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Edited Transcript of ARES earnings conference call or presentation 4-Aug-17 3:00pm GMT

Thomson Reuters StreetEvents

Q2 2017 Ares Management LP Earnings Call

Los Angeles Aug 12, 2017 (Thomson StreetEvents) -- Edited Transcript of Ares Management LP earnings conference call or presentation Friday, August 4, 2017 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Carl G. Drake

Ares Management, L.P. - Partner and Head of Public IR & Communications

* David B. Kaplan

Ares Management, L.P. - Co-Founder

* Michael J. Arougheti

Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC

* Michael Robert McFerran

Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC

* R. Kipp deVeer

Ares Management, L.P. - Head of Credit Group - Ares Management GP LLC and Partner of Ares Management GP LLC

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Conference Call Participants

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* Christopher Meo Harris

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

* Craig William Siegenthaler

Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry

* Daniel Jacoby

Goldman Sachs Group Inc., Research Division - Research Analyst

* Douglas Robert Mewhirter

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

* Kenneth Brooks Worthington

JP Morgan Chase & Co, Research Division - MD

* Michael Roger Carrier

BofA Merrill Lynch, Research Division - Director

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Presentation

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Operator [1]

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Welcome to the Ares Management, L.P. Second Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded on Friday, August 4, 2017.

I will now turn the call over to Carl Drake, Head of Ares Management, Public Investor Relations.

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Carl G. Drake, Ares Management, L.P. - Partner and Head of Public IR & Communications [2]

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Thank you, Denise. Good morning, and thank you for joining us today for our second quarter 2017 conference call. I'm joined today by Michael Arougheti, our President; and Michael McFerran, our Chief Financial Officer. In addition, David Kaplan, Co-Head of our Private Equity Group; and Kipp deVeer, Head of our Credit Group are also here with us and available for any questions.

Before we begin, I want to remind you that comments made during the course of this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in our SEC filings. We assume no obligation to update any such forward-looking statements. Please also note that past performance is not necessarily indicative of nor a guarantee of future results. Moreover, please note that performance of and investment in our funds is discrete from performance of and investment in Ares Management, L.P.

During this conference call, we will refer to certain non-GAAP financial measures, such as economic net income, fee-related earnings, performance-related earnings and distributable earnings. We use these as measures of operating performance, not as measures of liquidity. These measures should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles. These measures may not be comparable to like titled measures used by other companies.

In addition, please note that our management fees include ARCC Part I fees. Please refer to our second quarter 2017 earnings presentation that we filed this morning for definitions and reconciliations of the measures to the most directly comparable GAAP measures. This presentation is also available under the Investor Resources section of our website at www.aresmgmt.com and we will use this as a reference for today's call. Please note that we plan to file our Form 10-Q early next week.

I would like to remind you that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase an interest in any securities of Ares or any other person, including any interest in any fund.

Finally, this morning, we declared our second quarter distribution of $0.31 per common unit payable on September 1 to unitholders of record on August 18. We also announced our regular preferred distribution of $43.75 for Series A preferred unit with a payment date of September 30 to preferred unitholders of record as of September 15.

Now I'll turn the call over to Michael.

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [3]

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Great. Thanks, Carl. Good morning, everyone, and thanks for joining us.

This morning, we reported record second quarter earnings, reaching our highest levels ever for quarterly management fees, feel-related earnings and economic net income. We also surpassed the $100 billion AUM milestone for the first time, ending the quarter with $104 billion.

Over the last 12 months, we've raised more than $15 billion in gross commitments, despite the fact that we didn't benefit from a major successor fund raise during the period.

I really think this speaks to the breadth, balance and diversity of our business. I think people know that current environment is somewhat challenging from an investment perspective, given the significant liquidity in our markets. So as a result, we're generally being more measured on deployment across most of our strategies. Fortunately, we are patient, long-term locked-up and flexible capital allowing us to navigate changing markets and find the best relative value over time.

On the flip side, given all the market liquidity, we're repositioning our corporate liabilities, harvesting gains, launching new strategies and raising ever larger new funds, giving us significant dry powder to invest as the cycle evolves.

Our strong results in key financial metrics reflect the growth of our management fees and in turn, our fee-related earnings as well as our expanding asset base, from which we grow PRE and distributable learnings. One can clearly see this from the growth in our fee paying AUM, our incentive eligible AUM, our crude net performance fees and our investment portfolio.

Now as I walk through our highlights, hopefully, you'll see our strong fundraising momentum, our excellent investment performance, our measured yet consistent deployment and our increased harvesting activity.

As you can see on Page 4 of our earnings presentation, on the fundraising slide, we raised $5.5 billion in gross commitments for the second quarter and approximately $9 billion year-to-date. The capital raising was weighted towards credit across both liquid and illiquid strategies. And we raised approximately $1 billion in U.S. direct lending estimates from 4 different investors. Also as we discussed in our last call, we're raising and junior private capital fund with a target of $2.5 billion.

During the second quarter, we held an additional closing of more than $400 million bringing total commitments to date to just over $1.6 billion.

Within our liquid credit strategies, our momentum in the CLO sector is strengthening, as we closed the CLO of more than $800 million in the second quarter, and we just priced our second largest ever CLO of $1.1 billion in July.

In real estate, we held our first closing of $415 million for our ninth U.S. value add fund against a $1 billion target.

And lastly, within private equity, we held a final closing of more than $280 million for our fifth power and energy infrastructure fund, bringing EIF V to just over $800 million. Now since acquiring EIF in 2015, we've raised more than $1 billion in that strategy, including associated funds and co-investments.

Our forward -- fundraising pipeline remains healthy. Demand for both U.S. and European Direct Lending SMAs is robust, as global investors see high current and predictable income that's generally seen here in the capital structure, provides protection from rising interest rates and tends to be less correlated to the broader liquid market. In fact, since quarter end, we've closed an additional $1 billion in new direct lending SMAs, including a $350 million European Direct Lending SMA with a large U.S. pension client.

Also based on the investment page for ACE III, our third European commingled direct lending fund, which is $2.8 billion, we expect to begin initial fund raising for a successor fund later this year or early next year. And lastly, given strong deployment and performance in EU IV, our fourth European real estate fund, we're preliminary targeting a successor fund launch as early as Q4.

So we talked about in prior quarters, there are several important themes that continue to drive our momentum. We're benefiting from the consolidation of LP dollars with broader and more skilled managers. Investors are not only placing more dollars with managers that are executing well on their current mandates, but they're also seeking to partner with fewer managers to gain economies of scale and operational efficiencies. We're seeing this play out as our existing investors continue to commit greater amounts of assets to us. To make this point, if you look during the second quarter, while 2/3 of our direct investor commitments were from existing investors. They accounted for 83% of the direct capital that we raised. At the same time, larger investors were increasingly searching for customized investment solutions, often accessed through single funds or separately managed accounts.

This relatively new trend is triggering growth opportunities for managers like us, who can allocate capital in single [spoke] investment vehicles often across multiple asset strategies.

We're beginning to see significant growth in these managed accounts, particularly as investors seek to diversify across a range of alternative credit strategies.

And lastly, global allocations to alternative assets are on the rise for both retail and institutional investors. Specifically, insurance companies and pension funds continues to be significantly under allocated to alternative assets. In fact, approximately 60% of our new capital raised came from the insurance and pension fund sectors over the last 12 months.

With regard to performance. On the back of our flexible strategies and careful investment selection, we've experienced very strong investment performance. This recent value creation is most clearly reflected in the 59% growth rate in our net accrued performance fee balance over the last 12 months. Our strong second quarter performance was led by our corporate private equity strategy, with a composite gross return of over 16% for the second quarter and more than 40% over the past 12 months. Our strong performance has been bolstered by appreciation in both private and public positions, supported by EBITDA growth as well as a strong valuation environment.

Based on the stable credit environment, our direct lending funds continue to perform well with 9% to 11% returns over the last 12 months. And in real estate, favorable market fundamentals in both the U.S. and Europe have supported high-quality performance with LTM gross returns of approximately 20% in U.S. VIII and more than 30% for our European IV Fund.

As we talked about before, the current investment environment requires a high degree of selectivity. And we are using our global platform advantages to consistently deploy capital in attractive opportunities.

During the second quarter, we deployed $3.9 billion with $3.6 billion pertaining to our drawdown funds. Most of that deployment was in our U.S. and European Direct Lending strategies, leveraging our competitive advantages and scale, flexibility and long-standing relationships to source and underwrite high-quality assets at attractive risk returns.

As I mentioned in my opening remarks, the environment for realizations is quite favorable and as a result, we're certainly taking advantage of those current market conditions.

As discussed in our last call, our realizations of our investment in Clayton Williams and its successor, Noble Energy, contributed approximately $0.07 per share in distributable earnings per common unit to our current quarter's results. We continue to hold a significant amount of Noble Energy's stock. Monetizations have remained strong, thus far, in the third quarter as well.

Within our Private Equity Group, we recently announced the closing of a majority sale of one portfolio company in the OB/GYN sector and a minority sale in another portfolio company in the veterinary hospital and pet boarding sector. In both cases, we elected to lock in substantial gains, while maintaining an ownership position in these companies, given their strong growth prospects and favorable market position.

Lastly, our highly successful IPO, Floor & Decor, appreciated strongly throughout the second quarter. And as Mike McFerran will discuss momentarily, this drove very strong PRE for Q2. During July, we elected to monetize a small portion of our Floor & Decor position and lock in a solid gain.

And now, I'll turn the call over to Mike McFerran to give you a little more detail on Q2 financial results and future outlook. Mike?

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Michael Robert McFerran, Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC [4]

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Thanks, Mike. Let me begin by touching on some important themes that you will find in our financial results. As Mike stated, we had a record quarter that we believe appropriately illustrates the strength of our business. Our earnings reflect significant, unrealized appreciation in our private equity funds and higher base of recurring earnings driven in large part by a full quarter of ACOF V earning management fees.

Given our record levels of incentive-eligible AUM and a 59% year-over-year growth in our accrued net performance fees, we believe we are building significant future value and strong potential for higher levels of distributable learnings.

In addition, we expect gradual growth in our fee-related earnings as we deploy our AUM not yet earnings fees, continue our strong fund raising, and as we execute on profitability enhancement measures, related to the acquired American Capital portfolio over time.

With respect to margins, we continue to expect operating leverage to improve margins as we grow our management fees and realize a return on many of our growth investments in these strategies.

In the second quarter, we generated economic net income of $158.1 million, our highest ENI to date, which translated into $0.69 on an after-tax per unit basis after preferred distributions. The increase in ENI was supported by a record fee-related earnings of $53.4 million, up 35% from the same period last year, which reflects the increase in management fees from ACOF V and some catch-up fees form EIF V.

We generated record performance fees of $104.7 million, up 67% from the prior year period, primarily driven by market appreciation in our private equity and real estate funds.

With that overview, I'll take you through our results in greater detail starting with AUM. Over the last 12 months, our AUM increased by approximately $8.8 billion to cross the $100 billion mark and end the quarter at $104 billion. This represents a year-over-year net increase of approximately 9%. And our fee paying AUM increased by a very strong 19% over the last 12 months to $70.5 billion.

While our available capital increased 2.1% year-over-year to $24.8 billion. Our AUM not yet earning fees, otherwise referred to as shadow AUM, declined from $17.5 billion a year ago to $13 billion for the second quarter, primarily due to the activation of ACOF V. Of our Shadow AUM, approximately $10.6 billion was available immediately for future deployments, with corresponding management fees totaling approximately $109.4 million. Our incentive eligible AUM increased 20% year-over-year to $59.5 billion, of which $22.1 billion is incentive generating and $20.4 billion is still to be invested. Excluding the largely debt oriented ARCC portfolio, which is eligible for capital gains fees, more than 80% of our incentive eligible AUM that is invested is incentive generating.

Turning to revenue. Management and other fee income for the second quarter totaled $191.6 million, which includes a full quarter of revenue from ACOF V, net of the step down of the ACOF IV management fees, which on a net basis contributed approximately $16 million in management fees.

Additionally, we had a year-over-year increase in other fees from $1.3 million to $6 million due to an increase in transaction-based fees related to our direct lending funds. We also received increased base management fees of approximately $5.3 million from a full quarter's impact of ARCC's acquisition of American Capital.

In total, we're receiving approximately $10 million base management fees per quarter from the acquired American Capital portfolio acquisition. As an offset to our growth in management fees, ARCC Part I fees and the aggregate decline from $29 million from the -- for the second quarter of 2016 to $19.1 million after directing our $10 million fee waiver.

As a reminder, the fee waiver of up to $10 million per quarter of ARCC Part I fees was part of our transaction support for ARCC's acquisition of American Capital and it will continue until the fourth quarter of 2019. However, as our team continues to rotate the portfolio that we acquired from American Capital, it's higher-yielding assets an improve the yield [another] lower yielding assets at ARCC. We expect to see an increase in our ARCC Part I fees from current levels, net of the fee waiver. This should gradually improve the FRE contribution from ARCC during the second half of 2017 and into 2018.

The increase in our performance-related earnings was comprised of net fees of $76.1 million, up $23 million from the prior year period. And our investment portfolio generated net investment income of $28.6 million, up $19 million from this time last year.

During the second quarter, the appreciation in our Floor & Decor position generated $93 million of unrealized net performance fees and net investment income. As Mike mentioned, since quarter end, we monetized 6.7 million shares of our Floor & Decor holdings in the secondary offering, which generated approximately $0.05 per share of distributable earnings per common unit for the third quarter.

Our second quarter distributable earnings of $69.7 million compared to $76.8 million a year ago. Our after-tax distributable earnings, net of the $5.4 million preferred equity distribution were $0.33 per common unit versus $0.31 per common unit a year ago.

The pickup in after-tax distributable earnings from the prior year was primarily driven by the increase in FRE and a modest reversal of corporate income taxes related to the tax treatment of the ACOF acquisition support payment that I discussed momentarily.

As I highlighted, our net accrued performance fees increased $89.2 million from the same period a year ago to $240.6 million. Of the $240.6 million, approximately 2/3 is in our PE business and the 75% relates to funds with annual incentive fees or American-style waterfalls.

Looking at distributable earnings for the third quarter, while it's still early, we have visibility on monetization activity. And our current estimate is our third quarter after-tax DE per common unit should be directionally similar or potentially higher compared to our quarter's level.

Next, I'd like to discuss the favorable tax treatment of the financial support of $275.2 million that we provided for ARCC's acquisition of American Capital. We received an IRS ruling that the acquisition support would be treated as an immediate deduction.

Accordingly, we estimate that the tax -- cash tax savings in 2017 and 2018 related to DE will be approximately $0.46 per common unit, based on the number of common units outstanding as of June 30, 2017. We have realized $0.07 per common unit in tax savings through the first and second quarters, thus far, in 2017. And we expect to that we will not be paying corporate income taxes for the remaining 2 quarters of 2017, limiting the tax drag on distributable earnings. We expect the full benefit from the tax savings to be realized during 2017 and 2018. The exact quarterly timing will depend upon the amount of earnings that are subject to corporate-level taxes, recognition of other tax directions and whether we elect to carry our deductions in 2018 or file for a refund of previous year's taxes. Our current best estimate is that after the change in corporate tax rates, we will continue to use this deduction to offset taxes until fully utilized.

In summary, we remain well positioned to grow our fee-related earnings through our strong fundraising pipeline, deployment of Shadow AUM and gradually improved profitability from rotating the ACOF's portfolio and other lower yielding assets at ARCC.

Our growth in net accrued performance fees is expected to translate into future distributable earnings and distribution growth over time. In addition, our incentive eligible AUM is at record levels. We've doubled the level from 3 years ago. And as we invest these assets, we expect it will support a higher level of future performance related earnings over the full cycle.

Now I'll turn the call back to Mike for closing remarks.

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [5]

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Great. Thanks, Michael. And I think you summed that up pretty well. We have a number of obvious levers to pull to drive financial performance and growth. We are really enthusiastic about our firm's prospects right now. We have 3 very well positioned businesses, each with meaningful competitive advantages and strong growth prospects. And I think most importantly, all are delivering strong investment performance, which is, we always say here at Ares, supports growth in our assets over time. And thanks for everyone's time today.

And with that, operator, I think, we're going to open up the line for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question will come from Craig Siegenthaler of Crédit Suisse.

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry [2]

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It was great to see the additional SMA raise already in the third quarter. Can you update us on your overall strategy here? And just a few other kind of side questions. Is this mainly a U.S. and European direct lending strategy? And also, can the product be customized to your larger LPs? And how should we think about this in terms of, like, sizing the long-term growth potential here?

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [3]

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Sure. Why don't we cover to the high-level and then we can give you some specific numbers on that, the progress that we're making on the SMA front. As I mentioned in the prepared remarks, one very big trend in our space is that the larger institutional LPs, globally, are consolidating their manager relationships. And you see it in the press. We're seeing it in the day-to-day behavior. They are reducing the number of managers that they have on their platforms. And allocating larger commitments to folks like Ares who can manage multiple strategies for them, either in a portfolio of commingled funds, or now as we're talking about, more recently, managed accounts and customized solutions. I think the reason they're doing it is, it makes their business more efficient. They don't have to run a 100 different fund managers. They need less people. They, obviously, with significant size can try to drive more favorable economics from the managers. And I think they're recognizing that as the markets continue to get more volatile and more developed, that having the ability through managed accounts to move capital between strategies with less friction, actually, is going to drive better performance. So I think, this is a trend that will continue. Obviously, it's not for everybody. You have to be of a certain scale in order to desire one of these, and you have to be at a certain scale and sophistication in order to manage them.

In terms of where we're seeing the growth is largely in our credit businesses. It is not limited simply to direct lending, although in today's environment, that is an asset-class that is of significant interest. But it's typically across all of our credit strategies, direct lending in the U.S. and in Europe, structured credit and some of our liquid credit strategies as well. And in terms of what they look like, it can really run the gamut from a single-asset, single-geography strategy, as I mentioned, European Direct Lending where we just closed a $350 million account for a U.S. pension client, or it could be a very large multi-geography, multi-asset class strategy across everything that we do in credit and we run everything in between. In terms of our SMAs, just to put it in perspective, of the $3.6 billion of direct capital that we raised in the quarter, about $1.3 billion was from SMAs. And of that $1.3 billion, about $100 million came through restructured credits and about $1.3 billion came in through various direct lending and liquid credit SMAs. That's $300 million in liquid and about $1 billion in direct. And if you look at it -- since our inception, we've actually done about $10 billion of these type of strategies, broadly distributed across structured credit direct lending and liquid strategies. It's interesting, too, because when we talk a lot about the duration of our capital and we highlight the locked-up nature of the capital, we express these SMAs as a separate bucket, given that a lot of them don't have stated duration. But when we actually look at the percentage of our assets in managed accounts, it's now approaching 20% of our fee paying AUM. And while there is no attendant maturity on it, that tends to be our stickiest capital. So obviously, it's with some of our largest most important clients.

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Operator [4]

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And the next question will be from Chris Harris of Wells Fargo.

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Christopher Meo Harris, Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst [5]

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Appreciate your comments on the investing environment as being difficult. Wondering, as you guys look to deploy ACOF V, is that a -- is that fund constrained to just the U.S.? Or is it a go anywhere fund? And are you seeing better opportunities abroad, right now, than are available here in the U.S.?

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David B. Kaplan, Ares Management, L.P. - Co-Founder [6]

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This is David Kaplan. I'll take that question, which is ACOF V is a global fund. There are certain sub-limits in terms of geographies, but for the most part, you should think of it as a global fund, principally focused on North America and Europe and historically, are investing in deployment through funds 1 through 4. The vast majority of capital has been deployed in North America and the U.S. specifically. So in terms of geographic focus that really is where we stand. We have a significant resources in Europe as well, but largely, think of it is a majority North America and a minority in Europe. A relative value between the markets in North America and Europe in private equity today, I'd say, are largely equivalent. We're not seeing better relative value in private equity in one geography versus another.

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Christopher Meo Harris, Wells Fargo Securities, LLC, Research Division - Director and Senior Equity Research Analyst [7]

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Interesting. Okay. Quick unrelated follow-up. The OpEx this quarter was $138 million, is that a good run rate for you guys going forward?

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Michael Robert McFerran, Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC [8]

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Yes, I mean, I think, it's maybe (inaudible) seasonality built in, but I think, from a percentage standpoint, it's probably a reasonable number.

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Operator [9]

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The next question will be from Michael Carrier of Bank of America Merrill Lynch.

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Michael Roger Carrier, BofA Merrill Lynch, Research Division - Director [10]

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Maybe first question, just on the Part 1 fees, just wanted to understand the dynamics there. I understand the $10 million waiver. I think it dipped a little bit more than that. So maybe just in terms of the core business, the returns of the yields, just how's that trending? And how you should be thinking about it going forward?

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [11]

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Sure. So I'll take it. And if you have anything to add, jump in. But it is largely the fee waiver. And I think just remind people, the economic impact from the ACOF acquisition comes in, in the form of base management fee, which might highlight as running at roughly $10 million a quarter just based on the size of that asset base as well as potential Part 1 fees based on the pre-incentive net income at Ares Capital Corporation. As we talked about on the ARCC call earlier in the week and consistent with the comments I just made, we are being fairly measured in our deployment in that strategy, despite the fact that we're putting out large numbers on a relative basis, it's reflecting a cautious stance. As a result, ARCC is running below its target leverage level. For those that follow the BDC, I think, they have come to expect that we run the business at roughly 0.75 to 1 leverage on the heels of the ACOF acquisition, that number has been closer to 0.6x leverage. So part of the impact is just running a lower leverage level, given our risk appetite and the positioning of the book. And then the other two factors, which will begin to work themselves out over the course of 2017, are the repositioning of the ACOF book. For those of you who have looked at that, there is about $1.1 billion of low-yielding or non-yielding assets within the BDC book that we acquired that need to get rotated, and as they do will contribute to the ROE and the Part 1 opportunity. And then the second is the wind down and ultimate resolution of the SSLP, which was our significant joint venture relationship with GE. We spent a fair amount of time on the ARCC call talking about just having achieved the milestone of resolving that partnership, putting those assets on our balance sheet and beginning to march back in our 30% basket with the [SCLP] and other assets. So it's a combination of all of those things. But I think, it kept to the great job articulating earlier in the week, there is a clearly defined path that start moving that ROE up over the course of the back half of this year and into 2018.

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Michael Roger Carrier, BofA Merrill Lynch, Research Division - Director [12]

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Okay, that's helpful. And then maybe on the Real Estate segment, seemed like a good quarter kind of across being on performance, fee-related earnings, fundraising. Just -- when you think about the outlook of that segment and the relative contribution, what are some of the other opportunities that you guys are looking at in kind of growing that part of the business?

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [13]

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Sure. Just to remind folks, what we have now in our real estate business, we have a little over $10 billion of assets under management in the U.S. and Europe. And broadly speaking, think about that as a direct lending business in commercial real estate, similar to our direct lending business to corporates, as well as a very well developed private equity capability in the U.S. and Europe ranging from traditional value add investing through development, core plus type investing. The thing that we do not do, which could be a long-term growth opportunity is in the core real estate markets and that's something that we continue to look at. And we do believe that the opportunity to grow our real estate lending business is probably one of the most exciting opportunities that we have in front of us today, given our capabilities and the market opportunity we see. I'm glad you brought up the FRE trend there because obviously, we're couple of years removed from the acquisition area. We are now on our second significant fundraising each of the strategies there. So this has, obviously, been fully integrated, it's performing well. We're scaling our successor fundraises, which is obviously contributing to the margin expansion there. So I think, what you should expect is, we are going to continue to grow our core strategies. You've seen that already with our ninth value add fund with a target of $1 billion and $415 million close, which is over 20% increase in terms of fund size from the prior fund. So you'll see us grow existing strategies, the direct lending piece of our real estate business should show meaningful growth. And then, I think opportunistically, either through acquisition or the addition of teams, we'll go after some of the niche sectors that we're not currently active in.

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Operator [14]

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The next question will be from Ken Worthington of JPMorgan.

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Kenneth Brooks Worthington, JP Morgan Chase & Co, Research Division - MD [15]

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First, with the publicly traded BDC is still trading generally at discounts. Do you think that, that sector will continue to consolidate? And if it does or you think it will, does it make sense for Ares to kind of continue to participate there?

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [16]

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Kipp, do you want to talk about that.

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R. Kipp deVeer, Ares Management, L.P. - Head of Credit Group - Ares Management GP LLC and Partner of Ares Management GP LLC [17]

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Yes, I'm happy to. I mean, look, when we -- we've done 2 pretty substantial acquisition, I think, as people know in the space. And we've always said that our acquisition strategy is sort of twofold. Number one, we want to do something that presents reasonable value. So to your point about things trading below book, I definitely think there is some value-oriented opportunities. But secondly, we want to do things in a consensual fashion. So our BDC is not in the business of going out and launching some sort of hospital acquisition attempt or something like that just because the company happens to be trading at a discount for temporary period. So I would say if there is situation like in Allied Capital or an American Capital has in the past that presents itself. We are thrilled to be part of that discussion, but I think consolidation in that sector is difficult for a host of reasons.

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Kenneth Brooks Worthington, JP Morgan Chase & Co, Research Division - MD [18]

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Okay, fair enough. And just on the taxes, can you maybe reframe it either how much in taxes can you save over time? Or how much earnings is actually shielded over time? And is there any earnings that, for whatever reason, not qualified for the shield? Or is everything eligible?

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Michael Robert McFerran, Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC [19]

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Sure. So it's actually the way to think about the shielded -- a shield against corporate taxes in the U.S., which consists primarily of management fees, and to a lesser extent, some incentive fees primarily related to some liquid credit funds. As we mentioned in our remarks, there was -- we estimate $0.46 of DE benefit from the deduction. And through the second quarter, we've utilized $0.07 of that. So when you kind of think about the math going forward, we talked about some of our trajectory of FRE growth. We think this will be fully utilized in the -- during the course of '17 and '18. What I do want to highlight though is, is the shield from a cash standpoint, this doesn't impact fee-related earnings or economic net income. What this does do is remove the drag of corporate taxes on management fees from distributable earnings.

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Operator [20]

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(Operator Instructions) The next question will come from that Doug Mewhirter of SunTrust.

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Douglas Robert Mewhirter, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [21]

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First question on the real estate business. Really nice earnings from incentive fees and related net investment income. Unusually large this quarter, which implies you had some pretty good pricing, good exit opportunities. Would you expect that to be continued as -- or you in that cellar? Or -- and also does that make it more difficult to redeploy the capital if prices are that strong? And I realize it's a very diversified strategy, you could have gotten realizations from a wide variety of areas.

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [22]

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Yes, it's hard to generalize in the real estate business because, as I mentioned, we are doing development stage investing, we're doing transitional investing, we're doing core plus type investing in multiple geographies in the U.S. and in Europe. The good news is the performance across each of those strategies has been very, very strong and very consistent, that's showing up in the performance fee numbers. It's also showing up in the fund-raising momentum that we have. If you talk to our real estate folks, what they will tell you is that while there is elevated liquidity in that market as well, given the size of the addressable market and given the speed on the street that we have, they're still seeing very, very exciting opportunities to deploy capital. So I would actually say of all of the strategy -- that's probably where people are seeing the least amount of pressure right now. The fundamentals in the U.S. and European real estate business are very, very strong. You're seeing employment and rent growth in most of the markets we're investing in, moderate supply increases. So there is not a big supply-demand imbalance like we've seen, late cycle in prior cycles. And just a really good healthy amount of transaction activity, which puts us in a position to have a good balance between harvesting and deploying. If you look at the detail of where we are harvesting, that will tell part of the story. The other place to look is, to look at our crude net performance fee balances in each of our funds. As I mentioned in our prepared remarks, we're in the market now with our ninth value add real estate fund in U.S. We are likely to bring our fifth European fund here towards the back half of this year or early next year. And so by definition, just the ordinary course of rhythm of these businesses is, we harvest prior vintage funds as we start to raise and deploying new. So if you look at the net performance fee balance, you will see a very healthy build in our European real estate fund IV and our real estate opportunity Fund VI in our core plus property enhancement strategies in Europe and in our eighth value add real estate fund. So there is a significant amount of building performance fee behind it, just given the success that they're having in their markets.

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Douglas Robert Mewhirter, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [23]

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Okay. That's very helpful. Switching gears a little bit. Your overall fee-related earnings margin had a nice sequential uptick, and I expect that you will continue to get scale benefits. Is hitting that 30% full year fee-related margin a possibility, considering whatever the seasonality in your growth?

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Michael Robert McFerran, Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC [24]

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Yes, so I think, there are 2 points to highlight on this. The first is, as we said, I believe in our last earnings call, that we expected during the course of 2017, we would hit that 30% on a go-forward basis from that point. So we -- that view has not changed. So I don't know if it's Q3 or Q4, but we have stepped up from 26% to 28% on a quarter-over-quarter sequential basis. I think Q3, again, we still believe it will be this year. The one thing we do want to highlight is, if you look at the ARCC contribution and if -- and the timing of the rotation of the ACOF portfolio, if the Part 1 fees were flat year-over-year, we would have been over 30% this quarter. So I think, the absent even deploying incremental AUM, which we are, and we talked about the sizable amount of management fees we have tied to Shadow AUM. We've talked a lot about the capital we're raising. We've talked about how we believe we have a fairly scalable expense model. But in addition to all of that, we think just the continued rotation and working through that process with ACOF is going to get us to 30%.

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Michael Robert McFerran, Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC [25]

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Yes, Doug, one, this is going to be total simple back of the envelop math, but if you just take away that fee waiver, you'll see that we have an FRE margin in the low 30% rate already. So obviously there is a lot of levers to pull and a lot of things that play. But if you grossly over simplified it and just reversed the fee waiver, to get a sense of what the embedded margin opportunity in the businesses you're going to see that's already well into the low 30s.

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Operator [26]

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The next question will be from Alex Blostein of Goldman Sachs.

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Daniel Jacoby, Goldman Sachs Group Inc., Research Division - Research Analyst [27]

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This is Daniel Jacoby filling in for Alex. Just on realizations, how should we think about the timing of the sales for some of the larger public positions that you guys have?

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David B. Kaplan, Ares Management, L.P. - Co-Founder [28]

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This is David. These are public companies, so it's difficult for us to really comment on it. Generally speaking, many of the private equity positions in public companies, let's just say, we feel really, really good about those businesses, their management teams, their positions in the market, but really difficult to give specificity on what our liquidity plans are long term.

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Operator [29]

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And the final question this morning will be a follow-up from Craig Siegenthaler of Crédit Suisse.

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry [30]

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I appreciate the follow-up here. First one, European Direct Lending, I think, hits me back in the market in the second half with the fourth fund. I think the last one was around $5 billion. So just in terms of size, should we expect something in the $6 billion ballpark? And in terms of final close, any help there, it would be helpful?

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [31]

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We can't comment on specific fundraisers. So I'll just make a general comment about that business, which is similar to our U.S. direct lending business. We have very quickly established a significant leadership position in that market in terms of market share, number of people that we have on the ground, our return performance, our deployment pace. We really do have a differentiated business there. In terms of the AUM, we are already well over $10 billion AUM in that strategy alone. And that market continues to evolve and open up to us in a way that I don't think it's opening up for others. As you would see in other successor funds, where we have real competitive advantage, great performance and a great market opportunity, we come to expect larger successor fundraisers. So we're not going to specificity, I would expect that, that fund would be larger than the prior fund.

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Michael Robert McFerran, Ares Management, L.P. - CFO & EVP of Ares Mgmt GP LLC and Partner & Treasurer of Ares Mgmt GP LLC [32]

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And my -- let me just one thing to as your courtesy you have the fact the last fund was commingled fund, too, and $1 billion of equity, and it's modestly leveraged to create more assets. So this is -- you look and manage expectations around what you'll see down the line -- just see have your -- you have your facts straight.

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David B. Kaplan, Ares Management, L.P. - Co-Founder [33]

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One more thing, those are euros not dollars?

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Craig William Siegenthaler, Crédit Suisse AG, Research Division - Global Research Product Head for the Asset Management Industry [34]

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And then just one follow-up on infrastructure. I know you have a strategy there, that's pretty mature with EIF focused on sort of energy, but are there any plans to do anything in the kind of more traditional infrastructure space, roads, airport tunnels, shippings because there's been a lot of talk there, decent amount of fundraisers there, especially with what Trump maybe doing with his spending plan?

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [35]

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Yes, I think, the opportunity set in the market seems to be getting a lot of headlines and discussions just given the potential stimulus from the current or an administration. That said, we haven't really seen in those projects flowing. I do think that there is an opportunity for us to take what we already do really well in EIF and within our broader energy strategy, coupled with some of the project finance lending that we do in our direct lending business to expand the borders and boundaries that we currently do into other infrastructure-related assets. Whether or not we push fully into what folks would call core infrastructure, I think, is a TBD. But clearly, an opportunity for us to grow off and what already is a very unique competitive advantage and capability we have in the markets that we're in today.

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Operator [36]

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And ladies and gentlemen, this will conclude the question-and-answer session. I would like to hand the conference back over to Mike Arougheti for closing comments.

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Michael J. Arougheti, Ares Management, L.P. - Co-Founder, President of Ares Management GP LLC, and Director of Ares Management GP LLC [37]

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Well, thanks, everybody. We appreciate you spending time with us on a Friday in August. We appreciate all the time and great question. And we hope that you have a wonderful end to the some summer. And we will look forward to our next call in a couple of months. Thanks, everybody.

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Operator [38]

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Thank you. Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available through September 1, 2017, by dialing (877) 344-7529, and to international callers, by dialing 1 (412) 317-0088. For all replays, please reference conference #10110034. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.