Ares Capital Corp Q4 FY2021 Earnings Call

Good morning, and welcome to Ares Capital Corporation’s Fourth Quarter and Year-ended December 31, 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Wednesday, February 9, 2022. I will now turn the call over to Mr. John Stilmar, Managing Director of Ares Investor Relations.

Thank you. And let me start with some important reminders. Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. The Company’s actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in its SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results. During this conference call, the Company may discuss certain non-GAAP measures as defined by the SEC Regulation G, such as core earnings per share or core EPS. The Company believes that core EPS provides useful information to investors regarding financial performance because it’s one method the Company uses to measure its financial condition and results of operations. A reconciliation of core EPS to basic and diluted net income per share, the most directly comparable GAAP financial measure can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures may also be found in our earnings release filed this morning with the SEC on Form 8-K. Certain information discussed in this conference call and in the accompanying slide presentation, including information relating to portfolio companies, was derived from third-party sources and has not been independently verified. And accordingly, the Company makes no representation or warranty in respect to this information. The Company’s fourth quarter and year-end December 31, 2021 earnings presentation can be found on the Company’s website at www.arescapitalcorp.com by clicking on the Fourth Quarter 2021 Earnings Presentation link on the home page of the Investor Resources section. Ares Capital Corporation’s earnings release and Form 10-K are also available on the Company’s website. I’ll now turn the call over to Kipp deVeer, Ares Capital Corporation’s Chief Executive Officer. Kipp?

Thanks, John. Hello, everyone, and thank you for joining our earnings call today. I'm here with our Co-Presidents, Michael Smith and Mitch Goldstein, as well as our Chief Financial Officer, Penni Roll, and other members of the management team. I will start by sharing some highlights from the fourth quarter and the full year, after which I will discuss the current market and our Company's positioning. We are pleased to report strong results for both the fourth quarter and the entire year. We achieved record core earnings of $0.58 per share for the quarter and $2.02 per share for the year. Our financial performance is reflective of the highest level of quarterly and annual origination activity in our history, with $5.9 billion in commitments for the fourth quarter and $15.6 billion for the year, which is over double the amounts seen in 2020 or 2019. Our fourth-quarter earnings on a GAAP basis were $0.83 per share, concluding a year in which we achieved the second highest GAAP earnings in our Company’s history. The GAAP earnings for the year came to $3.51 per share, which included $258 million or $0.58 per share in net realized gains on investments. The strength of these earnings resulted in a 12% growth in our net asset value per share for the year, ending the year at an all-time high of $18.96. When factoring in our dividends paid during 2021, we yielded a 22% economic return for our shareholders for the year. Before Penni delves into our results in greater detail, I'd like to take a moment to emphasize our position in the rapidly growing U.S. direct lending market, valued at $1.5 trillion, and discuss some of the factors contributing to our robust investment activity. We believe our opportunities are expanding as borrowers increasingly favor private capital as their main source of financing for acquisitions and business growth. We have observed a significant shift in the size of companies seeking our financing solutions. Over the past five years, the average EBITDA of the companies we evaluate has risen by over 60%, and the number of reviewed companies with an EBITDA over $100 million has more than tripled. We are also encountering a broader array of opportunities across both sponsored and non-sponsored markets, making private credit feel more extensive and valuable to companies than ever. We continue to operate with a model of flexible capital suitable for nearly any scenario, allowing us to customize solutions for businesses, whether in senior, unitranche, subordinated debt, or preferred and non-controlled common equity. This tailored approach is beneficial for our borrowers and another reason we expect to achieve higher originations while upholding our strict standards for credit quality, documentation, and deal terms. However, we are noticing increased competition in this expanding yet fragmented market. We believe many of our competitors do not consistently act rationally concerning credit quality, pricing, leverage, documentation, and other critical factors. Despite this competition, we maintain a strong competitive position and continue to capture market share. In 2021, the estimated dollar volume of the transactions we considered grew to over $550 billion. Our reviewed transaction volume has increased 50% faster than reported market growth since 2019. These market share gains provide us the advantage of being highly selective. Today’s environment allows us to pass on some attractive businesses simply because we disagree with the deal structure, pricing, or proposed loan documentation. We actively pursue deals we want, but we also have the ability to walk away from situations when necessary, thanks to our broad range of opportunities. As the market has expanded, we have enhanced our direct origination capabilities, establishing what we believe is the largest direct lending platform in the United States, supported by 145 investment professionals and a robust operational structure. The size of our team has enabled us to cover significant market territory, allowing us to engage with over 420 different sponsors and more than 200 non-sponsored companies since our IPO. Our team is experienced and cohesive, with our investment advisors and committee members averaging 27 years in the industry and 17 years with Ares Management. This stability has fostered a well-established credit process that supports our growth, enabling a consistent market approach with both sponsors and companies. Besides our U.S. direct lending team, we have the advantage of an additional 175 investment professionals in the Ares Management Credit Group and 440 professionals within the broader Ares Management platform who interact daily with companies and sponsors. We believe the shared experiences, insights, and strong local relationships among our advisors and investment professionals enhance our market presence and underwriting capabilities, which are reflected in our portfolio's health and performance. Our portfolio credit quality remains among the strongest in our Company’s history, culminating in a year-end non-accrual rate at a 14-year low. Our sustained focus on market-leading companies with high free cash flows in resilient sectors has put our portfolio in a strong position to navigate challenges posed by inflation and supply chain disruptions. Consequently, our portfolio companies have shown solid earnings growth throughout the year, with the last 12-month weighted average EBITDA growth reaching 16% this quarter, the highest we've recorded in over a decade. In light of our portfolio's solid performance and our optimistic outlook for the Company's earnings potential, we are increasing our quarterly dividend for the second time in 12 months to $0.42 per share. This action reinforces our consistent record of delivering significant shareholder value. For the quarter ending September 30, 2021, Ares Capital has achieved the highest growth rate in regular base dividends per share and NAV per share over the past five and ten years among externally managed BDCs with a market cap surpassing $700 million. Moreover, recognizing the strength of our earnings in 2021, including another year of net realized gains from the portfolio, along with continued growth in our excess undistributed earnings, we will disburse additional dividends to shareholders totaling $0.12 per share for 2022. We plan to distribute these special dividends at $0.03 per share each quarter this year. With that, I will hand the call over to Penni to provide more details on our financial results and thoughts on our balance sheet positioning.

Thanks, Kipp, and good morning, everyone. 2021 was our most active year ever, and that helped drive our full year core earnings per share of $2.02. And these activity levels, along with $826 million of net realized and unrealized gains for the year helped drive our 2021 GAAP net income per share to $3.51. These results compared to $1.74 and $1.14 per share of core and GAAP EPS, respectively, for full year 2020. These strong overall earnings results helped our stockholders’ equity reach a record $8.9 billion at year-end 2021 or $18.96 per share. In comparison, our stockholders’ equity was $7.2 billion at year-end 2020 or $16.97 per share. Our total portfolio at fair value at the end of the year grew to just over $20 billion, up from $15.5 billion at the end of 2020. The weighted average yield on our debt and other income-producing securities at amortized cost was 8.7%, and the weighted average yield on total investments at amortized cost was 7.9% as compared to 8.9% and 8.2%, respectively, at September 30, 2021, and 9.3% and 8.5%, respectively, at December 31, 2020. It is worth noting one change as it relates to our yield calculations. Beginning with our reporting for this period, we updated our weighted average yield calculations to include dividend income from our equity investment in Ivy Hill Asset Management. Previously, we had excluded the impact of these dividends from our yield calculations because our Ivy Hill equity investment did not have a contractual stated yield component. In light of the fact that Ivy Hill has consistently paid a common dividend to Ares Capital for 50 consecutive quarters, we determined that including these dividends in our calculations more accurately represents the yield on our portfolio. For comparative purposes, we have updated the yield calculations for all periods presented to conform to the new methodology. Shifting to our interest rate sensitivity, we are well positioned to capture an earnings benefit from a rising interest rate environment, particularly if rates move past the interest rate floors on our investments. At December 31, 2021, 77% of our total portfolio at fair value was in floating rate investments. Additionally, excluding our investment in the SDLP certificates, 93% of the remaining floating rate investments had a weighted average floor of approximately 90 basis points, which is higher than today’s current one and three-month base rates. This portfolio composition in concert with our low level of leverage from predominantly fixed-rate unsecured notes should allow our earnings to benefit from rising rates. As of year-end and holding all else equal, we calculated that a 100 basis-point increase in short-term rates could increase our quarterly earnings by $0.01 per share, while a 200 basis-point increase in short-term rates could increase our total quarterly earnings by approximately $0.06 per share, after considering the impact of income-based fees. Now, turning to our capitalization and liquidity. Our balance sheet is composed of highly efficient sources of capital, including a significant amount of fixed-rate unsecured debt. We were highly focused throughout 2021 on strengthening our financial position by accessing diverse long-dated and cost-efficient forms of debt financing. During the year, we closed on over $3.4 billion of new unsecured term borrowings. We have continued to extend the maturity ladder, having taken advantage of the low rate environment to issue in the 5, 7, and 10-year parts of the curve, which will serve us well over time as we face a higher rate environment. This active balance sheet management has allowed us to lower the weighted average stated interest rate on our total borrowings from 3.4% at the end of 2020 to 3.1% as of December 31, 2021. As we look at our long-term approach to balance sheet management, we have a low level of debt maturities over the next two years, with only $388 million maturing in 2022, which was already repaid in early February and one $750 million maturity in mid-2023. After that, there are no other term maturities until mid-2024 and our nearest committed bank facility maturity is not until 2025. The duration of our liabilities and limited near-term maturities continue to provide for significant financial flexibility. Commensurate with the activity levels in our portfolio, we also raised over $800 million of accretive equity during 2021 to support our growth, completing our first secondary equity issuances since 2014. Touching on our leverage levels, at December 31, 2021, our net debt-to-equity ratio was 1.21 times. Pro forma for our year-to-date 2022 capital activity net leverage levels declined to 1.15 times and combined available cash and liquidity through undrawn revolvers was a healthy $4.8 billion. As Kipp stated, we increased our first quarter 2022 dividend to $0.42 per share, which is payable on March 31, 2022, to stockholders of record on March 15, 2022. Given our strong earnings for the year, we once again outearned the dividends we paid, resulting in an increase in our undistributed taxable income, sometimes referred to as our spillover. We currently estimate that our spillover income from 2021 after considering the shares issued in our January equity raise, reached $1.30 per share, an increase of $0.24 per share from 2020’s level. The expansion of our spillover was an important consideration in our decision to pay additional quarterly dividends totaling $0.12 per share during 2022. The first additional dividend of $0.03 per share is also payable on March 31, 2022, to stockholders of record on March 15, 2022. We will continue to monitor our undistributed earnings and balance sheet levels against prudent capital management considerations. Overall, we believe having a strong and meaningful undistributed spillover supports our goal of maintaining a steady dividend through varying market conditions and sets us apart from many other BDCs without our level of spillover. With that, I will now turn the call over to Michael to walk through our investment activities.

Thanks, Penni. I will focus on providing more details on our investment activity and portfolio performance for the fourth quarter and the year and then conclude with an update on post-quarter-end activity, backlog, and pipeline. Over the course of 2021, we invested in over 200 companies across 22 distinct industries with a weighted average EBITDA of approximately $200 million. The weighted average EBITDA of our overall portfolio during 2021 grew to $162 million, more than double the weighted average EBITDA five years ago. This growth reflects the expanded market opportunity for larger direct lending transactions and ARCC’s strong market position that Kipp described earlier. It is important to note that while our portfolio company’s weighted average EBITDA has grown over the past few years, the EBITDA of the companies we financed this year across sponsored and non-sponsored transactions ranges from approximately $15 million to more than $500 million. This wide range of investment opportunities underscores the breadth of our sourcing capabilities and the value that we find in high-quality market-leading businesses of varying sizes. One of our differentiated sourcing advantages remains our deep relationships with portfolio companies and private equity sponsors that we have developed over many years. Over the past quarter and year, 55% and 52% of our new commitments, respectively, were to incumbent borrowers. Additionally, in 2021, we continued to build upon our deep sponsor relationships as 75% of our sponsored transactions were with repeat firms. With such a large portfolio and many more companies that we have transacted with historically, we believe that our long-tenured market presence provides us access to unique deal flow and differentiates ARCC from other BDCs. The breadth of our sourcing capabilities is a key component and executing a conservative approach to constructing a highly diversified portfolio with significant downside protection. Our portfolio remains diversified across 387 different borrowers with an average hold size of only 0.3% at fair value. Excluding our investments in Ivy Hill and SDLP, which we believe are highly diversified on their own, no single investment accounts for more than 1.5% of the portfolio at fair value. And our top 10 largest investments totaled just 10.9% of the portfolio at fair value. Additionally, the loan to value on our debt portfolio, which was approximately 45% at the end of the fourth quarter, is below the mid-50s level seen prior to the pandemic. As a result of these attributes, the credit performance of our portfolio remains strong. As commented on earlier, our non-accruals at cost during the fourth quarter of 2021 declined to 0.8%, their lowest level since 2007, and down from 1.7% the prior quarter and 3.3% at year-end 2020. In addition, the weighted average grade of our portfolio at fair value improved modestly in Q4 to 3.1 from 3.0 at the end of Q3 2021. Before concluding with our investment activities to date in 2022, I want to take a minute to highlight our increased investment in Ivy Hill Asset Management over the past year and remind investors of the value that we believe Ivy Hill provides to ARCC. Ivy Hill is a wholly-owned portfolio company of ARCC that was started in 2007 to invest in and manage middle-market senior secured loans through structured investment vehicles and separately managed accounts. Today, Ivy Hill is a leading middle market loan manager of over 20 middle-market investment vehicles and SMAs and benefits from an experienced management team with strong middle-market relationships. Similar to ARCC, Ivy Hill has a long track record of profitability and the investment vehicles and SMAs that it manages are well diversified with investments across more than 280 distinct borrowers. Many of these borrowers are portfolio companies of our private equity clients. In order to support its AUM growth in an expanding middle market opportunity, ARCC increased its equity investment in Ivy Hill by $296 million in the fourth quarter, bringing its investment to $765 million on a cost basis. We are optimistic that our capital investment in Ivy Hill will support future growth in its AUM. Finally, I will finish with a brief update on our post-quarter-end investment activity and pipeline. From January 1 through February 2, 2022, we made new investment commitments totaling $607 million, of which $385 million were funded. We exited or were repaid on $956 million of investment commitments, including $529 million sold to vehicles managed by Ivy Hill, generating approximately $20 million of net realized gains on exits. As of February 2, our backlog and pipeline stood at roughly $1.2 billion and $125 million, respectively. Our backlog contains investments that are subject to approvals and documentation and may not close, or we may sell a portion of these investments post-closing. I will now turn the call back over to Kipp for some closing remarks.

Thanks a lot, Michael. In closing, we believe 2021 was an excellent year for the Company. Ares Capital showed strong growth in earnings, deployment and other metrics that we’ve discussed today. The strong position of the Company is reflected in our announced increase to the regular quarterly dividend and the declaration of an additional dividend of $0.12 per share, again, to be paid to shareholders over the four quarters of 2022. As we start this year with increasing market volatility across many risk assets, we note that these periods of volatility have historically led to continued demand for private capital, and we look forward with optimism. With significant structural tailwinds and multiple levers for growth, we remain optimistic about the company’s future. I’d like to close the call by simply thanking our entire team for their hard work and their dedication throughout 2021. And with that, operator, we can open the line for questions.

The first question comes from Ryan Lynch of KBW. Please go ahead.

Good morning. Thank you for taking my questions. It was a great quarter, and more importantly, a strong finish to 2021. My first question is based on a comment from a different BDC last week. The fourth quarter portfolio activity was very strong, and I'm not sure if we can expect that same level to continue in 2022, but please correct me if you think otherwise. One concern mentioned was that the rise in interest rates could put pressure on private market valuations for these businesses. This trickle-down effect might reduce the level of deal activity in some sponsor transactions in 2022 if interest rates continue to rise as expected. I would like to hear your thoughts on how concerned you are about rising rates driving down multiples in some of these private markets and potentially reducing deal volumes.

Thank you for the question. I think it's a valid point. When interest rates increase, the value of assets often decreases, which can temporarily dampen activity as people reassess valuations. The slow start many of us, including ourselves, have experienced this year follows an exceptionally busy fourth quarter in 2021, which I agree was somewhat unusual regarding activity levels. There seems to be a recalibration of expected activity and valuations now. On the positive side, this may lead to fewer repayments and longer asset durations. While I cannot disagree with the concern raised, I understand the validity of the observation made.

Understood. For my follow-up question, you touched on this in your remarks regarding the significant investments in Ivy Hill. The fair value markup of that investment has increased quite a bit throughout the year, showing a substantial rise in fair value over cost. What factors contributed to the increase in the net fair value mark during the year? Is it primarily due to higher profitability from Ivy Hill as it scales? Also, what are the fundamental drivers behind your increased investment guidance? Are these trends consistent with what you're observing across the direct lending sector?

So, Ryan, let's discuss this in more detail later. It's a bit complicated since we made a significant new investment, which will raise the fair value of our investment in that portfolio company. You're also asking about how the underlying valuation of the entity has changed regarding that capital contribution. The increase in value apart from the capital contribution is relatively small compared to our current cost basis. Just doing a quick calculation, the increase is only a couple of percent relative to our overall cost and fair value from last quarter. We can go over this later, but nothing significant is driving a major fair value increase. What you’re likely observing is the capital contribution. We can take this offline to ensure you have all the necessary information.

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

Good morning. It was a good quarter. Thank you for addressing my questions, and I appreciate the market update, Kipp. I'm considering the factors affecting originations this year and general deal activity. While it's been quite strong, there are numerous variables at play, including rising rates. How does that influence the refinancing market? What is the status of the mergers and acquisitions pipeline? Additionally, how do the private equity funds currently sitting on the sidelines affect the situation? Ultimately, I’d like to know how these factors might shape our outlook for this year compared to the past few years.

Sure. I mean, there’s a lot there. I’ll give you some thoughts, and feel free to follow on. But to Ryan’s point on some of the other comments, I think increasing rates will slow refinancing activity, probably slow repayments a little bit and extend the duration of the existing portfolio, which is fine with us. It makes our life a little bit easier in terms of growth and consistency of earnings. And then, the point on M&A activity, despite modest increases here in rates, I think once there’s a little bit of a recalibration as to what purchase prices look like. And maybe I do think some more evidence that folks are gathering today as to how quickly rates will rise and by how much. I think, things will settle and I think that it will be another busy year. If you ask just my opinion and others on the team can chime in, do I think ‘22 will be as busy as ‘21? Probably not, right? I mean, there was a huge hangover effect coming out of kind of deep COVID in 2020 that I think put folks on the sidelines and then had them come off the sidelines in a pretty vicious way in year to get things done. And to your point, deploy capital that had been on the sidelines, most of which have finite investment periods. But I think we’re through a lot of that. So I would expect ‘22 to be more of a regular year, maybe 2019, right, which was busy, certainly had some uncertainty, not around rates and inflation, but about other concerns. And nonetheless, it was a reasonably busy year for everybody.

Okay. That’s great color. And then, it looked like the yields, and I know there were some changes in calculations, but they’ve been coming down. But looking at Q1, it looks like the call it, the run on yields higher than the runoff. I’m wondering just maybe can you talk about spreads. Has there been any changes in kind of the pipeline of spreads, given, I don’t know, the volatility in the market? And is there any kind of outlook on the overall book yield over the course of the next few quarters, given rates in that element?

No. I mean, you’re right. What we onboarded was better than what exited, right? I mean, we had a modest decrease actually in debt and income-producing securities, which was largely actually because of the equity investments that we made. Ivy Hill being a significant contributor to that, a slightly lower percentage of the portfolio in SDLP, and then, to your point, slightly tighter market spreads. But between the fourth quarter activity and now, we haven’t really seen a compression in spreads. It’s about the same.

The next question comes from Kenneth Lee of RBC Capital Markets. Please go ahead.

Just want to follow up on the remarks you had in terms of the kind of competitive environment that you’re seeing right now. I wonder if you can talk a little bit more about that and especially within the upper end of the market, such as like larger corporate borrowers. Thanks.

Yes. I mean it seems to us that that portion of the market has gotten more competitive. I think if you look back at our prepared remarks and probably some of the Q&A over the last three years that we’ve delivered at this company, we’ve talked about how we thought there was better risk reward at the upper end of the market, frankly, than there was in the lower end of the middle market, which historically has not been the case, right? Having done this with the team here for 20-something years, you’ve always been offered this significant premium in the lower middle market. And over the last couple of years, that went away. We obviously played more and more into larger companies where we thought we were getting better credits and frankly, the same or better pricing. And that was largely because of our scale advantage and the lack of competition there. To your point, I think you’re referencing some folks in the market who have put together pretty significant pools of capital here over the last 12 to 18 months and are attacking that portion of the market. So, I think our view is it is more competitive there. That being said, we believe the Company has some pretty significant competitive advantages that continue to exist despite that. We’re able to compete effectively where we want to. And in the prepared remarks, I said we’re able to walk away when we want to, too. If we don’t like pricing or terms or documentation or whatever it may be, because we have confidence in our ability to continue to originate enough deal flow that we don’t get put in positions where we are forced to do things. And that’s just really important in terms of being selective and putting portfolios together that obviously are illiquid and that we think we’re going to be managing for years forward at a time, right? So, we need to feel good about where we’re coming in. And to your question, I’d say, yes, admittedly, the upper end of the market, which was wide open for us for years, is a little bit more competitive than it probably was 12 to 18 months ago.

Got you. Very helpful there. And one follow-up, if I may. Wondering if you could just share with us your thoughts around portfolio construction in the current environment, either relatively attractive sectors or any other positioning you have there in the near term? Thanks.

Yes. I mean, I think in terms of industries, things are very similar in terms of our viewpoint. We’re trying to take defensive industries with probably better than GDP growth, certainly, businesses that have good free cash flow and allow us to set up levered deals that can delever without a lot of uncertainty. Because of the origination and the flexible capital model, which I did call out again in the prepared remarks, we don’t have a strong view generally that senior secured debt is better than junior debt or whatever it may be as the kind of platitude or as a generalization, right? We kind of look at things on a deal-by-deal basis. If you look over a fairly long period of time, what you’ll see from us is a mix that’s reasonably consistent, but it can be inconsistent from quarter-to-quarter. And it really depends on the company, less than it is a view on how do we want the portfolio to respond from an asset mix perspective. We have parameters, right? And that if something got out of whack, percentage of equity was 15% or 20% of the portfolio, we’d probably say that’s too high. If we were putting 60% or 70% of the portfolio into pure senior debt, we probably wouldn’t have enough income in the company to pay the dividend, right? So, it’s a balance in terms of putting the portfolio together. But we don’t have any strong generalizations about one being better than the other. It’s really company-specific, and that’s how we think about things.

The next question comes from Finian O’Shea of Wells Fargo. Please go ahead.

Can you discuss the growth potential for Ivy Hill? Is it just in the traditional CLO business, or are there other unique aspects they are pursuing? What implications does this have for ARCC? Will this lead to a significant increase in the capital supplied to that business?

I mean, look, this is Ivy Hill’s one of the larger portfolio companies in one of the longer tenured portfolio companies, obviously, at Ares Capital. We think very highly of the management team there. We look at a 10-plus-year track record of them delivering excellent returns to the company. But to your point, their business is reasonably simple, and it’s a good time for them to grow, i.e., there’s lots of middle-market senior secured product. They’re able to buy from us. They’re able to buy from others. And they’re seeing significant demand for growth generally. So, because of their strong track record, we feel very comfortable increasing the size of our investment in that company by a couple of hundred million today. That brings it to rough numbers of 5%ish position. We think it can continue to grow from there. We haven’t really thought about an upper limit as to how big would be too big. But the size today puts it on par with our investment in SDLP, which is the other significant contributor to the 30% basket, and we think similarly about that program. So again, it’s just trying to ride the winners and continue to invest more money in things that have done well for us.

Sure. That’s helpful. And then, a follow-up for Penni, sort of high level. On top of interest rates moving, it feels like the proliferation of these very large BDCs is stretching the demand from the unsecured market. I’m wondering if that’s something you’re seeing? And do you think that there will be sort of a tilt back toward bank funding in the BDC industry?

Yes. Thanks, Finian. Yes. I mean, we’re certainly seeing more BDCs out there raising capital. And we did see that in Q4. It was a very active quarter for BDCs raising debt in the term market. I think we feel really good about our position in those markets. We’ve been very long tenured issuing in them and expect to be able to continue to issue in them. But certainly, it takes more consideration around just timing and when we want to go to the market, given the greater activity. So, we’ve continued to be successful issuing in the market. We are back in Q1 in early January. And we’re able to continue to issue term debt at much tighter spreads than most. So, we feel good about our position and where we are with our capitalization today.

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

My first question is really a maintenance question, mostly for Penni. In the recent developments, the $48 million loss on the extinguishment of debt. Was any of that baked into the financials at the end of the fourth quarter, or is that all being fully recognized against earnings per share in the first quarter?

No, that will all be baked in, in Q1 because that’s when the repayment happens.

Okay. So, there was nothing like reserve against it or anything like that?

No. It will be treated as a loss on the extinguishment of debt in Q1.

Okay, great. And then, my follow-up is for you, Kipp. There’s almost an $80 million difference in the quarters in terms of the capital structuring fees over the course of 2021. So, I’m going to ask you to put my hat on. And how would you model those capital structuring fees going forward, if you were me, as an analyst looking at that wide differential?

The simplest approach, although not entirely straightforward, is to consider a percentage of new originations. However, this method may not account for instances where we earn a higher rate than normal due to specific transactions where we underwrite and syndicate but do not retain the final hold. For modeling 2022, I would recommend being less aggressive concerning new originations. The special dividend this year was partly due to exceptionally high activity levels, prompting us to acknowledge that it warranted something unique. Moving forward, it would be beneficial to reflect on our origination activity over the past few years, average it out, and examine what percentage of new gross commitments yield a fee, such as a 2% or 2.5% fee. For us, it's more of a modeling exercise for you, as we believe our dividend remains well-supported even amid lower activity levels, which is our primary focus. We can assist further if needed, but I trust you are familiar with the methodology and can create your model accordingly.

Well, anytime I can get you to do my job for me, I'm getting some well-priced, well-informed talent. So, I might as well try. I appreciate you taking my questions.

No. It’s all good. I think we have enough to do around here, but thanks for the offer.

The next question comes from Melissa Wedel of JP Morgan. Please go ahead.

The first one is for Kipp. Kipp, you talked about the pace of rate increases. And I think when you mentioned that earlier, it was in the context of how that might impact activity levels in ‘22. But, I’m also curious if you have any thoughts or concerns about portfolio companies’ ability to kind of service bad debt or pass on higher costs as their cost of borrow increases and whether that’s specific to your portfolio or the industry generally? I’m curious what you’re thinking about that.

Sure. Thanks for the question. I think we don’t have those concerns yet, and I believe most of the market feels the same way. We're discussing the initial stages of modest rate increases affecting borrowers, while the industry generally has LIBOR floors set at a minimum of 75 to 100 basis points. This means that issuers are currently servicing debt at significantly higher LIBOR levels than what the market indicates. The companies are already equipped for this. It may take two or three rate increases before some companies and their managers begin to consider whether rising rates will pressure credit metrics and underlying credit fundamentals. For now, we're not worried, and I don’t think many others in the industry are either.

Okay. Got it. Follow-up question for Penni on the convert issue that will flow through and with the realized loss flowing through in the first quarter. Just to clarify, is that something that would be excluded from your core EPS number?

Yes, because it will go through as a loss on extinguishment of debt. And if you look back historically when we’ve had that, it goes in the same section as realized gains and losses. So, it’s not part of core or net investment income.

The next question comes from Kevin Fultz of JMP Securities. Please go ahead.

Looking at portfolio activity during the quarter, new investments to equity investments were elevated relative to prior quarters, and I realized that was partially due to Ivy Hill. And then quarter-to-date, that trend has continued. Can you talk about the opportunities that you’re seeing on the equity side that have led you to lean in there?

Yes, thank you for the question. It was definitely influenced by the Ivy Hill investment, and there weren't any other major changes. We made a few larger preferred and common investments this past quarter compared to what we've done previously. I wouldn't attribute this to a specific strategy regarding our portfolio mix; rather, it was mainly based on the opportunities that came up in Q4. However, we have a strong history of equity investing, which has helped us earn significantly more than our dividend over the years. We've mentioned the realized gains for 2021 and how impactful they were. This remains an important part of our strategy, but the only notable point is the substantial Ivy Hill investment for Q4.

Okay. That’s helpful. And then, my follow-up, you’ve touched on a bit on this call. 2021 was clearly an incredibly strong year for deployment and in turn portfolio growth. Can you talk about your expectations for the pace of investment portfolio growth in 2022? And how we should think about that?

Yes. I mean, I’ve covered it on a couple of the other questions that folks have asked and don’t have much to add. I think that this year, again, we’ll look more like a traditional pre-COVID year, right? You have all of the tailwinds still in place, lots of uninvested private equity, strong and growing economy, despite some of the inflation concerns or thoughts about rising rates. The backdrop for the economy actually seems quite good, and nothing that would contribute to slow down. But I think we’re in a slow Q1 here as things evolve, right? Again, folks are taking a little bit of a wait-and-see approach as to what the Fed is going to do, how quickly they’re going to move, and that’s just tempering activity for the time being. But I would expect to have a healthy, busy year, maybe not like ‘21, but a healthy and busy year both from an M&A and a lending perspective.

Our next question will come from Robert Dodd of Raymond James.

Hi. Congrats on the quarter and even more so on the credit quality, honestly. Two kind of follow-ups. I mean, Kipp, on the irrational market. I mean you answered Ken’s question was mainly at the upper end. Have you seen any signs that that level of competition at the higher end of the market is starting to squeeze people lower down maybe to try and mimic some of the flexible capital solutions like more preferred or anything like that? Is there any concern that it’s going to drive other players into areas of the market where you’ve been there for a long time and gotten some yield-enhanced investments like preferred equity, things like that? I mean, do you think it’s going to shift that market?

You mean for folks to be more aggressive down the Company’s balance sheet, i.e., take on more sub debt or...?

Yes.

No, I don’t think so. The point I was making is that we've seen some high-end transactions that we've had to walk away from for various reasons in the last couple of quarters, more so than in the previous three years. However, I don't believe this is affecting our behavior at all, nor is it really impacting our competitors. Some of them are focusing on that market, and I just wanted to highlight that we might not have fully grasped it all the time and have likely walked away from more transactions than we would have preferred. Besides that, our behavior and investment strategy really haven’t changed at all.

Got it. Thank you. And if I can, on Ivy Hill, I mean, obviously, pre-COVID, it was a $500 million investment now it’s $1.1 billion today, I think has been growing. Over time, it’s tended to produce a very nice, about a 14% dividend yield on fair value of equity higher on the cost basis of the equity. Is there anything which is comparable to the SDLP, which is a 13.5% return on capital? I mean, is there any reason we should expect that dividend yield on fair value, say, to decline at Ivy Hill, or do you think that level of return is sustainable with this new amount of capital that has a potentially greater capital as it goes forward?

Yes. I mean, without trying to be too forward-looking, we’re obviously investing $475 million of additional capital into that business and the returns that we’ve been generating from Ivy Hill have been pretty darn consistent over the last 10-plus years. So, I think our expectation is that those returns continue to be achievable, obviously, without making any promises. But, those are our expectations, Robert.

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

We didn’t have any other than to thank the folks on the call for their time, and we’ll catch up with you all next quarter. 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 the call will be available approximately one hour after the end of the call through February 23, 2022, at 5:00 p.m. Eastern Time, to domestic callers by dialing 877-344-7529 and to international callers by dialing 1-412-317-0088. For all replays, please reference conference number 10162158. An archived replay will also be available on a webcast link located on the homepage of the Investor Relations section of Ares Capital’s website.