Ares Capital Corp

NASDAQ:ARCC

Earnings Call Transcript 2018-Q1

[Operator]

Good afternoon. Welcome to Ares Capital Corporation’s First Quarter Ended March 31, 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Wednesday, May 2, 2018.

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

[John Stilmar, Investor Relations]

Thank you, Austin and good afternoon everybody. Welcome to Ares Capital Corporation’s first quarter ended March 31, 2018 earnings conference call. At this time, all participants are in a listen only mode. As a reminder, this conference is being recorded on Wednesday May, 2, 2018.

Let me start with some important reminder. Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of such words as anticipates, believes, expects, intends, will, should, may and similar such expressions.

The Company’s actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in its SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results.

During this conference call, the Company may discuss core earnings per share or core EPS, which is a non-GAAP financial measure as defined by the SEC Regulation G. Core EPS is the net per share increase or decrease in stockholders’ equity resulting from operations, less professional fees and other costs related to the acquisition of American Capital, realized and unrealized gains and losses and any capital gains, incentive fees attributable to such realized and unrealized gains and losses as well as any income taxes related to such realized gains or losses.

The reconciliation of core EPS to net per share increase or decrease in stockholders’ equity resulting from operations to the most directly comparable GAAP financial measure can be found in the accompanying slide presentation for this call by going to the Company’s Web site. The Company believes that core EPS provides useful information to investors regarding financial performance, because it is one method that Company uses to measure its financial condition and results of operation. Certain information discussed in the presentation, including information related to portfolio companies, was derived from third-party sources and has not been independently verified and accordingly, the Company makes no representation or warranty with respect to this information.

As a reminder, the Company’s first quarter ended March 31st earnings presentation is available on the Company's Web site at www.arescapitalcorp.com by clicking on the Q1 2018 Earnings Presentation link on the homepage of the Investor Resources section of the Web site. Ares Capital Corporation’s earnings release and 10-Q are also available on the Company’s Web site.

I will now turn the call over to Mr. Kipp deVeer, Ares Capital Corporation’s Chief Executive Officer.

[Kipp deVeer, Chief Executive Officer]

Thanks a lot, John. Good afternoon and thanks to everyone for being with us today. I’m joined by members of our management team, including our Co-President Michael Smith; our Chief Financial Officer, Penni Roll, and other members of the finance, investment and investor relations teams. You will hear from Penni and Michael later in the call.

Let me start by reviewing our first quarter results. And afterwards, I will provide some thoughts on the current investing environment and a brief update on the American Capital transaction. This morning, we reported strong first quarter core earnings of $0.39 per share, which is our fourth consecutive quarter of sequential core earnings improvement since the first quarter of 2017 when we closed the American Capital acquisition.

Our core earnings exceeded our quarterly dividend and represented an increase of more than 20% in the same period a year ago. The improved sequential earnings were driven by higher yields on the investment portfolio as we benefited from continued portfolio rotation initiatives and from increases in LIBOR. We’re also able to generate another quarter of great GAAP earnings, which totaled $0.57 per share as a result of the strong net appreciation in our investment portfolio, which increased net asset value. We believe our continued ability to generate these incremental earnings from strong investment performance further distinguishes us from other BDCs in the marketplace.

Let me change course and provide an update on the current market conditions. Market terms continue to be challenging with many aggressive participants willing to provide high leverage to companies along with looser documentation and structures. We’re not immune to this. However, we do believe we see a much broader opportunity set than our competitors and as a result, are able to selectively invest in what we believe are more attractive situations with better risk-adjusted returns.

We use our long-standing relationship, flexibility of our capital and large commitment sizes and final hold capabilities to differentiate ourselves in a more competitive situation. We currently are only closing on about 3% to 4% of the transactions we review for new companies and we continue to stress-backing our strongest incumbent borrowers. For example, in the first quarter, we reviewed more than 330 new portfolio company transactions, and we closed 12.

We continue to use our platform significant informational advantages to lend the leading non-cyclical businesses with attractive growth prospects and strong sponsorship. Michael will provide more color on our recent investment activity later in the call. But we remain vigilant in an admittedly tough market with a focus on companies with the strongest fundamentals, while maintaining the integrity of our loan structures and documentations through our investment process. This is not our first time managing through these types of markets.

As a reminder, we have a very experienced long tenured team that’s been together a long, long time, every member of our eight person investment committee has spent more than a decade investing together here at Ares.

Before I turn it over to Penni, I’d like to provide an update on American Capital. Since our initial acquisition of the $2.5 billion portfolio that we closed in January 2017, we received more than $1.5 billion of principal proceeds from excess and repayments, including cumulative net realized gains of $91 million, and we’ve generated an asset level gross realized IRR in these excess of more than 20%. The remaining ACAS portfolio was $1.6 billion at fair value at March 31, 2018, which includes $271 million of net unrealized appreciation. The remaining portfolio also includes $1 billion of fair value and lower non-yielding non-core assets, which provides us more opportunity going forward.

Now, let me turn the call over Penni to provide some more detail on the financials and the balance sheet.

[Penni Roll, Chief Financial Officer]

Thank you, Kipp and good afternoon. As Kipp stated, our basic and diluted core earnings per share was $0.39 for the first quarter of 2018 as compared to $0.38 for the fourth quarter of 2017, and $0.32 for the first quarter of 2017. Our basic and diluted GAAP earnings per share for the first quarter of 2018 were $0.57, including net gains for the quarter of $0.23 per share. This compared to GAAP net income of $0.54 per share for the fourth quarter of 2017, and GAAP net income $0.28 per share for the first quarter of 2017, which was reduced by American Capital related expense of $0.06 per share.

As of March 31st, our investment portfolio totaled $12.2 billion at fair value and we had total assets of $12.7 billion. At the end of the first quarter, the weighted average yield on our debt and other income producing securities at amortized costs increased to 10.1% and the weighted average yield on total investments at amortized costs increased to 8.9% as compared to 9.7% and 8.7% respectively at December 31, 2017. The total yield increased since the end of the fourth quarter, primarily due to the increase in LIBOR.

We experienced net unrealized appreciation on our portfolio of $84 million in the first quarter supported by the fair value increase in our investment in Alcami, which was driven by the Company’s strong performance. In total, we reported net realized and unrealized gains on investments and other transactions for the first quarter of $98 million. Our current dividend remains well supported by our core earnings and our spillover income. We currently estimate that undistributed taxable income carried forward from 2017 into 2018 will be approximately $346 million or $0.81 per share. The second quarter dividend of $0.38 per share is payable on June 29, 2018 to stockholders of record on June 15th.

Moving to the right hand side of the balance sheet. Our stockholders’ equity at March 31st was $7.2 billion, resulting in net asset value per share of $16.84, an increase compared to $16.65 a quarter ago and $16.50 per share, a year ago. During the first quarter, we’ve remained proactive in managing our liabilities and in particular, we issued our longest dated institutional investment grade notes in a $600 million transaction priced at 4.25% coupon and maturing in seven years. Given the continued increase in interest rates, we are pleased to have opportunistically completed this longer debt issuance at very attractive pricing.

In addition, during the first quarter, we repaid $270 million of 4.75% convertible notes at their maturity in January. For the remainder of 2018, we have $750 million maturing later in the year. Given the significant unused capacity under our revolving credit facilities after having issued a significant amount of term debt over the past nine months, we have plenty of liquidity to repay this maturity without needing to access the term debt market.

At the end of the first quarter, we also amended our revolving credit facility to increase the facility size by $25 million to a total of $2.13 billion, extend the maturity and reinvestment period by one year and reduce the borrowing base driven interest spread grid from 1.75% or 2% to 1.75% or 1.875%. Note that the reduction in the grid pricing doesn’t impact our current spread as we were already borrowing at the low end of the range at 1.75%.

As of March 31st, our debt to equity ratio was 0.73 times and our debt to equity ratio net of available cash of $254 million was 0.69 times compared to 0.7 times and 0.66 times respectively at December 31, 2017. Our total available liquidity at the end of the first quarter was approximately $2.8 billion.

Our balance sheet continues to be asset sensitive and a further rise in short-term rates should benefit our earnings. For example, using our balance sheet at March 31st and assuming an up to 100 basis point increase in LIBOR, our annual earnings excluding the impact of income based fees, are positioned to increase by up to approximately $0.21 per share.

And now with that, I’d like to turn the call over to Michael.

[Michael Smith, Co-President]

Thanks Penni. I would like spend a few minutes reviewing our first quarter investment activity and portfolio performance, and then we’ll provide a quick update on post quarter end activity and our backlog and pipeline.

During the first quarter, we used our scale, relationships, and extensive market coverage to originate $1.8 billion of new investment commitments, while remaining highly selective and consistent in our investment approach. Excluding the $263 million investment in Ivy Hill, which I will discuss momentarily, we made 33 new commitments with initial fundings of $1.2 billion. Approximately 60% of these new investments were to incumbent borrowers and more than half of these investments were in first lien secured positions.

At quarter end, our portfolio reached $12.2 billion, consisting of more than 350 different borrowers. The size of our portfolio provides us with a significant advantage as our incumbency often enables us to support the additional capital needs of our best borrowers as they seek to grow. Providing capital in these types of situations, we believe, has been an important contributor to our long-term investment outperformance.

For example, during the first quarter, we committed to $355 million first lien loan in supportive Starr Investment’s acquisition of ACA Compliance. ACA provides risk management and technology solutions focused on regulatory compliance, performance, financial crime, and cybersecurity to over 2, 800 clients. ACA was a portfolio company of Ivy Hill. Based on our relationship with the company, as well as our ability to commit the full transaction, we are awarded this investment opportunity in a franchise business in a non-cyclical industry. This example underscores part of the strategic value that Ivy Hill brings to ARCC, and allowing ARCC to have broader positions of incumbency to support future origination opportunities.

That brings me to our investment in Ivy Hill that we made during this quarter. As Mitch mentioned on last quarter's call, in Q1, we closed on the purchase of a roughly $1.4 billion portfolio of senior secured loans from Pacific Western Bancorp as the bank decided to exit middle market lending during the first quarter. The transaction was consummated predominantly at Ivy Hill with the support of a $263 million debt and equity investment from ARCC.

Given Ivy Hill’s strong market presence and firm market conditions, Ivy Hill successfully priced $1 billion middle market CLO, which included most of the acquired loans on favorable terms. With this execution, we expect our additional equity investment in Ivy Hill will generate a comparable level of dividends compared to our existing equity investment, while also providing further incumbent positions to support future investment opportunities at ARCC.

Shifting to the portfolio. Performance continues to be strong in our underlying companies. As of March 31st, ARCC’s portfolio companies continue to generate solid growth in their aggregate earnings as the weighted average EBITDA growth over the past 12 months increased to approximately 7% compared to the approximate 6% LTM growth rate last quarter. We also saw reduction in the number of companies on non-accrual. During the first quarter, we had three companies come off of non-accrual compared to one new non-accrual investment. At the end of the quarter, non-accruals as a percentage of the total portfolio at cost, decreased to 2.7% as compared to the fourth quarter 2017 at 3.1%. Non-accruals at fair value also declined to 1% in Q1 2018 from 1.4% in Q4 2017.

Before I turn the call back over to Kipp, I would like to provide some brief comments on our post quarter end investment activity. From April 1st through April 26th, we made new investment commitments totaling $736 million and exited or were repaid on $362 million of investment commitments, while generating approximately $2 million of net realized gains. Finally, as of April 26th, our total backlog and pipeline stood at roughly $755 million and $105 million respectively. As always, these potential investment opportunities are subject to approvals and documentations, and we may actively sell or syndicate post closing. Please note that there is no certainty that these transactions will close.

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

[Kipp deVeer, Chief Executive Officer]

Thanks, Michael. In closing, we’re really pleased with our first quarter earnings. We’re well aware that many investors have been waiting for our core earnings to revert to a level where it exceeds our dividend. We’re pleased to have crossed that bridge this quarter. In addition, strong realizations continue to help us build net asset value and the total return proposition from the ACAS acquisition is providing a nice tailwind.

We continue to manage the Company in what we believe to be a prudent fashion than in the same manner that we’ve operated over the last 14 years. And we believe that serve us well even if the environment becomes more difficult. And I almost forgot one last item before we turn it over to Q&A. As most of you know, the Small Business Credit Availability act was signed into law in March. The law includes a provision that allows the BDC to achieve significant regulatory relief by increasing the asset coverage ratio required to BDC is 200% to 150%. Or said another way, it increases the debt to equity limitation from 1:1 to 2:2.

As we stated in press release that we issued last month, we believe this regulatory release is significant positive for the industry as widening the leverage limitation improves the risk profile of our company. Very simply if no other action is taken by a BDC other than adopting the change in the asset coverage ratio, the probability of default for all of our lenders decreases. In addition, we believe this relief may allow for added flexibility in the asset side by extending the portfolio into lower risk senior debt investments.

As for the new laws impact on ARCC specifically, we’re carefully considering the next steps. We’ve begun to engage with banks, rating agencies and other key constituents. I want to emphasize that we’re considering a range of options, and we’ve made no decisions about where we are headed nor do we have any formal action in front of our Board of Directors regarding new legislation. We will be happy to answer some questions on this call, but please understand that there will be many topics related to this new legislation that we’re still evaluating and therefore, not a position to comment on at this time.

Thanks for your understanding, your continued support of Ares Capital. That concludes our prepared remarks. Operator, would you open the line for questions?

[Operator]

[Operator Instructions] And our first question today comes from Jonathan Bock with Wells Fargo Securities. Please go ahead.

[Jonathan Bock, Wells Fargo Securities]

Kipp, my first question will just center on the investment environment. In particular, in the more senior lower risk bucket that you outlined as a forthcoming opportunity. Would you be able to give us a sense of what the all-in spread returns are in that market right now? What you and Mike and the team are seeing across on a return basis that’s just the first part of the question? The second part of the question would be, what's the financing costs generally on those types of assets?

[Kipp deVeer, Chief Executive Officer]

Through middle market, call it $50 million of EBITDA, bank debt, LIBOR 400, would probably be the middle of the range. And there are some nuances to whether it’s rated or its unrated sub-deal, et cetera. But with LIBOR wherever it is now 2.8%, the all in return on assets is about 6.5% depends on how you book fees or think about fees too, which would obviously increase that number. We tend originate a lot of our deals, as you know, and that number goes up with higher origination fees.

So cost of financing is an interesting one for sure. And I think you know where outstanding debt has been issued both secured or unsecured. So I think we did more of that, we do it by drawing down under our bank facilities, which is generally rough number is 4% money today. The cost from most of our recent fixed debt issuances have been 4% or below these rough number. But what is interesting is in the expanded leverage context really don't know if we went there, what the cost of our borrowings would be, would they change, would they not. We’re substantially over collateralized relative to our existing senior debt today. I’d make an argument that we should have lower cost of financing based on the amount of assets that we’ve pledged against that.

The only other data point that might be useful for you is thinking about some of the reasons CLO issuance. I did have a chance to listen to your call, whenever it was a couple of weeks back where you laid out a couple CLOs and Ivy Hill and Terry's, some others have done some middle market CLOs of scale where the costs of financing there has been lower than all of that. And you’re talking about blended LIBOR plus 160 type numbers, so call it 3.5%-ish. So hopefully, that gives you some context.

[Operator]

And our next question comes from John Hecht with Jefferies. Please go ahead.

[John Hecht, Jefferies]

Maybe just diving a little bit into portfolio, I saw you had a pretty big increase in the number of portfolio companies from 314 to 360. I am wondering was there -- whether there's some movement in definitions there, or would you guys manage to have a successful quarter of bringing in new borrowers?

[Kipp deVeer, Chief Executive Officer]

It’s actually related to the jump transaction and a lot of its associated revolvers.

[John Hecht, Jefferies]

And then just similarly though, and Mike talked about the pick-up in EBITDA in the quarter. I wonder -- your average company EBITDA is up pretty good pick-up in that item. Is that organic? Is that mix shift? I wondered if you could talk about the transition within the portfolio of companies.

[Michael Smith, Co-President]

Nothing new and different, we closed the transaction with a very large company called air medical, it’s a business we’ve known for a long time here at Ares, very, very large $500 plus million of EBITDA, public company et cetera. So that skewed the number up. If you exclude that for Q1, the average EBITDA number is about $64 million, which relative to Q4’17 of $62 million doesn’t represent much of the change. So it’s literally a single name.

[John Hecht, Jefferies]

And final, Kipp, I am wondering if you could just give us some color. I mean you’ve talked a fairly competitive market. Where do -- have turns changed, have covenants changed? I realize spreads have changed with the benchmark rates and so forth. But any commentary on what you’re seeing on the marginal deal at this point?

[Kipp deVeer, Chief Executive Officer]

I would say that more than spreads coming in, which we really haven’t seen. And again, we’ve seen yields expand largely because of the increase in LIBOR. We’ve seen just all-around need for weaker underwriting. So more covenant light, lower quality, earnings being financed, value loss adjustments being financed to high multiples, structural loosening of all sorts of provisions and documentations, provisions for restricted payments that we haven't seen before, capital structures that allow for layering of debt, covenants that actually don't decline if they exist. So people -- that will give you a 9 times leverage covenant forever, which is a new invention in today's market, so just all sorts of things that we don't think represent particularly sound underwriting metrics.

[Operator]

And our next question comes from Rick Shane with JPMorgan. Please go ahead.

[Rick Shane, JPMorgan]

Penni, you made the point that you have the capacity to fund the 2018 maturities, the November of ’18 maturity off the revolver. That’s absolutely true. But when we look at what you just executed your seven year deal at and think about what the forward LIBOR curve looks like. It strikes me that terming out more of your financing should be pretty compelling. I'm also wondering in light of the potential of increasing leverage over time, whether it makes sense to get ahead of that given how attractive the financing is currently?

[Penni Roll, Chief Financial Officer]

I think you make a good observation. If you think about my comment, I was really commenting in the context of our resolution of maturities for this year is basically done. So we have no risk of repayment. But as we always do, we constantly look at the markets. We look at the interest rate environment. And we look to see where we can opportunistically issue new debt into the capital markets, and that’s something you will continue to see us assess and do as we move forward. So I don’t think it’s a statement of saying we won’t to do something if we have the right market, it’s really just a statement of saying we don't need to do anything.

[Rick Shane, JPMorgan]

It was funny when he made the comment as one parent to another, I thought it’s the difference between nice to have and need to have in that conversation.

[Penni Roll, Chief Financial Officer]

Exactly, so always like to go to the markets when it’s really a nice time to go where we have good positive dynamics to effectively and efficiently issue capital, and that’s been our history and that’s what we’ll continue to strive to do.

[Operator]

And our next question comes from Allison Taylor Rudary with Oppenheimer. Please go ahead.

[Alison Taylor]

So two questions, I noticed that the Ivy Hill dividend stepped up from $10 million to $13 million. And I wanted to ask how we might think about that going forward. Is that a new steady state? Is there opportunity for that to go up as new things might come on there? And then my follow-up would be, there are still few million dollars costs related to ACAS going to the portfolio and I am wondering -- going to the P&L. And I am wondering, if those are relate -- are those still -- how do we think about those rolling off? Are they related to the portfolio transition or might those stick around for the next few quarters?

[Penni Roll, Chief Financial Officer]

For that we continue to see, I would call it, circling of ACAS related expenses that are primarily portfolio related. So certain expenses are coming through related to certain portfolio companies, we are presenting that expense through this line item. So there may continue to be a modest amount of related expenses as we go forward that we’ve broken out. But the more significant, like operational expenses and things that we were incurring last year, are behind us.

[Kipp deVeer, Chief Executive Officer]

And on Ivy Hill, Allison, I think we increased the quarterly 10 to 13 this quarter. It’s likely I would say to go up from there and that we’re waiting until the closing of this CLO at Ivy Hill, which enhances the economics of our investment in that transaction. So I would say we’re conservative for Q1 on the 13 number. I don’t think we completely settled on where we were headed from a perspective number. I expect it to be a little bit higher. But if you give us second quarter, we’ll come out and lay number after all that and it’s more representative of what you expect going forward.

[Operator]

And our next question comes from Ryan Lynch with KBW. Please go ahead.

[Ryan Lynch, KBW]

If I look at commitments you guys made in this quarter $1.8 billion as well as what you guys have done quarter-to-date about $700 million have a pretty good backlog of about $800 million. If I compare that your comments, talking about very competitive environment, can you just get investors comfortable with the amount of deals and originations you guys are putting on the books today in contrast to what you guys speak of as a very competitive environment?

[Kipp deVeer, Chief Executive Officer]

I don’t know if I can get you guys comfortable, but we’re comfortable. It’s a tough question to answer. I think we’ve been incredibly selective. We think that we’ve got a long history of being able to pick the right credits. We’re focusing on doing deals that we think have very little business risk, is the most important things. It’s really a market where right on credit is going to be exceptionally important. So a continued emphasis on incumbent borrowers or new deals, something like in air medical, I hold out as a very large public company that has $500 million of EBITDA. We’re excited about opportunistic deals like that where we’re able to write big checks. But I don’t know how to get you comfortable and others comfortable other than to say we feel comfortable with what we’re doing and despite the market conditions.

[Ryan Lynch, KBW]

One question on SDLP, it looks like your guys investment commitments shrunk a little bit this quarter. Can you guys just talk about what is the growth potential outlook for the SDLP? And then also related to the 2:1 leverage, I would assume that if guys do eventually end up passing that a lot of the loans that could fit in the SDLP could potentially now fit on your guys’ balance sheet with additional leverage. So I guess how are you guys thinking about potentially growing that if you guys do start to put some more lower risk loans on your balance sheet with the 2:1?

[Kipp deVeer, Chief Executive Officer]

Again, I don’t know if that falls into the question we’re not going to answer, so to speak today. But I’d just say that the SDLP remains a very important strategic partnership and program for the company today and so as Ivy Hill. As of this moment, we have no interest or desire or intent to change the way that we’re deploying in that program. Beyond that, I really don’t have a whole lot to add.

[Operator]

Our next question comes from Robert Dodd with Raymond James. Please go ahead.

[Robert Dodd, Raymond James]

So on obviously the double leverage issue. Given you guys were one of the strongest voices lobbying the double leverage provision over the last six plus years, so that’s been ongoing. One, is it a foregone conclusion you are going to ask for it. And the question then is how long is it going to be before do you think -- before the review of your options is complete and the Board is presented with a recommendation one way or the other?

[Kipp deVeer, Chief Executive Officer]

So I think we’re moving along at where we think is patient and judicious pace -- I don’t think we’re going to provide anybody on this call a timeline for if and when we chose to make any changes to the way that we operate the business. But certainly, if we do that we’ll let you know. I don’t think it’s a foregone conclusion. I’ll just make a few observations, because while we’re believers that putting additional leverage on these assets actually wouldn’t put undue financial risk on our company. And when we look at other financial institutions, investment in these types of assets almost all of them have substantially higher leverage than we do, that’s 0.7: 1.

So the reason that we’ve been supportive is that we thought it would increase operational flexibility of the company, widen the fairway so to speak, in terms of our ability to invest. And we feel safer albeit at lower return first lien assets. Some of the things that have happened since the passage of the legislation it surprised us. I think as you are aware, we have an investment grade rating in our company that we feel fortunate to have. We’d like to maintain and use we feel as a competitive advantage to low cost financing against the assets.

And some of the considerations there or some of the observations there perhaps are different than what we might have expected. We would have expected that the relapsing of a debt covenant and loosening, so to speak, of the regulatory regime that we’re under would have actually created a safer, better credit profile for a lot of our lenders. And certain folks in the ratings community have viewed it differently, perhaps differently than we might have. And we’ve had some conversations as you’d expect with them.

So look we’re in the process of taking in all of these variables today to think about where we go from here. And we’ve got a lot of options and we don't take the decision lightly and certainly want to think about our shareholders’ best interests and have a good solid in-depth conversation with our Board. So I definitely would not call it a foregone conclusion. And again, we’ll revert back to you guys when we have more comfort in getting to a conclusion.

[Robert Dodd, Raymond James]

If I can just -- second question. Obviously, on the nonqualified bucket, you had 13% right now, so it’s underutilized already today, relatively speaking. So if you do double average, so obviously in the non-qualified bucket we’ll see even greater relative to the size of your equity base, because it’s a percentage of asset. And when people took the SDLP and some of the other non-qualified type assets, the return on assets can obviously be considerably above the 6.5 that we see in middle market lending. So just general question about -- are you reviewing how to utilize the non-qualified asset bucket right now? And would if, the caveat only if double that but you do go forward with double leverage, would that further alter how you would utilize the non-qualified bucket?

[Kipp deVeer, Chief Executive Officer]

I think your observation is the right one. One of the things it is nice about the non-qualifying 30% number is that we can use it in ways that we’ve obviously used it in the past to enhance the return on equity at the company. So I think we’ll continue to do that. If the balance sheet was larger and we had a larger basket, I think we’d continue moving towards the goal of increasing utilization there. So I think it continues to tick up.

We’re always trying to find, as we’ve talked about on past calls, interesting new things that we can bring to the benefit of the shareholders, and Ares Ca Corporation, with particular focus on other things that we’re doing here at Ares that ARCC may not be getting the benefit of. So we’ve highlighted some examples that in the past and those things, as well as many others are definitely in the lab.

[Operator]

And our next question is from Chris York with JMP securities. Please go ahead.

[Chris York, JMP securities]

So the first question is a clarifying question. What do you think the ROE potentially is at Ivy Hill after the close of the CLO? And then maybe Michael, your comments that the run rate will be comparable -- the dividend run rate will be comparable to previous period, a function of yield or is another metric?

[Kipp deVeer, Chief Executive Officer]

I think we’ve always -- Ivy Hill, we’ve always targeted a low to mid-teens return on. And I think we’re moving back even with the substantial increased investment there, so to the same territory back to Alison’s question as to when we cover off the Q2 dividend and what it looks like on a run rate basis.

[Michael Smith, Co-President]

It’s on a yield basis based on the equity investment that we made into Ivy Hill. And given the execution of the CLO, which were on very favorable terms, we think we can generate the yields that Kipp just mentioned in that low teens rate. And hopefully, as Keith mentioned earlier, increase that dividend back to ARCC from Ivy Hill.

[Chris York, JMP securities]

Low teen, so 13, 15, and it’s what I was thinking. And then next question is on portfolio management. Depreciation Alcami has obviously been a very welcome event to investors. But it has created a situation with the top two investments at 4.4%, and then I think the other first and third are two diversified portfolios. So I am curious whether you are comfortable with the concentration to the single investment and then are there any other steps that you could be taking to reduce the concentration?

[Kipp deVeer, Chief Executive Officer]

Alcami has been just a really, really strong performer just a real pleasant surprise. It’s a company that we acquired obviously with the working capital portfolio. And look I reminded somebody that it’s been a while when we first started working on that transaction, it was Christmas 2015, which seems like a long time ago. So company was in a very different place in terms of its profitability and its operating metrics, and all that. And we don’t talk all that often about single portfolio companies. So we have really, really clearly based on the number of strong management team there that continues to do just a fabulous job with that company, so resulted in a lot of unrealized appreciation to-date.

While there is a debt component there, the unrealized depreciation is, of course, largely due to the fact that we control business today. And I think as you’re aware, we’re not really a BDC that likes to operate as their control owner of portfolio companies. So I think to mitigate that concentration in time, you'd likely see us be a seller. But the performance there has been so strong that we felt that it’s been the right thing to do for shareholders to hold onto it here over the last couple of years, let the management team do their thing.

[Operator]

Our next question comes from Terry Ma with Barclays. Please go ahead.

[Terry Ma, Barclays]

Just wanted to touch on the lending environment a little bit more we’re now more than a full quarter after tax cuts. Just wondering if you've seen any change in appetite from borrowers or your portfolio companies for debt capital?

[Kipp deVeer, Chief Executive Officer]

I am looking around the room, I don’t think so, would be the simple answer.

[Terry Ma, Barclays]

And then on any additional portfolio purchases like the PacWest deal out there. How many more are out there and how competitive are those situations?

[Kipp deVeer, Chief Executive Officer]

I’m certainly not the only person who works here, so I’m not aware of anything but we’re particularly interested or working through right now. But I think we’re always seeing examples like PacWest pop up. We continue to believe that it’s just such a typical transaction that is where bank acquires middle market lending franchise, tries it out for a little while and then decides it doesn’t want to do it anymore, which was the situation with PacWest. And of course the [CapSource] transaction which they did in the past, there is certainly other things going on. I mean you saw the transaction we’ve got done with Triangle. We thought it was interesting BlackRock acquiring Tennenbaum Capital. So there are loads of things out there. We get a lot of calls from bankers on a lot of things, but there’s nothing to comment on I think that we’re engaged in right now or that we see it near term.

[Operator]

And our next question comes from Doug Mewhirter with SunTrust. Please go ahead.

[Doug Mewhirter, SunTrust]

Regarding the competitive environment and your portfolio activity, I am not sure if this was a mix issue or is distorted by the Ivy Hill transaction. But it seemed like you had originated -- you have been originating an increasing number of subordinated loans, which it just strikes me a little odd given that if things are just getting tighter and underwriting centers are dropping, the logical conclusion would be to go higher in the capital structure. But maybe it's a cause and effect where everyone is going higher in the capital structure and that’s what’s screwing everything up. I just wondered if you could just maybe break it down a little bit in a little bit more detail your reasoning on how you're looking at the portfolio.

[Kipp deVeer, Chief Executive Officer]

I don’t think we’re doing anything differently frankly, obviously, things can move a little bit quarter to quarter. But there were two transactions there, medical being one another deal last quarter that influenced that a little bit. There's actually a name in there called Gehl Foods that we actually underwrote, the junior piece of and actually it’s indicative. So I think there is a little more noise in the number rather than there is any shift in philosophy and generally speaking I’d agree with your comments. So we’ve been continuing to try to position ourselves up the balance sheet as best we can. But we do find some good situations to do junior capital and we’ll stick to it where we’ve got conviction.

[Doug Mewhirter, SunTrust]

And my second and final question, now that LIBOR has obviously gone up considerably and you are busy trying to fix out as much as you can at attractive rates on the liability side of your balance sheet. Are you seeing any demand on the asset side of your balance sheet from borrowers or their sponsors, one thing to try fixed rate loans? Or is there some structural part of the industry, which really would prevent a wholesale shift towards fixed in this environment?

[Kipp deVeer, Chief Executive Officer]

I think it’s a good question. It’s good observation. We haven't seen it. There have been a couple of that I think that we've seen and that probably is a good idea for companies obviously to try to be fixing their debt. But not really, which perhaps a little bit of a surprise. Remember that even if they’re borrowing floating, they actually do have hedging agreements in place to require them to swap with some of their floating rate debt into fix as some of the companies already have fixed some of their exposures just in terms the way leverage credit agreements work. But again not to be too simplistic, the answer to your question is not really.

[Operator]

Our next question comes from Casey Alexander with Compass Point. Please go ahead.

[Casey Alexander, Compass Point]

In relation to the Ivy Hill acquisition, how did you determine -- I mean, if I read the release right, which portions of the acquisition to pull onto your balance sheet as opposed to leaving with Ivy Hill?

[Kipp deVeer, Chief Executive Officer]

So when you -- you probably appreciate this, or most people do. But if you don’t, I’ll give you little color. So obviously CLOs require certain diversification standard. So to the extent we had assets on our balance sheets, one of the reasons that we may have held on to something was size of position. So diversity of the portfolio that we eventually securitized as of the other day was part of it. The second piece of it, there’re couple of loans in there that I would categorize as just less traditional to frankly get financed in a CLO, some media oriented stuff, just some things that don’t fit as well. We left at in what I think of as the remainder of financing, which we’re calling Ivy Hill 13, which again is a pool of assets that’s meaningfully less diverse financed with a warehouse line from one of the investment banks. And it’s our intention to effectively exit those assets either quickly or in natural course, and we think that will lead to repayment of some of our capital in terms of what we invested in that field. Does that make sense?

[Casey Alexander, Compass Point]

Yes, it does. And my follow-up is you made an allusion in last quarter too, the SSLP assets, which during the Investor Day they were identified as things that come on to balance sheet that you’d like to redeploy. And then in the last quarter, it was -- well in case of the leverage bill, you might just want to hang onto those assets. Are you delaying redeployment of those assets until you make a determination with the Board as to which the way you want to go?

[Kipp deVeer, Chief Executive Officer]

No, we’re not…

[Casey Alexander, Compass Point]

Because I noticed that you didn’t mentioned…

[Kipp deVeer, Chief Executive Officer]

Yes, most of it do not look fair at all.

[Operator]

Our next question is a follow-up from Jonathan Bock with Wells Fargo Securities. Please go ahead.

[Jonathan Bock, Wells Fargo Securities]

One item that we've always debated and discussed Kipp was the mix between senior and junior debt, and clearly the returns have parsed that out over the period of two to three years. The question that I think folks will ask in this environment, just as you mentioned about moving up the balance sheet and at times the second liens being a bit more situational, and I happy to ask this both to Mike and yourself at the same time. Can you give us a sense of the types, if you could describe some themes of opportunities where second lien can and it does make sense in this environment? We’ve heard folks talk about bridge financing, or pick a number large EBITDA company that’s never going to lose money. Whatever the theme is, but parse out where you believe the opportunistic second lien investment really does make sense in environment when folks are now being conditioned to focus a bit more on the senior part of the stack?

[Kipp deVeer, Chief Executive Officer]

We definitely again emphasize existing borrowers, companies that we know, that we think offer less risk than a potential new deal. So I mean some of the second lien investments we did Q1, junior deals to give you a flavor, invested again in a company called Mavis, a tire company which I bet a lot of people know. It’s our bet that a very diversified retailer of car repair and tires is probably unlikely to have very substantial changes in their business model anytime soon. It’s a great company, found around -- been around a long time now with the new sponsor. So that’s an example.

Another incumbent name that we added some capital to is a great business that we’ve been invested in for I think 11 or 12 years, called OTG. They run restaurants and airports. As long as people keep flying, my guess is they are going to order food and beverages, while they sit and wait for their flights. That company has done exceedingly well. We’re very close with the CEO, also a founder on business that I've been involved in along with many others here for long period of time, and just have a lot confidence in.

Another one, the company called Dent Wizard that we've been invested in for a long period of time. Not necessarily like a collision repair center, but literally if you get a dent in your car and you need to go in and not have any dent in your car anymore, you drive into their store and you get the dent work done. I guess the dynamics of that business don’t change a whole lot any time soon. So these are the types of just reliable services where we think there’s pretty inelastic demand and the types of things that large companies are established, we’ve known them a long time, et cetera.

And the new example this quarters is again a company called Air Medical, which we take a lot of comfort in. The fact that it’s very large public company, provides airlift, healthcare services all over the country. It’s a business that multiple people, myself included at Ares and I’d include our tradable credit business, our healthcare analyst there, our PET team et cetera, known the management team there for literally 10 to 15 years maybe more, controlled by KKR very strong sponsorship, very resilient financial performance over the year.

So those are a couple of examples where we just have a lot of conviction. That being down a balanced sheet doesn’t put us in a terrible risk position, so to speak. And we're able to generate really, really strong returns.

[Operator]

And our next question is from Christopher Testa with National Securities Corp. Please go ahead.

[Christopher Testa, National Securities]

Just curious guys if you could just provide some color on your discussions with banks, specifically with regards to increasing leverage. In your opinion, have the banks treated this much differently from the rating agencies and seem to be more amenable to you guys, making -- having potentially more leverage on safer credits. Or are the banks pretty much more bent on driving up your borrowing cost, even if you’re making safer loans that have less likelihood of a default. Just curious if any detail you could provide there.

[Kipp deVeer, Chief Executive Officer]

All of our lenders probably do it a little bit differently. I think your comments around are the banks more amenable potentially than the rating agencies, I think the simple answer to that is yes. The banks have always financed these types of assets not in BDCs at substantially higher leverage ratios that are comfortable with an advanced rate methodology against these assets that would allow for more borrowing, i. e. our borrowing base today is substantially in excess of our current drawn secured debt.

The convention at the banks has always been simply to rely -- I think if I spoke for them, I don’t want to. But I think it’s just been rely on the regulatory leverage constrain of one-to-one being the covenant. I am hopeful that as we continue to advance if we choose to go there that they would relax the covenant if we ask them to, and we took the company in that direction. But I do think based on at least some of our early conversations that they’re a bit easier and amenable, and all of that to answer the question.

[Christopher Testa, National Securities]

And do you think it ever becomes economical to effectively wind down the SDLP and put all these loans on balance sheet with higher leverage to reduce any frictional costs between them?

[Kipp deVeer, Chief Executive Officer]

Probably not. And that again, if we’re looking at an expanded leverage model, which obviously we’ve got a lot of them out here and you're looking at increased leverage on assets to pay you 6.5% and you’re financing those assets at 4%. You can do the math as to even if you max the leverage ratio out to some numbers, I don't think we’re remotely close to talking about. Here it doesn’t generate an ROE that’s even remotely in the same zip code as SDLP or Ivy Hill. So I think again, those are two important programs and partnerships for us and we intend to continue to support them both, and we hope they’ll both keep growing.

[Operator]

And our next question comes from Henry Coffey with Wedbush. Please go ahead.

[Henry Coffey, Wedbush]

Really two questions, I’ll get the first one out quick and then go to the second. Yes, it's a very competitive environment, but are you seeing the tone of your ability to [harvest] either companies that you would prefer to be out of or companies where you have significant gains? Is this becoming a better environment for creating liquidity there? And then my second question is really just going all the way back to what Robert was about. When you think of increasing internal leverage, is that going to go into its own special product bucket that you’ll add leverage, but there will be to loans with say very senior characteristics or some other dynamic?

[Kipp deVeer, Chief Executive Officer]

There is one real benefit, the tremendous amount liquidity that exist both in the credit markets and the TE markets, and that it’s an excellent time to sale. I think we’ve said this for the last -- I don’t know how many years now, but we continue to generate record gains at this company. We think that we’re reasonably intelligent and know what we’re doing but we’re also taking advantage of what’s a very good market to sale things. So we have lots to sell over the last couple of years, which is one of the reasons that we purchased American Capital, and we buy a very large portfolio at a discount NAV. And you hold it through a rising multiple environment and you find yourself in a good position to exit and generate gains, which is what we’ve done.

But I think your second question or part of the first question is actually more interesting. And I’ve made this point in the past as have others on calls. But it’s a great time for us to exit companies that we don’t think are actually on the right path. We want to set up companies that were leveraged and deleverage over the first couple of years, that’s how we ensure that we actually get paid back. But we underwrite a business that’s levered 6 times, and three years later it levered 6 times, not performing.

So if other lenders come in and say, oh we’d love pitch on that business, I would say great 6 times levered credit. There have been a whole host of examples of exits that we’ve made from companies and frankly we weren’t thrilled with performance in. So we talk about backing our incumbent winners a lot. The companies that we see show up in other people’s portfolios that used to be our portfolio companies. We typically have an ability to keep those in the portfolio if we want to. So if we’re exiting them, you can assume that we’re exiting them for a reason, unless we’re simply being outcompeted.

And I think we’ve avoided some future problems as a result of the liquid market and the amount of competitions that’s out there. And I think that’s an important point that people don’t pick up on and appreciate that question. In terms of the increased leverage, I am not quite sure what you mean by the special products bucket. So if you wanted to clarify that, you can. But I am not quite sure how to answer that second question.

[Henry Coffey, Wedbush]

Well, I mean if you add it -- let’s just use numbers. If you went from having $100 million worth of debt to $50 million -- $150 million worth of debt, would those incremental investments just look like what you're doing today? Or would you then say no we’re going to go into a different bucket, different type of investment, a more senior investment, a small business investment. I am not -- I am just thinking of examples where you’d be more comfortable with adding the leverage, et cetera?

[Kipp deVeer, Chief Executive Officer]

I think it’s safe to say that if we did choose to increase leverage on the portfolio, we do it to again extend the fairway and invest in more first lien assets that had lower returns and we’re safer. But again, we’re early days in terms of this discussion. You can model it a whole host of different ways. But that’s probably if we took it there where we take it.

[Operator]

And our next question comes from Chris York with JMP Securities. Please go ahead.

[Chris York, JMP securities]

A quick follow-up on the group, I don’t know if Mr. Arougheti is on the call. But we already discussed, Area was instrumental in advocating for the modernization of BDC operations. So I am curious if you guys have any thoughts on whether either legislators or regulators that you see, maybe more supportive to modernizing shareholder obstacles like AFSCs for public BDC investors?

[Kipp deVeer, Chief Executive Officer]

I don’t think Mike is on the call. I know he is in Los Angeles, but I don’t think he joined us today. I've been involved in everything from the legislation, as well as the AFSC discussion as has Penni, Mike, Mitch. Josh Bloomstein, our General Counsel is here with us today. So look I think that there is a better tone, I guess is what I would say in this SECs and there wasn’t in the prior wasn’t in the prior SEC. And we’ve had some more productive dialogue that I am hopeful will lead us to again what I think would be the next most important regulatory relief that we could see from DC.

So I think it's particularly impactful on us as a large company in the space, because I’ve had enough meetings with folks who’ve just said we love what you’re doing at the company, but we just can’t own it. And our mutual funds were maxed out and our mutual funds already has 3% position that I have is the max I can be in. And look this is a firm that’s very comfortable and very appreciative of the institutional support that we get for all of the investment vehicles that we run, ARCC being first and foremost there. So we’d love nothing more than regulatory relief that does seem obvious that would increase institutional ownership in the space.

[Chris York, JMP securities]

Great, that was the motivation for my question as I was given a lot of that same feedback. So thanks Kipp.

[Operator]

And our last question today will come from Derek Hewett with Bank of America Merrill Lynch. Please go ahead.

[Derek Hewett, Bank of America Merrill Lynch]

All my questions have been addressed, so maybe just a housekeeping issue. Kipp, you had mentioned that there was about $1 billion dollars of lower yielding, American Capital assets on the books that could eventually rotate out of the portfolio. What was the average yield on those assets?

[Kipp deVeer, Chief Executive Officer]

6.8%, okay. And just when you cut through it, about half of its Alcami, so just to make that clear in case people hadn’t figured it out.

[Operator]

This concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Kpp deVeer for any closing remarks.

[Kipp deVeer, Chief Executive Officer]

I don’t have many, but I’ll just thank everybody for their time. And hope you have a great day.

[Operator]

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately one hour after the end of the call through May 16th at 5 PM to domestic callers by dialing 877-344-7529 and to international callers by dialing 1-412-317-0088. For all replays please reference conference number 10118465. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our Web site. Thank you for attending today's presentation. You may now disconnect.