Ares Capital - Q3 2024

Transcript

John Stilmar (Head of Investor Relations)

Thank you. Let me start with some important reminders. Comments during the course of this conference call and webcast and 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 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 SEC Regulation G, such as core earnings per share or core EPS. The company believes the 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.

A reconciliation of GAAP net income per share, the most directly comparable GAAP financial measure, the core EPS, can be found in the accompanying slide presentation for this call. In addition, a reconciliation of these measures may also be found in an earnings release filed this morning with the SEC on Form 8-K. Certain information discussed in this conference call and the accompanying slide presentation, including information related to portfolio companies, was derived from third-party sources and has not been independently verified, and accordingly, the company makes no representation or warranties with respect to this information. The company's third quarter-ending September 30th, 2024 earnings presentation can also be found on the company's website at www.arescapitalcorp.com by clicking on the third quarter 2024 earnings presentation link on the homepage of the Investor Resources section of the website.

Ares Capital Corporation's earnings release and Form 10-Q are also available on the company's website. I'll now turn the call over to Mr. Kipp deVeer, Ares Capital Corporation's Chief Executive Officer. Kipp.

Kipp deVeer (CEO)

Thanks a lot, John.

Hello, everyone, and thanks for joining our earnings call today. I'm here with our Co-President, Kort Schnabel, and our newly appointed Co-President, Jim Miller. Jana Markowicz, our Chief Operating Officer, Scott Lem, our Chief Financial Officer, and other members of the management team will also be available during our Q&A session. Before discussing our third quarter results, I want to recognize the leadership changes that we announced this morning. As I mentioned, Jim Miller will now join Kort Schnabel as a Co-President of ARCC, and by way of background, Jim joined Ares in 2006 and currently serves as a co-head of our U.S. direct lending strategy and as a member of our Investment Advisor's Investment Committee.

Jim has been one of the key contributors to the success of ARCC and the Ares direct lending platform, and we look forward to having him play an even more prominent role in this company's direction in the years ahead. As part of this change, Mitch Goldstein is stepping down as Ares Capital's co-president, but he is joining Ares Capital's board, where he and Michael Smith will serve as co-chairman. Mitch will also continue to lead Ares' global credit group as a co-head, and as part of this transition, Michael Arougheti will relinquish his role as chairman but will remain a director of the company. This transition demonstrates the depth and tenure of our team and the continued evolution of our company and its success over a long period of time. With that, let me now turn to the third quarter results.

This morning, we reported another quarter of strong core earnings of $0.58 per share and another quarter of record NAV per share of $19.77. As we've discussed in the past, we believe we are well positioned. What we expect will be a more active deal environment in the future, driven by expanding M&A and sponsor activity as private equity managers are benefiting from lower rates while at the same time feeling growing pressure to return capital to their investors. In the third quarter, we saw a further increase in overall M&A volume with an acceleration in sponsor-backed transactions in particular. Against this backdrop, direct lenders have continued to finance a high percentage of new leveraged buyouts, specifically representing about half of the loan volume supporting buyouts in the third quarter.

We believe that Ares is well positioned to take advantage of this environment, given our deep and long-standing sponsor relationships and our focus on strategic transactions in defensive industries with strong secular trends. Due to our strong competitive position and a more active investing environment, we saw meaningful year-over-year growth in both transactions reviewed and new commitments during the third quarter. Specifically, we reviewed nearly 30% more transactions compared to the same period last year, resulting in an estimated $155 billion in quarterly deal volume reviewed. For context, this amount exceeded the completed transaction volume reported for the entire broadly syndicated leveraged loan market for the quarter. Our long-held approach of sourcing as many transactions as possible is a key factor in remaining highly selective, which we believe ultimately results in strong long-term portfolio performance.

Our ability to grow with our existing portfolio companies that we know well is another key factor in our high level of selectivity, further reducing underwriting risk and driving stronger credit performance. This advantage supported our loan growth in the third quarter as over 75% of our new commitments were to incumbent borrowers. We believe the growing trend of existing portfolio companies consolidating their financing relationships with us is an encouraging trend. We also added 23 new companies to the portfolio, bringing our highly diverse portfolio to over 530 companies. Ares Capital's strong credit profile, rather, can be seen in the health and performance of our portfolio companies. Our non-accrual rates declined quarter over quarter and remain at levels well below industry averages, and the fair value of our risk-rated one and two loans also declined from the second quarter.

Further underscoring the consistent health of our borrowers, the LTM EBITDA growth of our portfolio companies remained in the low double digits for the third consecutive quarter, and finally, as Scott will discuss in more detail, the right-hand side of our balance sheet continues to support our investing activities and remains a competitive advantage. You've seen that we were recently upgraded by Moody's to a higher investment-grade notch, which we believe further solidifies Ares Capital as the highest-rated company in our sector by all three major rating agencies. With moderate leverage, just over one times debt to equity, and well over $5 billion in available liquidity, incorporating post-quarter-end financing activities, we believe we have significant financial flexibility and leading access to efficient forms of capital.

With that, let me turn the call over to Scott to provide more details on our financial results and some further thoughts on the balance sheet.

Scott Lem (CFO)

Thanks, Kipp. Let me walk through our income statement before discussing our balance sheet and the actions we took during the quarter to enhance our capital position. This morning, we reported GAAP net income per share of $0.62 for the third quarter of 2024, compared to $0.52 in the prior quarter and $0.89 in the third quarter of 2023. We also reported core earnings per share of $0.58 for the third quarter of 2024, compared to $0.61 in the prior quarter and $0.59 in the third quarter of 2023. Overall, our total investment income increased compared to the prior quarter, largely due to higher interest and dividend income from net portfolio growth offset by lower structuring fees, as a majority of the new commitments during the quarter were with existing portfolio companies.

In terms of our expenses, the increase in our interest and credit facility fees was consistent with our higher leverage during the quarter to fund a portion of our portfolio growth. Our total portfolio at fair value at the end of the quarter was $25.9 billion, up from $25 billion at the end of the second quarter. The weighted average yield on our debt and other income-producing securities at amortized costs was 11.7% at September 30th, which was down from 12.2% at June 30th and 12.4% for the same period a year ago. Our total weighted average yield on total investments at amortized costs was 10.7%, which compares to 11.1% a quarter ago and 11.2% from a year ago. The declines in our yields were largely due to reduced base rates and, to a lesser extent, spreads on new investments.

Our stockholders' equity ended the quarter at $12.8 billion, or $19.77 per share, another record high for us, as Kipp noted earlier in the call. Before discussing our capitalization and liquidity, let me start by highlighting the notable accomplishment Kipp mentioned related to our credit ratings. At the end of September, Moody's upgraded the long-term issuer and senior unsecured rating for Ares Capital to Baa2 from Baa3. In addition to being rated investment-grade by all three of the major rating agencies, we now have two of our three ratings firmly mid-BBB. We believe this should lead to even more efficient funding costs and potentially increased debt capacity over time. These ratings further distinguish Ares Capital not only within the BDC sector, but also among a select universe of firmly BBB- or higher-rated public companies in the U.S.

Within the BDC sector, we are the only BDC that has both the highest credit ratings from all three major agencies and positive outlooks from S&P and Fitch. In terms of our recent debt capital activity, we amended our revolving funding facility, which included extending the end of the reinvestment period and the maturity to a full three and five years, respectively, and upsizing the facility from $1.78 billion to $2.15 billion. We also announced that we priced our second on-balance sheet CLO for ARCC, which we expect will close next month, subject to customary closing conditions. This closing will bring an additional $544 million of low-cost secured debt capital priced at SOFR plus 158 basis points.

We are happy to continue both diversifying and lowering the weighted average cost of our debt capital and believe CLO financing can continue to be a nice addition to our debt capital going forward. Lastly, as we discussed in our last earnings call, earlier in the third quarter, we amended our BNP Paribas funding facility, where we extended the end of the reinvestment period and maturity each by more than one year, upsized the facility from $865 million to $1.3 billion, and reduced the drawn spread by 40 basis points. In total, pro forma of all these transactions since June 30th, we have added over $1.3 billion of new debt capacity and reduced the weighted average spread of our committed floating-rate debt capital.

Our overall liquidity position remains strong, with nearly $5.8 billion of total available liquidity, including available cash, on a pro forma basis for the post-quarter-end activity that I just highlighted. We also ended the quarter with a debt-to-equity ratio net of available cash of 1.03 times. We believe our significant amount of dry powder positions us well to continue supporting our portfolio company commitments and new investing activities. Moving on to the dividend, we declared a fourth quarter 2024 dividend of $0.48 per share. ARCC has been paying stable or increasing regular quarterly dividends for over 61 consecutive quarters. This dividend is payable on December 30th, 2024, to stockholders of record on December 13th, and it's consistent with our third quarter 2024 dividend. In terms of our taxable income spillover, we finalized our 2023 tax returns.

We are happy to report that we ended 2023 with approximately $631 million, or $1.04 per share, available for distribution to stockholders in 2024. In addition to our third quarter core earnings being well in excess of our current dividend, the spillover level is more than two times our current regular quarterly dividend, which we believe is a significant differentiator for us in the BDC sector and helps provide further visibility and stability to our dividend in a potentially declining rate environment. I will now turn the call over to Kort to walk through our investment activities.

Kort Schnabel (Co-President)

Thanks, Scott. I'm now going to spend a few minutes providing more details on our investment activity, our portfolio performance, and our positioning for the third quarter. I will then conclude with an update on our post-quarter-end activity and backlog. In the third quarter, our team originated approximately $3.9 billion of new investment commitments across 74 different transactions. Excluding the $670 million of loans we originated and distributed as agent, our new investment commitments more than doubled year over year, reflecting the strength of our platform and a more active overall M&A market. Our level of originations also reflects our growing market share with our existing borrowers, as Kipp discussed previously. Evidencing this trend, our share of the overall financings for our top 10 largest incumbent commitments in the quarter more than doubled.

Shifting to our portfolio, we ended the third quarter with a $25.9 billion portfolio at fair value, which grew 4% from the prior quarter and 18% from the prior year. In addition to our expanding market share with incumbent borrowers, our growth is supported by our ability to provide flexible capital solutions to a wide variety of new companies seeking a direct lending solution. This can be seen in the total number of companies in our portfolio, which reached 535 in the third quarter and increased 9% year over year. Further underscoring our focus on covering the broader middle market, the median EBITDA of the borrowers in our portfolio was $82 million in the third quarter, with approximately one-third having less than $50 million of EBITDA. As Kipp mentioned, our portfolio companies remain healthy and credit performance remains strong.

Our weighted average portfolio grade of 3.1 remained unchanged from the prior quarter's level. Our non-accrual at cost ended the quarter at 1.3%, representing another 20 basis points decline from the prior quarter and is within 50 basis points at our lowest level in the last decade. Our current non-accrual level remains well below our 2.8% historical average since the Great Financial Crisis and the BDC historical average of 3.8% over the same time period. Our non-accrual rate at fair value also decreased to 0.6% from 0.7% last quarter, which continues to be well below historical levels for us as well. Further underpinning the strength of our portfolio, at the end of the third quarter, the weighted average loan-to-value in the portfolio was 43%, which we believe provides us with strong downside protection for our loans. This loan-to-value is also significantly below our 10-year average.

When looking at performance by company size, it is noteworthy that company size continues to not be a driver of performance, as companies in all size bands in our portfolio had similar EBITDA growth rates over the last 12 months. In our view, our underwriting and portfolio management processes and our ability to select what we believe are the best companies in attractive industries drives these results. It is also noteworthy that to further our advantages and to support our broad middle market coverage, Ares Management acquired Riverside Credit Solutions during the third quarter. Riverside is a well-established, lower middle market-focused firm managed by a team that we have known for a long time with a very strong investing track record. We believe this team is additive to Ares' direct lending platform's coverage in this important part of the market.

As we discussed in detail at our Investor Day in June, we believe Ares is the only direct lending platform of scale that actively focuses across the lower, middle, and upper middle markets. This differentiated coverage approach supports our ability to focus on market segments that offer better risk-adjusted returns while remaining highly selective. Across our markets, we have seen credit dispersion start to emerge, with certain other managers experiencing growing and elevated levels of non-accruals. We continue to believe the merits of our many competitive advantages are driving differentiated results, as diversification and industry selection have contributed to ARCC's strong credit performance in comparison with other BDCs.

Through our time-tested underwriting processes and collaborative culture, our highly selective approach to investing, and focus on incumbent borrowers as a differentiated opportunity for growth, we have been able to avoid many of the problems that have driven recent non-accruals in the BDC space. Another point of differentiation for ARCC versus other BDCs is our high level of portfolio diversification. By maintaining small individual company position sizes of less than 0.2% of the portfolio on average, ARCC has been able to mitigate the impact of negative credit events in any one company or industry. Finally, let me highlight our active start to the fourth quarter. From October 1st to October 24th, 2024, we made new investment commitments totaling $408 million, of which $320 million were funded. We exited or were repaid on nearly $1.2 billion of investment commitments, which resulted in us earning $4 million of net realized gains.

As of October 24th, our backlog stood at roughly $2.8 billion, more than triple the level one year ago. Our backlog contains 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 so much, Kort. So let me just take an opportunity to share a few thoughts on our past and our future. As many of you know, we're celebrating the company's 20th anniversary this month. Over the course of our 20-year history, my partners and I have seen the growth of direct lending evolve from a small handful of BDCs competing with banks for their lower middle market loans to a proven industry with real institutional backing and recognition. During this time, we've continued to refine our processes, grow our team, and leverage some new thinking. However, we've remained consistent in our approach, our investment philosophy, and our focus on the team and our culture, which underpin everything that we do. Our third quarter earnings and credit results build upon our 20-year track record of successfully managing the companies throughout a wide variety of economic and market cycles.

Over the past two decades, Ares Capital has made nearly 4,000 investments with a cumulative net realized loss rate of 0% and an asset-level realized gross IRR of approximately 13%. And over the same time period, our shareholders have been rewarded, having enjoyed an average annual total return of roughly 13%, which represents outperformance of over 225 basis points per year to the S&P 500 Index. Needless to say, we're very proud of this performance. Looking forward, we believe Ares Capital and its competitive advantages remain strong. With the declaration of the fourth quarter dividend, ARCC's regular quarterly dividend has been stable, or growing now for more than 15 years, and we remain confident in our ability to maintain this dividend level in the foreseeable future, even in the face of lower expected interest rates.

Furthermore, should market interest rates decline, we believe the value of our attractive dividend yield that is well covered by core earnings and supported by a strong level of spillover income will become even more valued by equity investors. As we look to the future, we believe the company remains very well positioned to address what we see as a growing market opportunity, and the management team and the board remain committed in continuing to build upon what we believe is a successful long-term track record. As always, we appreciate you joining the call today. We'll look forward to speaking with you next quarter, but with that, Operator, we'd like to open the line for questions. Thanks.

Operator (participant)

At this time, if you'd like to ask a question, please press the star, then the one on your touch-tone phone. If you would like to withdraw your question, please press star, then two. Please note, as a courtesy to those who may wish to ask a question, please limit yourself to one question and a single follow-up. If you have any additional questions, you may re-enter the queue, and the investor relations team will be available to address any further questions at the conclusion of today's call. We'll take our first question from John Hecht with Jefferies. Please go ahead. Your line is open.

John Hecht (Analyst)

Morning, guys. Congratulations on the 20th anniversary. Very cool. First question is, Kipp, you've been talking, well, I guess the whole market's been talking about this potential for when rates stabilize, if not drop, and maybe people get a little bit more confident about the economy, that there's this massive wave of private equity that needs to be somewhat churned. You've had a couple of good quarters of investment activity, and it sounds like the pipeline's good. I mean, are we now entering that phase of the market, and are you guys kind of bracing for a really active '25 at this point, or is it too early to make that call?

Kipp deVeer (CEO)

No, I mean, I think and appreciate the comment, John. The last two quarters have been good, and I mean, the simple answer is yes, we remain pretty busy. I mean, I think getting the election behind us will help, and then we'll obviously be getting into year-end, but I expect a busier next year for sure.

John Hecht (Analyst)

Okay. And then just a quick question on Riverside, and maybe give us a sense of what's their kind of origination, I guess, trend. And this sounds like it's lower middle market. So will that kind of take you into a slightly different asset class than you guys have been focused on the last few years?

Kort Schnabel (Co-President)

Yeah, it's Kort. I can jump in on that. I wouldn't say it's a slightly different asset class. I think the takeaway is Riverside is a very active lower middle market lender. It's not a large team. It's a nine-person team. We've known them for a really long time, and we have immediately integrated them into our team and our process, and they're going to help us energize and double down on our commitment to cover the lower middle market even as we scale. And I think we're excited to have them on board. They're going to bring deals to our investment committee just like any of our other 200 investment professionals, and it should be a good thing for our broader market coverage.

John Hecht (Analyst)

Great. Thanks, guys, very much.

Kort Schnabel (Co-President)

Thanks, John.

Operator (participant)

We'll take our next question from Finian O'Shea with Wells Fargo Securities. Please go ahead. Your line is open.

Finian O'Shea (Analyst)

Hi, everyone. Good afternoon. On the market opportunity for the asset class, so today we have a lot of spread compression, and hopefully volume heals and relieves that dynamic. But we wanted to ask your view, in light of all the capital being raised, if the direct lending premium is on more of a secular decline?

Kipp deVeer (CEO)

I don't think so, because the way that the market works typically is folks lock up capital in a liquid credit when they look at other reference securities in liquid credit in particular, and frankly, other surrounding markets, right? So the risk premium, the complexity premium that we get for locking up investor capital in a liquid credit, of course, varies over time, right? If you look at historical numbers, it's somewhere between 150 and maybe 400 basis points. But for me, it's that relationship that really needs to remain in place for the capital to continue to support growth in the market.

I think your point on spread compression is fine, and it's there, but it's in response not so much to lack of deal flow, but just, I think, to most of our teams, as well as some of our competitors' belief that the economy is in a better place than we might have expected. Defaults are very low. There's growth. And when you see less risk investing in a market, you're willing to take less return. And that's what's happened over the last year or two.

Finian O'Shea (Analyst)

That's helpful. Thanks. If I could do a small follow-up on Riverside, just seeing how perhaps one-off that was, or if maybe this is indicative of another large trend where large managers such as yourselves are able to consolidate and add on a lot of sort of investment origination capacity that way amongst the perhaps likely sprawling lower middle market firms out there? Thanks.

Kipp deVeer (CEO)

Yeah. I mean, all I'd say is something that I can add on to what Kort said, which is really the meat of the bone or the meat on the bone. Look, I mean, we've been at this 20 years, and the key is that you continue, in our experience, to build the best origination team you possibly can, which leads to the best outcomes. So we've been adding people in a whole host of different segments and industries and all of that for 20 years. Riverside is just another example of that, right? As Kort mentioned, a lower middle market team that can add to what we're doing, and it remains our commitment to keep adding things that we think bring value to the company and the shareholders.

Kort Schnabel (Co-President)

And Finian, as you know, we've talked a lot about our ability to cover all different parts of the market. And I think, again, this is just a reiteration of our commitment to that lower middle market. I think it might be natural for us, as we scale, to potentially take our eye off the ball or focus a little less on that part of the market. And I think we want to make sure that we are intentionally not doing that, both with our existing team as well as adding resources here through the acquisition of Riverside. So hopefully that helps.

Finian O'Shea (Analyst)

Yes. Thanks so much.

Operator (participant)

We'll take our next question from Melissa Wedel with J.P. Morgan. Please go ahead. Your line is open.

Melissa Wedel (Analyst)

Good afternoon. Thanks for taking my questions. And congrats to everyone with a new or expanded role with the company. I was hoping to follow up on the comments about growing share with existing clients and as they sort of consolidate relationships. I assume that that involves a good amount of refi activity that happens within the portfolio. Is that the case in the third quarter? And do you have sort of a view on what that could look like going forward?

Kipp deVeer (CEO)

I mean, not really necessarily, Melissa. I think the point is we've got a very, very diverse set of clients, right? I mean, the company today literally has representation with 200-plus sponsors, and that doesn't even take into account industry groups and non-sponsored deals and all of that stuff. But look, the key is that we keep doing more with the folks that we want to do more with. And I think that the large players with big teams have been able to continue to capture more and more share with the most relevant clients. It's not just us, it's others. But the focus is there. It's not needing to be heavier on refi activity in our minds.

Kort Schnabel (Co-President)

Yeah. And in fact, I would say it's not a lot of refi activity. It's a lot of add-on capital activity into our existing portfolio companies to support growth and M&A. And the fact of the matter is we are providing more of that add-on capital than our other club members in those facilities, which is what's contributing to our market share gain. So it's definitely more of that and less refinancing.

Melissa Wedel (Analyst)

Okay. I appreciate that context. Just as a follow-up, was there anything we should be thinking about in terms of sort of timing of originations during the third quarter? I think they generally tend to be a little bit back-end loaded. Was there anything exacerbated and tricky? Was it pretty normal? Thank you.

Kipp deVeer (CEO)

Yeah. I think it was a pretty good quarter. I mean, it comes and goes, unpredictable from quarter to quarter, but I don't think there's anything other than just circumstance and randomness.

Melissa Wedel (Analyst)

Okay. Thank you.

Kipp deVeer (CEO)

Yeah. Thanks for your questions.

Operator (participant)

We'll take our next question from Casey Alexander with Compass Point. Please go ahead. Your line is open.

Casey Alexander (Analyst)

Hi. Good morning, and I guess good afternoon. Thanks for taking my questions, and happy anniversary.

Kipp deVeer (CEO)

Yeah. Thank you.

Casey Alexander (Analyst)

I noticed that your second-lien exposure over the last three years has been cut by more than half, and so I'm wondering, have we been watching sort of a defined internal strategy on the run, or does this have to do more with the way that structure has changed across the private credit industry?

Kort Schnabel (Co-President)

Yeah. I mean, look, I can jump in on that. I think what you're seeing is a little bit more of a change in the market that's happening now. I'm not sure it's we go through a lot of cycles, and what we're seeing now is a lot of unitranche transactions, and that's taking market share from the second-lien market. And so I would not say that it's an intentional shift on our part. It's more us looking for good relative value in all market environments and investing into the opportunities that are in front of us. Obviously, we like the returns we're getting on the first-lien asset class, and leverage levels are still lower than the average. Returns are higher, so we think it's a good place to be putting dollars. But we'll see how the market develops from here.

Casey Alexander (Analyst)

Okay. Well, then let me follow up on that question. Okay? 53% of your portfolio is first-lien. Kind of how does that balance between pure first-lien versus unitranche? And when you do a unitranche, which is going into that first-lien bucket, what type of yield premium are you generally getting on that relative to a pure first-lien?

Kipp deVeer (CEO)

Yeah. I mean, it's a little bit in the eye of the beholder, right? We've talked about what a unitranche is versus a first-lien term loan. That's kind of a hard question to answer, to be honest, Casey.

Casey Alexander (Analyst)

Okay. Thank you. Appreciate you taking my questions.

Kipp deVeer (CEO)

Thanks for the follow-up.

Operator (participant)

We'll take our next question from Robert Dodd with Raymond James. Please go ahead. Your line is open.

Robert Dodd (Analyst)

Hi, everybody, and good morning from St. Pete. I mean, congratulations to everybody on the new role. So a couple of questions, mainly about spreads and yields. I mean, I think Scott in the prepared remarks said a dominant part of the decline in the weighted average yield this quarter was base rates. I mean, have you seen? I mean, the 3.50 at the beginning of the quarter wasn't that different from the beginning of the previous quarter, but resets aren't always that recent. Have you seen a shift in elections to, or should we expect to see a shift in elections towards a shorter term, like one month if rates start falling versus three months, or when the reset dates are happening or anything like that? Because it seems like normal course, three-month resets at the beginning of the quarter shouldn't have had that much impact.

This quarter, for fourth quarter, yes. But can you give us any color on that?

Kipp deVeer (CEO)

Yeah. So I think the comments about the decline in the yields were really those yields we disclosed were at the end of the period. So the effects of that really have not flown through until really the following quarter. In terms of the resets, I mean, it'll vary depending on the borrower. So usually it's at a month end, but we haven't really seen a shift yet in terms of the terms of the contracts from three to one, just given the rates just recently moved.

Robert Dodd (Analyst)

Got it. Thank you.

Kipp deVeer (CEO)

I was just going to say, just to hit it really hard on the head and put some math around it. I mean, so there's been a 70 basis point decline in three-month SOFR from Q2 to Q3. We've seen about 10 basis points of that flow through the numbers, actually, in Q3 due to the lag effect that occurs. So there will be a lag as the base rate declines. And we did not see much of that yet in this quarter. I think it's probably just important to highlight in our 10-Q, we put out disclosures so that people can do the math. Every 100 basis point reduction in SOFR results in a $0.03 quarterly reduction for us.

So I think the good news is people can see there's a lot of cushion relative to our dividend, which was very purposeful and intentional because we knew that eventually rates were going to decline. And we've operated through lots of different rates and rate environments over our history and feel good about the ability to continue to do so.

Robert Dodd (Analyst)

Got it. Thank you. And then kind of the follow-up one, it looks this quarter like new onboarded, not refinanced, not repriced, but new portfolio companies onboarded for first-lien. Spreads looked like they were sub-500. And I mean, you've talked about spread compression before. That seems like, I mean, that's the lowest I can find in a decade. I mean, is there something unique about this quarter, or is that spread compression not just there, but getting worse? Can you give us any thoughts on that?

Kipp deVeer (CEO)

Yeah. I mean, I think, look, spreads we've said, I mean, I think we said this last earnings call, have come in at least 100 basis points this year, right, from the beginning of this year towards the finish as we come up upon it. There are plenty of large-cap unitranches getting done with fours, but middle market deals are not. So I'd just say that the range is generally kind of a 450-550 market, depending on quality of credit, size of company, etc. Which, when you consider the base rate plus the spread and the fees, is still getting you a pretty attractive gross unleveraged return on the asset, in our opinion. So when I said this in an answer earlier, when the economy demonstrates strength and the portfolio is in good shape, people, Ares included, feel comfortable seeing returns go down modestly.

So we expect that.

Robert Dodd (Analyst)

Got it.

Kipp deVeer (CEO)

I don't think it's. I don't see it continuing. I think.

Kort Schnabel (Co-President)

Well, that's an important point, which is.

Kipp deVeer (CEO)

Follow-up.

Kort Schnabel (Co-President)

I think that they have actually stabilized. We did see spreads stabilize this past quarter relative to the prior quarters where there was consistent decline. So I think that's an important point. And then Kipp's point around looking at the absolute return, again, relative to our historical experience, we're still getting 10% on senior debt at leverage levels that are well below historical averages. So I think on an absolute basis, we're still feeling pretty good.

Robert Dodd (Analyst)

Thank you.

Kipp deVeer (CEO)

Thank you.

Operator (participant)

We'll take our next question from Doug Harter with UBS. Please go ahead. Your line is open, and Doug, your phone may be on.

Kipp deVeer (CEO)

There, Doug?

Operator (participant)

Moving on, we'll take our next question from Kenneth Lee with RBC Capital Markets. Please go ahead. Your line is open.

Kenneth Lee (Analyst)

Hey, good afternoon. Thanks for taking my question. Just in terms of the portfolio there, it looks like average interest coverage ratio has ticked up to 1.8 times. Just wondering, do you still expect to see a pickup in terms of credit losses across the industry, or are things just getting much better, especially with the potential rate outlook there? Thanks.

Kipp deVeer (CEO)

Thanks. I was forecasting, frankly, that things would get worse than they've gotten. I mean, I see it currently as stable, right? You have very low non-accruals as a percentage of the portfolio, both on a fair value and cost basis. When we look at sort of the watch list names, ones and twos, again, the count has been pretty consistent. So at this point, for me, it's a little bit difficult to predict. I guess we'll see what the economy does, and we'll see what the trajectory of rate decreases likely are. But I see it as a pretty stable picture. I don't see an increase in defaults. I don't see things also materially getting much better than this. They're pretty good from a credit quality perspective today when you look against the historical numbers.

Kenneth Lee (Analyst)

Gotcha. And just in terms of just a little bit of housekeeping, any color around amendment activity seen in the quarter, and as well, any kind of revolver facility drawdowns that you want to highlight? Thanks.

Kort Schnabel (Co-President)

I'll just say amendment activity has been very stable, if not even a little bit lighter than normal. And then on the revolver draw points, revolver draws at our portfolio companies have actually gone down this quarter versus prior quarter. So liquidity at our borrowers feels healthy.

Kenneth Lee (Analyst)

Gotcha. Very helpful there. Thanks again.

Operator (participant)

We'll take our next question from Mark Hughes with Truist. Please go ahead. Your line is open.

Mark Hughes (Analyst)

Yeah. Thank you. Good afternoon. Exits in the fourth quarter, there was a chunk that went over to Ivy Hill, but it looked like the net activity was still negative. How do you see that playing out for the full quarter?

Kort Schnabel (Co-President)

Yeah. I think you're just talking about the post-quarter end activity. It's 24 days. I think it's not a lot.

Yeah. I wouldn't read too much into that. As you mentioned, $450 million of the exits were sales to Ivy Hill. Obviously, like you pointed out, still a net negative number, but the backlog we disclosed being in the mid-$2 billion level. We feel good about the level of activity out there.

Mark Hughes (Analyst)

Understood. And then the improvement in interest coverage, was that largely the lower portfolio yields, or was there some improvement in the?

Kipp deVeer (CEO)

I think EBITDA was down a little bit sequentially, but that could be misleading. We saw EBITDA growth on the portfolio and slightly lower rates for portfolio companies.

Kort Schnabel (Co-President)

Yeah. The growth rate of EBITDA was down sequentially from 12% to 10%, but still 10% growth, which will help with the interest coverage math, as well as the modest rate declines.

Mark Hughes (Analyst)

And then I did want to ask Jim Miller, any plan to improve the 20-year process that's been put in place?

Jim Miller (President)

It's really difficult to come in after 20 years and improve something that's been run this well. That is.

Kipp deVeer (CEO)

But you've been here for, what, 18 of the 20?

Jim Miller (President)

Yeah. The first two years, I was not here, so they can take full credit on it. But no, I'm very excited to be part of the team, closer working with ARCC. But this is a great business with a great team. So nothing exciting from my end.

Mark Hughes (Analyst)

Appreciate it. Thank you.

Operator (participant)

As a reminder, if you'd like to ask a question today, please press the star and one on your telephone keypad. We'll take our next question from Paul Johnson with KBW. Please go ahead. Your line is open.

Paul Johnson (Analyst)

Thank you for taking my questions. Congrats on the 20 years as well as the upgrade. On the spread compression that you've kind of seen this year, has that also impacted structuring fees at all for new deals, or is it just maybe a little too early to tell, just given we're still kind of waiting on an area coverage?

Kipp deVeer (CEO)

I mean, I think you have to take it all together and say borrowers are looking at the all-in cost of financing, fees, the base rate, and obviously spreads. A little bit of pressure on fees too, the same way we've seen some pressure on spreads. We'll see where it goes from here. I don't think we have anything to take away quite yet.

Paul Johnson (Analyst)

Appreciate that. And then on just one line, Emergency Communications, I saw that that was removed from non-accrual from last quarter. Is there anything you can say, I guess, on the resolution there? Is that still in the portfolio, or has that been exited fully at this point?

Kort Schnabel (Co-President)

It's been fully exited from the portfolio.

Mark Hughes (Analyst)

Got it. Thanks for that. Last question, just broader. I mean, in terms of inflation, I guess, what do you see kind of from your broader observation of the portfolio? I mean, if we kind of passed the worst points of inflation at this point, has it sort of remained persistent? I mean, it seems to be a story that doesn't completely go away. Just kind of wondering just with the higher inflation outlook due to the potential outcome of the election.

Kipp deVeer (CEO)

We think it's moderated a lot. I mean, if you follow us from quarter to quarter, it had been a theme that we actually had talked about and something that was very evident in our portfolio as far back as probably the third, fourth quarter of 2021, as we sort of emerged from that difficult period with the pandemic. It continued and was quite persistent. But I would say this year, even in the last year, it's moderated quite a lot to levels that feel much more normalized on a go-forward basis.

Paul Johnson (Analyst)

Thanks. That's all for me.

Operator (participant)

We'll take our next question from Derek Hewett with Bank of America. Please go ahead. Your line is open.

Derek Hewett (Analyst)

Good afternoon, everyone, and reiterate the congratulations on the successful 20 years. My question has to do with PIK. So it's been stable at about 15% of revenue the past few quarters. So the first part of my question is, do you think PIK has peaked at these levels? And more importantly than that, what percentage of PIK was just temporarily built into the original deal to kind of give the borrower some additional flexibility versus kind of PIK related to any sort of borrower liquidity issues?

Kipp deVeer (CEO)

Yeah. And thanks, Derek. I think you know this, but for others who may not think about it quite the same way, we do a fair amount of junior capital investing at this company, and we think we do it quite well. And a portion of that is particularly in a higher interest rate environment, being able to structure deals that have PIK components. That's why we win business in a lot of these circumstances. And we're doing them in what we think are really high-quality companies that simply are needing to adjust to the higher rate environment and having less cash on hand. So the answer to your question is most of the PIK income is by choice, as I describe it, not as a concession for a portfolio company underperformance.

It's very different from, obviously, where we were in 2020, where most of it was coming as a concession to companies that weren't open and weren't generating cash. But I think a lot in the BDC world is made of PIK. And we spend a lot of time looking at the numbers. The number that I look at is just what percentage of your total interest and dividend income is PIK, right? And the number that I'm looking at for this quarter for the company is down pretty substantially from 2020, 2021, and 2022. So it just doesn't give me a significant amount of concern today because, again, most of this is by choice and part of our investment philosophy, and I think has been one of the reasons we've been able to generate such significant ROEs in, frankly, this company relative to some of the competition.

Kort Schnabel (Co-President)

And we actually did disclose at our Investor Day, and it still holds true today, 90% of our PIK income was structured at the time of the investment versus only 10%, which is amendment-oriented PIK.

Derek Hewett (Analyst)

Okay. Thank you for that. And then my follow-up question is, are there any, for lack of a better term, credit blind spots that investors need to kind of pay attention to within the sector, just given the surprisingly strong trends that we continue to see within the middle market?

Kipp deVeer (CEO)

Yeah. I think, personally, I think the one that everyone always misses is a lack of diversification. It's not something that we get enough credit for at this company with 500-plus portfolios. We're not exposed to a single name. And you've seen over time that we've had some credit problems, losses, whatever it may be. But over a 20-year history investing in 4,000 companies, diversification is actually a pretty big deal. And what you'll see, we get asked questions about, "Oh, what happened to this portfolio company?" At the end of the day, most of the time, it doesn't matter. And companies have been able to generate really, really consistent results over a long period of time, which is why we really don't comment very often on single-name risks because we don't believe the company actually has any.

Derek Hewett (Analyst)

Great. Thank you.

Kipp deVeer (CEO)

Thanks for the question.

Operator (participant)

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

Kipp deVeer (CEO)

Nothing as usual other than thanks for attending the call. And we will catch you next quarter. Have a great day.

Operator (participant)

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of the recording is available for approximately one hour after the end of the call through November 30th at 5:00 P.M. Eastern Time. To domestic callers by dialing 1-800-839-5127, and to international callers by dialing +1-402-220-2692. An archived replay will also be available on a webcast link located at the homepage of the Investor Resources section of the Ares Capital website. Thank you for your participation, and you may now disconnect.

Melissa Wedel (Analyst)

Goodbye.