Ares Capital Corp

NASDAQ:ARCC

Earnings Call Transcript 2022-Q2

[Operator]

Good afternoon, welcome to Ares Capital Corporation’s Second Quarter ended June 30, 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference call is being recorded on Tuesday, July 26, 2022.

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

[John Stilmar, Managing Director-Investor Relations]

Thank you. Let me start with some important reminders. Comments made during the course of this conference call and webcast and the accompanying documents contains 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 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 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 per share, 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 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 such representation or warranty with respect to this information.

The company’s second quarter ended June 30, 2022 earnings presentation can be found on the company’s website at www.arescapitalcorp.com by clicking on the Second Quarter 2022 Earnings Presentation link on the home page of the Investor section of the website. 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, Chief Executive Officer]

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

This morning, we reported second quarter core earnings of $0.46 per share, an increase of approximately 10% compared to the first quarter, driven by the early benefits of rising interest rates, higher dividend income and continued credit stability within the portfolio. Our NAV of $18.81 per share declined 1% quarter-over-quarter, largely due to unrealized losses we took to reflect wider credit spreads in the market.

These unrealized marks are to be expected with more volatile markets. However, I will say it’s a welcome trend as more volatile markets tend to provide more deal flow for direct lending participants and most likely more interesting investment opportunities for the longer term.

Volatility within the leveraged finance and equity market continued during the second quarter. The central banks around the world became more aggressive in their fight with elevated inflation by rapidly raising interest rates. With this tightening monetary policy or concerns over an economic slowdown or a recession of increase. The leverage stance markets are experiencing significant spread widening, weak secondary liquidity and minimal primary issuance as the large banks are highly focused on working out their unsold inventory of committed financing, many of which, we believe are being held at significant losses.

During these time, we rely on a playbook that we’ve developed over the past 17 years. We try to be opportunistic on these situations with banks. We become incrementally more selective with our core deal flow to focus on the highest quality investments and to drive better pricing in terms. We aggressively manage our portfolio, and we strive to build additional liquidity at the company. Against this more volatile backdrop, the stability and scale of our capital is resulting in incremental demand from both our existing portfolio companies and from new borrowers, including some much larger companies that otherwise would turn to the liquid markets in less uncertain times.

We believe our long-standing and disciplined approach to investing has resulted in an attractive, highly diversified portfolio that is focused on upper middle market businesses that have significant long-term franchise value and operate in resilient industries. Demonstrating our focus on diversification, our average investment represents to 0.2% of the portfolio and this minimizes our exposure to any single portfolio company.

In addition, we focused on larger companies in recent years and the weighted average EBITDA of our portfolio has now reached $179 million. This number has more than doubled over the past five years. Our experience in previous cycles has demonstrated that larger companies tend to be more resilient during market dislocation. All things being equal, we believe these larger companies have more diverse revenue streams, broader customer bases, deeper management teams and more robust sources of capital. These attributes should all serve to support the credit performance of our portfolio.

While we recognize the increasingly complex operating environment that many companies face in today’s economy, our portfolio companies are performing well. Our nonaccrual to costs remain well below our 10-year average, and we reported another quarter of strong underlying portfolio company EBITDA growth.

Furthermore, the weighted average loan-to-value on the aggregate loan portfolio remains comfortably below our five-year average of 51%, which reflects the significant structural support provided by the equity of our clients as well as private equity-backed companies and a non-sponsored borrowers.

As we discussed at our recent Analyst Day, we have a proactive and deeply embedded credit-oriented culture. We believe our portfolio management team provides an important and differentiated element to our overall approach to risk management. During our quarterly portfolio review, our portfolio management team alongside our deal team have put a heightened focus on the risks brought by today’s high inflationary environment. While our analysis of our industry sectors and underlying company fundamentals is objective, we take comfort that this quarter’s review revealed only between 5% and 10% of our portfolio within the higher risk category, specifically regarding the potential impact from inflationary pressures such as rising energy prices, supply chain disruption and staffing shortage.

Looking forward, we believe the continued increase in market interest rates present a potential opportunity for the growth of our core earnings given our largely floating rate loan portfolio and is financed by mostly low-cost, fixed-rate, unsecured sources of financing. Penni will discuss in more detail, if the full impact of the market rate moves this quarter had flowed through our entire quarter, we calculate that our second quarter core earnings could have been about 11% higher on a run rate basis.

Additionally, should market rates increase 100 basis points from the June 30 levels, our quarterly core earnings could benefit by about $0.08 per share or a 17% increase over our second quarter core earnings. We believe the benefits of these market rate increases to earnings will be more impactful in the third quarter and beyond.

We also do not believe the currently projected increase in rates will result in deteriorating credit performance. Holding all else equal, including leverage at the borrower level, a 150 basis point increase in market rates would result in a weighted average interest coverage ratio in the portfolio of approximately two times. Importantly, this analysis doesn’t consider any EBITDA growth or deleveraging that has historically occurred in the portfolio. We feel good about the ability of our portfolio companies to navigate a higher rate environment, and we believe these dynamics will further differentiate Ares Capital through many other income-oriented alternatives in the market today.

Before I turn the call over to Penni, I wanted to highlight the dividend increase we announced this morning. As a result of our run rate core earnings outlook and the expected further benefit from higher interest rates coupled with our strong portfolio performance, we increased our regular quarterly dividend to $0.42 per share to $0.43 per share for the third quarter. This amount is in addition to the $0.03 per share additional dividend that we’ve already declared for each of the third and fourth quarters of this year.

Let me now turn the call over to Penni to provide more details on second quarter results and some other thoughts on the balance sheet position.

[Penni Roll, Chief Financial Officer]

Thanks, Kipp. Good afternoon, everyone. Our core earnings per share of $0.46 for the second quarter of 2022 were $0.04 higher than a quarter ago and down $0.07 from the same quarter a year ago. The second quarter of 2022 earnings were driven by strong recurring interest and dividend income, some higher one-time nonrecurring dividends and a solid level of capital structure and service fees from new originations.

Our GAAP earnings per share for the second quarter of 2022 were $0.22, which compares to $0.44 for the prior quarter and $1.09 for the second quarter of 2021. Our GAAP earnings for the second quarter of 2022 included net realized and unrealized losses of $0.30 per share. The net realized and unrealized losses on our investments this quarter were largely a result of the unrealized losses we took for certain of our investments to reflect the current widening spread environment Kipp mentioned earlier.

Our total portfolio at fair value at the end of the second quarter was $21.2 billion, and we had total assets of $21.8 billion. As of June 30, 2022, the weighted average yield on our debt and other income-producing securities at amortized cost was 9.5% and the weighted average yield on total investments at amortized cost was 8.7%. The total investment yield at the end of the quarter increased approximately 60 basis points from last quarter, supported by the rise in base rates.

As it relates to our future interest rate sensitivity, we remain well positioned to continue benefiting from a rising rate environment. As of June 30, 2022, 74% of our total portfolio at fair value was in floating rate investments. As Kipp mentioned earlier, we expect continued increases in short-term rates to have a positive impact on the net interest earnings performance of the company.

For starters, we have yet to see the full quarter benefit from higher market rates that have already occurred in the second quarter. Given about 60% of the base rates for our floating rate loans currently reset every 3 months and the increase in base rates through these resets generally occurred in the latter part of the quarter, our second quarter earnings did not fully benefit from the increase in market rates reflected in our yields at quarter end.

By holding all else equal for the second quarter and assuming that the June 30 base rates were in effect for the full quarter, we estimate our second quarter core earnings would have been about $0.05 per share higher resulting in core earnings of approximately $0.51 per share or about an 11% increase over our actual Q2 2022 core EPS results. It is worth pointing out that this analysis does not forecast any other changes, including the incremental benefit from interest rate changes since June 30, 2022.

To look at this with a longer-term lens, as of quarter end, holding all else equal and after considering the impact of income-based fees, we calculated that a further 100 basis point increase in market rates from June 30 could increase our annual earnings by approximately $0.31 per share, a 17% increase above this quarter’s annualized core EPS. We have provided details on our sensitivity to interest rate movements in this quarter’s Form 10-Q for those who want to further examine these impacts.

Shifting to our capitalization and liquidity. During the quarter, we continued to enhance our liquidity by growing our committed debt capital more than $300 million by upsizing two of our revolving credit facilities. Aside from the base rate transition from LIBOR to SOFR, the terms of the two facilities remain the same, including the existing pricing.

After considering our investment in capital activities during the quarter, we ended the second quarter with nearly $4.6 billion of total available liquidity, including available cash of $200 million and a debt-to-equity ratio net of the available cash of 1.25 times, up from 1.06 times at the end of the first quarter.

Overall, with our significant dry powder and only $750 million in debt obligations maturing in the next 18 months, we believe our capital and liquidity remain 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 $694 million or $1.41 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 third quarter dividend of $0.43 per share, an increase to our regular dividend rate, the second such increase in the past year, the third such increase in the past six quarters and our 53rd consecutive quarter of unchanged or growing dividends. This third quarter regular dividend is enhanced by the $0.03 per share additional third quarter dividend that we previously declared in February. Both are payable on September 30, 2022 to stockholders of record on September 15, 2022.

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

[Michael Smith, Co-President]

Thanks, Penni. I’m going to spend a few minutes providing more detail on our investments and portfolio performance for the second quarter and then provide an update on post quarter end activity and our backlog and pipeline.

During the second quarter, our team originated $3.1 billion of new investment commitments across 52 transactions and more than 20 distinct industries. 72% of the commitments issued were senior secured and approximately 60% of these transactions were to incumbent borrowers. As we noted in our Analyst Day, incumbent portfolio companies, which we have provided additional financings have historically had greater EBITDA growth and stronger interest coverage ratios on average in comparison to the rest of our portfolio. We believe the opportunity to finance some of our best portfolio companies clearly provides informational and investing advantages.

Additionally, we believe our track record and ability to finance a business as it grows, continues to be a key differentiating advantage in today’s dynamic market. Further to Kipp’s point earlier about the upper middle market focus of our portfolio, the weighted average EBITDA of companies to whom we issued commitments during the quarter was $183 million as compared to the average EBITDA of exited investments of $102 million. While larger companies continue to be our focus, we are reviewing transactions with EBITDA that ranges from approximately $10 million of EBITDA to more than $1 billion of EBITDA, and we continue to be very selective and only finance approximately 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 results in a differentiated and attractively positioned portfolio. Our portfolio company’s performance during the quarter supports this view. The weighted average EBITDA growth of our portfolio companies over the last reported 12-month period was very strong at approximately 16%.

Importantly, this performance is broad-based, with all of our top 10 industry concentrations demonstrating a healthy level of positive EBITDA growth. It is also worth noting that industries where we have chosen to invest more heavily measured as industries that comprise 4% or more of the portfolio have experienced higher growth than the portfolio weighted average in aggregate.

In terms of credit quality metrics, the weighted average portfolio grade at fair value for the quarter slightly improved to 3.2 and continues to be above the 10-year average of 3.0. Underscoring the overall stability of underlying portfolio companies, only 5% of our portfolio companies had a change in their portfolio grade this quarter, which is consistent with our five-year average. We experienced more upgrades than downgrades for the quarter, which resulted in a decline in the number and percentage of our high-risk Grade 1 and Grade 2 investments at fair value.

Our nonaccrual rated cost of 1.6% increased slightly from 1.2% at Q1 2022, largely driven by the addition of one new nonaccrual, but continues to be meaningfully below our 10-year average of 2.5%.

Now, as Mitch and I do on a quarterly basis, I would like to shift our post-quarter end investment activity and pipeline. From July 1, 2022 to July 20, 2022, we made new investment commitments totaling $245 million, of which $142 million were funded. We exited or were repaid on $379 million of investment commitments. As of July 20, our backlog and pipeline stood at roughly $1.7 billion and $45 million, respectively. Our backlog and pipeline contain investments that are subject to approvals and documentations 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 a few closing remarks.

[Kipp deVeer, Chief Executive Officer]

Thanks a lot, Michael. I’ll conclude simply by saying we believe that Ares Capital remains well positioned to navigate the economic and market uncertainty ahead. The stability of our capital and our ability to be a strong and capable financial partner to our borrowers is likely to only be more valuable and continue the trend of increasing borrower demand for private capital at scale. While we anticipate further market volatility and the potential for additional spread widening as the cycle progresses, we feel very good about our portfolio and the capabilities of our team.

The size and breadth of our team’s experience through cycle positions us well to address any future challenges. We also feel the investing environment going forward should begin to look more and more attractive. This confidence in our position and the potential for meaningful earnings growth from rising interest rates is reflected in our election to raise our quarterly dividend.

I’d like to finish by quickly taking a moment to thank our team for their continued focus and dedication to the success of the company.

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

[Operator]

[Operator Instructions] Our first question today comes from Melissa Wedel of JPMorgan. Please go ahead. Your line is open.

[Melissa Wedel, JPMorgan]

Thanks so much. First question, I’m hoping Kipp, that we can go back the comment you made about the earnings potential being driven by higher rates into 3Q. I think you said it was an $0.08 increase potentially. And I guess I wanted to make sure I’m understanding sort of what’s driving that. Is that based off of sort of 6/30 LIBOR rates? Or should we be thinking about that differently?

[Kipp deVeer, Chief Executive Officer]

Yes, Melissa, I may pull Penni in here to or John for help on the numbers. So what – it’s a little technical and that the borrowers obviously reset LIBOR typically every three months. And the point is, as we got to the end of the quarter, we still had a bunch of companies that had not actually applied for their LIBOR resets, which when they do will imply a much higher base borrowing rate. So, what we were trying to say is, at the end of the quarter, if we pulled forward our expectation of what our interest income would look like with all of those LIBOR resets getting done, i.e., we’re going to evidence all that in Q3, we thought we had just $0.08 of additional earnings from where we kind of left off at June 30. Does that make sense?

[Penni Roll, Chief Financial Officer]

Yes. And I’ll just maybe add a couple of clarifying points on that, because I know we threw a lot of math at you on this, but kind of for this particular 100 basis points increase, there is some hypothetically, if you increase rates by 100 basis points from where we were at June 30, then we would have approximately $0.31 per year in additional core earnings, which translates to about $0.08 a quarter. Because we did not see the full benefit of rates in Q2, there – we’re just seeing further increases in base rates benefit the earnings. So the $0.08 is really more of the hypothetical side.

Where, in addition to that, we said if you would have taken the full quarter of higher rates where they did reset to during the second quarter and had those rates in effect for the full quarter would have been $0.05 pro forma to Q2. So, you kind of have this $0.05 to $0.08 range and two different metrics at work, but the second one is more just to say, look, we think we have further benefits from rising rates. And if you added 100 bps, it would be about $0.08 a quarter.

[Kipp deVeer, Chief Executive Officer]

Thank you. Does that help?

[Melissa Wedel, JPMorgan]

Okay. It does. I appreciate that I think one other point...

[Kipp deVeer, Chief Executive Officer]

It’s going to be a lot year here once we get through Q3. It will be easier once we get through Q3.

[Melissa Wedel, JPMorgan]

Okay. So on that potential $0.08 increase per quarter, that you’ve hypothetically laid out here. Does that also include the impact that we’ve seen on the dividend income line, because we’ve seen a lot of growth there. I know it’s something you talked about in prior quarters, but I’m also wondering how much growth in dividend income from IHAM and recurring income, in particular, are you sort of baking into that number? Thanks so much.

[Kipp deVeer, Chief Executive Officer]

Sure. So it does include anything in regards to dividend income. In this quarter, we actually had a not necessarily expected onetime dividend from an equity investment in a portfolio company. But then the lion’s share of the increase as you can probably expect is our continued investment in Ivy Hill, that’s larger, it’s going to just be paying us a larger dividend going forward.

[Melissa Wedel, JPMorgan]

Thank you.

[Kipp deVeer, Chief Executive Officer]

Thank you.

[Operator]

Our next question comes from Finian O’Shea of Wells Fargo. Your line is open.

[Finian O’Shea, Wells Fargo]

Hi everyone. Good afternoon. Another question on Ivy Hill was the $379 million sold down this quarter. Was that the total allotted amount from Annaly or are there other Ares affiliated origination groups that may also syndicate down to Ivy Hill?

[Kipp deVeer, Chief Executive Officer]

Yes, that number is not part of the Annaly numbers. So, I just call that ordinary course, Fin.

[Finian O’Shea, Wells Fargo]

All the $379 million, sold down was not – okay. That’s helpful.

[Kipp deVeer, Chief Executive Officer]

That’s right. People ask the question – yes. And with the Annaly portfolio, Ivy Hill bought north of $1 billion of that portfolio. So those are two separate numbers.

[Finian O’Shea, Wells Fargo]

Okay. Thanks so much.

[Operator]

Next in the queue today is Devin Ryan of JMP Securities. Please go ahead.

[Kevin Fultz, JMP Securities]

Hi, thanks. This is Kevin Fultz on for Devin. Kipp, you mentioned the increased market volatility has led to an improved competitive environment with more attractive terms on new transactions. Just curious if you could talk a bit about the shift to a more lender-friendly environment and how that’s materializing, both in terms of documentation and more specifically, if you could quantify how pricing has improved on new transactions?

[Kipp deVeer, Chief Executive Officer]

Yes. I mean, I think we’re in a bit of a volatile period. We made reference, obviously, to the fact that banks have underwritten some transactions that they are looking for liquidity on, right? That’s probably going to continue through the remainder of the summer and even into the early part of the fall. So all it’s done is simply widen, what we’re seeing in the public markets. And thankfully now, I think we and most of our other friends and competitors in the private lending space are widening pricing out as well. So an early just preview is probably an additional 100 basis points of spread across most of the tranches as well as higher fees.

And we’re also benefiting to your question from much more lender-friendly documentation, you have reemergence of covenants in some of the smaller deals that perhaps tried to shed covenants during our froth year period. So pretty much every aspect of the investing environment, from pricing terms and documentation has all improved materially in the last 30 to 60 days.

[Kevin Fultz, JMP Securities]

And then just looking at new commitment trends over the past two quarters, you’d significantly reduced commitments to second lien loans. Just curious, is that mainly driven by less attractive spreads on second lien deals? Or is there an ongoing effort to reduce the mix of second liens in the portfolio given a more uncertain economic outlook?

[Kipp deVeer, Chief Executive Officer]

Yes. I mean I think a little of that. I mean there’s probably less opportunity on the junior side. There are more unitranches getting done. But I do think also we saw – we’ve got a large public facing credit platform here. So when we think about where we were in March and April, I think we took a pretty conservative tone around how we wanted to play a transitioning market.

We might have been a little bit less busy than some others during the second quarter, certainly less busy than we could have been, but I think we were taking a bit of a pause as we expected a widening spread environment. And we were trying to make sure that we had capital here going through the summer into the fall to take advantage again of what we thought was an improving investment environment. So it’s a little bit of everything to your point.

[Kevin Fultz, JMP Securities]

I’ll leave it there and congratulations on a really nice quarter.

[Kipp deVeer, Chief Executive Officer]

Thanks very much.

[Operator]

Our next question comes from John Hecht from Jefferies. Your line is open.

[John Hecht, Jefferies]

Morning guys. Thanks very much for taking the question. A quick question in is as sort of maybe a segue from the last question a little bit is, of your gross depreciation, Kipp, I think you cited that most of that was from credit spread widening. Can you kind of, kind of allocate some of the gross depreciation to base rate changes versus credit spread changes, I’m trying to just decipher how much of a change in your book value is tied to, call it generic credit risk versus rates?

[Kipp deVeer, Chief Executive Officer]

Yes. I mean I think – thanks for the question, John. We don’t – we didn’t see really material change in the overall credit in the portfolio. Most of what we observed was simply unrealized losses pretty broadly across the portfolio in reference just at the reference securities that we obviously look to the value of the portfolio, mostly the loan market and the high-yield market.

[John Hecht, Jefferies]

Okay. And then just thinking about that, I mean, because you guys obviously have a pretty detailed view and perspective on credit spreads. I mean if you look at the past 15 years, including the great financial crises kind of where are we right now with respect to how credit spreads are impacting the market relative to say, more extreme times? And in other words, as do you see a lot more potential for widening spreads? Or are we already at a point where the market is pressing and some pricing in some distress?

[Kipp deVeer, Chief Executive Officer]

I mean it’s a good question. I think, again, we’re not seeing significant change in the overall credit metrics in the portfolio. That being said, for valuation, we’re generally working off April and May numbers, right, we’re getting here towards the end of the summer. So I think the question will be, what do the Q2 and Q3 numbers look like at some of these companies. That’s going to impact, I think more potential stress in the portfolio than anything.

Look, the other thing that’s difficult to call right now, John, is everything is widening because there is this underwritten, unsyndicated backlog of some pretty large transactions that the banks are trying to clear out. And depending on how aggressive they are in clearing those, you could set some pretty low levels on price, which would imply very, very widen spreads. What I then expect that to potentially come back, right, as deal flow is, I think, a little bit lesser and you don’t have this unfortunate backlog of things to get to the market.

Look, I mean I think you’ve had a very low base rate environment with base rates going up, credit spreads typically only widen when you see defaults go up. And again, we’re not seeing that really. This is in our market in reference to, I think, the phenomenon of this summer and inventory trying to get cleared out. So we keep taking kind of a patient wait-and-see approach. I don’t have a great crystal ball on that one. I wish I did, but I think we’re just taking a little bit of a patient wait-and-see approach as to how we get through the summer and into the fall.

[John Hecht, Jefferies]

Great. Thanks very much for the color.

[Kipp deVeer, Chief Executive Officer]

Thanks, John.

[Operator]

Our next question comes from Ryan Lynch of KBW. Please go ahead with your question.

[Ryan Lynch, KBW]

Hey, good morning everybody. My first question is Ivy Hill has been just an incredible asset for you all. But my question is we’ve seen that have pretty considerable growth over the last four or five years and really, in particular, the last couple of years of the AUM as well as the dividend growth at Ivy Hill. So could you talk about: one, what is driving kind of the really accelerated growth that you guys have then achieving an Ivy Hill on the assets that are going there, and what has sort of changed in that marketplace to kind of had that accelerated growth recently?

And then also, it’s obviously done really well generate very high income but it’s also becoming a very large portion of your portfolio. Now I know it’s a very diversified kind of asset managers, not like individual loan credit risk with that large investment. But is there any sort of size limitation at 8.5% in your portfolio today, is there any sort of size limitation where you guys say, okay, this is enough, we’re not going to grow this anymore?

[Kipp deVeer, Chief Executive Officer]

Yes. I mean there’s not. Obviously, it’s a judgment call. It’s been going up because they’ve done a great job, obviously managing portfolios of bank loan assets and the cash-on-cash return, if you think about the dividend relative the total investment we’ve made has been very consistent and very attractive over a long period of time. Look, when I see something at 8.5% of the portfolio, it obviously begs the question you’re asking, which is how large could it get, should it get.

We just did a very large transaction there, obviously buying this portfolio from Annaly. They took on $1 billion plus of assets. We made a substantial investment in the company that’s a little bit of a needle mover for this quarter relative to others. But for me, and I would certainly pull the management team, too. For me, it’s getting to be at the upper end, right? 8% or 9% positions is probably feeling pretty chunky. That being said, the underlying there is very diversified. And we don’t really have any concentration in terms of the dividend income coming from one particular investment there. So it’s not something that’s keeping me up at night, but it is starting to test the, the limits a little bit. Mitch is going to jump in here, too.

[Mitch Goldstein, Co-President]

Yes. One thing I want to make sure you understand is the valuation of Ivy Hill through a number of different mechanisms, right, there’s the management see as an asset manager. And we also invest in the subsets of a lot of the CLOs and levered loan funds that we manage because it’s such a tremendous return for ARCC. Over our history, and remember, Ivy Hill has been around since 2007, we’ve had many times where other third-party equity investors have invested in Ivy Hill. So if it ever came to a point and I agree with Kipp, it’s getting up to the upper level. There’s probably still room to grow. But it ever came to a point; we’ve always had the ability to sell equity and continue to invest in the assets that drive the core of our business. So we have the many levers to pull to moderate the size of Ivy Hill.

[Kipp deVeer, Chief Executive Officer]

That’s great.

[Mitch Goldstein, Co-President]

Hopefully, that makes sense?

[Ryan Lynch, KBW]

I understand. That makes sense. That definitely makes sense. And again, it’s been a great asset. It’s just – kind of where [indiscernible] you guys feel comfortable with that. The other question I had, and I really do appreciate the color that you guys gave on kind of the run rate ending the quarter from kind of if you reset interest rates for the full quarter of Q2 and then also kind of the overall 100 basis points at the end of the quarter, those statistics show and kind of a forward LIBOR, SOFR curve shows earnings are going to go up pretty meaningfully over the next several quarters likely.

And so when I look at the core earnings today and the potential increases in the future and then I look at your dividend that you have today and the one you’ve declared from the third quarter even with the $0.01 increase and then the $0.03 kind of special dividends you guys have at the end of the year, earnings look like they’re going to be well above those combined when you kind of look at 2023 earnings potential. And so can you remind us what are you guys thinking as far as dividend policies going forward? Is your expectation to kind of pay out all of your earnings in the form of a dividend? And how do you guys plan on achieving that via core dividend versus special dividends?

[Kipp deVeer, Chief Executive Officer]

Yes. So I think we all agree with your analysis. As you look forward, we think that we’ve got a great positive earnings trajectory here with a much, much higher base rate. We’ve obviously been citing these persistently low base rates for a long time, took advantage as an issuer. But yes, we do pick up some very easy earnings going forward. And look, I’ll just say, Ryan, we never talk about dividends beyond this quarter, but we felt highly confident in our ability to increase the dividend this quarter. And I’ll couple that by saying we’ve also built a pretty substantial amount of spillover income, as you’re aware of the company. And I don’t feel the need, frankly, to add any more to that number. I could argue that number might even be a little bit high, which is why we’ve been using it to pay a special dividend throughout this year. So we feel good about the earnings trajectory, and we feel good about the dividend where it is today and potentially growing from here.

[Ryan Lynch, KBW]

Okay, I appreciate the time today.

[Kipp deVeer, Chief Executive Officer]

Thanks for the questions.

[Operator]

Our next question today comes from Kenneth Lee of RBC Capital Markets. Your line is open.

[Kenneth Lee, RBC Capital Markets]

Hi, good afternoon and thanks for taking the question. You mentioned in the prepared remarks in terms of the internal credit ratings you saw more upgrades then downgrades within the portfolio. Just wanted to get a little bit more details behind perhaps some of the key drivers behind more of those upgrades? Thanks.

[Kipp deVeer, Chief Executive Officer]

It’s what you’d expect. I mean I said generally all around good credit performance, as we mentioned, we had one name that we had to add to nonaccrual, which was pretty small number and well below sort of our historical average, if you look. But no, it’s a large diversified portfolio, Kenneth. And there’s nothing in particular to pull out there. I’d say it was good credit performance all around a couple of equity gains, I think in certain areas that probably moved that number up a little bit. But there’s – it’s a pretty broad and diversified portfolio. I don’t think there are any big takeaways that are worth sharing.

[Kenneth Lee, RBC Capital Markets]

Got you. And just one follow-up question, if I may. Wonder if you could talk a little bit more about or share your thoughts on how leverage could extend over the near term, just given the activity out there? Thanks.

[Kipp deVeer, Chief Executive Officer]

Yes. So we had a busier quarter, the Annaly situation and the upside that Ivy Hill kind of got us to a point where our leverage is now at the upper end of our target range at about 1.23 times, I think on a net basis. Frankly, in a more volatile market like the one we’re experiencing, I’d like to have that number come down. I think we all would – that being said, the ability to upsize Ivy Hill and the ability to make that portfolio acquisition at that we did was just too attractive. So we pushed the leverage to the upper end, but I think the goal longer term would be to be managing that down here in the third and fourth quarters.

[Kenneth Lee, RBC Capital Markets]

Got you. Very helpful. Thanks again.

[Kipp deVeer, Chief Executive Officer]

Thank you.

[Operator]

Next, we have a question from Robert Dodd of Raymond James. Please proceed.

[Robert Dodd, Raymond James]

Hi everyone and yes. Congrats on the quarter and the outlook. A question Kipp kind of a bigger picture question. I mean as – your size of your bar has gone up a lot, and you’ve made comments about how those are more stable businesses, et cetera, et cetera. A question, generally speaking, I would imagine you get to almost $200 million EBITDA businesses. These are global businesses.

The economic outlook right now to me, looks a lot better in, there’s headwinds in the U.S. but compared to Europe, for example, the clouds are less dark. So can you give us any color on how much of the end customer demand for some of these larger businesses comes from those international markets where the economic outlook might be more troubled? And do you have any concerns on that front? Obviously, it might not show up in the numbers yet because it’s still more looking backwards. But again, then the offset is FX can help on that side as well, so any color there?

[Kipp deVeer, Chief Executive Officer]

Yes. I mean it’s a good question. And with the 400 named portfolio, I can’t say, I can actually give you an answer. We have to go back and dig through a lot of data. For the most part, despite the size of these companies, they are U.S. companies, right? That’s the primary focus of what we do here. We’ve got a very large business over in Europe too, but we choose to do that away from the BDC. So certainly, with some of these businesses being large and global, I share your concern as we think about risk management.

Europe does look more difficult, I think, to your point than it does over here in the U.S. But just trying to get to the risk and the heart of your question, we don’t see any unusual risks in our portfolio where we’re heavily weighted to Europe because we tend to be in some larger companies than other BDCs. So – but again, we’d have to go pull through a whole lot of data to get you a really good answer on that.

[Robert Dodd, Raymond James]

I mean just to follow up to hound you a little bit less people. I mean, S&P, I think the estimate is 40% to 50% the U.S. domiciled companies, obviously, but 40% to 50% of revenues are international. Do you have a ballpark estimate, very ballparking, maybe Yankee stadium size?

[Kipp deVeer, Chief Executive Officer]

I mean I would ballpark guess that – I would guess that it is much, much lower than that, right? If you think about the industries and the sectors that we’re in, you think U.S. health care companies, software businesses, et cetera; I mean a lot of this business is getting done in the States, Robert, right? So 40% in the S&P, that’s a very large number, I think, relative to where I would even guess at our portfolio, I would guess that we’re at like a 10% relative to a 40% for your index.

[Robert Dodd, Raymond James]

Okay, got it. Thank you. Yes, perfect. Appreciated

[Kipp deVeer, Chief Executive Officer]

Thanks for the question.

[Operator]

Our next question today comes from John Rowan of Janney Montgomery Scott. Please go ahead.

[Unidentified Analyst]

Hi, this is Rishi Kabushkar [ph] on behalf of John Rowan. Were the unrecognized losses on directly originated loans or broadly syndicated loans?

[Kipp deVeer, Chief Executive Officer]

Both, I would assume.

[Unidentified Analyst]

Is there any way to get a better breakdown on either or? Or is it just all together, are you reporting the...

[Kipp deVeer, Chief Executive Officer]

No. And we could probably go off-line and pull that for you guys. I don’t have it at my finger tips. And the reality is most of what we’re doing is directly sourced loans. We don’t have a lot of broadly syndicated loans on ARCC’s balance sheet. But the larger borrowers, right, larger EBITDA companies probably have quotes. And obviously, we don’t ignore quotes. We look at even in a thin market, something that’s quoted, and we’ll typically use that. But again, there’s not a significant focus at ARCC on broadly syndicated loans.

[Unidentified Analyst]

All right. Thank you very much.

[Operator]

[Operator Instructions] Our next question comes from Casey Alexander from Compass Point. Please go ahead.

[Casey Alexander, Compass Point]

Hi, good afternoon. This is Casey Alexander on behalf of Casey Alexander. I’m just kind of wondering the – this period of economic uncertainty or potential recession that we may or may not be going into or already in, seems – is obviously far more telegraphed than the COVID recession. And it allowed you to do an analysis that said 5% to 10% of your companies are in higher-risk categories from inflation and supply chain impacts.

Does the telegraphed nature of this particular cycle as we go into it, give you a better opportunity to work with your portfolio companies and it gives them a better opportunity to prepare for it by bolstering balance sheets, managing expenses? And would it be your expectation that there would be a better outcome through this cycle of companies that are at a higher risk category than perhaps in the past?

[Kipp deVeer, Chief Executive Officer]

I think it’s a great question. I think the simple answer is yes. And as we’re all looking at our crystal balls, this is a situation. We have a team here that’s been doing this together prior to even getting to Ares 20-plus years. This to me feels like a very traditional, although being influenced by different reasons credit cycle, right, where you’re going to have companies that are having more trouble operating.

And I do take your point when you look back at COVID, that was very unpredictable, something we’ve never experienced before that impacted portfolio company is in a way that we probably wouldn’t have expected on underwriting. And the credit cycle prior to that for me in the GFC was really much more of a banking crisis, right? And something that was influenced away from traditional corporate credit.

So we’re taking some satisfaction that we’ve got a playbook to handle more traditional credit situation, right? So our deal teams and our portfolio management teams are obviously in regular contact with borrowers and with private equity firms. But I think to your point, everybody sees what’s happening now, and it’s not happening so quickly that you can’t take measures to mitigate and help companies operate through this, right? It feels like a much more traditional credit cycle, and we’ve got a very experienced team that I think knows how to navigate through that so.

[Casey Alexander, Compass Point]

All right. Great. Thanks for answering my question. I appreciate.

[Kipp deVeer, Chief Executive Officer]

Thanks for representing yourself.

[Operator]

And finally, we have a follow-up question from Ryan Lynch with KBW. Your line is open again.

[Ryan Lynch, KBW]

Hey, I just had a couple more follow-up questions. I appreciate the time. You mentioned earlier in your prepared remarks turning to some new larger borrowers that would normally turn to the broadly syndicated loan market and now that those are under some more stress that you have the ability to underwrite some of those deals. I know in the past, some of the deals that could have one of the broadly syndicated loan market that maybe went to the direct route.

I know in order to make the yield profile, sometimes you are participating in the second lien for those positions and you felt comfortable as such just because they were larger safer borrowers. I’m just curious with the kind of the stress and the uncertainty with the broadly syndicated loan market as well as the increase in base rates we’ve seen recently, are you able to participate in more of these in more traditional first lien or unit tranche positions than you have in the past?

[Kipp deVeer, Chief Executive Officer]

I mean, I think what we’re seeing, Ryan, because the traditional sort of bank-led syndicate in a first lien, second lien or first lien sort of high-yield issuance is it’s just kind of really not there, particularly on the junior side. I mean the market, I don’t want to say it’s close, but it’s generally not operating very well around rated LBOs, getting sold by underwriters to new investors.

So what’s happening is there’s a desire in particular, on the parts of private equity firms and doing LBOs to find partners that they feel can offer certainty of closing. And the preponderance of some of these larger unit tranches has helped solve that, right? That being said, we’re trying to find the right balance between extracting better terms and extracting higher fees there as sort of one of the few games in town that are available for those types of transactions. And the good news is we’re able to push it there, but it doesn’t happen overnight. But no, nothing is different.

I mean, I think we’re as well positioned as we’ve been in past cycles where volatility comes in and makes the capital markets less reliable. We become again, more reliable. But you’re right, the only difference maybe is the numbers are a little bit larger these days because we’re bigger and a lot of our competition is bigger.

[Ryan Lynch, KBW]

Okay. That’s helpful. And then the last one that I had was, obviously, you guys had put up very strong results, I would say, this quarter. There is the volatility in the marketplace, but overall book value held up well and nonaccruals are still pretty strong and well below your guys’ historical average. So very good results. But I think everybody in the BDC space in which BDC investors are worried about kind of what does the next 12-months look like from a credit quality standpoint. You guys provided a statistic in your slide, I think maybe even mentioned on the call, 16% EBITDA growth in your portfolio of companies over the last 12-month period.

But I think the question that I think a lot of investors have – and I’m not sure if you get the data from your portfolio companies, if you guys work on this. Do you guys get any sort of forecast from portfolio companies of what they are expecting from an EBITDA growth over the next 12 months? Are you guys have any sort of forecast that you guys provide? Because I think that is kind of the real crux and that’s, what really I think investors are worried about what happens over the next 12 months in these portfolio companies?

[Kipp deVeer, Chief Executive Officer]

Yes, I mean I think there’s some math – yes, I mean that’s obviously what we’re talking about all the time here, Ryan. So I mean I share some concern. Am I truly worried? I actually think that with slower growth, which we will likely see again because we’re comping off some COVID numbers, right? So there’s a little bit of a nuance there. But yes, I would expect slower growth in the portfolio. I think I’ve said publicly, too, we would expect defaults broadly will go up. That being said, we’ve always been able to manage those aspects of the company better than most.

So we feel pretty confident. But yes, I mean I share your forecast for probably not as rosy a back half of the year as we’ve seen for the first four to six months of this year and probably a little bit tougher sledding. But again a traditional credit cycle where to Casey’s question, we can be out early, we can be proactive with companies expecting a weaker second half. It really doesn’t keep me up at night. I mean that’s kind of what we do here during periods of less certainty and more volatility as we obviously manage credit. We try to minimize nonaccruals and losses, and we push forward. So – but I share your concern and others.

[Ryan Lynch, KBW]

Okay, I appreciate the, both the follow-up questions.

[Kipp deVeer, Chief Executive Officer]

Yes. Thanks, Ryan.

[Operator]

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

[Kipp deVeer, Chief Executive Officer]

I know just thanks for everybody attending. We’re happy with the quarter. And hope you enjoy the month of August and get some time with your friends and your families because I think it’s going to be an interesting one as we get positioned here for September and beyond. But thanks again for attending today.

[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 August 9, 2022 at 05:00 p.m. Eastern Time to domestic callers by dialing [phone] and to international callers by dialing [phone]. For all replays, please refer to conference number 715312. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital website. Thank you for joining.