our realized income of $271.5 million translated to after-tax realized income per common share of $1.01, an increase of 19% year-over-year. This growth is almost entirely driven by the growth in our fee-related earnings, which accounts for approximately 70% of total realized income. As you may have noted, we are no longer highlighting economic net income in our earnings release, since we believe ENI as a measure that is less useful to investors and management. ENI does not reflect our investing style of realizing outcomes patiently and opportunistically, instead emphasizes the impact of quarterly mark-to-market fluctuations. Therefore we will focus our reporting, our current fee-related earnings and realize income measures going forward.

As Carl stated earlier, we declared a quarterly dividend of $0.28 per common share for the fourth quarter, consistent with our third quarter's level. As a reminder, along with our election for corporate tax status earlier in the year, we move to a level qualifying quarterly dividend that would be reassessed annually and pegged to the expected trajectory of our after-tax fee-related earnings. Our core fee-related earnings continues to grow against the stable dividend and our realized income in excess of our dividends, allows us to retain earnings for growth. We expect to announce our 2019 dividend levels at our next earnings call in February.

One of the key drivers of our future earnings is the embedded management fees we expect to generate from capital already raised, but that only pays management fees upon deployment. We ended the third quarter with another record amount of dry powder and shadow AUM. Our available capital totaled $34.4 billion, up 34% from prior year and our AUM not yet earning fees or shadow AUM, increased 75% from prior year to $25.8 billion. Of this $25.8 billion, approximately $21.7 billion is available for future deployment, with corresponding management fees totaling $233.3 million or approximately 29% of our last 12 months management fees. Approximately 90% of the management fees tied to AUM available for deployment with HR direct lending strategies with the deployment horizons ranging from 12 to 36 months. With this growth in future management fees, with an average fee rate of approximately 110 basis points, we also expect to be able to gain efficiencies in our margins through operating leverage. Please note, the $233.3 million in incremental management fees, does not include any potential ARCC Part I fees we expect to earn in the future, any management fees Ares Capital would earn above its 0.75x debt to equity ratio or the expiration of the $10 million per quarter Part 1 fee waiver at the end of the third quarter of 2019. As you may recall, Ares Capital has elected to increase its leverage capacity as permitted by the Small Business Credit Availability Act and the plans to increase its leverage over 1 to 3 year period to a new range of 0.9x to 1.25x, beginning in June of 2019, when its increased leverage capacity takes effect. Assuming ARCC's leverage reaches the midpoint of this range from current third quarter levels, we estimate that our future ARCC and Part I fees will provide an additional $100 million of incremental fees on an annualized basis, or $75 million above the amount included in the $233.3 million I referenced. Therefore, adding the $233.3 million to $75 million and the $40 million, totals approximately $350 million of potential future annual management fees or about 40% of our current run rate management fees.

Incentive-eligible AUM also reached a record high in the third quarter of more than $76.3 billion, up 26.3% year-over-year. Of that amount, $30.8 billion is not yet invested and available for future deployment, which is up more than 80% of our third quarter incentive generating total. Our incentive generating AUM of $37.2 billion, which is comprised of 72% in our credit strategies and 20% in private equity strategies, increased 71% year-over-year. Of the amount of incentive eligible AUM invested, over 80% is generating performance fees. I want to emphasize that our expected growth is not coming at the expense of stability. Our management fees continue to represent more than 80% of our total fees and are derived from locked-up, long-dated capital. Approximately 89% of our third quarter management fees were generated from permanent capital, CLOs or long-dated closed-end funds.

Before I hand the call back to Mike, I would like to provide an update on our corporate structure. As you know, we elected to be taxed as a corporation beginning March 1st of this year, but we did not undergo a complete legal conversion to a state law corporation. We have seen significantly greater institutional interest in our stock this year, approximately doubling the number of institutional investors as of the most recently available data, compared to the beginning of the year. However, we have not yet been eligible for index inclusion, which we believe will provide material passive demand for our shares. At this time we are progressing with our legal conversion to a state law corporation and we currently expect to be completed by November 30th of this year. We plan to structure the company's governance in a manner that we believe will meet eligibility requirements for certain stock indices, including providing voting rights for common holders through a multi-class high/low vote construct. We are still working through the details and there is no assurance, however, that we'll be included in any specific index.

Mike will now close with his thoughts on our historical and future growth.

Great. Thanks, Mike. Before opening the call up to questions, I'd just like to take a minute to share some concluding thoughts. As you can see from the numbers and quarterly performance, our business is growing at a double-digit pace and we continue to invest in new products, people and operating infrastructure to support our continued expansion. We believe our future is bright and the levers for future growth already exists in our current operating model, our shadow and incentive-eligible AUM and our current fundraising pipeline. Importantly, our clients continue to give us a greater share of their capital and with our expanding product suite, we have had our best fundraising year in our history.

As for the investment environment, we believe that we're well positioned for increased market volatility. We've historically grown our management fees through past volatile periods. In fact, we grew our management fees at a faster rate during the financial crisis in 2007 to 2009 than our historical growth rate of 19% over the last dozen years. This is largely because of our strength is distressed investors and the long life and flexible nature of our funds.

Our emphasis on self-originated assets positions us as a leader in each of our chosen markets. We believe that we're in a great place today with the depth of our investment professionals, global footprint, record available capital, flexible strategies and overall defensive positioning.

And so with that, we always appreciate your time and support. We'd like to open up the line for questions now, operator.

(Operator Instructions) Our first question will come from Michael Carrier of Bank of America Merrill Lynch.

Maybe first one, Mike, just on the credit side, so obviously you guys have seen great fundraising this year given demand for some of the products. I mean, there's obviously some concern just given where we are in the cycle and the amount of money maybe going into some of these new categories particularly with rising rates and depending on like the economic outlook. So just wanted to get your take on maybe what you're seeing from an industry perspective and then how Ares is kind of managing the current environment, whether it's how you're selecting the opportunities. I mean just how you're thinking about the underwriting, some of these credits as the environment gets a little dicier.

Yes, Kipp, I thought, did a really nice job talking about this on ARCC's earnings call yesterday, so I'll refer people to some of that conversation as well. But I'd highlight a couple of things. One, we talked about this in the prepared remarks. Scale in the credit business is a huge competitive advantage in terms of our ability to originate more flow and be more selective ultimately in the investments that we pursue and close. And as we've scaled our capital, we've actually been driving lower close rates and more asset selectivity. Two is, we've scaled, we've broadened out our product set that's allowed us to attack different parts of the market where we see inefficiencies. And three, and probably most important which we highlighted in the prepared remarks is given the amount of incumbent relationships we have, we've been very focused in continuing to lend deeper into portfolio companies where we have an existing relationship. And I don't think that the market fully appreciates the value of those embedded portfolios and if you look across the U.S. and European direct lending businesses as an example, we highlighted over 50% of the deal flow there is actually into companies where we have a pre-existing relationship. And the importance of that is, these are companies that have been in the portfolio for a number of years. We've been living with the company, developing a deep relationship with the management team. We've been seeing daily cash flows to the extent that we're a revolver lender, oftentimes we'll be sitting on or observing the boards. So there's just a level of comfort and conviction around those underwriting that it's hard to get, going to the market for a new issue. When we're not financing incumbent relationships, obviously, as I said, we have to have a little bit more caution and scrutiny. We have to be a little bit more flexible and nimble about how we are navigating the markets. So generally in our credit businesses, we are being more selective. We're moving up the balance sheet and pursuing more senior secured investments, probably taking a little less absolute return, but pursuing what we think is going to be the best risk-adjusted return through the cycle. And in our private equity strategies, we're being incredibly selective both in terms of the industries and the companies that we're investing in with a focus on durable franchise businesses where we see continued cash flow growth through the cycle. But it is a tough investment environment to say the least, I think, given our scale and flexibility, we're still finding ample opportunities to deploy capital into really attractive situations, but we're probably working a little bit harder to do it.

Then, Mike, maybe one on -- you kind of mapped out, I think on the management fees, whether it's the shadow AUM, the ARCC, whether it's the leverage, the waivers. There's kind of a lot of opportunity to grow the management fees over the next few years because some of that is predicated on deploying the capital like maybe taking the other side, meaning if we are -- if we continue to be in a favorable environment and like the deployment pace isn't as strong when I think about the performance fees, maybe if you can just give us some context of where the portfolio is particularly though that part that seasoned where we could see more exits over the next few years that could drive realized performance fees in the realized income?

Sure. Mike, you want to touch on that? Maybe a good place to start is just to give people a sense for the incentive-eligible AUM and a complexion there but...

Mike, I think, when we think about realization, let's think about 2 ways. For our credit business as you know, incentive fees are primarily driven by effectively the yield on those portfolios. So there's less of a -- what we call a multiple to cost that you have compared to private equity or real estate. So I think incentive fees on the credit business are more linear in fashion and as those -- all that capital we raise, starts seasoning as most of those funds are European salt waterfalls, will start seeing accrued performance fees increase near years, with realizations coming later. Legacy funds there will start generating their performance fees more meaningfully over the next couple of years. Then, if you look at where we are today with the -- our current balance of carry, the majority of it is represented by private equity and real estate. And if you think about debenture to those funds, most of our carry is comprised of our third and fourth corporate -- corporate opportunities funds and private equity. Our most recent European real estate fund, which we've now started raising the successor fund around. So all those funds are now out of investment period and are into harvesting period. I think the respective heads of those businesses would say, this remains a very favorable environment for realizations. So while it could be lumpy quarter-to-quarter, most of that carry sits in funds that are now in harvesting mode.

The next question comes from Gerry O'Hara from Jefferies.

Perhaps one on the outlook for private credit and direct lending, I clearly saw the $1.6 billion closed in the quarter, but curious to hear the impact, if any, really, on how rising rates have affected demand relative to perhaps kind of public debt and those instruments that are now offering or could potentially be offering higher yield in the future?

Sure. I'll give you my thought, and Kipp, if you feel differently. So I think there was a view early on in the development of the private credit space that people were allocating into the asset class largely because of the persistently low interest rate environment and the desire to generate excess return. What I will tell you is in the earlier days of the development of the asset class, we were seeing people allocate either out of their alternatives bucket into higher yielding, higher risk-adjusted return private credit or more aggressively out of their traditional fixed income books into private credit. What I will tell you as I sit here now, as people have gotten comfortable with the asset class in terms of the durability of the excess return opportunity because of the liquidity, complexity and private nature of the asset. With interest rates are rising, the total return on those assets is going up, given that they are floating rate instruments. And the allocations are actually increasing, I think, with the increased awareness that people have seen, and again, the durability of the premium that we get in the private credit space relative to the public space, we're not seeing people allocate away from private credit back in traditional fixed income as rates go up. So I think there may be some marginal segments of the market at the lower end of the return spectrum that may allocate back to traditional fixed income alternatives as rates go up. But I think as rates go up, you will see more people allocating from the lower end of their alternative basket into private credit to capture -- capture that premiums well. So we've been pleased with the flow of capital. I don't -- I don't expect it to reverse in our current experiences that we're actually seeing more people given the awareness of the asset class and what it can do, from a portfolio construction standpoint, we'd expect it to continue.

And then perhaps one for Mike McFerran as it relates to just sort of the fee-related earnings margin, kind of my math looking across the 3 main segments puts you sort of in the mid-to-low -- low-to-mid 50s for credit and private equity, but a little bit lower on the real estate side. Is it something that we might be able to expect to see that ramp a little bit or expand as you add scale or perhaps maybe you can discuss some of the puts and takes around what drives that margin for real estate?

Sure. Yes, your math is spot on. Real estate, and we've talked about this before, is a business that while profitable hasn't reached the same scale, clearly based on the size of our private equity or credit businesses. To that end, we think there's a lot of opportunity there as that is a fully built out business both on the investment side and on the support side around it. So we think as we're continuing to raise capital, we talked on the call about -- we're now raising for the first time private real estate debt funds. With the resources in place, we think there's a very high -- much higher margin associated with incremental management fees than with -- what we have in place today because the expense model is for the most part built out. So real estate remains a place where we think clearly was achieving higher scale. We could see meaningful margin improvement, which would drive obviously the overall firms margin growth, but clearly is a big source of opportunity.

And our next question will come from Craig Siegenthaler of Credit Suisse.

So the big driver of the C-Corp conversion was really to increase your shareholder base with active long-onlies and passive investors. And the passive investors are coming after the November 30th up-C conversion. But based on your estimates, was there a lot of long-onlies that needed the up-C conversion or the migration to state law Corp before they bought the stock or is the K-1 tax filing the bigger hurdle?

I think it's twofold. I don't -- I think removing the K-1s and the tax change on March 1st, removed the key obstacle for most institutions to participate. That being said, a lot of -- especially long-only money managers like to see the ability for passive. I think as they think about the sizing, or which funds they want to include it in. So, while I think we meaningfully opened up that institutional shareholder base, in addition to become an index eligible of the legal conversion, I think it opens up more meaningful broader interest on the institutional side that'll capitalize on what we've already done.

I think one quick just anecdotal comments Craig. Mike referenced in the prepared remarks. If you just look at the published ownership, you can see a meaningful shift in the ownership of the stock over the last 7 months to the types of investors that you're referencing, what's not shown in those numbers, but I can tell you anecdotally is the number of investor interactions in the long-only space that we're having now versus what we were having a year ago is dramatically different. Whether or not that converts obviously is TBD, but in terms of the interest in the company and the ability to own anecdotally, it's just been a huge tailwind for us in terms of the types of folks that we're now talking to.

And then just one last question. Can you guys comment on your plans to move the voting rights into the float, especially around timing, as we think about the Russell 1000 Index add deadline in May.

So, as we mentioned, Craig, in the prepared remarks, this conversion we expect to have done by November 30th, we are going to adopt the high or low vote construct, which we expect will have over 5% of the total vote in common hands, which we think meets the Russell requirements with a cushion below where we end up. Obviously, the Russell and different indices have different timing of when they re-balance and include new names. But by November 30, our structure will be there and the votes will be in people's hands.

And the next question comes from Alex Blostein of Goldman Sachs.

Wanted to follow up to the discussion around FRE margins. You talked about real estate specifically, but I guess taking a step back when you look at the organization as a whole, you guys are running at a 30% margin, give or take right now, and that doesn't even include DNA or equity-based comp. Your realization incentive fee comp rate is over 70% and then the industry is kind of in the 40% to 50%. So understanding you've been investing a lot, but taking a step back, is there something structural around Ares that prevents FRE margins expanding materially from here and ultimately what do you guys expect it to go, assuming you get to sort of scale across the key initiatives?

I will take it -- Mike, just a minute, I'll take a quick stab and then you can follow on. I think structurally -- there is nothing that is structurally constraining margins but 2 things that hopefully people appreciate, some of the competitive advantages that I talked about in our prepared remarks are because of the meaningful investments we've made in origination and people. And when you look at the position that we have in our markets, a lot of that is because of the office footprint and the investment we've made in people to continue to source proprietary deal flow. And I gave you the numbers just in the direct lending business alone which, I think, dwarfs the investment that most others have made behind some of these industry trends and growth markets. So what's structural in our business is a keen awareness and belief that investment and origination ultimately drives growth and performance. The second thing that's somewhat structural is because of the focus on credit, most of those funds are paying on deployed, rather than invested capital, but in order to go out with conviction around scaling the capital base, we have to hire those folks out ahead of the fees turning on and you can see that in the embedded profit potential that's represented by the shadow AUM. What's not shown, we don't talk a lot about it, but there is a constant focus on developing new growth areas at the firm as well, and when you look at the growth rate that Ares has been able to achieve relative to others in the market, it is a direct result of the investments that we're making in new strategic initiatives around the firm. Two examples that I mentioned in the prepared remarks are the growth in our opportunistic investment business, where we've added close to 20 people over the last year and a half out ahead of a new flagship fundraise. Those are meaningful investments that are hitting the P&L today, out ahead of those fees turning on. Another example, we mentioned in the prepared remarks is our shift into climate infrastructure and the investments we're making there to position that business for growth behind what we think is a very large market opportunity, and developing market trend. So there are some, I wouldn't call them structural constraints, but people should appreciate that the origination business is more people-intensive, and in the P&L are meaningful investments in future growth engines that are not being backed out. So lastly, I'd say, at various times in our history, we've had significantly higher FRE margins when we weren't focusing on investing in growth the same way that we are now. So I think that there is plenty of room to continue to grow -- grow the FRE margin behind these new growth areas as they mature, as we deploy capital, and as Mike mentioned, we do have subscale businesses like real estate where there's just an obvious embedded margin improvement opportunity as well.

Yes, the only thing I'd add to that -- Mike said was -- as we've been raising this amount of capital, we're now -- and since we're getting paid on the deployment of it, the expenses are coming in front of the revenue. We've touched on the call, the significant amount of management fees that's tied to what we've already raised, and that starts coming online over the next couple of years. We believe you will continue to witness a nice expansion in the operating margin. So we haven't -- we'll probably give you further color on that on our next call -- the fourth quarter, but I think today we can sit here and comfortably say, we'll be above 30% in '19 and expect that to continue to grow in '20 and '21.

And then a couple of just cleanup questions. So, fair to assume that you guys will stop reporting ENI and we should all be sort of thinking about the DE as the primary reporting metric going forward. And then, maybe just kind of clean up on...

Or IEAUM.

Sorry, yes. And then just thinking about the taxes, I'm assuming there is no implication on the tax rate given the legal change, but maybe just kind of clarify that and what should be the cash tax rate we should be baking in for you guys going forward?

So there -- first yes, the legal conversion had absolutely no economic implications, other than just paying for the paper to get it done. So, but it has no effect on taxes or anything else around our business. As far as tax rates go, we'll describe the business assuming fully converted on a 100% of common shares, because I think that's probably the easiest way to look at it. If you think about it this quarter, our effective tax rate on realized income was about 13.5%. As we've said in past calls, Alex, it's really going to be based on the mix of fee-related earnings to performance fees, but I think kind of assuming a mid-teens and if I was doing a model today, I think 15% feels like kind of a rational tax rate.

Got it, on a fully converted basis.

The next question will come from Robert Lee of KBW.

Mike, just kind of curious to me, you have a lot of new strategies, I guess, you're launching or going to be launching it. If you think of a new strategy and how -- your expectations around kind of first time fundraisers, I mean, I know it's obviously going to be strategy dependent, but how has that maybe changed versus a couple of years ago, just if I think versus 3, 4 years ago when you first went public, not as well known, not at scale. I mean the environment is certainly favorable for a lot of fundraising, so did your general expectations for your first time fundraise is higher today than it was couple of years ago. And at the risk of being too specific, do you consider successful first time fundraise being $750 million, [$500 billion] how do you kind of frame that?

So, it's a good question and it's going to be strategy specific. So the simple answer to your question is, yes, our first-time funds are significantly larger today than they were historically. And that's just a direct function of all of the investments that we've made in capital gathering globally that positions us to just have more investor interaction and a reflection on our continuing ability to invest in people and growth. Two great examples of that are PCS last year, which was our junior capital fund here in the U.S. where we had a first-time fund close to $3.5 billion. Another great example of that is our first U.S. senior direct lending fund, which as I articulated, we had originally targeted about $3.5 billion of total capital raise there for a first-time fund and that'll be closer to $ 4.5 billion plus. One thing -- I think it's important to appreciate that -- when we're talking about new strategies, these are all areas of the firm where we have embedded capability already, and it's very rare that we are going to go out within untested, unproven asset class or fund where we don't have track record and people that we feel confident can invest behind the opportunity. What we try to do and, I think, we've done it successfully is launched funds that sit adjacent to something that we already do well. So 2 of the things that we talked about in the prepared remarks were special opportunities and climate infrastructure. I think as people know, we have a very large power infrastructure business here at Ares that historically has focused on more traditional fossil fuel oriented power generation. That team's been in the market for 30 years and has been in and around the climate infrastructure renewable space throughout their tenure. All we're really doing is taking that embedded capability, adding people and resources to it to reorient towards a new market opportunity. Similarly, with the opportunities fund, we have a very significant distressed for control and distressed for not controlled practice here within our private equity business, but the ability to add new people and new product capabilities around the new fund launches is pretty straightforward for us. So I don't want people to have the impression that we are birthing strategies that don't sit adjacent to something that we already do well, and so when we're out with a "first-time" fund, it's typically in a part of the market where we already have a lot of track record and investor support, which obviously lets us go out with much more significant first-time fund sizes than other managers or where we were 10 years ago. And then, the only other thing I'll add because we've talked about it before, is in terms of investor behavior we have seen and we've been a big beneficiary of this that the larger institutional LPs are giving a greater share of their wallet to broad-based managers like us. And they're doing it to try to promote efficiencies in the way that they're allocating and managing their own capital. So we have seen an increase in check size, if you will from our larger LPs over time once you're on the platform. And as a result of that, you're able to launch larger funds with significantly more momentum coming from your existing investor base than we were able to do 10 or 15 years ago. And that's promoting at a -- faster speed to market and larger funds even for first-time strategies.

The next question comes from Chris Harris of Wells Fargo.

Mike, I appreciate your comments on how you guys are investing today in some of the strategies you're using. And I know it's difficult to address a hypothetical, but if market conditions stay like this and the cycle continues to extend, do you guys feel like you can continue to invest at the pace you have been?

Yes, we do as I mentioned, we're -- we are deploying. We have more people behind that deployment than we've ever had. We have more product and capability than we've ever had and as I said we're probably looking at more things and doing less, but given the breadth of the platform, we are absolutely comfortable and pleased with the risk-return opportunity that we're seeing in our business and we've been able to deploy pretty consistently.

Another follow-up question on the C-Corp conversion. I know you guys can't clearly know what the indices are going to do, but is there a reason why you potentially wouldn't be added to the eligible indices. I'm just trying to gauge what the risk might be, if you guys go through all of this, and then you just flat out not added, is that risk pretty close to zero?

Well, you kind of answered that question. You're -- we are clearly are doing this for one reason, which is to get into the indices. So you have to appreciate that we've spent a lot of time with different advisers and talking to the indices directly to make sure that we are structuring this conversion to lend itself to index eligibility. The reason we can't give guarantees of what indices we will be in is, we just don't speak for them or as the rules may evolve. But we have high conviction that we will be in the indices we expect to be in, and we're -- we're doing all of this to accomplish that goal.

I'd also say the good news is there are precedent conversions and companies in and around our peer set, but I think we've a pretty clear roadmap as to how the indices will view our proposed structure.

The next question comes from Kenneth Lee of RBC Capital Markets.

Just one on the insurance JV that was mentioned in the prepared remarks. We've certainly seen many insurance companies choosing to emphasize investments in illiquid, potentially higher yielding assets to mitigate spread compression. I'm wondering if Ares is creating a more generalizable platform to help service insurance companies and wondering if you could also give us some details on how Ares is earning fees within this JV.

Sure. So, there is a lot to unpack there and -- I'll try not to be too long-winded in the answer, but as we've talked about before, growth in insurance assets has been a focus area here at Ares for quite some time. We've had an insurance solutions team here for 5, 6 years. The focus of that team has been around multiple areas. One is, as we highlight with the joint venture developing unique product and partnership opportunities for our larger insurance company partners to achieve some kind of an investment outcome that they can achieve in the liquid markets. This most recent JV is a good example of that, but people are probably familiar with the JV that we have with AIG and another insurance company within our direct lending group that's investing behind a similar need for insurance company clients as well. So it's just focusing on productizing our capability set for insurance companies. Insurance companies continue to be a core consumer of our core alternative product, and so they've been consistent and meaningful investors in our core products across the spectrum of what we do. We have been investing behind some interesting [IDS] products that's been a nice growth area for us. And as you've seen with some of our peers, there continues to be an opportunity within the fixed-indexed annuity business as well as the closed block life business to acquire liabilities that are a good match for some of the alternative investment strategies that we do here. And we are executing on all of those fronts. Insurance company assets today represent about 10% of our aggregate AUM. It's probably been our fastest growth market maybe second to pension funds, but depending on the time frame. So a big growth area for us and as you highlighted, it's really a -- there is a comfort generally in the insurance market with fixed income product, but there is a general lack of awareness and lack of consumption of floating rate alternative credit product, and we've just seen a big shift in that market and it's been a big boon to growth. In terms of how we get paid, it really, it depends on the nature of the product and the joint venture. Sometimes, it's a simple management fee, sometimes it's going to be an advisory fee where we see benefits of accessing their balance sheet in other parts of our business. So it's really all over the map, but the value of partnerships like the one that we referenced here and we saw this with our SDLP relationship and direct lending is through partnerships like this, we can aggregate a scale of capital in certain segments of the market where we think that scale is a big origination advantage and can be pretty disruptive. I think we demonstrated that in the direct lending business and our hope is that we can do it in other parts of the business as well. The only other comment, I'll make is that $3 billion in the joint venture isn't reflected in our AUM numbers until it's invested. And so, while we've had some early successful investing, you'll see those assets come into our AUM metrics over time as we deploy.

And just one quick follow-up if I may. Any updated expectations on potential asset growth through the remainder of the year given that you guys have already cleared the $125 billion AUM that was previously mentioned?

Yes, we talked about this on the last call. It's hard to tell just given the timing. But given what we've closed quarter-to-date, we're likely to be at or above $130 billion by the end of the year.

The next question comes from Michael Cyprys of Morgan Stanley.

just wanted to follow up on the governance changes. If you could just talk a little bit about more broadly what governance changes you're making, if there's anything beyond the 5% voting. And then, which indices specifically are you targeting for inclusion, and how many shares do you think could be eligible for them to purchase?

So I'll take that reverse order. On the number of shares to purchase, I think there's 2 pieces. So there's the direct investment from the indices, as well as what we call shadow purchasing from investors that are looking to replicate those indices or buy you because you're included in them. So it's hard to quantify. We've seen certain others in our industry, continue to have growth in their passive ownership from single digits into the high teens in the last several months. So it's really hard for us to measure, but we think it's not insignificant. On which indices, the ones we're most focused on are the Russell, which we think could be the most significant to be included in the near term -- the CRSP and the MSCI, which we think will probably be the smallest of the 3, but I think the Russell is clearly the most important one for us in the foreseeable future. How the governance changes the way we're structuring, the high or low vote construct is, it will be comfortably above 5% of -- in the public's hand. So we feel good about that, but it also enables us to replicate and maintain existing control with having that common vote there. And as far as details of the classes and the high/low ratio, we will have all that out publicly no later than November 30th and probably sooner.

Yes, I'd just add, this is Carl, I would just add on the CRSP, it does have a quarterly reconstitution in December and March. So those are some dates coming up as well.

And just a follow-up question on index inclusion, but with respect to your BDC, I understand there's an application in front of the SEC that can make it easier for the indices to include BDCs in an index. So just curious if you could talk a little bit about this, what your expectations are, and which indices do you think would be more likely to include BDCs?

Yes, this is Carl, again. In terms of BDC inclusion, the current indices have a definition that excludes BDCs. If the AFFE exemptive application were to be approved, we believe it may trigger a review for those indices and that would create further discussion with the indices. But that's the -- the key element is to actually get the AFFE exemptive application approved first and then have the discussion with the indices.

We could go back, Michael, and look historically what indices we were in before we got the index, I actually don't know off the top of my head what we were in.

We were in the Russell 1000.

When we got the index but it was definitely in the Russell 1000 and a number of others. We can handicap it. I will say, just having spent a lot of time in and around the Small Business Credit Availability Act, I think the receptivity at the SEC to this issue is as good as we've ever seen it and the fact that the exemptive order or the application for exemptive relief was welcomed. I think it was a meaningful change in tone around the specific issue. So while we can't guarantee if and when it would happen, just having kind of been on the front lines of this for many, many years, we have never seen such a constructive tone coming from the regulators on this issue. So we're cautiously optimistic.

And the next question will come from Ken Worthington of JPMorgan.

Michael, just got the last of my question. So, everything else has been asked and answered.

And next we have a follow-up question from Michael Carrier of Bank of America Merrill Lynch.

Just real quick just on the private equity side, I know we saw the publics that had some negative performance, obviously getting a little lift today, but just on the private side, just wanted to get some color on how the trends have been, maybe the performance of private equity like ex the publics in the quarter, just to get some context on the outlook.

From a performance of the -- performance of the company has actually been quite good. Obviously, you can see Floor & Decor in the third quarter was a big driver of that underperformance in the PE portfolio. Ex Floor & Decor, the portfolio was actually up 3.5% in the quarter. And if you look at the ratio of -- marks that go up versus marks that are down, it's a very, very highly in favor of marks that go up. So performance is very good and the underlying portfolio prospects for exits are very strong. I would say unlikely you see anything material in the fourth quarter, but we're actively looking at exits in the first quarter and second quarter going forward.

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

We appreciate everybody's time today and for all the thoughtful questions and we look forward to continuing to execute against the plan and give you guys an update on the fourth quarter early in the New Year. Thanks again.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be made available through December 1, 2018 by dialing (877) 344-7529 and to international callers by dialing 1 (412) 317-0088. For all replays please reference conference number 10124524. An archived replay will also be available on a webcast link located on the homepage of the Investor Relations section of our website.