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Edited Transcript of ARCC earnings conference call or presentation 2-Nov-17 4:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 Ares Capital Corp Earnings Call

NEW YORK Dec 5, 2017 (Thomson StreetEvents) -- Edited Transcript of Ares Capital Corp earnings conference call or presentation Thursday, November 2, 2017 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John W. Stilmar

Ares Capital Corporation - IR and Corporate Development

* Michael A. Dieber

Ares Capital Corporation - Partner

* Penelope F. Roll

Ares Capital Corporation - CFO and Member of Enterprise Risk Committee

* Robert Kipp DeVeer

Ares Capital Corporation - Director and CEO

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Conference Call Participants

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* Christopher John York

JMP Securities LLC, Research Division - MD & Senior Research Analyst

* Christopher Robert Testa

National Securities Corporation, Research Division - Equity Research Analyst

* Douglas Robert Mewhirter

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

* John Hecht

Jefferies LLC, Research Division - Equity Analyst

* Jonathan Gerald Bock

Wells Fargo Securities, LLC, Research Division - MD and Senior Equity Analyst

* Leslie Vandegrift

Raymond James & Associates, Inc. - Analyst

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

* Ryan Patrick Lynch

Keefe, Bruyette, & Woods, Inc., Research Division - Director

* Scott Scher

LMJ Capital - Analyst

* Terry Ma

Barclays PLC, Research Division - Research Analyst

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Presentation

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Operator [1]

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Good afternoon, and welcome to Ares Capital Corporation's Third Quarter Ended September 30, 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded on Thursday, November 2, 2017.

I will now turn the conference call over to Mr. John Stilmar of Investor Relations. Mr. Stilmar, the floor is yours, sir.

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John W. Stilmar, Ares Capital Corporation - IR and Corporate Development [2]

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Great. Thank you, Mike, and good afternoon, everybody. Let me start with some important reminders.

Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar such expressions. The company's actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in its SEC filings. Ares Capital Corporation assumes no obligation to update such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results.

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

A reconciliation of core EPS to the net per-share increase or decrease in stockholders' equity resulting from operations, the most directly comparable GAAP financial measure, can be found in the accompanying slide presentation for this call by going to the company's website. The company believes that core EPS provides useful information to investors regarding financial performance because it is one method the company uses to measure its financial condition and results of operation.

Certain information discussed in this presentation, including information relating to portfolio companies, was derived from third-party sources and has not been independently verified, and accordingly, the company makes no representation or warranties with respect to this information.

As a reminder, the company's third quarter ended September 30, 2017 earnings presentation is available on the company's website at www.arescapitalcorp.com by clicking on Q3 '17 earnings presentation link on the homepage of the Investor Resources section. Ares Capital Corporation's earnings release and 10-Q are also available on the company's website.

I'll now turn the call over to Mr. Kipp DeVeer, Ares Capital Corporation's Chief Executive Officer.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [3]

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

Let me start by reviewing our third quarter results and investment activity, including an update on our continued progress with the American Capital portfolio. This morning, we reported third quarter core earnings of $0.36 per share, a $0.02 improvement from the $0.34 per share we reported in the second quarter. The improved earnings were driven by higher yields on our investment portfolio due to the resolution of the SSLP and the early returns from our ongoing portfolio rotation effort.

In addition to these core earnings, we generated another quarter of net realized gains which totaled an additional $0.08 per share. When taken together, our core earnings plus our net realized gains were $0.44 per share, which is a measure that we believe is the best proxy to evaluate our dividend. They were again well in excess of our historical regularly quarterly dividend of $0.38 per share. The ability to generate earnings from a variety of sources highlights the diversity of our business and our ability to deliver earnings even in aggressive market conditions. And in times of increased competition and lower yields, we believe our strategy enables us to take advantage of a strong liquid market environment by monetizing investments at gains.

Consistent with prior quarter levels, we announced our fourth quarter dividend of $0.38 per share.

Now turning to some commentary on the market. Our feeling is that pricing on new deals is generally stabilized, but underwriting terms are fairly aggressive driven by strong liquidity from a variety of sources, including new entrants who seem eager to put capital to work. We maintain our focus on careful credit selection these days and sticking to our time-tested investment process of picking leading non-cyclical business that we feel have attractive growth prospects and strong sponsorship.

Beyond this, we believe that maintaining the integrity of loan structures and documentation is an important part of our investment and portfolio management process. We're fortunate that our people, our strategy, our platform, our track record and our long-standing relationships in the market have put us in the best possible position to navigate these types of markets. We believe we see the broadest market opportunity from which to select investment opportunities. We believe our size and scale, which includes our ability to commit and hold larger amounts of a borrower's loan, along with our flexible underwriting approach and our structuring capabilities, allow us to negotiate the best terms and the best capital structures in our deals. We are not afraid to pass on the roughly 90% to 95% of investments that we see, particularly those that include weaker terms, insufficient credit protection and unrealistic adjustments to EBITDA.

I'll highlight we also have the benefits of incumbency and a large existing portfolio. ARCC today has over 300 portfolio companies with whom we're consistently discussing new investment opportunities and we often support our best companies' growth needs. This past quarter, about half of our $1.5 billion in gross commitments were to existing portfolio companies. We think this enhances long-term credit quality at the company as it removes the risks inherently associated with taking on new portfolio companies that often come with surprises and it allows us to remain active but defensive in the current market.

With respect to our new investments, we are generally finding better relative value with upper middle market companies since there is often no meaningful pricing differentiation between small and larger mid-market companies. And given that we expect these larger companies to generally be more durable with better credit performance over time, we tend to favor these companies in the current market, unless of course there is a meaningful difference in terms or in pricing.

The point to all of this is in our opinion that despite tougher market conditions, Ares Capital maintains clear and durable competitive advantage. Despite these market conditions, we were able to improve our portfolio yields by approximately 30 basis points at the end of the third quarter when compared to the end of the second quarter. And the two biggest drivers of this yield improvement were new investment yields in excess of exited yields and the resolution of the SSLP.

Excluding the SSLP resolution, we exited or were repaid during the third quarter on $1.5 billion investments yielding just over 7% and we funded $1.4 billion of investments yielding just over 9%. In addition, we exited our investment in the SSLP in July of 2017, which at the time of the transaction was a $1.5 billion investment yielding just 5.75%. And as part of the effective termination of the SSLP, we purchased $1.6 billion in first lien senior loans from the program with a weighted average yield of 7.1%, which improved the yield on our invested capital. The full earnings benefit from these rotation events should be captured during our fourth quarter.

Let me now spend a moment to update you on some continued good news with respect to the American Capital portfolio. As we've discussed in the past, the core debt positions we acquired are performing well and they fit in the current portfolio, but the remaining non-core assets are still targeted for exit.

During the third quarter, we exited $415 million in American Capital assets, generating net realized gains of approximately $56 million. Since the initial acquisition of the $2.5 billion portfolio, we have exited more than $1 billion of assets, generating cumulative net realized gains of $79 million through September 30th.

The weighted average yield at fair value on the remaining portfolio was approximately 80 basis points higher at September 30th than the originally acquired portfolio. We currently have $875 million at fair value in lower non-yielding non-core assets remaining in the American Capital portfolio that have an aggregate yield of 7.6%. And again, we continue to target these for rotation purposes.

We believe that based on this position today, we continue to have significant opportunities to further improve our earnings largely from rotating these assets, again specifically the $1.6 billion in former SSLP asset yielding 7.1% and the $875 million in non-core former American Capital assets yielding 7.6%. Of course, the full benefit from the repositioning of these lower yielding assets into new higher yielding assets may take multiple quarters in order for the company to see the full earnings benefit.

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

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Penelope F. Roll, Ares Capital Corporation - CFO and Member of Enterprise Risk Committee [4]

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Thanks, Kipp. As Kipp stated, our basic and diluted core earnings per share were $0.36 for the third quarter of 2017 as compared to $0.34 for the second quarter of 2017 and $0.43 for the third quarter of 2016. Our basic and diluted GAAP earnings per share for the third quarter of 2017 were $0.33, including net losses for the quarter of $0.03 per share and a reduction for American Capital related expenses of $0.01 per share. This compared to GAAP net income of $0.42 per share for the second quarter of 2017, which was reduced by American Capital related expenses of $0.03 per share, and GAAP net income of $0.35 per share for the third quarter of 2016, which was reduced by American Capital related expenses of $0.01 per share.

As of September 30, 2017, our investment portfolio totaled $11.5 billion at fair value and we had total assets of $12 billion. Also at the end of the third quarter, the weighted average yield on our debt and other income producing securities at amortized cost increased to 9.6% and the weighted average yield on total investments on amortized cost increased to 8.5% as compared to 9.4% and 8.2%, respectively, at June 30, 2017.

The total portfolio yield increased since the end of the second quarter, primarily due to the rotation out of lower and non-yielding investments, including the SSLP and certain American Capital equity investments into higher yielding investments, as Kipp previously mentioned.

We generated $35 million in net realized gains during the third quarter, representing the 13th straight quarter we have reported net realized gains on investments. In total, we reported net realized and unrealized losses on investments and foreign currency transactions for the third quarter of $14 million. Our current dividend remains well supported by our current earnings, including core earnings and net realized gains and our spillover income.

After filing our final tax return for 2016, we determined that the undistributed taxable income carried forward from 2016 into 2017 was $340 million or $0.80 per share. The fourth quarter dividend of $0.38 per share that Kipp mentioned is payable on December 29, 2017, to stockholders of record on December 15, 2017.

Moving to the right-hand side of the balance sheet, our stockholders' equity at September 30 was $7 billion, resulting in a net asset value per share of $16.49 compared to $16.54 a quarter ago. Given our size, scale and strong investment grade credit profile, we continue to drive the pricing down for our various debt instruments. During the quarter, we issued our lowest cost unsecured investment grade notes in our history with a $750 million issuance at a fixed coupon of 3.5%. Also, just subsequent to quarter end, we amended our $1 billion revolving funding facility, reducing the drawn spread from LIBOR plus 230 basis points to LIBOR plus 215 basis points.

As of September 30, 2017, our debt-to-equity ratio was 0.67x and our debt-to-equity ratio net of available cash of $247 million was 0.64x compared to 0.7x and 0.64x, respectively, at June, 30. Our leverage remains below our target leverage range, leaving significant room for new investments. And our total available liquidity at the end of the third quarter was approximately $2.9 billion, which will allow us to easily repay our upcoming convertible notes at their maturity in January 2018.

Our balance sheet continues to be asset sensitive and a further rise in short-term rates benefits our company. For example, using our balance sheet at September 30th and assuming an up to 100 basis point increase in LIBOR, our annual earnings net of income based fees are positioned to increase up to approximately $0.16 per share.

Now I'll turn the call over to Michael to review our recent investment activity and to discuss the portfolio.

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Michael A. Dieber, Ares Capital Corporation - Partner [5]

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Thanks, Penni. I'll spend a few minutes reviewing our third quarter investment activity and portfolio performance and then provide a quick update on post quarter end activity and backlog and pipeline. During the third quarter, we used our scale, market coverage and extensive relationships to originate a strong level of new investments, mostly in senior first lien loans.

Excluding the loans -- assets we purchased from SSLP, we made 40 new commitments totaling $1.5 billion and had gross fundings of $1.4 billion. As Kipp mentioned earlier, approximately half of the new commitments were to existing borrowers of ARCC and its affiliates.

Taking a closer look at our activity, you will see that we funded companies that we feel are operating in less cyclical sectors such as business services, food and beverage and healthcare services. To give you an idea of the breadth of our transactions, we committed to companies with EBITDA ranging from $14 million on the low end to $170 million on the high end, with a weighted average EBITDA of $55 million.

ARCC has 325 portfolio companies with an average investment size of $35 million per portfolio company, providing us with significant room for growth within our existing borrowers. Providing capital to incumbent borrowers allows us to selectively deploy capital to our best companies and we believe this has been an important contributor to our long-term track record and credit outperformance. For example, in the third quarter, we were the lead administrative agent and lead arranger and bookrunner for a $429 million first lien term loan and administrative agent and investor in approximately $95 million of junior capital to support Genstar's growth strategy for Accruent.

The company is a leading provider of real estate and facility management software, serving customers across several industry verticals, including retail, telecom, healthcare, higher education and public-sector businesses. Accruent has been an ARCC portfolio company since 2016 when we supported Genstar's initial acquisition of the business.

To shift gears, we do believe that our deep relationships and our competitive advantages allow us to continue to find new deals to invest in even in this environment. One example would be our investment in SCM Insurance Services. During the third quarter, we served as administrative agent and bookrunner for a large first and second lien credit facility to support the acquisition of a minority stake in the company by Warburg Pincus, a repeat sponsor client of ARCC. SCM is a leading provider of claims and risk management solutions for the Canadian property and casualty insurance industry.

In addition to the value we believe we create by sourcing and structuring our investments, I also wanted to highlight the value we can create upon exiting investments, particularly in today's highly liquid market conditions.

Included in the exits from the American Capital portfolio this past quarter is our sale of Hillarys Blinds. Hillarys was a control equity position in the American Capital portfolio which ARCC sold in the third quarter, generating a realized gain of $58 million. This gain represents a premium of more than 20% to the value we attributed to Hillarys on January 3, 2017. In the case of Hillarys, we leveraged the expertise and market knowledge of our Ares London-based direct lending team, which helped us evaluate the exit of this U.K. based company.

Our ongoing focus in portfolio management more generally is to monetize gains when they are available and to encourage some of our underperforming companies to refinance us out with alternative sources of capital in this highly liquid market.

In terms of portfolio performance, as of September 30th, our portfolio companies continued to generate solid growth in their aggregate earnings. Over the past 12 months, our portfolio companies' weighted average EBITDA increased approximately 4%, generally consistent with prior quarter levels. The weighted average EBITDA of our portfolio companies was $66 million and leverage levels and interest coverage levels for the portfolio improved slightly as the individual SSLP loans came into our portfolio.

At the end of the third quarter, non-accruals as a percent of total portfolio at cost increased slightly from 3.4% compared to the second quarter at 2.7%, essentially driven by one new company being placed on non-accrual. That company continues to make interest payments on our loan, but it is very highly leveraged today. At fair value, non-accruals increased to 0.9% from 0.5% in the second quarter.

Before I turn the call back over to Kipp to conclude, let me provide some quick comments on our post quarter investment activity. Since September 30 and through October 26, we have made new investment commitments totaling $294 million and exited or were repaid on $80 million of investment commitments, realizing approximately $18 million in net realized gains.

In addition, as some of you might have seen, yesterday we sold a significant majority of our venture finance assets to Hercules Capital. Specifically, we sold approximately $125 million of commitments and recognized a net realized gain of approximately $2 million. Post this sale, we have retained a small venture portfolio, which has approximately $40 million fair market value, which will run off over time and we do not intend to make any new investments in the venture finance sector going forward.

Finally, as of October 26, our total backlog and pipeline stood at roughly $810 million and $340 million, respectively. As always, these potential investments are subject to approvals and documentations and we may sell or syndicate some or all of these investments post closings. We are not certain that any of these transactions will close.

And now I'll turn it back over to Kipp for closing remarks.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [6]

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Thanks a lot, Michael. So we feel we had a productive third quarter with improving core earnings, increased portfolio yields, strong net realized gains and significant positive initiatives executed with respect to our balance sheet and our funding costs. We're making excellent progress against our goals of enhancing earnings through portfolio optimization with the resolution of the SSLP and the strong execution to date on the American Capital portfolio.

Going forward, we're confident in our ability to reinvest lower yielding assets into new investments that are higher yielding and we believe we can enhance earnings further with additional utilization of our 30% non-qualifying basket. To highlight this point, following the resolution of the SSLP, we now have very significant unused capacity in our 30% basket that provides us with meaningful operating flexibility, which we have not had in quite a while. Our plan is to continue to use this capacity wisely by investing in higher returning investments that we feel are appropriate for ARCC and aligned with the core competencies that we've developed in our credit group here at Ares.

To date, both SDLP and Ivy Hill have been strong contributors and we feel both can continue to grow. However, we also continue to evaluate new investments and new credit strategies where we can generate higher, long-term risk-adjusted returns. Many of these opportunities we believe are already resident at Ares and we are working on ways to leverage the high caliber credit platform of our external manager.

We believe Ares Capital is well positioned today, and we remain focused on delivering strong returns for our shareholders over the long term, without taking what we feel is undue risk. We believe we're well capitalized, and we have multiple opportunities to grow our core earnings using our existing capital base.

That concludes our prepared remarks. Mike, would you open the line please for questions?

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question we have will come from Jonathan Bock of Wells Fargo Security.

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Jonathan Gerald Bock, Wells Fargo Securities, LLC, Research Division - MD and Senior Equity Analyst [2]

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I'll just ask 2. First, Kipp, you were kind enough to mention that utilization of your 30% basket serves as an opportunity to drive a greater portfolio yield or likely income over time. Give us an example of what you believe might be an adequate or worthwhile use of that available capacity, understanding that given your size an SSLP arrangement, the SDLP, et cetera, it's already set, and that you have additional capacity to grow that. Are there others outside of the SDLP that you find worthwhile in the current environment?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [3]

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Yes. Thanks for your question, Jonathan. Look, we've got a lot of things in the lab. I think what you'll hear from us is -- in regards to the future is what you've heard in the past. We want to make sure that things that we're doing in our non-qualifying asset basket where we do have more flexibility, kind of stay on the fairway is how we think about it. So we'd like to bring some of the things that we're particularly good at here at Ares that may not have made their way into the BDC, perhaps into the BDC. So a couple examples of that, things that we think that we do well here that could be suitable for the Company.

Our investments into an asset based lending franchise, we have a very high quality one here that we've developed privately, and we're hopeful that we may find an ability to access that opportunity. Another interesting business that we've been building here at Ares is around the private ABS and securitization market where quite a lot of capital has left banks and bank trading desks, and are coming to alternative credit firms like Ares. Much like our core sponsor and non-sponsored lending business, it's reliant on origination, it's reliant on finding new deal flow, but it's just a bit of a twist on what we've done historically. But again, we want to pursue higher return opportunities only where we're really investing in things that we know that we understand, that we have our arms around, that feel manageable, but exciting for the company.

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Jonathan Gerald Bock, Wells Fargo Securities, LLC, Research Division - MD and Senior Equity Analyst [4]

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Got it. And then just a common theme that I think every institutional investor is likely -- sits in the back of their mind, gets to. We see NAVs today and understand that there are some drivers, right? NAV can fall to the extent that credit is a problem, which clearly it's not, and it's actually rises, you have gains that you've had. But also fall if the dividend is effectively set higher than what we'll consider to be core -- just true EPS. And I noticed a small decline in NAV, the comment of you actually protecting NAV by not doing stupid investments is well suited. But the one question folks want to better understand is, in the event the current environment persists, they see effectively a couple of choice -- and you choose to protect NAV, does the dividend level at all, in any way, shape or form concern you given that earnings are slightly below the dividend today? And more importantly, do you believe that there other ways, aside from a dividend reduction or perhaps significant capital being deployed -- are there other ways to ensure that that dividend in and of itself can and always will be stable at the current $0.38 level?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [5]

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I think we've tried to express a high level of conviction and confidence in the current dividend level which we absolutely would reaffirm sitting here today on the call. We, again, spent most of our prepared remarks trying to communicate the path that we laid for folks in January as to how we intended to spend 2017, which is again rotating a portfolio of roughly $3 billion of assets into higher yielding new deals. We're doing that, we're on the path, we're very confident the plan. We are quite certain that once it's resolved, our core earnings will again exceed our dividend. But for the time being, we just have to recall what we set ourselves up for in 2017, which was buying a portfolio effectively of low-yielding investments and equity positions which we thought we could monetize and generate gains. And just to reiterate it, we've continued to generate gains. When we take our core earnings and the earnings that we've generated from those gains, both in this quarter and in past quarters, we have more than sufficient earnings to pay our dividend, which is why we have high confidence in the dividend.

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Jonathan Gerald Bock, Wells Fargo Securities, LLC, Research Division - MD and Senior Equity Analyst [6]

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The track record speaks for itself, folks understand it, and clearly there is, at a point, I'd believe we'd all expect some level of spread widening based on the abilities of some others to actually underwrite profitably. So maybe more normalcy will return to the market at some point.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [7]

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Yes, of course. Perhaps, Jon, one of these days. I hope you're right, but thanks for the questions.

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Operator [8]

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The next question we have will come from John Hecht of Jefferies.

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John Hecht, Jefferies LLC, Research Division - Equity Analyst [9]

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One question, just a clarification for some of the prepared remarks. What's the remaining -- you guys said the figure, but I didn't catch it -- the remaining value of the ACAS assets that you want to reposition? And then if you have handy, what's the value -- current fair value of those relative to the cost?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [10]

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Yes, I'm just going back here. So this is the number from the -- right. We laid out in the prepared remarks $875 million in non-core, quote, former American Capital assets that yield 7.6%. And I'd have to go back and look actually, John, at kind of cost versus fair value. I don't have that in front of me.

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John Hecht, Jefferies LLC, Research Division - Equity Analyst [11]

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Okay. And then if you get that, we can talk offline and get that, I'm sure it's a positive number to -- for book value potential, but nothing meaningful. But the second question I have is -- and we talked about this on the last quarter call, the opportunity to take some of the SSLP assets and reposition them into the SDLP. Any update on that? Is there -- do those have to be refinanced in order to move into the SDLP or how do we think of that opportunity to ramp up the SDLP?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [12]

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Yes. Look, I mean, there are definitely opportunities for SDLP. They do need to "be refinanced" right? So typically, a company has to have some reason to do a "new deal," right? Which often incurs new fees to the company. So that's the barrier, maybe to just moving those over, so to speak. So look, there are, like any other portfolio company, over 300 plus ongoing discussions with them about their future and all of that and SDLP is a solution that we certainly pitch a lot of our existing companies as well as many of the new borrowers we're talking to. But really, really not a big update there.

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John Hecht, Jefferies LLC, Research Division - Equity Analyst [13]

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And then final question, I know this is a more topical than any significant detail we have, but I just figured since this has been evolving and probably had some internal discussions, do you guys have any opinions in how the type of tax reform we're starting to see laid out would impact you? Have you talked to your other -- the general constituents and your borrowers to determine what type of intermediate and long-term impacts we should see?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [14]

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No, I mean, not really. It's obviously all new and just -- I think people are watching on TV, at least I was before joining the earnings call. I mean, look, my understanding is that corporate tax rates are going to go down. That I hear is good for business, my guess is good for our portfolio companies as well. There is an exemption, is my understanding, in there that allows small businesses to completely benefit from tax deduction at a greater level with the idea that it helps Main Street or smaller businesses. But beyond that we have not had deep ongoing conversations with folks in the portfolio or to CEOs of portfolio companies to get a feel. But I'd have to imagine it's a long-term positive.

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Operator [15]

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Next we'll have Rick Shane of JPMorgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [16]

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I know you don't love to go into pipeline stuff in too much detail, but given that this is so much about reinvestment at the moment, I'd love to go through some numbers and get a little bit of an outlook. Commitments quarter-to-date are up substantially year-over-year. The pipeline, which we see as sort of likely to close is up 50% year-over-year, but the backlog is down 60% year-over-year. That would suggest that you guys are positioned to have a big origination quarter in the fourth quarter but a lot more uncertainty as we head into 2018. Is that the right way to be looking at this?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [17]

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Yes, it's hard to be scientific, right? I mean, we try to make that determination of what's backlog and what's pipeline, right. I mean backlog really is generally signed up and more or less ready to go subject to either final due diligence or documentation or whatever it may be. Pipeline are the things that we see -- that we think are higher probability opportunities. But again, I think if we went through our existing pipeline of things that are in due diligence, it would literally be 50 or 60 different things that we're working on here, right? We have 100 people so we're constantly shifting that backlog and pipeline. I put them together. I have a very difficult time comparing and contrasting the two just because the pipeline can accelerate, backlog can follow way for an issue.

I just look at the end of Q3. Where we sit now, our backlog and pipeline was about $1.4 billion I think is what we said. Compared to a year ago, Q3 '16, it's down a little bit from $1.7 billion I think that's us being probably a bit more selective on what we're working on. But it is up from the end of Q2. So we feel fine about the amount of things that we're seeing and the level of deal flow. And again, the key is that we're able to onboard new deals at yields, but also with ROE that we think is commensurate with what we've got in the portfolio today certainly and in the past. And look, the weighted average yield on that backlog and pipeline is around 9% and that's not taking into account fees and the potential for prepayments upon resolution or equity gains or other things. So we're happy with where the backlog and pipeline sits today, Rick. We're not worried about what's ahead of us. We've been able to execute in what's been a challenging market all year, and I think we'll look forward feeling just as optimistic.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [18]

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I have to admit I had to go back and look at the footnotes to differentiate backlog and pipeline myself. The other question in -- Jonathan touched upon this and I think it's -- I'll try to hit it maybe in a more direct way. You're in a unique situation, which is that you're likely to have increased liquidity over the next year as you continue to rotate out of the ACAS portfolio. You have identified that, at least for now, unless there's dislocation in the market, the incremental returns, the spreads are not necessarily what you would think is the best risk adjusted pricing. Given the stock's trading near book, it's actually slightly below book at this point, does it make sense to add as a tool to the toolbox a buyback, just so that you're not in a situation where you're over capitalized? Because the history is sound capital management here.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [19]

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Yes. Look, I mean to your first point, we actually are finding enough to do from a risk/reward perspective. I mean, I do think the market's challenging but I tried to reinforce in some of the prepared comments that despite that we're finding enough to do here from the existing portfolio and from some of the new things that we're seeing. But to answer your question at the end, we have an existing buyback program in place and we've had one for years and our intention, as we've said in the past, to put it in place to use it if we think it's a valuable tool. I did notice the stock traded off a bit more today. It's traded off for 5 or 6 days now in a row, confusing us again. But that being said, it can be a pretty effective tool, we think, to generate value for shareholders.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [20]

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Yes, Kipp, I guess the observation I would make is that I don't at this point necessarily see buyback as a way to reward shareholders in terms of stock performance. But I actually see it potentially more as a capital management tool, given the dynamics that you're facing in the industry.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [21]

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Yes. Couldn't agree more.

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Operator [22]

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Next we'll have Ryan Lynch of KBW.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - Director [23]

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I wanted to touch on your capital structuring fees. I would think in today's environment being very competitive, that certainty of close, which you guys can provide, wouldn't be as important when guys can maybe tap the broadly syndicated loan market. But you guys have been able to generate very good capital structuring fees. I mean, the first quarter was kind of a dip down in the $12 million, but the last two quarters you guys have been able to generate about $30 million of capital structuring fees the last couple of quarters. So I just wanted to kind of get your outlook on -- do you guys foresee the ability to still be able to generate significant fee -- capital structuring fees going forward even in this competitive environment?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [24]

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I'm glad you noticed. We do. We tend to earn higher fees than most others because we actually lead our deals. Other people say that they do, but they don't. So hopefully that's continued evidence of kind of the way that we come at the market, some of our advantages, frankly, in terms of our approach. We this quarter saw some higher fees. Sometimes it's -- in this case, just to get the mix, right? So the more new deals and new portfolio companies you're engaged with, the higher your fees tend to be. Sometimes, if you're just adding on or kind of redoing or upsizing an existing deal, you don't take a full fee on all the capital. So my guess is a little bit of the bump this quarter is just the percentage of new is higher than it was last quarter. But look, I think that our advantages of truly leading deals and writing big checks when people need commitments remains real in the circumstances and the situations where we're choosing to get involved in today's market. So I do think its evidence of perhaps some things that we may be doing differently than others.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - Director [25]

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And then if we move to the liability side of your balance sheet looking into 2018, you all have about $1 billion of debt coming due, some convertible notes and then an unsecured bond later in 2018. You guys just did a very low cost, very attractive $750 million bond this year. Do you guys foresee this bond that you guys just issued basically being the replacement to the unsecured debt that's coming due in 2018? And that the additional -- the paydown of those unsecured debt issuances are coming due in 2018 will then be paid down? Or do you guys just withdraw from your revolver to repay those? Or do you guys foresee doing more unsecured bond issuances in 2018 to replace those bonds that are coming due?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [26]

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I'll let Penni take those. I'm not sure we know, right. We think we took advantage of an attractive market for us to issue some longer term fixed rate liabilities, but one debt issuance doesn't necessarily replace another. I mean, I look forward and I'll turn it over Penni. Billing and maturities, I'll just say that to us seems very easy to resolve on multiple fronts, to your point, either using excess liquidity, drawing under the revolver, doing another deal, et cetera. So Penni, feel free to jump in if you have anything to add.

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Penelope F. Roll, Ares Capital Corporation - CFO and Member of Enterprise Risk Committee [27]

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Well, I really look at the August issuance we just said, which we were able to tap the market at a time where we could get extremely efficient pricing. What we've always tried to do is to go to the market when we have the right market to issue into and we'd like to have the flexibility to do that. So I feel like the deal we just did basically de-risks any refinancings into 2018. Clearly, we have a lot of capacity now on our revolving lines of credit, and so we -- I said in the prepared remarks, we look at basically that flexibility of just repaying the January 2018 convert maturities, which are small at $270 million, with our revolving lines of credit. And then when we look into '18, it is nice to be in the market so at least on an annual basis if we get the right opportunities to do that and I think we'll continue as we've done in the past to watch the market and look at times to issue debt at a time where it is the right pricing but also considers having a continued maturity ladder that's very prudent that we've built over time.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - Director [28]

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Okay, that makes sense. And then one final question. While I know it's not a large portion of your portfolio, but you guys exiting the venture lending space, can you just provide what was the thought process behind getting out of that asset class?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [29]

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Sure. Look, we got into the venture finance business years ago, we were a much smaller company. I think that we assessed that the long-term opportunity to grow that business into something that would really be additive and meaningful at our company today and at scale was going to be difficult, right? The portfolio in total had $200 million plus, $200 million-ish of invested capital. The loans are small, they're complicated, they require a lot of oversight, and they just became something that was for us too challenging to monitor in terms as a percentage of fair value. But the good news was, not a failed experiment, right? I mean, trying to figure out ways to continue to create growth at the company; worst case thing happen, we decided to actually exit a small portion of our business. We were able to sell most of the portfolio, obviously as you saw in the press release, to Hercules, who we've got a lot of respect for and we thank obviously for collaborating with us on that transaction. And we will just retain a few investments there, and a smaller team as we exit the asset class, but nothing more than that. Just too difficult to scale, too complicated, too far away from the core of what we're doing here these days.

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Operator [30]

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Next we'll have Doug Mewhirter of SunTrust.

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Douglas Robert Mewhirter, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [31]

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Two smaller questions, and then one bigger picture question. My two smaller questions, which are unrelated from each other. The first, was there any tailwind from LIBOR in the uptick -- the sequential uptick in the yield?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [32]

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Yes, I don't have an exact measurement of maybe what it added, but the benefit of LIBOR, look, if it continues to go up, I think we'll finally start to see in the earnings in Q4 and into 2018. So just as a reminder, most of our assets have LIBOR floors at 1. This is probably the first full quarter where we've seen benefit of LIBOR above 1. So we're hopeful that there is some tailwinds at our back vis-a-vis for the rate increases. I guess we'll hear about a new Fed governor and all that, and see where we go from here, but I think so.

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Douglas Robert Mewhirter, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [33]

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My second smaller question is, noticed you did a fairly sizable loan, second lien loan, to what appears to be an E&P company. I thought that was interesting, given sort of the industry got a shell shock during the last downturn, and people stayed pretty far away, including you. And I was just kind of surprised to see that in there. Is there anything special about the deal or the company or the basin which attracted you to it?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [34]

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Yes. We think -- we actually, I think, made 2 new investments in the E&P space. Look, we've said in the past quarters, we have a team focused on the oil and gas space. Again, we think we're finding some select, really interesting opportunities in the oil and gas space. Commodity price deflation, inflation, kind of not expecting in the future, certainly what we saw over the last 5 years. I think broadly the energy and oil and gas space is still quite a problem that will need to be resolved by a lot of folks. But yes, we found 2 deals where we thought we saw significant merit relative to 2 specific company opportunities operating in really good geographies with really high-quality assets, so happy about both.

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Douglas Robert Mewhirter, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [35]

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My last bigger picture question. We've heard the last couple quarters about too much capital in the private debt space chasing too few deals, which has definitely ramped up the competitive pressure. But I've also seen a tremendous amount of capital raising in the private equity space, which to me would create the fuel for more deals to sort of rebalance that supply/demand situation. Do you see it the same way? Or is sort of the private debt side still sort of overwhelming what's coming into the private equity side?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [36]

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I think there is a balance and maybe a natural extension between the fundraising in both. I mean there is clearly been a lot of money raised in private equity. I think that will certainly continue to help provide good deal flow on our sponsor business, which is obviously our largest business here. But no, I think they are sort of symbiotic. The reality is, investors are looking for alternative assets in a world where I think they view yields in traditional fixed income to be uninspiring and they see a lot of volatility in the public equity markets.

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Operator [37]

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Next we'll have Chris York of JMP Securities.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [38]

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So maybe Kipp or Michael, what was the weighted average cash yield of the loan portfolio sold to Hercules?

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Michael A. Dieber, Ares Capital Corporation - Partner [39]

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The weighted? About 12%.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [40]

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12%.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [41]

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And then Kipp, could you maybe expand on your comments and potentially share some observations on the threat of new entrants affecting your business, given that your size and scale for -- the average size of your obligor is generally thought to provide some barriers to entry?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [42]

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Yes, I mean, look, in the prepared remarks, I think we tried to lay out some of the competitive advantages that we feel that we have vis-a-vis some of the new entrants. So in any investment business like this or like private equity, you are kind of selling your capital, but we think ours is a frankly more attractive capital relative to a lot of new entrants. We've got a strong platform, we've got really longstanding relationships in the industry, we've got a brand name here and a company that I think means something and stands for something and tested through cycles, just long-track record of liability, I think for our clients. And those are all things that -- a lot of the new guys are working to build today. So I think our history in the market and the longstanding franchise that we have here just continues to allow us to compete quite effectively with those folks. And all the money in direct lending I would say is not created equal. So I don't really have any additional thoughts beyond that.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [43]

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Makes sense, okay. And then maybe staying on competition. So I presume you're aware of some of the chatter on leverage loan guidance, and the potential for some supervisors of the banks to relax that. How do you think that would affect your business?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [44]

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I don't know. I mean, I think there has been a belief that all direct lending has really been built on the regulatory scrutiny on banks. I would tell you that most of the large banks that we know quite well on a whole host of levels would tell you just that their businesses have changed, that they've consolidated. And just middle market leveraged finance, and particularly making middle market loans to small companies and holding them on their balance sheet, is just not part of their business anymore. They're not staffed to do that, they don't have interest in doing it, they'd in fact rather lend to us to get access to the asset class than they would rebuild those teams in the face regulatory relief. So that's not something that keeps us up at night.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [45]

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Good. Last one from me. Michael, I see you commented in the prepared remarks and then the deck has the weighted average EBITDA growth. Now, is this generally your base case in underwriting for the portfolio over the life of the loan? And I clearly recognize that each industry and business model will be a bit different.

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Michael A. Dieber, Ares Capital Corporation - Partner [46]

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Yes, each will be different, but that's generally in the entire portfolio.

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Operator [47]

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Next is Leslie Vandegrift of Raymond James.

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Leslie Vandegrift, Raymond James & Associates, Inc. - Analyst [48]

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Quick question on the venture loan portfolio. You've given a lot of color on it so far. But the $40 million left in the portfolio, what made you guys decide to keep that? And was not -- weren't you using the SBIC license you have for that venture loan? Will that be used for other loans now?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [49]

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I'm sorry, I missed the first question. I heard, what's left; there is $40 million of fair value, but why did we keep it? I guess other people heard it and I didn't. We retained some of these investments because we think that they have a reasonably good option value, obviously. So some upside relative to where we sit today. So certainly anytime you go out and look to sell assets, it's easier to sell them all. But I'll just say we thought there was upside in what we've retained. So we'll keep around a smaller team and obviously focus on those remaining names and hopefully be able to generate some upside there.

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Leslie Vandegrift, Raymond James & Associates, Inc. - Analyst [50]

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And then the second part was on the SBIC license, originally isn't that -- the portfolio you were using that in, so will you use it for something else now?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [51]

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Yes, I mean, look, it's an asset to the company, it's something that we'll look to repurpose. It certainly has a particular use, but it's very, very small, and I think it's just under consideration as to how we handle that going forward. I don't have a conclusion for you today.

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Leslie Vandegrift, Raymond James & Associates, Inc. - Analyst [52]

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Okay. And then on the ACAS rotation, missed the number writing it down on how much was rotated out this past quarter. And then of the non-core assets that you want to get rid of, how much is left as of September 30?

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Penelope F. Roll, Ares Capital Corporation - CFO and Member of Enterprise Risk Committee [53]

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So, Leslie, it's Penni. If you look at the ACAS portfolio at September 30, and there is more detail in our earnings slide deck on page 25 if you want to dig into a little more later, but we basically have a $1.8 billion portfolio at fair value today. That has embedded in it a $94 million net unrealized appreciation. So the portfolio in the aggregate has been written up. If you look at the $875 million at fair value that's targeted for rotation, that's earning 7.6%, that Kipp mentioned, that unrealized appreciation today is sitting primarily in those assets, because they're primarily write-offs on more junior securities. So that $94 million, a good bit of it is already embedded in the $875 million.

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Operator [54]

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Next we'll have Terry Ma of Barclays.

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Terry Ma, Barclays PLC, Research Division - Research Analyst [55]

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Just wanted to follow-up on the 30% bucket. You had mentioned asset-based lending and also private ABS market investments. Can you give us a sense of type of returns you can generate in those businesses relative to the other 30% investment, like the SDLP?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [56]

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You might be a little bit premature, Terry. I mean they're all over the map, right? I mean, when you're investing in asset-based lending franchises, you've seen what some of the competition in the BDC space has done. You can buy a company that has embedded leverage, you can make direct asset level investments, which of course would have lower returns. It's sort of hard to generalize without actually coming back to people to tell them kind of what our intentions are and what our strategy is. And look, in private ABS it depends how much risk you're taking. If you're at the top of the capital structure, you might make 7% or 8%, and if you're the equity in an ABS transaction, you could probably make 13% to 15%, but it also depends on where you are in the cycle and the type of assets, so it's just really hard to generalize.

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Terry Ma, Barclays PLC, Research Division - Research Analyst [57]

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And then in terms of the desire to get into other types of 30% investments, is it more just a diversification thing or is there kind of like an inability to ramp the SDLP quickly or to size?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [58]

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No, we're very happy with the ramp of SDLP, and as I mentioned in the prepared remarks, we think that will be a continued strong contributor to how we deploy assets in that non-qualifying asset basket. We think it will be a driver of our earnings for sure going forward. To the point on diversification, yes, sure it's good. I mean we love the idea of having more diversity, we like the idea of taking what's today a larger company into some other assets that we haven't explored, that we know that we understand well here at Ares, that we think would offer strong returns for our shareholders. That's really always been the litmus test, and I think will remain on what we're focused on.

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Terry Ma, Barclays PLC, Research Division - Research Analyst [59]

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And in terms of steady state, how big the SDLP can get, is it like 10% of the portfolio, 15%? Will it ever get as big as the SSLP?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [60]

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I'm not sure. I mean I think that the program is working really well. Part of what we are doing there is investigating the ability to scale that either with AIG and with Varagon or with other clients. With our current path, I think our investment today is under $500 million. We've got a lot of runway with the existing structure. I think have big it gets in time will -- time will just have to tell. Obviously, it's -- we can try to make it as big as we want to, but it obviously has to be an attractive product for our customers and our borrowers to use, and of course that's market dependent. So I think we're happy with where we're at. We're going to keep trucking. We think it'll continue to grow from here and we'll just continue to reevaluate it as the time moves along.

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Operator [61]

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And we have time for 2 more questions today. And the next question will come from Christopher Testa of National Securities.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [62]

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It's been several quarters since you guys received exemptive relief from the SEC to co-invest across the Ares platform. Just curious if you have a ballpark estimate as to how much co-investment has been done since you received that exemption?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [63]

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I don't have that handy. We can probably go dig it up and maybe some of what you'll hear about just what we're doing broadly at Ares in credit can come up on our Ares Management earnings call tomorrow. So maybe give that a listen, and we'll go back and maybe pull some numbers together. But I don't have that handy here, Chris. But thanks for your question.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [64]

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Okay, no problem. And obviously you guys have been selling out of the CLO equity, which has been a really hot market, to say the least, that you acquired from ACAS. Just wondering, as of late, if you're -- if kind of the appetite from the traditional purchasers of those has tapered off at all given that spreads have compressed so much, or if people still can't seem to get enough of that asset class?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [65]

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No, it hasn't. There seems to be a continued sort of voracious appetite for all sorts of CLO equity. So again, I don't think we're going to be long-term owners, as we mentioned in the past, of those assets. And it's safe to say that the sales that you've seen are likely to continue for all those reasons that we've discussed in the past.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [66]

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And last one for me, just more a high-level question. In the past, call it 5, 6 months or so, have you seen an acceleration in sort of the covenant-light, broadly syndicated structure creeping into the more traditional upper middle market?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [67]

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Yes.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [68]

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And would you like -- just can you give us an example of just how bad that's gotten? Has it really accelerated a lot the past quarter or is it just more of a slow creep? Just any detail there you could give us as to just how frothy that's gotten would be appreciated.

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [69]

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Yes, I think it's sort of --- it's a slow creep that kind of comes and goes relative to how sentiment is in the market, vis-a-vis a deal that comes to market. Larger deals certainly are more prone to be covenant-light, so the barrier has always been that $50 million of EBITDA. We've started to see it more and more in the 30s and the 40s in terms of requests from folks and we just typically say no for smaller companies. We've been able to avoid a lot of the covenant-light nuisance just because of the incumbency and the scale that we have in terms of our portfolio. But I'd characterize it, to your description, as a bit of a creep. I think when there's less, I don't know, frothiness in all markets right, that's likely to subside; typically creeps in very early in the cycle, and then with some dislocation kind of tends to go back away. But no, it's definitely a concern. It's something that we're, as I mentioned in the prepared remarks, very cautious about. So I hope that answers your question.

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Operator [70]

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And our last question will come from Scott Scher of LMJ Capital.

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Scott Scher, LMJ Capital - Analyst [71]

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Can you just clarify the loan that went down to non-accrual? What was the size of it? And what's the nature of the business? And what's the prospect of recovery?

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Robert Kipp DeVeer, Ares Capital Corporation - Director and CEO [72]

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Sure, Scott. We added one non-accrual. It's in a company where we've got a loan to business called Totes Isotoner. And probably know it; it's a branded consumer products business, they sell umbrellas and socks and gloves and all that kind of stuff. I think the prospects there are quite good. I mean we've got 2 very, very strong sponsors that own the company in Freeman Spogli and Investcorp that have a tremendous amount of equity invested below us. So it's on non-accrual despite the fact that it continues to make interest payments to us. So I think we're just being conservative. We've seen a deterioration in performance. It's one of those companies that has experienced changing consumer buying patterns. Certainly I'm sure you do, and I do buy gloves and umbrellas and socks a very different way now than we did 10 years ago. And I think the company is transitioning their business model and has been transitioned their business model to deal with the changing face of retail, but I'm optimistic it will get sorted out.

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Operator [73]

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Well, thank you, ladies and gentlemen. This concludes our question-and-answer session and also our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately one hour after the end of the call, through November 15, 2017, at 5 o'clock PM Eastern Time to domestic callers by dialing 877-344-7529, and to international callers by dialing area code 412-317-0088. For all replays, please reference conference number 10112891. Again, that's conference number 10112891. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website. Again, we thank you all for participating on today's conference call. At this time, you may disconnect your lines. Thank you. Take care, and have a great day, everyone.