Ares Capital Corp Q1 FY2022 Earnings Call

Good morning, welcome to Ares Capital Corporation’s First Quarter ended March 31, 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Tuesday, April 26, 2022. I will now turn the call over to Mr. John Stilmar, Managing Director of Investor Relations.

Thank you. Let me start with some important reminders. Comments made during the course of this conference call and webcast and the accompanying documents 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 documents. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results. During this conference call, the Company may discuss certain non-GAAP measures as defined by the SEC Regulation G, such as core earnings per share or core EPS. The Company believes that core EPS provides useful information to investors regarding financial performance because it’s one method the Company uses to measure its financial condition and results of operations. The reconciliation of core EPS to GAAP net income, the most directly comparable GAAP financial measure can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures can also be found in our earnings release filed this morning with the SEC on Form 8-K. All per share information discussed during this call is basic per share information. See the Company’s Form 10-Q filed with the SEC this morning for more information. Certain information discussed on this call and the accompanying slide presentation, including information relating to portfolio companies, was derived from third-party sources and has not been independently verified. Accordingly, the Company makes no representation or warranty in respect to this information. The Company’s first quarter ended March 31, 2022 earnings presentation can be found on the Company’s website at www.arescapitalcorp.com by clicking on the First Quarter 2022 Earnings Presentation link on the home page of the Investor Resources section. Ares Capital Corporation’s earnings release and 10-Q are also available on the Company’s website. I’ll now turn the call over to Kipp deVeer, Ares Capital Corporation’s Chief Executive Officer.

Thanks, John. Hello, everyone, I hope you're all doing well and we appreciate you joining the call. I'm here in New York with our Co-Presidents, Mitch Goldstein and Michael Smith, our Chief Financial Officer, Penni Roll, and several other members of the management team. I'd like to start by highlighting our first quarter results and then provide some thoughts on the market and our position today. This morning we reported first quarter core earnings of $0.42 per share. We also generated net realized gains on our investments adding $0.14 per share. Our net realized gains on investments now totaled over $175 million since year-end 2019 and approximately $1.1 billion since our inception. Our net asset value per share reached another record and it's up 9% over the past 12-months. Credit metrics in the portfolio were strong, and overall the portfolio continues to perform well. Our non-accruals at cost are well below our 10-year long-term average and we reported strong underlying portfolio company EBITDA growth. Furthermore, the weighted average loan to value in the aggregate portfolio remains historically low at 44%, which reflects significant structural support for our loan portfolio. After a very strong finish to 2021 market transaction activity was slower to start the year as we expected, and as market volatility stemming from geopolitical events, and a more aggressive tone from the Federal Reserve is creating uncertainty for us and many other investors. The 2022 outlook for macroeconomic growth has been tempered by inflation, increasing short term rates and a more challenging outlook for global growth in part caused by the war in Ukraine. As one would expect, the liquid markets are bearing the brunt of the volatility with wider credit spreads and uneven trading. However, as is often the case in the direct lending market, volatility is not as apparent and changes in pricing and terms are slow to materialize. This lag in response in the private markets, relative to liquid markets is not unusual. We've seen many of these market transitions over our history, and the private markets often take a bit longer to reset to new economic and market conditions. During these times our playbook is to become incrementally more selective, build additional liquidity and be opportunistic by leveraging our competitive advantages and vast sourcing capabilities. The Ares platform is one of our most significant competitive advantages. We have the largest direct lending team in the business with 150 investment professionals in the US, coupled with another 640 investment professionals in adjacent businesses in Ares. We believe this provides distinct advantages to source investments in middle market companies. Our ability to generate significant deal flow, which we estimate is running at roughly $550 billion annually continues to allow us to be highly selective and to pass on transactions when pricing or terms don't meet our standards, which is increasingly frequent in today's environment. We also benefit from the large size and long tenure of our existing portfolio of nearly 400 incumbent portfolio companies who may seek additional growth capital over time. We believe that our ability to finance and grow with our winners enables us to reduce portfolio risk and often attain better-than-market terms. In line with this, this past quarter, over two-thirds of our commitments were to incumbent borrowers. Beyond these sourcing advantages, we believe our large team and the Ares management platform provide a unique vantage point for doing research and conducting due diligence. Ares has over 1,600 investments in our private credit strategies and more than 900 corporate credit investments across 60 industries within our liquid credit strategies. In our view, the perspectives and insights we gain as a result, provide a significant advantage in informing our credit and pricing decisions, especially in assessing relative value for illiquid credit. Changing gears a bit, these advantages have also allowed us to drive value through portfolio acquisitions consistently throughout the company's history. Earlier this week, Ares management announced the acquisition of Annaly Capital's U.S. middle-market direct lending portfolio, which followed Annaly's strategic review of its business. We believe Ares' track record in making acquisitions continues to produce attractive and differentiated opportunities for our investors, and we're excited about this transaction. Looking forward, we feel very good about our positioning and the fundamental long-term drivers of growth in our market. North American private equity dry powder, which we believe is a key indicator of future M&A activity, sits at near record levels and larger companies are recognizing the value in seeking private capital solutions. In addition, we expect the continued volatility in the liquid capital markets will lead to increased demand from issuers for private credit solutions as we can deliver more certainty in these uncertain times. These factors are widening the fairway for us, particularly as our scale and flexibility allow us to be meaningful partners to a wide variety of borrowers. The last point I'll leave you with is that we don't believe a tightening monetary cycle will have negative effects on us. Our large weight floating rate loan portfolio is financed by mostly fixed rate unsecured sources of financing and our assets are largely floating rate investments. We believe this positions us well to have our net interest earnings benefit from rising rates. As of quarter end, holding all else equal and after considering the impact of income-based fees, we calculated that a 100 basis point increase in short-term rates could increase our annual earnings by approximately $0.23 per share, a 14% increase above this quarter's core EPS run rate. A 200 basis point increase in short-term rates could increase our total annual earnings by approximately $0.44 per share, a 26% increase above this quarter's core EPS run rate. We also do not expect that a projected increase in rates will result in deteriorating credit performance, particularly given our strong starting point with portfolio weighted average interest coverage of nearly 3 times. What this means is that holding all else equal, including the leverage at the borrower level, short-term base rates would need to rise above 3% before aggregate interest coverage would dip below 2 times, which is similar to the 5-year pre-pandemic weighted average of 2.3 times. Importantly, this analysis doesn't consider EBITDA growth or deleveraging that often occurs in our portfolio. We feel good about the ability of our portfolio companies to navigate a higher rate environment and believe these dynamics will further differentiate Ares Capital versus many of the other income-oriented alternatives in the market today. So with that, I'll turn the call over to Penni to provide some more details on first quarter results and other thoughts on our balance sheet positioning.

Thanks, Kipp. Good morning, everyone. Our core earnings per share of $0.42 for the first quarter of 2022 were in line with the $0.43 from the same period a year ago, but lower than our record fourth quarter 2021 core earnings of $0.58 per share. Our first quarter core earnings reflect the often typical slower first quarter of origination activity, much like we saw in the first quarter of 2021. The first quarter of 2022 earnings were driven by strong recurring interest and dividend income and a solid level of capital structuring service fees from new origination and capital markets activities. Our GAAP earnings per share for the first quarter of 2022 were $0.44, which compares to $0.87 for the first quarter of 2021 and $0.83 for the prior quarter. Our GAAP earnings per share for the first quarter of 2022 included net realized and unrealized gains on investments of $0.13 offset by a realized loss of $0.10 related to the repayment of our 2022 convertible notes, which were in the money as a result of the significant stock price appreciation and our dividend increases over the five years since the notes were issued. The net realized and unrealized gains on our investments this quarter reflect the overall healthy performance of the underlying portfolio as a whole. As of March 31, 2022, our stockholders' equity grew to $9.4 billion, resulting in yet another record net asset value per share of $19.03 as compared to $18.96 at December 31, 2021, and $17.45 at March 31, 2021. Our NAV per share for the first quarter represents a 0.4% increase from a quarter ago and a 9% increase from a year ago. Our total portfolio at fair value at the end of the first quarter was $19.5 billion, and we had total assets of $20.5 billion. As of March 31, 2022, the weighted average yield on our debt and other income-producing securities at amortized cost was 8.9% and the weighted average yield on total investments at amortized cost was 8.1%, each increasing approximately 20 basis points from last quarter, supported by market interest rate levels as base rates rise. As it relates to our future interest rate sensitivity, as Kipp mentioned, we remain well positioned to benefit from a rising rate environment and are now past the interest rate floors for certain of our investments. As of March 31, 2022, 74% 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 an average interest rate floor of approximately 90 basis points. As Kipp mentioned earlier, we would expect increases in short-term rates, especially as these rates exceed the floors to have a meaningful positive impact on the future net interest earnings performance of the company. We have provided details on this in this quarter's Form 10-Q for those who want to further examine our sensitivity to rate movements. Shifting to our capitalization and liquidity, we remained very active during the quarter, raising additional capital and extending debt maturities in order to maintain strong liquidity for our growing investment portfolio. During the quarter, we grew our committed debt capital by more than $650 million. In January, we took advantage of what may have been the interest rate low point for the unsecured notes market for BDCs by issuing $500 million of 2 and 7/8 percent unsecured notes maturing in July 2027. While not our lowest coupon issuance in our history, it did represent the lowest spread at new issuance for us or any other BDC. We are very pleased with the success that we have had since the beginning of 2021 to lock in low fixed borrowing rates, which we expect will benefit our aggregate cost of capital and our earnings as we move into a higher rate environment. In addition, we extended our corporate revolving credit facility by approximately one year to bring it back to a full five years and upsized it by over $550 million bringing the total facility size to $4.8 billion. As part of the amendment to the credit facility, consistent with other bank-led deals closing in 2022 and going forward, we updated certain base currency reference rates, which included replacing the LIBOR rate with SOFR plus an applicable credit spread adjustment. Pricing and advance rates are otherwise unchanged on this facility. Alongside raising additional debt, we also repaid our $388 million of convertible notes at fair maturity in February, resulting in a realized loss as stated before. Following the repayment of these convertible notes, we only have one term debt maturity in the next two years, which occurs in 2023, providing us significant flexibility when it comes to our debt capital structure. To support the continued long-term growth of our investment portfolio, we also accretively raised incremental equity capital during the first quarter through a secondary issuance early in the quarter as well as through our ATM program. After considering our investment in capital activities during the quarter, we ended the first quarter with nearly $5.9 billion of total available liquidity, including available cash of $690 million and a debt-to-equity ratio, net of the available cash of 1.06 times, down from 1.21 times at the end of the fourth quarter. While our leverage ratios will vary over time depending on activity levels, we will continue to work to operate within our stated target leverage range of 0.9 times to 1.25 times. Overall, with ample amounts of dry powder, we believe our capital and liquidity remain one of our most significant competitive advantages and positions us well to remain active, yet patient investors. Before I conclude, I want to discuss our undistributed taxable income and our dividends. We currently estimate that our spillover income from 2021 into 2022 will be approximately $651 million or $1.32 per share. We believe having a strong and meaningful undistributed spillover supports our goal of maintaining a steady dividend throughout market cycles and sets us apart from many other BDCs that do not have this level of spillover. This morning, we announced that we declared a regular second quarter dividend of $0.42 per share the second straight quarter at our new regular dividend rate and our 52nd consecutive quarter of unchanged or growing dividends. This second quarter regular dividend is enhanced by the $0.03 per share additional second quarter dividend that we previously declared in February. Both are payable on June 30, 2022, to stockholders of record on June 15, 2022. I will now turn the call over to Mitch to walk through our investment activities for the quarter.

Thanks, Penni. I would like to spend a few minutes providing more detail on our investments and portfolio performance for the first quarter of 2022. I will then provide an update on post-quarter end activity and our backlog and pipeline. During the first quarter, our team originated $2 billion of new investment commitments, a 14% increase from the first quarter of 2021. Our commitments during the quarter were to a diverse set of high-quality companies across more than 20 distinct industries. The EBITDA of these companies ranged from $13 million to over $1 billion, underscoring the breadth of our opportunity set and our ability to be a solutions provider to a wide array of companies. We continue to be very selective and finance less than 5% of the new deals we review. We believe that our selectivity and focus on high free cash flow businesses with market leadership positions ultimately result in a differentiated and attractively positioned portfolio. It is important to note that our portfolio does not have any direct exposure to companies domiciled in Russia or Ukraine. While we are keeping a watchful eye on inflation and supply chain issues, our portfolio companies are continuing to experience strong overall fundamentals, which is reflected in the 20% weighted average EBITDA growth of our portfolio companies over the last reported 12-month period, the highest in our company's history. Importantly, this performance is broad-based. All of our top 15 industry concentrations showed a healthy level of positive EBITDA growth. This growth supported an increase in the weighted average EBITDA of our portfolio from $162 million last quarter to $173 million this quarter. It is important to note that while our portfolio has a definitive upmarket focus based on dollars invested, examining the portfolio by the number of credits shows that most of our portfolio companies remain in the core middle market. By number of companies, approximately two-thirds of our portfolio companies have less than $100 million in EBITDA. We believe our track record and ability to finance businesses as they grow continues to be a key differentiating advantage in today's competitive market. This quarter, our weighted average portfolio grade at fair value of 3.1 remained unchanged from last quarter. Our non-accrual rate at cost of 1.2% increased slightly from 0.8% at Q4 '21. As Kipp mentioned, our non-accruals at cost continue to be meaningfully below our 10-year average of 2.5%. Before finishing up with some comments on our backlog and pipeline, I want to discuss the exciting portfolio acquisition that Kipp mentioned earlier. Last night, Ares management announced the acquisition of the direct lending portfolio of Analog Capital Management, which decided to exit its direct lending strategy. The overall $2.4 billion portfolio is comprised of U.S. senior secured loans to over 40 companies backed by numerous private equity sponsors. Given the breadth of market coverage at Ares, there was a familiarity with a significant percentage of the investments either through overlapping portfolio companies or through a historical review of these companies. These advantages and the scale of the Ares platform allowed for a diligent underwrite of each loan in the portfolio to create what we believe is a highly informed and granular view of value. In terms of specific impacts to our company, approximately half of this $2.4 billion portfolio will be funded by both Ares Capital and Ivy Hill with a significant portion of the loans being purchased by Ivy Hill, given the senior orientation of this portfolio. We believe one benefit of this transaction is to further support the growth of Ivy Hill. We expect the revenue growth from these investments may ultimately support additional dividends from Ivy Hill to Ares Capital after the transaction closes, which is expected to be at the end of the second quarter. As a reminder, Ivy Hill is a wholly owned portfolio company of Ares Capital that was started in 2007 to invest in and manage middle-market senior secured loans through structured investment vehicles and separately managed accounts. The business is highly diversified across more than 290 distinct borrowers and is enjoying continued success given its market position and track record. We believe Ivy Hill's success and profitability is also reflected in its $43 million first quarter dividend to Ares Capital, a $15 million increase from last quarter and the 48th consecutive quarter of Ivy Hill paying a stable or increasing quarterly dividend to Ares Capital. Now we'd like to shift to our post-quarter end investment activity and pipeline. From April 1 through April 20, 2022, we made new investment commitments totaling $106 million, of which $57 million were funded. We exited or were repaid on $94 million of investment commitments, including $77 million in loans sold to vehicles managed by Ivy Hill, generating approximately $1 million of net realized losses on exits. As of April 20, our backlog and pipeline stood at roughly $2.3 billion and $110 million, respectively, including investments expected to be made by Ares Capital as part of the portfolio acquisition mentioned. Our backlog and pipeline contain 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, Mitch. In closing, while there seems to be a lot of uncertainty as to where we are headed for the remainder of this year and beyond, we feel the company is well positioned to deliver for our shareholders. We have a dividend that is well covered by earnings and a strong balance sheet that allows us to be patient as the market likely transitions amidst continuing volatility. Our experience navigating changing times should continue to allow us to outperform and we can assure you the team is focused on generating great results for 2022. That concludes our prepared remarks. We'd be happy to open the line for questions.

The first question comes from Finian O’Shea with Wells Fargo Securities. Please go ahead.

Hey everyone, good morning. Kipp, your opening comments on interest coverage. I think you said about 3 times at underwriting. Can you talk about if that includes items like CapEx and EBITDA adjustments and so forth? And if not, what the ballpark figure is like on a cash basis?

Yes, good morning and thank you for the question. The interest coverage calculation is straightforward, as it is operating cash flow divided by interest. Any additional requirements for the company, such as free cash flow or capital expenditures, would not be included in that calculation.

Awesome. Thank you. And as a follow-up, what's the picture like for a recurring revenue deal? I think to our understanding, those generally start with a cash infusion or runway. How materially does that change when interest rates double or triple, the base rates that is?

Let me try and answer that, but if you want to, you can follow on. So I mean the idea with some of the recurring revenue lines that are getting done in the market is, obviously, you're looking at a company that's growing extraordinarily quickly, but it tends to have operating expenses promoting that growth. So you're talking about R&D, you're talking about sales and marketing where these companies hope to be much, much larger, and most of them have to be profitable in time. For now, though, what you're underwriting is stable recurring revenue where you could simply change if you wanted to, the way that the company was pursuing growth and generate free cash flow pretty quickly. So that's sort of the construct. We're sort of limited in that space. We're happy to play in that market. I think we're one of the more conservative lenders. And today, we've got roughly 3% of the portfolio at fair value in recurring revenue loans, just as a reminder.

Sounds very well. It’s helpful. Thanks so much.

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

Good morning everyone. Thank you for taking my questions. Kipp, you mentioned in your remarks that you're waiting for the private markets to adjust similarly to how the public markets have responded to all this disruption. Can you quantify that? Is it related to credit spreads, or are there other factors regarding deal structures that we should consider in terms of when this catch-up might happen?

Yes. I mean I think what we were trying to get back to is a notion that we've left you with and many others with in the past, which is the public markets, as you've probably seen, particularly anything fixed rate, longer duration, etc., whether it's high-grade corporates, the high-yield market, etc., is off pretty substantially this year. The loan market a little bit less so because the duration is shorter. It's obviously a LIBOR, SOFR plus asset, which benefits from rising rates. The public equity markets as well don't seem very happy over the last couple of months. That being said, a lot of what's getting closed or has been getting closed in our opinion in the first quarter in the private markets are often deals that get originated in a different environment. They get signed up. They have term sheets issued November, December, January. And because a lot of what we're doing is longer duration holds with relationships that are important to us, you don't go reprice your term sheets. Generally speaking, you go and you close those deals with an understanding that you're in a fundamentally good credit. But what we're looking for, John, is with a widening in spreads broadly in the credit markets, which we've seen a bit of. We're waiting for the private markets to kind of catch back up to recognizing the volatility that's been very obvious to all of us from maybe February to April, and I think that's happening right now. And that can get reflected in everything from pricing, which, of course, spreads to tighter documentation, whatever it may be. So it can come in a whole host of different forms. But first things first, I think that there may be some price exploration on the part of a lot of investors, frankly, whether they're lenders, private equity firms, buyers of real estate, etc., that with less economic uncertainty or more economic uncertainty, less certainty about growth, concerns about inflation, concerns about the Ukraine, tightening monetary cycle, etc. That there's a little bit of a wait-and-see approach for those who maybe have been doing this a bit longer than some.

Okay. That's very helpful color. Second question, you gave us very good information about the interest coverage and how that's impacted from a rising rate environment. I'm wondering in addition to that, how does the rising rate environment affect appetite for borrowing from middle market companies? Is there anything for us to think about in that regard?

I mean I think it's less sensitive than, say, the high-grade market, right, which has done loads and loads of refinancing over the last 5 to 10 years, taking advantage of historically low rates. A lot of what we do, as you know, is driven by private equity and acquisitions, and that's why we made the comment in the prepared remarks about the extraordinary amount of dry powder in the hands of U.S. private equity firms. And the reality is our opinion is despite increased borrowing costs, they will be looking to deploy and generate returns for their investors because that's what they were hired to do. Most private equity funds have 5-year investment periods. So you can take a wait-and-see approach, but you can't take a wait-and-see approach forever. If I had to guess, if I'm sitting in one of those tables, what that tells me is you want to pay less for things because when rates go up, assets tend to be worthless. So a little bit of the feeling around, I think, is the part on all private markets investors trying to find what may be a new equilibrium again with some more uncertain market conditions and presumably materially higher rates.

That makes sense. Thanks very much.

The next question comes from Devin Ryan with JMP Securities. Please go ahead.

Thanks. Good morning, everyone. How are you?

Good morning.

Just to maybe a follow-up here on John's questioning. Just as the markets are adjusting, Kipp, as you mentioned, I just want to maybe think about kind of the stated leverage and liquidity. I think your leverage range is 0.9 to 1.25 times, you're currently at 1.06 net of cash. And just kind of based on the lagging dynamics in the private markets, is this impacting how you're thinking about managing maybe liquidity and leverage and just the very near term, perhaps maybe deliberately slowing activity just to take advantage on the other side as the market kind of gets to that equilibrium point? Just thinking about kind of the near term versus long term because you may get some more compelling risk reward on the other side?

Yes. I mean, the crystal ball is a little less clear perhaps than at other times. I mean I would hope that the vintage for doing what we do from an investment standpoint is better towards the back half of this year than it was maybe early days of this year and late last year in terms of terms and pricing. The only other thing I'd say, Devin, the answer to your question, in more uncertain times that at least to us feel volatile, we would like to run less leveraged. So I think 0.9 honestly is too low when you look at the asset mix in the portfolio here, but somewhere in line with where we are today, it feels comfortable for us.

Yes. Okay, I appreciate it. And then just a follow-up here on prepayment. Just if you can give us any insight into kind of how you're thinking about the cadence from here. And it feels like just the backdrop has shifted from last year. So any thoughts on kind of the intermediate term on that front as well would be helpful.

Yes. I think playing off some of your first question as well as Fin and John. When you see an environment of higher rates, which offers fewer opportunistic refinancings and the volatile market. Our best guess is that we will see a slower pace of repayments going forward. We obviously build a quarterly model here where we're looking at our pipeline and our backlog, and we're also looking at identified paydowns that we know are coming because we're close to companies. But as you probably imagine, as we forecast quarters in the year, we look at unidentified pipeline and we look at unidentified repayments. And I would tell you, we've made the conscious decision to try to take that down a little bit in terms of what we expect to come in from a liquidity perspective through repayments.

Okay great. Thanks very much. I’ll leave it there.

The next question comes from Ryan Lynch with KBW. Please go ahead.

Hey, good morning. First question I had, I was pleasantly surprised to see that when you look at your unrealized and realized net portfolio, you guys actually had gains this quarter. I was a little bit surprised just given that you had seen kind of widening credit spreads, a little bit of decline in liquid leveraged loan prices this quarter. So what drove your net portfolio gains this quarter? I'm not sure if there were equity investments in there that drove it higher or what was the situation.

Yes. I mean, basically, a quick answer is debt resolution sort of net-net to 0, but the equity gains and a couple of specific names allowed us to show the net realized gains number, Ryan.

Some equity gains in there. And the other question, kind of looking forward on how the market has moved and then kind of regarding short-term rates. The last time we had a rate hike cycle, of course, every rate hike cycle is going to be different. But what we saw was kind of a more gradual pace of rising rates by the Fed and LIBOR. And what we saw was a lot of spread compression. And so the net benefit to the BDCs was substantially less than what a lot of these disclosures showed as kind of a sudden shock in interest rates of 100 to 200 basis points rising because of that, that's spread compression. I'm just curious now that LIBOR has effectively gotten above the LIBOR floors and a lot of these loans. Are you seeing meaningful spread compression in deals in the market? And what do you think about going forward? Do you think a lot of those spreads will start to get in a way or competed away by the substantial amount of capital looking to be deployed in the direct lending market? Or do you think there's going to be a meaningful increase in benefit from rising rates in your portfolio?

So I actually think your last question is the most interesting one, the most heavily debated and the one that I'm probably the least sure in answering, meaning is the continued interest in everything that we and others do in illiquid credit is going to overwhelm a market that feels like it's going to widen, I don't know, it never has before. And we've been doing this for a long time. So let me answer your first and second questions sort of directly. I think you are right and that it's very rare that we see 100% of the pickup in the base rate. So there's an acknowledgment that the all-in rate, whether it's what we're getting for our investors or what a borrower is paying expands with the base rate, there's likely some credit spread compression, particularly in an environment where default is very low, which is certainly the environment we're sitting in today, which tends to really widen credit spreads is when you actually see a pickup in defaults. So for us, it's all about what's your economic forecast for the year. How do you see companies handling a more difficult operating environment, higher rates, etc.? And we've gotten asked this question a lot, how's the portfolio, well, the answer is the portfolio is in unbelievably good shape here in April. But if you ask folks around our table, if they're nervous about what we'll see towards the back end of the year and potentially into early next year, I think you'll certainly find plenty of folks who are. So I do expect, as we come here through Q2 and even into Q3 to see the lion's share of the benefit of base rate increases because to your point, we're finally through the floors. And there will be a little bit of catch-up time before anybody adjusts new business to account for that. So we should see some good tailwinds with rising rates, but I think the back half of the year is debatable. And I think the last question you asked is most interesting.

I appreciate the color on that and I hope back in queue.

The next question comes from Melissa Wedel with JPMorgan. Please go ahead.

Good morning, everyone. Thank you for taking my questions. I wanted to revisit some of the EBITDA trends you’re currently observing in the portfolio. If I understood correctly, you mentioned approximately 20% EBITDA growth over the last 12 months. Is that accurate? If so, could you elaborate on that, particularly regarding what you observed in the first quarter and how that compares to the fourth quarter, which I believe you indicated was in the mid-teens range? How did things hold up in the first quarter?

Sure. And we're looking to see if we can pull some numbers. That 20%, Melissa, I appreciate your question, is obviously a very large number and frankly, one larger than we'd expect. You're playing off obviously easy comps against COVID periods, right, coming out of that period into something more normalized. So we're poking around here and let me just see. I'm not sure if we actually even pay a lot of attention to that on a quarterly basis. Mitch made the point, I think, in his prepared comments that I think, Mitch said, we had growth across all 15 of the industry sectors that we measure. So while it's a big number, it's also pretty broad-based. And I'll just reemphasize, we think the portfolio is healthy and doing quite well.

Okay. The other thing that stood out to me in just going through the results this quarter was the big jump up in dividend income. And I think you talked about with the anticipated growth in Ivy Hill and potential upside on that dividend, also an uptick, I think, in some of the recurring dividend income. And I believe in the Q that was attributed to sort of increased exposure to some preferred hoping we could dig into that a bit. And if you can elaborate if we should sort of think of 1Q as a revenue base level of dividend income that could see upside to it later in the year.

I'm going to let Penni answer part of that. There are a few items that contribute to that line, with the largest being Ivy Hill, which has been increasing over the last couple of quarters. This suggests a new base level of recurring dividends from Ivy Hill. However, as you try to model this, it's important to note that we receive dividends from our equity investments that aren't necessarily recurring and can vary from quarter to quarter. We have 400 portfolio companies, making it challenging to forecast accurately. We can discuss this further offline, and the Investor Relations team can provide more details. I'll pass it to Penni to see if there's anything she would like to add.

No. I think we continue to grow the dividend in Ivy Hill, and that's in line with the increased investment that we've made. So I think you could look at that more as a baseline. But the other nonrecurring dividends are such that they're episodic. So they come from individual companies periodically and aren't necessarily recurring each quarter, but tend to still come throughout the course of the year. And just as a baseline for Ivy Hill, the Ivy Hill dividend grew this quarter as a total of $43 million.

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

Hi, good morning. I might be asking a similar question to what Ryan did, but from a different angle. If this seems a bit repetitive, I apologize. It seems like some of your comments were somewhat contradictory. You expressed concerns about the current environment with inflation, rising interest rates, and geopolitical issues, which indicates that you might be more selective and looking to increase liquidity. However, rising interest rates have positively impacted your net investment income, and you don’t foresee this affecting credit performance negatively. That appears inconsistent, if you see what I mean. Could you provide some clarification on that?

Yes. I believe there's no contradiction here, Casey. What we're conveying is that focusing solely on the period of rising rates, we haven't seen any benefits from the recent increases in short-term rates. Most of our borrowers are affected by LIBOR SOFR floors, meaning that until rates rise above one, the company hasn't experienced any improved earnings from these increases, which has been the case in recent quarters. Now we are finally reaching a point where we can start to see those benefits. We don't believe that in the next 9 to 12 months, even if rates are raised more aggressively, our portfolio companies will face significant challenges. If the base rate reaches 2.5% or 3% by the end of the year, that's the key point we're making. Our portfolio companies aren't in a particularly tough spot, creating a favorable situation where our company performs well, and our portfolio companies won't be in significantly worse positions that could lead to defaults or credit issues. We hope to navigate through a higher rate environment where rates are 5%, which would clearly enhance our earnings, though we may need to apply some pressure on the portfolio. That summarizes our perspective and clarifies our position a bit.

Was there a follow-up, Mr. Alexander?

Yes. My follow-up is more of a request. Given the growth of Ivy Hill and the upcoming Analyst Day, there seems to be a lack of clarity regarding Ivy Hill. I would appreciate a more in-depth explanation so that investors can have a clear understanding of what Ivy Hill is, how it operates, and its significance to the BDC. That's all.

Yes, we're glad to do that. It's not very complicated. Ivy Hill is managed by a bank loan manager with third-party investors, including Ares Capital. The income from Ivy Hill mainly comes from management fees on assets under management and revenue from some of the investments that we and others have made that return to us. For wholly owned investments, we focus on what the company generates on a cash flow basis after expenses each quarter. We typically take a conservative estimate, around 80% of the quarterly cash flow generated at Ivy Hill, to pay its capital and dividend. We're looking forward to providing more details when we meet in June. I don't want it to be unclear and believe it has been and continues to be a great investment for the company, which is why we've invested more money in it.

The next question comes from John Rowan with Janney. Please go ahead.

Good morning. Just two questions. So what percent of your assets right now are past the floor?

We're looking around. We think it is...

About two-thirds of the portfolio is floating. The weighted average floor is around 90 basis points for the floating rates outside of SDLP. Depending on whether borrowers are using one-month or three-month terms, some are already above the floors while others are nearing that point. Since there is an option to reset monthly or quarterly, it typically takes a full quarter to observe the effects of those resets over time.

There's a little bit of gaming event, a little bit of gaming of the system, right, by the borrowers because they do have the ability to elect 1 and 3-month LIBOR contracts. So it really depends when you're rolling over in what spot rate you're playing, whether you're going to borrow at 1 or 3. But to Penni's point, everybody will be up for redoing those contracts again. And even if they're choosing 1-month LIBOR in a month. My guess is they'll be through the floor. So we're largely there. I think fundamentally is the answer, John.

Yes. I mean just to give a little more insight, about two-thirds of the floating-rate portfolio today is choosing 3-month LIBOR.

To revisit the questions about rate sensitivity, I understand that you changed one of your funding liabilities from LIBOR to SOFR. Is there an effect on your rate sensitivity with SOFR, considering that it reprices not as quickly as LIBOR?

Yes, where we've already migrated so far is reflected in the interest rate sensitivity table in the 10-Q. A small piece of the portfolio is starting to migrate as well because as you may be familiar with the rules, as things get amended or changed post the beginning of this year, there's a migration to SOFR, but that will take some time. So it's a small impact today, but we are factoring that into the interest rate sensitivity to the extent that the base rate is already elected to you so far.

Yes. I mean I would just say to you, John, as a reminder to you guys as analysts, but also to the folks that own the stock. This is not a particularly rate-sensitive company because it's not very leveraged. Most of the economic value in this company is generated by excess net interest margin and frankly, generating more gains than you realized losses in the portfolio. We've been doing that a long time. So while there's a shift obviously in where we are from a rate perspective, you're not going to see it at all by the end of the summer. It's all going to play through. And then we'll see where we are. But just as a reminder.

Okay. Thank you.

The next question comes from Robert Dodd with Raymond James. Please go ahead.

Hi everyone, good morning. Regarding the question about SOFR and LIBOR, currently the spread between the 3-month LIBOR index and overnight SOFR is 100 basis points. SOFR is relatively new, but that spread seems quite wide by historical standards. Is this causing any disruptions in the market, such as in lending or refinancing? Additionally, is there fallback language in the borrower terms that allows for alternatives like Fed funds, given the current wide spread compared to LIBOR?

Certainly. The base rate isn't something I spend much time on when managing the company, but I'll address your question. This transition has its complexities. The approach taken to allow the market to adapt includes a credit spread adjustment between SOFR and LIBOR to navigate through this term period as we changeover. To answer your question directly, Rob, this is not altering how people are lending money or making deals. We’re simply navigating a transition phase, which will soon be behind us so we can move forward.

Okay. Got it. And one more if I can. Very helpful color on the interest rate coverage and how much rates have to go before the aggregate interest coverage to be at two. But what about at the margin? Like, I mean, what proportion of your portfolio companies have interest coverage below two today? And what would that proportion be if rates went up, say, 200 basis points? I mean, obviously, at the margin, I don't expect the aggregate portfolio to have a credit problem. It's always the weakest credit. So any color there?

We don't have that metric in front of us. We can go try to dig it up. For sure, your comments are spot on. I just reemphasize. We do a pretty rigorous portfolio view here on a quarterly basis as well as running our watch list every two weeks. We've got probably the largest asset and risk management team of any BDC out there. We've demonstrated a track record along with our investment team of being able to manage through. So I am sorry, Robert. I don't have the number right here in front of me. But I would tell you the portfolio is in great shape, and we don't think, again, continued short-term rises or continued rises in short-term rates is going to be the issue for portfolio companies. The issues that we're seeing in the portfolio are much more specific to inflation, supply chain issues, etc., where management teams are just having to operate in a much more complicated environment. We do not have management teams coming to us and saying, we're really, really nervous about our interest coverage because rates seem to be going up.

Got it. I appreciate it. Thanks very much.

The next question comes from Bryce Rowe of Hovde Group. Please go ahead.

Thank you. Good morning. I wanted to maybe ask a little bit about Ivy Hill and the injection of some of the Annaly assets into both Ares and Ivy Hill. Just curious, do you anticipate any kind of return profile changing for Ivy Hill with that injection? And then curious what the incremental investment into Ivy Hill might look like based on when that deal is expected to close.

Yes. I mean I think in terms of what it will look like by the end of Q2, I'd rather just let you guys wait and see. It's probably not appropriate for us to comment on that. What I would say is every time we make incremental investments in Ivy Hill. We are doing it with a mindset that we'll be generating additional earnings and dividends coming from that company. I would just say, over the last couple of years, Bryce, we've sort of insisted and frankly, longer than the last couple of years. But the last couple of years, we've consisted on a 15-ish kind of percent rate of return coming from Ivy Hill in terms of the dividends at cost, and the same underwriting standards and strategic view as to what we're doing here with the expanded portfolio remain in place. I wouldn't expect to see any degradation of the return there. We're excited about the transaction. We think it's great for us. We think it's great for Ivy Hill.

Okay. That's helpful, Kipp. I have one more question. Regarding the portfolio mix, we've observed a trend in recent quarters where there has been an emphasis on building preferred and common equity positions, especially with the increase from Ivy Hill. Do you anticipate that this shift in portfolio mix might be reaching a conclusion now that market conditions are becoming more volatile? I'm trying to get an understanding of how the portfolio will develop in the upcoming quarters.

Yes, it's a good question. I don't have a direct answer to because it's actually one that we are talking about a fair amount around here as an investment management team. The impetus for some of the more active preferred investing that we've done has just been additional non-equity capital, so to speak, and some of these extraordinarily high multiple LBOs that we've been involved with where we felt like we had great loan to value through a preferred we could generate great returns, often do that with a co-invest. Look, if that environment backtracks a little bit and valuation multiples come down, and that slice of preferred frankly, isn't available, it may not be part of as many transactions going forward. We were joking about this a little bit last week, but we think we may look back on some of those investments and some of the best investments that we made because they're very low loan to value. They've got high total returns. They've got a tremendous amount of equity cushion below you. So we'll see. Bryce, I don't have a direct answer. We're just to have to see where the market goes. There will be an upper limitation as to how we see noncash pay securities in the portfolio. We've always capped it at 10 to 15-ish percent rough numbers during normal times. I don't think you're going to see a huge shift where all of a sudden we're running a portfolio that has a 30% equity mix or something in it like that. So I would expect that at the higher end of where we would get, but we're going to have to see where the market in the world takes us.

Got it. Appreciate the color.

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

Don't have any other than to say thank you all for joining us, and we look forward to seeing you for sure at our Investor Day. And if not on the road, after that. Thanks so much.

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 May 10, 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 395-7963. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital's website.