Ares Capital Corp

NASDAQ:ARCC

Earnings Call Transcript 2022-Q1

[Operator]

Good morning, welcome to Ares Capital Corporation’s First Quarter ended March 31, 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded on Tuesday, April 26, 2022.

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

[John Stilmar, MD, IR]

Thank you. Let me start with some important reminders. 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. 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 documents. 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 certain non-GAAP measures as defined by the SEC Regulation G, such as core earnings per share or core EPS.

The Company believes that core EPS provides useful information to investors regarding financial performance because it’s one method the Company uses to measure its financial condition and results of operations. The reconciliation of core EPS to GAAP net income, the most directly comparable GAAP financial measure can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures can also be found in our earnings release filed this morning with the SEC on Form 8-K.

All per share information discussed during this call, is basic per share information. See the Company’s Form 10-Q filed with the SEC this morning for more information.

Certain information discussed on this call and the accompanying slide presentation, including information relating to portfolio companies, was derived from third-party sources and has not been independently verified. And accordingly, the Company makes no representation or warranty in respect to this information. The Company’s first quarter ended March 31, 2022 earnings presentation can be found on the Company’s website at www.arescapitalcorp.com by clicking on the First Quarter 2022 Earnings Presentation link on the home page of the Investor Resources section. Ares Capital Corporation’s earnings release and 10-Q are also available on the Company’s website.

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

[Kipp deVeer, CEO]

Thanks, John. Hello, everyone, I hope you're all doing well and we appreciate you joining the call. I'm here in New York with our Co-Presidents, Mitch Goldstein and Michael Smith, our Chief Financial Officer, Penni Roll, and several other members of the management team. I'd like to start by highlighting our first quarter results and then provide some thoughts on the market and our position today.

This morning we reported first quarter core earnings of $0.42 per share. We also generated net realized gains on our investments adding $0.14 per share. Our net realized gains on investments now totaled over $175 million since year-end 2019 and approximately $1.1 billion since our inception. Our net asset value per share reached another record and it's up 9% over the past 12-months.

Credit metrics in the portfolio was strong, and overall the portfolio continues to perform well. Our non-accruals at cost are well below our 10-year long-term average and we reported strong underlying portfolio company EBITDA growth. Furthermore, the weighted average loan to value and the aggregate portfolio remains historically low at 44%, which reflects significant structural support for our loan portfolio.

After a very strong finish to 2021 market transaction activity was slower to start the year as we expected, and as market volatility stemming from geopolitical events, and a more aggressive tone from the Federal Reserve is creating uncertainty for us and many other investors. The 2022 outlook from macroeconomic growth has been tempered by inflation, increasing short term rates and a more challenging outlook for global growth in part caused by the war in Ukraine.

As one would expect, the liquid markets are bearing the brunt of the volatility with wider credit spreads and uneven trading.

However, as is often the case in the direct lending market, volatility is not as apparent and changes in pricing and terms are slow to materialize. This lag in response in the private markets, relative to liquid markets is not unusual. We've seen many of these market transitions over our history, and the private markets often take a bit longer to reset to new economic and market conditions.

During these times our playbook is to become incrementally more selective, build additional liquidity and be opportunistic by leveraging our competitive advantages, and vast sourcing capabilities.

The Ares platform is one of our most significant competitive advantages. We have the largest direct lending team in the business with 150 investment professionals in the US, coupled with another 640 investment professionals in adjacent businesses in Ares. We believe this provides distinct advantages to source investments in middle market companies. Our ability to generate significant deal flow, which we estimate is running at roughly $550 billion annually continues to allow us to be highly selective, and to pass on transactions when pricing or terms don't meet our standards, which is increasingly frequent in today's environment.

We also benefit from the large size and long 10-year of our existing portfolio of nearly 400 incumbent portfolio of companies who may seek additional growth capital over time. We believe that our ability to finance and grow with our winners enables us to reduce portfolio risk and often attain better-than-market terms. In line with this, this past quarter, over two-thirds of our commitments were to incumbent borrowers.

Beyond these sourcing advantages, we believe our large team and the Ares management platform provides a unique vantage point for doing research and conducting due diligence. Ares has over 1,600 investments in our private credit strategies and more than 900 corporate credit investments across 60 industries within our liquid credit strategies.

In our view, the perspectives and insights we gain as a result, provide a significant advantage in informing our credit and pricing decisions, especially in assessing relative value for illiquid credit. Changing gears, a bit, these advantages have also allowed us to drive value through portfolio acquisitions consistently throughout the company's history.

As Mitch will discuss in more detail. Earlier this week, Ares management announced the acquisition of Annaly Capital to U.S. middle-market direct lending portfolio, which followed Annaly's strategic review of its business. We believe Ares' track record in making acquisitions continue to produce attractive and differentiated opportunities for our investors, and we're excited about this transaction.

Looking forward, we feel very good about our positioning and the fundamental long-term drivers of growth in our market. North American private equity dry powder, which we believe is a key indicator of future M&A activity, sits at near record levels and larger companies are seeing the value in seeking private capital solutions.

In addition, we expect the continued volatility in the liquid capital markets will lead to increased demand from issuers for private credit solutions as we can deliver more certainty in these uncertain times. These factors are widening the fairway for us, particularly as we -- as our scale and flexibility allow us to be meaningful partners to a wide variety of borrowers.

The last point I'll leave you with is that we don't believe a tightening monetary cycle will have negative effects on us. Our large weight floating rate loan portfolio is financed by mostly fixed rate unsecured sources of financing and our assets are largely floating rate investments. We believe this positions us well to have our net interest earnings benefit from rising rates. As of quarter end, holding all else equal and after considering the impact of income-based fees, we calculated that 100 basis point increase in short-term rates could increase our annual earnings by approximately $0.23 per share, a 14% increase above this quarter's core EPS run rate.

A 200 basis point increase in short-term rates could increase our total annual earnings by approximately $0.44 per share, a 26% increase above this quarter's core EPS run rate.

We also do not expect that a projected increase in rates will result in deteriorating credit performance, particularly given our strong starting point with portfolio weighted average interest coverage of nearly 3 times. What this means is that holding all else equal, including the leverage at the borrower level, short-term base rates would need to rise above 3% before aggregate interest coverage would dip below 2 times, which is similar to the 5-year pre-pandemic weighted average of 2.3 times.

Importantly, this analysis doesn't consider EBITDA growth or deleveraging that often occurs in our portfolio. We feel good about the ability of our portfolio companies to navigate a higher rate environment and believe these dynamics will further differentiate Ares Capital versus many of the other income-oriented alternatives in the market today.

So with that, I'll turn the call over to Penni to provide some more details on first quarter results and other thoughts on our balance sheet positioning.

[Penni Roll, CFO]

Thanks, Kipp. Good morning, everyone. Our core earnings per share of $0.42 for the first quarter of 2022 were in line with the $0.43 from the same period a year ago, but lower than our record fourth quarter 2021 core earnings of $0.58 per share. Our first quarter core earnings reflect the often typical slower first quarter of origination activity, much like we saw in the first quarter of 2021. The first quarter of 2022 earnings were driven by strong recurring interest and dividend income and a solid level of capital structuring service fees from new origination and capital markets activities.

Our GAAP earnings per share for the first quarter of 2022 were $0.44, which compares to $0.87 for the first quarter of 2021 and $0.83 for the prior quarter. Our GAAP earnings per share for the first quarter of 2022 included net realized and unrealized gains on investments of $0.13 offset by a realized loss of $0.10 related to the repayment of our 2022 convertible notes, which were in the money as a result of the significant stock price appreciation and our dividend increases over the five years since the notes were issued.

The net realized and unrealized gains on our investments this quarter reflect the overall healthy performance of the underlying portfolio as a whole. As of March 31, 2022, our stockholders' equity grew to $9.4 billion, resulting in yet another record net asset value per share of $19.03 as compared to $18.96 at December 31, 2021, and $17.45 at March 31, 2021.

Our NAV per share for the first quarter represents a 0.4% increase from a quarter ago and a 9% increase from a year ago. Our total portfolio at fair value at the end of the first quarter was $19.5 billion, and we had total assets of $20.5 billion. As of March 31, 2022, the weighted average yield on our debt and other income-producing securities at amortized cost was 8.9% and the weighted average yield on total investments at amortized cost was 8.1%, each increasing approximately 20 basis points from last quarter, supported by market interest rate levels as base rates rise.

As it relates to our future interest rate sensitivity, as Kipp mentioned, we remain well positioned to benefit from a rising rate environment and are now past the interest rate floors for certain of our investments. As of March 31, 2022, 74% of our total portfolio at fair value was in floating rate investments. Additionally, excluding our investment in the SDLP certificates, 93% of the remaining floating rate investments had an average interest rate floor of approximately 90 basis points.

As Kipp mentioned earlier, we would expect increases in short-term rates, especially as these rates exceed the floors to have a meaningful positive impact on the future net interest earnings performance of the company. We have provided details on this in this quarter's Form 10-Q for those who want to further examine our sensitivity to rate movements.

Shifting to our capitalization and liquidity, we remained very active during the quarter, raising additional capital and extending debt maturities in order to maintain strong liquidity for our growing investment portfolio. During the quarter, we grew our committed debt capital by more than $650 million.

In January, we took advantage of what may have been the interest rate low point for the unsecured notes market for BDCs by issuing $500 million of 2 and 7/8 percent unsecured notes maturing in July 2027. While not our lowest coupon issuance in our history, it did represent the lowest spread at new issuance for us or any other BDC.

We are very pleased with the success that we have had since the beginning of 2021 to lock in low fixed borrowing rates, which we expect will benefit our aggregate cost of capital and our earnings as we move into a higher rate environment. In addition, we extended our corporate revolving credit facility by approximately one-year to bring it back to a full five years and upsized it by over $550 million bringing the total facility size to $4.8 billion.

As part of the amendment to the credit facility, consistent with other bank-led deals closing in 2022 and going forward, we updated certain base currency reference rates, which included replacing the LIBOR rate with terms so for plus an applicable credit spread adjustment. Pricing and advance rates are otherwise unchanged on this facility.

Alongside raising additional debt, we also repaid our $388 million of convertible notes at fair maturity in February, resulting in a realized loss as stated before. Following the repayment of these convertible notes, we only have one term debt maturity in the next 2 years, which occurs in 2023, providing us significant flexibility when it comes to our debt capital structure.

To support the continued long-term growth of our investment portfolio, we also accretively raised incremental equity capital during the first quarter through a secondary issuance early in the quarter as well as through our ATM program. After considering our investment in capital activities during the quarter, we ended the first quarter with nearly $5.9 billion of total available liquidity, including available cash of $690 million and a debt-to-equity ratio, net of the available cash of 1.06 times, down from 1.21 times at the end of the fourth quarter.

While our leverage ratios will vary over time depending on activity levels, we will continue to work to operate within our stated target leverage range of 0.9 times to 1.25 times. Overall, with ample amounts of dry powder, we believe our capital and liquidity remains one of our most significant competitive advantages and positions us well to remain active, yet patient investors.

Before I conclude, I want to discuss our undistributed taxable income and our dividends. We currently estimate that our spillover income from 2021 into 2022, will be approximately $651 million or $1.32 per share. We believe having a strong and meaningful undistributed spillover supports our goal of maintaining a steady dividend throughout market cycles and sets us apart from many other BDCs that do not have this level of spillover.

This morning, we announced that we declared a regular second quarter dividend of $0.42 per share the second straight quarter at our new regular dividend rate and our 52nd consecutive quarter of unchanged or growing dividends. This second quarter regular dividend is enhanced by the $0.03 per share additional second quarter dividend that we previously declared in February. Both are payable on June 30, 2022, to stockholders of record on June 15, 2022.

I will now turn the call over to Mitch to walk through our investment activities for the quarter.

[Mitchell Goldstein, Co-President & Co-Head of Ares Credit Group]

Thanks, Penni. I would like to spend a few minutes providing more our on detail our investments and portfolio performance for the first quarter of 2022. I will then provide an update on post quarter end activity and our backlog and pipeline.

During the first quarter, our team originated $2 billion of new investment commitments, a 14% increase from the first quarter of 2021. Our commitments during the quarter were to a diverse set of high-quality companies across more than 20 distinct industries. The EBITDA of these companies range from $13 million to over $1 billion, underscoring the breadth of our opportunity set and our ability to be a solutions provider to a wide array of companies.

We continue to be very selective and finance less than 5% of the new deals we review. We believe that our selectivity and focus on high free cash flow businesses with market leadership positions ultimately result in a differentiated and attractively positioned portfolio. It is important to note that ARCC's portfolio does not have any direct exposure to companies domiciled in Russia or the Ukraine.

While we are keeping a watchful eye on inflation and supply chain issues, our portfolio companies are continuing to experience strong overall fundamentals, which is reflected in the 20% weighted average EBITDA growth of our portfolio companies over the last reported 12-month period, the highest in our company's history.

Importantly, this performance is broad-based. All of our top 15 industry concentrations showed a healthy level of positive EBITDA growth. This growth supported an increase in the weighted average EBITDA of our portfolio from $162 million last quarter to $173 million this quarter. It is important to note that while our portfolio has a definitive upmarket focus based on dollars invested, examining the portfolio by a number of credits shows that most of our portfolio companies remain in the core middle market. By a number of companies, approximately two-thirds of our portfolio companies have less than $100 million in EBITDA. We believe our track record and ability to finance the business as it grows continues to be a key differentiating advantage in today's competitive market.

This quarter, our weighted average portfolio grade at fair value of 3.1 remained unchanged from last quarter. Our nonaccrual rate at cost of 1.2% increased slightly from 0.8% at Q4 '21. As Kipp mentioned, our non-accruals at cost continue to be meaningfully below our 10-year average of 2.5%.

Before finishing up with some comments on our backlog and pipeline, I want to discuss the exciting portfolio acquisition that Kipp mentioned earlier. Last night, Ares management announced the acquisition of the direct lending portfolio of Analog Capital Management, which decided to exit its direct lending strategy. The overall $2.4 billion portfolio is comprised of U.S. senior secured loans to over 40 companies backed by numerous private equity sponsors.

Given the breadth of market coverage at Ares, there was a familiarity with a significant percentage of the investments either through overlapping portfolio companies or through a historical review of these companies. These advantages and the scale of the Ares platform allowed for a diligent underwrite of each loan in the portfolio to create what we believe is a highly informed and granular view of value.

In terms of specific impacts to ARCC, approximately half of this $2.4 billion portfolio will be funded by both ARCC and Ivy Hill with a significant portion of the loans being purchased by Ivy Hill, given the senior orientation of this portfolio. We believe one benefit of this transaction is to further support the growth of Ivy Hill. We expect the revenue growth from these investments may ultimately support additional dividends from Ivy Hill to ARCC after the transaction closes, which is expected to be at the end of the second quarter.

As a reminder, Ivy Hill is a wholly owned portfolio company of ARCC that was started in 2007 to invest in and manage middle-market senior secured loans through structured investment vehicles and separately managed accounts. The business is highly diversified across more than 290 distinct borrowers and is enjoying continued success given its market position and track record.

We believe Ivy Hill's success and profitability is also reflected in its $43 million first quarter dividend to ARCC, a $15 million increase from last quarter and the 48th consecutive quarter of Ivy Hill paying a stable or increasing quarterly dividend to Ares Capital.

Now we'd like to shift to our post quarter end investment activity and pipeline. From April 1 through April 20, 2022, we made new investment commitments totaling $106 million, of which $57 million were funded. We exited or were repaid on $94 million of investment commitments, including $77 million in loans sold to vehicles managed by Ivy Hill, generating approximately $1 million of net realized losses on exits.

As of April 20, our backlog and pipeline stood at roughly $2.3 billion and $110 million, respectively, including investments expected to be made by ARCC as part of the portfolio acquisition that I mentioned. Our backlog and pipeline contain investments that are subject to approvals and documentation and may not close or we may sell a portion of these investments post-closing.

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

[Kipp deVeer, CEO]

Thanks, Mitch. In closing, while there seems to be a lot of uncertainty as to where we are headed for the remainder of this year and beyond, we feel the company is well positioned to deliver for our shareholders. We have a dividend that is well covered by earnings and a strong balance sheet that allows us to be patient as the market likely transitions amidst continuing volatility. Our experience navigating changing time should continue to allow us to outperform and we can assure you the team is focused on generating great results for 2022.

That concludes our prepared remarks. We'd be happy to open the line for questions.

[Operator]

[Operator Instructions]. The first question comes from Finian O’Shea, with Wells Fargo Securities. Please go ahead.

[Finian O’Shea, Wells Fargo]

Hey everyone, good morning. Kipps your opening comments on interest coverage. I think you said about 3% at underwriting. Can you talk about if that includes items like CapEx and EBITDA adjustments and so forth? And if not, what the ballpark figure is like on a cash basis?

[Kipp deVeer, CEO]

Yes. I mean, the -- good morning by the way and thanks for the question. The morning is a simple interest coverage calculation, so it's operating cash flow divided by interest. So anything else that a company requires, whether it's free cash flow, amortization -- or sorry, CapEx amortization payments, et cetera, would be excluded from that calculation.

[Finian O’Shea, Wells Fargo]

Awesome. Thank you. And as a follow-up, what's the picture like for a recurring revenue deal? I think to our understanding, those generally start with a cash infusion or runway. How materially does that change interest rates double or triple, the base rates that is?

[Kipp deVeer, CEO]

Let me try and answer that, but if you want to, you can follow on. So I mean the idea with some of the recurring revenue lines that are getting done in the market is, obviously, you're looking at a company that's growing extraordinarily quickly, but it tends to have operating expenses promoting that growth. So you're talking about R&D, you're talking about sales and marketing where these companies hope to be much, much larger and most of them have to be profitable in time.

For now, though, what you're underwriting is stable recurring revenue where you could simply change if you wanted to, the way that the company was pursuing growth and generate free cash flow pretty quickly. So that's sort of the construct. We're sort of limited in that space. We're happy to play in that market. I think we're one of the more conservative lenders. And today, we've got roughly 3% of the portfolio at fair value and recurring revenue loans, just as a reminder.

[Finian O’Shea, Wells Fargo]

Sounds very well. It’s helpful. Thanks so much.

[Operator]

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

[John Hecht, Jefferies]

Good morning guys. Thanks for taking my questions. Kipp in your remarks, you talked about that you're waiting for the private markets to adjust in a manner that the public markets have adjusted given all this disruption. I'm wondering can you maybe quantify that. Is that like a function of credit spreads? Or is there other factors in terms of deal structures or something that we should be thinking about. Just sort of in terms of when that might catch -- that catch-up might occur?

[Kipp deVeer, CEO]

Yes. I mean I think what we were trying to get back to is a notion that we've left you with and many others with in the past, which is the public markets, as you've probably seen, particularly anything fixed rate, longer duration, et cetera, whether it's high-grade corporates, the high-yield market, et cetera, is off pretty substantially this year. The loan market a little bit less so because the duration is shorter. It's obviously a LIBOR, SOFR plus asset, which benefits from rising rates. The public equity markets as well don't seem very happy over the last couple of months.

That being said, a lot of what's getting closed or has been getting closed in our opinion in the first quarter in the private markets are often deals that get originated in a different environment. They get signed up. They have term sheets issued November, December, January. And because a lot of what we're doing is longer duration holds with relationships that are important to us, you don't go reprice your term sheets. I guess, is the -- generally speaking, you go and you close over those deals with an understanding that you're in a fundamentally good credit.

But what we're looking for, John, is with a widening in spreads broadly in the credit markets, which we've seen a bit of. We're waiting for the private markets to kind of catch back up to recognizing the volatility that's been very obvious to all of us for maybe February to April, and I think that's happening right now. And that can get reflected in everything from pricing, which, of course, spreads to tighter documentation, whatever it may be. So it can come in a whole host of different forms.

But first things first, I think that there may be some price exploration on the part of a lot of investors, frankly, whether they're lenders, their private equity firms, their buyers of real estate, et cetera, that with less economic uncertainty or more economic uncertainty, less certainty about growth, concerns about inflation, concerns about the Ukraine, tightening monetary cycle, et cetera. That there's a little bit of a wait-and-see approach for those who maybe have been doing this a bit longer than some.

[John Hecht, Jefferies]

Okay. That's very helpful color. Second question, you gave us very good information about the interest coverage and how that's impacted from a rising rate environment. I'm wondering in addition to that, how does the rising rate environment affect like appetite for borrowing from middle market companies? Is there anything for us to think about in that regard?

[Kipp deVeer, CEO]

I mean I think it's less sensitive than, say, the high-grade market, right, which has done loads and loads of refinancing over the last 5 to 10 years, taking advantage of historically low rates. A lot of what we do, as you know, is driven by private equity and acquisitions, and that's why we made the comment in the prepared remarks about the extraordinary amount of dry powder in the hands of U.S. private equity firms.

And the reality is our opinion is despite increased borrowing costs, they will be looking to deploy and generate returns for their investors because that's what they were hired to do. And most private equity funds have 5-year investment period. So you can take a wait-and-see approach, but you can't take a wait-and-see approach forever.

If I had to guess, if I'm sitting in one of those tables, what that tells me is, you want to pay less for things because when rates go up, assets tend to be worthless. So a little bit of the feeling around, I think, is the part on all private markets investors trying to find what may be a new equilibrium again with some more uncertain market conditions and presumably materially higher rates.

[John Hecht, Jefferies]

That makes sense. Thanks very much.

[Operator]

The next question comes from Devin Ryan with JMP Securities. Please go ahead.

[Devin Ryan, JMP Securities]

Thanks. Good morning, everyone. How are you?

[Kipp deVeer, CEO]

Good morning.

[Devin Ryan, JMP Securities]

Just to maybe a follow-up here on John's questioning here. Just as the markets are adjusting, Kipp, as you mentioned, I just want to maybe think about kind of the stated leverage and liquidity. I think your leverage range is 0.9 to 1.25 times, you're currently at 1.06 net of cash. And just kind of based on the lagging dynamics in the private markets, is this impacting how you're thinking about managing maybe liquidity and leverage and just the very near term, perhaps maybe deliberately slowing activity just to take advantage on the other side as the market kind of gets to that equilibrium point. Just thinking about kind of the near term versus long term because you may get some more compelling risk reward on the other side?

[Kipp deVeer, CEO]

Yes. I mean, the crystal ball is a little less clear perhaps than at other times. I mean I would hope that the vintage for doing what we do from an investment standpoint is better towards the back half of this year than it was maybe early days of this year and late last year in terms of terms and pricing. The only other thing I'd say, Devin, answer to your question, in more uncertain times that at least to us feel volatile, we would like to run less leveraged. So I think 0.9 frankly, is too low when you look at the asset mix in the portfolio here, but somewhere in line with where we are today, it feels comfortable for us.

[Devin Ryan, JMP Securities]

Yes. Okay, I appreciate it. And then just a follow-up here on prepayment. Just if you can give us any insight into kind of how you're thinking about the cadence from here. And it feels like just the backdrop has shifted from last year. So any thoughts on kind of the kind of intermediate term on that front as well would be helpful.

[Kipp deVeer, CEO]

Yes. I think playing off some of your first question as well as Fin and John. When you see an environment of higher rates, right, which offers fewer opportunistic refinancings and the volatile market. Our best guess is that we will see a slower pace of repayments going forward. We obviously build a quarterly model here where we're looking at our pipeline and our backlog, and we're also looking at identified paydowns that we know are coming because we're close to companies.

But as you probably imagine, as we forecast quarters in the year, we look at unidentified pipeline and we look at unidentified repayments. And I would tell you, we've made the conscious decision to try to take that down a little bit in terms of what we expect to come in from a liquidity perspective through repayments.

[Devin Ryan, JMP Securities]

Okay great. Thanks very much. I’ll leave it there.

[Operator]

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

[Ryan Lynch, KBW]

Hey, good morning. First question I had, I was pleasantly surprised to see that when you look at your unrealized and realized net portfolio, you guys actually had gains this quarter I was a little bit surprised just given that you had seen kind of widening credit spreads, a little bit of decline in liquid leveraged loan prices this quarter. So what drove your net portfolio gains this quarter? I'm not sure if there were equity investments in there that drove it higher or what was the [indiscernible].

[Kipp deVeer, CEO]

Yes. I mean, basically, a quick answer is debt resolution sort of net-net to 0, but the equity gains and a couple of specific names allowed us to show the net realized gains number, Ryan.

[Ryan Lynch, KBW]

Some equity gains in there. And the other question, kind of looking forward on how the market has moved and then kind of regarding kind of short-term rates. The last time we had a rate hike cycle, and of course, every rate hike cycle is going to be different. But what we saw was kind of a more gradual pace of rising rates by the Fed and LIBOR -- and what we saw was a lot of spread compression. And so the net benefit to the BDCs was substantially less than what a lot of these disclosures showed as kind of a sudden shock in interest rates of 100 to 200 basis points rising because of that, that's spread compression.

I'm just curious now that LIBOR has effectively gotten above the LIBOR floors and a lot of these loans, are you seeing meaningful spread compression in deals in the market? And what do you think about going forward? Do you think a lot of those spreads will start to get in a way or competed away by the substantial amount of capital looking to be deployed in the direct lending market? Or do you think there's going to be a meaningful increase in benefit from rising rates in your portfolio?

[Kipp deVeer, CEO]

So I actually think your last question is the most interesting one, the most heavily debated and the one that I'm probably the least sure in answering, meaning is the continued interest in everything that we and others do in illiquid credit is going to overwhelm a market that feels like it's going to widen it I don't know, it never has before. And we've been doing this a long time. So let me answer your first and second question sort of directly.

I think you are right and that it's very rare that we see 100% of the pickup in the base rate. So there's an acknowledgment that the all-in rate, whether it's what we're getting for our investors or what a borrower is paying expands with the base rate, there's likely some credit spread compression, particularly in an environment where default very low, which is certainly an environment -- the environment we're sitting in today, which tends to really widen credit spreads is when you actually see a pickup in defaults.

So for us, it's all about what's your economic forecast for the year. How do you see companies handling a more difficult operating environment, higher rates, et cetera? And we've gotten asked this question a lot, how's the portfolio, well, the answer is the portfolio is an unbelievable shape here in April. But if you ask folks around our table, if they're nervous about what we'll see towards the back end of the year and potentially into early next year, I think you'll certainly find plenty of folks who are.

So I do expect, as we come here through Q2 and even into Q3 to see the lion's share of the benefit of base rate increases because to your point, we're finally through the floors. And there will be a little bit of catch-up time before anybody adjusts new business to account for that. So we should see some good tailwinds with rising rates, but I think the back half of the year as is debatable. And I think the last question you asked is most interesting.

[Ryan Lynch, KBW]

I appreciate the color on that and I hope back in queue.

[Operator]

The next question comes from Melissa Wedel with JPMorgan. Please go ahead.

[Melissa Wedel, JPMorgan]

Good morning, everyone. Thanks for taking my questions. I was hoping to just back to some of the EBITDA trends that you're seeing in the portfolio right now. I think you cited, if I caught it correctly, it was about 20% EBITDA growth, but that was really the last 12 months, again, if I heard you correctly. So I guess that's the first question, did I catch that right?

And if so, could you pull that apart, maybe and talk about what you saw specifically in the fourth -- I'm sorry, in the first quarter and how that compared to 4Q, which I think -- in 4Q, you said it was sort of in the mid-teens range. How that holding up in the 1Q?

[Kipp deVeer, CEO]

Sure. And we're looking to see if we can pull some numbers. That 20%, Melissa, I appreciate your question, is obviously a very large number and frankly, one larger than we'd expect. You're playing off obviously easy comps against COVID periods, right, coming out of that period into something more normalized. So we're poking around here and let me just see.

I'm not sure if we actually even pay a lot of attention to that on a quarterly basis. Mitch made the point, I think, in his prepared comments that I think, Mitch said, we had growth across all 15 of the industry sectors that we measure. So while it's a big number, it's also pretty broad-based. And I'll just reemphasize, we think the portfolio is healthy and doing quite well.

[Melissa Wedel, JPMorgan]

Okay. The other thing that stood out to me in just going through the results this quarter was the big jump up in dividend income. And I think you talked about with the anticipated growth in Ivy Hill and potential upside on that dividend, also an uptick, I think, in some of the recurring dividend income. And I believe in the Q that was attributed to sort of increased exposure to some preferred hoping we could dig into that a bit. And if you can elaborate if we should sort of think of 1Q as a revenue base level of dividend income that could see upside to it later in the year.

[Kipp deVeer, CEO]

I'm going to let Penni answer part of that, too. I mean, look, there are a few items -- a few line items that contribute into that line. The largest one, of course, being Ivy Hill, and that's been moving up the last couple of quarters. So there will be a new base level, I think, of recurring dividend from Ivy Hill.

The problem was as you guys try to model, and I think that's probably what you're trying to do is we do see dividends come through from our equity investments that are not necessarily recurring, they'll come quarter-to-quarter. We obviously have 400 portfolio companies that are pretty difficult to forecast. Maybe we could take it offline and the IR team can help give you a little bit more detail. But I'll kick it to Penni if there's anything you wanted to add on top of that.

[Penni Roll, CFO]

No. I think we continue to grow the dividend in Ivy Hill, and that's in line with the increased investment that we've made. So I think you could look at that more as a baseline. But the other nonrecurring dividends are such that they're episodic. So they come from individual companies periodically and aren't necessarily recurring each quarter, but tend to still come throughout the course of the year. And just as a baseline for Ivy Hill, the Ivy Hill dividend grew this quarter as a total of $43 million.

[Operator]

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

[Casey Alexander, Compass Point]

Hi, good morning. Maybe this is -- this might be the same question that Ryan asked but I might ask it in a different way. And if it causes some eye rolling, I kind of apologize. But it felt like you said a couple of things that just felt like they were in conflict with each other.

Your expression of your weariness of the current environment both inflation, rising interest rates, geopolitical suggests that you've become more selective and might want to build liquidity. But the rising interest rates obviously helped your net investment income, but you don't expect any of that to relate to any deterioration in credit performance. And feels contradictory, if you understand what I mean. And I was wondering if you could throw me a little more color regarding that.

[Kipp deVeer, CEO]

Yes. I mean, I guess to try to. I don't think it's contradictory at all, Casey, but I think what we're saying is in a period of -- so forget the economic backdrop. But purely in a period of rising rates. We haven't benefited at all from the recent increases in short-term rates. I think most of our borrowers are subject to LIBOR SOFR floors where until you get north of one, the company doesn't generate any better earnings from rates going up, and that's what's been happening in the last couple of quarters.

So now we're finally at that inflection point where we're able to generate those benefits. And with that, we don't think that we're in a base rate environment in the next 9 to 12 months that even if you're on the more hawkish side of raising rates. If the base rate gets to 2.5% or 3% by year-end, I think's the point we're trying to make. We don't think our portfolio companies are a particularly difficult situation.

So there's a little bit of a Goldilocks moment where our company does well. Our portfolio of companies doesn’t do any worse or materially worse in a way that we think will create defaults or credit problems. And we hope we can sail through with that combination in a higher rate environment where rates are 5%, obviously, we're going to pick up those earnings benefits, and we think we may start to stress the portfolio just to pick a number. So that's what we're trying to get at. Hopefully, that clarifies it to a certain degree.

[Operator]

Was there a follow-up, Mr. Alexander?

[Casey Alexander, Compass Point]

Yes. My follow-up is -- less a follow-up and more of a request, which is given the size to which Ivy Hill has grown, with your upcoming Analyst Day, there's sort of almost a natural opaqueness to Ivy Hill. I would kind of request that you give a deeper dive so that investors have a good understanding of what Ivy Hill is, how it functions and what it means to the BDC? That's it.

[Kipp deVeer, CEO]

Yes, we're happy to do that. I mean it's not really that complicated. Ivy Hill was the bank loan manager they have third-party investors, which obviously include Ares Capital. The income coming from Ivy Hill is basically management fees on assets under management, as well as revenue coming off some of the investments that we and others have made that accrue back to us.

When they're wholly owned, all we're doing is looking at net of expenses, what the company is generating quarterly on a cash flow basis. And then we tend to take a conservative number, call it, 80% of the cash flow getting generated at Ivy Hill on a quarterly basis and payer’s capital and dividend.

So we're happy to try to lay that out in some more details when we see all of you guys in June. I don't want it to be opaque. I don't think it is. It's a fabulous -- has been, continues to be a fabulous investment for the company, which is why we've continued to invest more money in that company.

[Casey Alexander, Compass Point]

Appreciate. Thank you.

[Operator]

The next question comes from John Rowan with Janney. Please go ahead.

[John Rowan, Janney]

Good morning. Just two questions. So what percent of your assets right now are past the floor?

[Kipp deVeer, CEO]

We're looking around. We think it is...

[Penni Roll, CFO]

About two-thirds of the portfolio is floating. The -- where you have the floating rates outside of SDLP, I think about -- the weighted average floor is about 90 basis points. So depending on whether people are borrowing on a one month or three months, there's an iteration there of some are past the floors and some are getting close to being past the floors. But given they have the option of resetting monthly or quarterly, I always feel like it takes about a full quarter to see the impact of that resetting as you go through time.

[Kipp deVeer, CEO]

There's a little bit of gaming event, a little bit of gaming of the system, right, by the borrowers because they do have the ability to elect 1 and 3-month LIBOR contract. So it really depends when you're rolling over in what spot rate you're playing, whether you're going to borrow at 1 or 3. But to Penni's point, everybody will be up for redoing those contracts again. And even if they're choosing 1-month LIBOR in a month. My guess is they'll be through the floor. So we're largely there. I think fundamentally is the answer, John.

[Penni Roll, CFO]

Yes. I mean just to give a little more insight about two-thirds of the floating rate portfolio today is choosing 3-month LIBOR.

[John Rowan, Janney]

And then -- just to kind of go back to the rate sensitivity questions as well, you did change one of your funding liabilities, I believe, from LIBOR to SOFR. Is there an impact in your rate sensitivity to having so far, which I believe reprices not quite as fast as LIBOR?

[Penni Roll, CFO]

Yes, where we've already migrated so far is reflected in the interest rate sensitivity table in the 10-Q. A small piece of the portfolio is starting to migrate as well because as you may be familiar with the rules, as things get amended or changed post the beginning of this year, there's a migration to SOFR, but that will take some time. So it's a small impact today, but we are factoring that into the interest rate sensitivity to the extent that the base rate is already elected to you so far.

[Kipp deVeer, CEO]

Yes. I mean I would just say to you, John, as a reminder to you guys as analysts, but also to the folks that own the stock. This is not a particularly rate-sensitive company because it's not very leveraged. Most of the economic value in this company is generated by excess net interest margin and frankly, generating more gains than you realized losses in the portfolio. We've been doing that a long time. So while there's a shift obviously in where we are from a rate perspective, you're not going to see it at all by the end of the summer. It's all going to play through. And then we'll see where we are. But just as a reminder.

[John Rowan, Janney]

Okay. Thank you.

[Operator]

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

[Robert Dodd, Raymond James]

Hi, everyone. Good morning. Back to the SOFR LIBOR question. I mean right now, the 3-month LIBOR index versus overnight so far at least. I mean the spread is 100 bps, which so far hasn't been around that one, but that seems pretty wide by any kind of historic measure I can come up with. Is that itself causing any disruption in the market, either where you're lending in terms of or refinancing or anything like that? Or is it causing -- is there any fallback language in borrower terms, not just three months or one month LIBOR, but can they go back to -- is there another alternative in there, like Fed funds, right, where the spread versus LIBOR is pretty wide right now?

[Kipp deVeer, CEO]

Okay. So they're telling me -- the base rate is not how I spend a lot of my time, frankly, thinking about managing the company, but I'll answer the question nonetheless. I'd say there is complexity in this transition. The way that they've tried to allow the market to resolve it is obviously creating something called a credit spread adjustment between SOFR and LIBOR to get us through the term period as we flip over. To broadly answer your question, Rob, is it changing the way people are lending money or doing deals or any of that? It's not. We're just kind of getting through a transition period, and it will be behind us reasonably soon and we move on.

[Robert Dodd, Raymond James]

Okay. Got it. And one more if I can. Very helpful color on the interest rate coverage and how much rates have to go before the aggregate interest coverage to be at two. But what about at the margin? Like, I mean, what proportion of your portfolio companies have interest coverage below two today? And what would that proportion be if rates went up, say, 200 basis points? I mean, obviously, at the margin, I don't expect the aggregate portfolio to have a credit problem. It's always the weakest credit. So any color there?

[Kipp deVeer, CEO]

We don't have that metric in front of us. We can go try to dig it up. For sure, your comments are spot on. I just reemphasize. We do a pretty rigorous portfolio views here on a quarterly basis as well as running our watch list every two weeks. We've got probably the largest asset and risk management team of any BDC out there. We've demonstrated a track record along with our investment team of being able to manage through. So I am sorry, Robert. I don't have the number right here in front of me.

But I would tell you the portfolio is in great shape, and we don't think, again, continued short-term rises or continued rises in short-term rates is going to be the issue for portfolio companies. The issues that we're seeing in the portfolio are much more specific to inflation, supply chain issues, et cetera, where management teams are just having to operate in a much more complicated environment. We do not have management teams coming to us and saying, we're really, really nervous about our interest coverage because rates seem to be going up.

[Robert Dodd, Raymond James]

Got it. I appreciate it. Thanks very much.

[Operator]

[Operator Instructions]. The next question comes from Bryce Rowe of Hovde Group. Please go ahead.

[Bryce Rowe, Hovde Group]

Thank you. Good morning. I wanted to maybe ask a little bit about Ivy Hill and the injection of some of the Annaly assets into both Ares and Ivy Hill. Just curious, are you -- do you anticipate any kind of return profile changing for Ivy Hill with that injection. And then curious what the incremental investment into Ivy Hill might look like based on when that deal is expected to close.

[Kipp deVeer, CEO]

Yes. I mean I think in terms of what it will look like by the end of Q2, I'd rather just let you guys wait and see. It's probably not appropriate for us to comment on that. What I would say is every time we make incremental investments in Ivy Hill. We, obviously, are doing it with a mindset that we'll be generating additional earnings and dividends coming from that company. I would just say, over the last couple of years, Bryce, we've sort of insisted and frankly, longer than the last couple of years.

But the last couple of years, we've consisted on a 15-ish kind of percent rate of return coming from Ivy Hill in terms of the dividends at cost and the same underwriting standards and strategic view as to what we're doing here with the NEE portfolio remain in place. I wouldn't expect to see any degradation of the return there. We're excited about the transaction. We think it's great for us. We think it's great for Ivy Hill.

[Bryce Rowe, Hovde Group]

Okay. That's helpful, Kipp. And then maybe one more for me. In terms of kind of portfolio mix, we've seen -- we've seen this over the last few quarters in terms of maybe building preferred and common equity positions. And obviously, the increase from Ivy Hill. Do you see the portfolio mix transition maybe coming to some level of an end now that market conditions are getting more volatile? Just trying to kind of get a feel for, how the portfolio might shape up over the coming quarters?

[Kipp deVeer, CEO]

Yes, it's a good question. It's actually -- I don't have a direct answer to because it's actually one that we are talking about a fair amount around here as an investment management team. The impetus for some of the more active preferred investing that we've done has just been additional non-equity capital, so to speak, and some of these extraordinarily high multiple LBOs that we've been involved with where we felt like we had great loan to value through a preferred we could generate great returns, often do that with a co-invest.

Look, if that environment backtracks a little bit and valuation multiples come down, and that slice of preferred frankly, isn't available it may not be part of as many transactions going forward. We were joking about this a little bit last week, but we think we may look back on some of those investments and some of the best investments that we that we made, because they're very low loan to value. They've got high total returns. They've got a tremendous amount of equity cushion below you. So we'll see.

Bryce, I don't have a direct answer. We're just to have to see where the market goes. There will be an upper limitation as to how we see noncash pay securities in the portfolio. We've always capped at it 10 to 15-ish percent rough numbers during normal times. I don't think you're going to see a huge shift where all of a sudden we're running a portfolio that has a 30% equity mix or something in it like that. So I would expect that at the higher end of where we would get, but we're going to have to see where the market in the world takes us.

[Bryce Rowe, Hovde Group]

Got it. Appreciate the color.

[Operator]

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

[Kipp deVeer, CEO]

Don't have any other than to say thank you all for joining us, and we look forward to seeing you for sure at our Investor Day. And if not on the road, after that. Thanks so much.

[Operator]

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of the call will be available approximately one hour after the end of the call through May 10, 2022, at 5:00 p.m. Eastern Time to domestic callers by dialing [phone] and to international callers by dialing 1 [phone]. For all replays, please reference conference number 395-7963. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital's website.