Ares Capital Corp Q2 FY2023 Earnings Call

Good morning. Welcome to Ares Capital Corporation's Second Quarter June 30, 2023 Earnings Conference Call. As a reminder, this conference is being recorded on Tuesday, July 25, 2023. I will now turn the call over to Mr. John Stilmar, Managing Director of Ares Investor Relations.

Thank you very much. Let me start with some important reminders. Comments made during the course of this conference call and webcast as well as 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 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 operation. A reconciliation of GAAP net income per share, the most directly comparable GAAP financial measure to core EPS 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 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 such representations or warranties with respect to this information. The company's second quarter ended June 30, 2023 earnings presentation can be found on the company's website at www.arescapitalcorp.com by clicking on the Second Quarter 2023 Earnings Presentation link on the home page of the Investor Resources section of our website. Ares Capital Corporation's earnings release and Form 10-Q are also available on the company's website. I'll now turn the call over to Mr. Kipp DeVeer, Ares Capital Corporation's Chief Executive Officer. Kipp?

Thanks, John. Hello, everyone, and thanks for joining our earnings call today. I'm here with our Co-Presidents, Mitch Goldstein and Kort Schnabel; our Chief Financial Officer, Penni Roll; our Chief Operating Officer, Jana Markowicz, and other members of the management team. I'd like to start by highlighting our second quarter results, and I'll follow that with some thoughts on the economic environment and the current market. This morning, we reported strong second quarter results. Our core earnings per share of $0.58 increased 26% year-over-year, primarily driven by the benefit of higher interest rates on new and existing investments. Our GAAP earnings per share for the quarter were $0.61 driven by our strong core earnings and a modest increase in the overall value of our investment portfolio. These results led to another quarter of sequential growth in our net asset value per share to $18.58. We are pleased with these results and we think it's important to put them into context of what we're seeing in the broader credit markets. Over the past two decades, direct lenders have demonstrated their ability to be a stable source of capital, supporting the growth of U.S. companies, even when bank and syndicated capital markets are volatile and hard to access. More recently, this trend has accelerated and direct lenders such as Ares have stepped in to fill the void. Although second quarter transaction activity remains slower than recent history, it picked up compared to the first quarter, and the firming tone of the capital markets is an important step towards greater M&A deal activity. Importantly, we are seeing direct lenders gain significant share as 85% of new issue LBO financing in the U.S. was completed by direct lenders. In less volatile market, this percentage would typically be lower and transactions, particularly the large deals, would be more heavily weighted towards the broadly syndicated bank loan and high yield markets. Direct lending also continues to be increasingly active away from the LBO market as direct lenders completed 1.5x as many non-buyout financings as the broadly syndicated market during the second quarter according to data by LCD. As it relates to our business, the number of deals we reviewed in the second quarter increased 20% over the first quarter. This includes certain incumbent portfolio companies seeking incremental financing opportunities, which provides us with a steady source of differentiated originations. Overall, we're sourcing many compelling transactions and we're cautiously optimistic that a recent pickup in activity will translate into a higher level of closed transactions. During the second quarter, market pricing and terms continued to be highly attractive as it relates to our new deals. Spreads on our new loans are well above historical averages. Leverage levels are lower, and equity contributions are higher. Similar to the existing portfolio, most of our new investments are floating rate deals that benefit from higher base rates. Market data provided by LCD underscores our view that the current vintage of buyout transactions has the highest level of equity support at any time in history. At the same time, the risk-adjusted returns in our lending business are historically very attractive as spread per unit of leverage, which measures returns relative to risk, are 15% better than the 10 year average. We believe the current vintage ranks as one of the best for our lending business in the past 10 years. Within this attractive and growing market, we continue to enhance our leading market position. We believe our large and long-tenured U.S. direct lending team of 170 investment professionals delivers a compelling brand in the market, and this provides us with many intangible benefits, particularly in sourcing. Given the impact of our participation and the value we add in transactions, we believe we sometimes get more looks on new opportunities and have the ability to negotiate preferred terms with our counterparties. In recent periods, we've taken additional steps to further support our sourcing and credit advantages. Expanding on our extensive sponsor and non-sponsor coverage over the past five to 10 years, we have continued to develop a significant amount of industry expertise, specifically in software and technology, specialty healthcare, financial services, infrastructure and power, and sports, media, and entertainment to name a few. More recently, we have formalized these industry specializations creating eight dedicated industry teams that enhance the significant sponsored and non-sponsored coverage that we enjoy today. We believe that formalizing these teams has further contributed to the strength of our process and our risk management capabilities, and made us an even more compelling partner for sponsors and portfolio companies. Despite companies dealing with higher borrowing costs, we believe corporate fundamentals remain solid, perhaps stronger than we would have expected. Our portfolio companies continue to perform well, and we see no evidence of what many believe is an imminent recession. Credit quality has been stable, and inflationary pressures have begun to show some easing. Our weighted average portfolio grade is flat quarter-over-quarter and slightly better than our 15-year average. Our non-accruals and costs decreased slightly and remain well below our own and BDC averages over the past 15 years. Despite the constructive view that we maintain on the economy and the portfolio, we are paying particular attention to the cash flows at our portfolio companies. EBITDA continues to grow nicely, as Kort will describe, and our portfolio interest coverage ratio remains relatively stable quarter-over-quarter. While some market participants are calculating interest coverage ratio tests using actual interest expense over the past 12 months, we don't necessarily think this is particularly relevant; we calculate the ratio using pro forma annual interest expense using market rates at quarter end. If we instead did the calculation using the actual interest expense over the past 12 months, our portfolio interest coverage ratio would have been 30% higher for the second quarter to approximately 2.1x. The loan-to-value in our portfolio continues to be conservative, and at quarter end, we estimate it to be around 43%. There is significant invested capital and value beneath us in most capital structures, a lot of it supplied by large and well-established private equity firms with whom we have great relationships and do repeat business. We continue to believe that a lot of the focus should and will be on the behavior of our partners who own the equity in these businesses. And we would expect solutions for companies needing assistance to come from a partnership approach between lenders and these partners if history has any indication. As a result of these dynamics and the company's overall performance, we feel confident about the results we were able to deliver for the second quarter and our competitive positioning going forward. With that, let me turn the call over to Penni to provide more details on our results and our strong balance sheet position.

Thanks, Kipp. For the second quarter of 2023, we had core earnings per share of $0.58, compared to $0.57 in the prior quarter and $0.46 in the second quarter of 2022. We continue to see the benefits of higher base rates on our predominantly floating rate portfolio in the second quarter of 2023, as our interest and dividend income increased both from the prior quarter and the second quarter of the prior year. Our income was bolstered by higher capital structuring fees, as compared to the prior quarter despite a generally continued slower origination environment in the quarter. On a GAAP basis, we reported GAAP net income per share of $0.61 for the second quarter of 2023, compared to $0.52 in the prior quarter and $0.22 in the second quarter of 2022. Our higher GAAP net income per share in the second quarter of 2023 benefited from modestly higher portfolio values during the quarter. Our stockholders' equity ended the quarter at nearly $10.4 billion or $18.58 per share, which is an approximate 1% increase in NAV per share over the prior quarter. Our annualized return on equity this quarter was greater than 12.5%, whether one measures this on a core or a GAAP basis. This strong level of profitability further builds upon our long-term track record of a 12% GAAP based annual return on NAV since inception. Our total portfolio at fair value at the end of the quarter was $21.5 billion, up from $21.1 billion at the end of the first quarter, reflecting net fundings from the portfolio. The weighted average yield on our debt and other income-producing securities at amortized cost was 12.2% at June 30, 2023, which increased from 12% at March 31, 2023, and 9.5% at June 30, 2022. The weighted average yield on total investments at amortized cost was 11%, which increased from 10.8% at March 31, 2023, and 8.7% at June 30, 2022. Yields on our portfolio reflect the continued increases in interest rates. Shifting to our capitalization and liquidity. We ended the second quarter with a debt-to-equity ratio net of available cash of 1.07x, as compared to 1.09x a quarter ago. Our liquidity position remains strong with approximately $4.7 billion of total available liquidity, including available cash. We believe our significant amount of dry powder positions us well to continue to support our existing portfolio commitments to remain active in the current investing environment and to have no refinancing risk with respect to next year's term debt maturities. We declared a third quarter 2023 dividend of $0.48 per share, which marks the 56th consecutive quarter of steady or increasing dividends. This dividend is payable on September 29, 2023, to stockholders of record on September 15, 2023, and is consistent with our second quarter of 2023 dividend. With that, I would like to turn the call over to Kort to walk through our investment activities for the quarter.

Thanks, Penni. I am now going to spend a few minutes providing more details on our investment activity and our portfolio performance and positioning for the second quarter. I will then conclude with an update on our post-quarter end activity, backlog, and pipeline. In the second quarter, we originated $1.2 billion of new investments across 46 different transactions, as broader middle-market sponsors and businesses continued to value Ares as a consistent and reliable source of capital. Underscoring the breadth of our market coverage, the EBITDA of the portfolio companies we financed during the quarter ranged from below $20 million to over $1 billion, and we were the lead arranger on 77% of the transactions we closed in the second quarter. We believe that our ability to lead transactions is an important benefit of our scale, providing us greater control over capital structures, pricing, and documentation, and longer-term better tools to drive successful credit outcomes. We continue to find compelling value in today's market. This is demonstrated by the first lien investments we originated in the quarter, which had a weighted average yield in excess of 11.5%, but leverage of only 4.5x debt to EBITDA. Underscoring Kipp's earlier point about the historically attractive relative value we are able to achieve on our new investments, the weighted average LTV of our second quarter commitments, including our junior capital investments, was below 40%. We also believe the breadth and quality of our incumbent portfolio provides differentiated access to attractive new investment opportunities. We continued to invest in what we believe are our strongest portfolio companies as over 70% of our transactions during the quarter were to existing borrowers, many of whom are executing tuck-in acquisitions or seeking growth capital and have elected to grow with us as their financing provider of choice. Our portfolio continues to perform well and we are seeing a lot of stability within our credit metrics. We believe this is largely due to our defensively positioned portfolio in market-leading companies with high free cash flow in resilient industries. In the second quarter, the weighted average annual EBITDA growth rate of our portfolio companies was a healthy 7%, in line with historical levels, and the weighted average portfolio grade of our borrowers at cost was stable with last quarter at 3.1. As we have discussed in the past, we are carefully monitoring the impacts of inflation. While our portfolio companies are not immune, the percentage of the portfolio that we estimate to be highly impacted by inflation risk has improved modestly and is now at the lower end of our 5% to 10% range, as we are seeing some improvements from supply chain pressures. All of these factors resulted in our non-accrual rates continuing to be well below historical levels. Our non-accruals at fair value improved modestly from 1.3% last quarter to 1.1% this quarter. While our non-accrual rate at cost also improved from 2.3% last quarter to 2.1% this quarter and remains well below our 3% 15-year historical average and the KBW BDC average of 3.8% for the most recent 15-year period available. Looking forward, we remain confident about the performance of our portfolio, in part due to our disciplined approach to risk management and portfolio diversification, which reduces the single name risk in the portfolio. Our $21.5 billion portfolio at fair value is diversified across 475 different companies and 25 different industries. This means that any single investment accounts for just 0.2% of the portfolio on average and our largest investment in any single company, excluding SDLP and Ivy Hill, is just 2% of the portfolio. We believe we have the greatest level of portfolio diversification of any publicly traded BDC. In addition to the benefits of diversification in our portfolio, there is a meaningful amount of enterprise value beneath us. The weighted average LTV of our portfolio is 43% inclusive of our second lien and subordinated investments. On average, these junior capital investments are in meaningfully larger companies in defensive industries and with significant equity capital, supporting our positions. At quarter end, our entire junior capital portfolio had a weighted average EBITDA in excess of $400 million and a weighted average LTV of less than 50%. Our compelling junior capital track record, which includes annualized loss rates of less than 20 basis points over our nearly 20-year history, supports our continued strategy of seeking attractive risk-adjusted returns through selective deployment into this asset class. Finally, I will provide a brief update on our post-quarter end investment activity and pipeline. From July 1st through July 19, 2023, we made new investment commitments totaling $211 million, of which $119 million were funded. We exited or were repaid on $118 million of investment commitments. As of July 19th, our backlog and pipeline stood at roughly $470 million. 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 a lot, Kort. In closing, we believe that our portfolio continues to demonstrate strong overall performance, and we are well-positioned to navigate any potential future economic challenges. We believe our many long-term competitive investing advantages, the strength of our balance sheet, and the defensive positioning of our portfolio should allow us to deliver differentiated performance and attractive risk-adjusted returns for our shareholders. We are hopeful that activity will pick up as volatility subsides, and as market participants have a more certain outlook in the direction of interest rates and the economy. And we stand ready to capitalize on this highly attractive new investment climate. For Ares Capital, we believe that this is a good time to focus on our diversified portfolio and our sourcing, underwriting, credit and portfolio management strengths, with a view to delivering strong financial results and a significant level of core earnings from our diversified portfolio. As always, we appreciate you all joining us today. We are happy to open the line now for questions.

Please limit yourself to one question and one follow-up to allow courtesy to others who wish to ask. If you have more questions, you can rejoin the queue. The Investor Relations team will be available to address any additional questions after today's call. Our first question comes from Melissa Wedel with JPMorgan. Please go ahead with your question.

Good morning. Thanks for taking my questions today. Wanted to touch on actually some of the activity that you disclosed in the press release for 3Q to date. You noted that, I think it was 49% in preferred and fixed rate deals so far in 3Q, which was down, I think, a decent amount from 2Q levels in terms of fixed rate allocation. I was hoping you could just elaborate on that and what you are seeing?

Thanks for the question, Melissa. Nothing that for me jumped off the page, Penni and Kort are looking at it. It's in fact a single fixed rate large preferred investment that skews the mix on a pretty small denominator.

Yes. The other thing to add maybe to that would be on some of these preferred investments, we actually are able to get warrants and equity upside kickers as well. So the fixed-rate component doesn't capture the totality of the return.

Yes.

Understood. Is this part of your strategy moving forward considering the uncertainty in the rate environment, or are you becoming more open to increasing your allocation of fixed-rate deals and more responsive to borrower requests for those? Thank you.

Not really. I think Melissa just to follow on. I think this is just literally a single circumstance of one negotiated deal with one particular company. So…

Our next question comes from the line of Finian O'Shea with Wells Fargo Securities. Please proceed with your question.

Hi, everyone. Good morning. Can you talk about the change at Varagon and what that might mean near or long-term for the SDLP?

To be honest, not in a lot of detail, and that news is pretty new. We are excited. And then I think our partners at Varagon are feeling good about having a large institution to partner with. My guess is that Man Group is going to want to run Varagon the way it's been run and continue to grow it. I'd expect that that relationship with them would be unchanged. But since the news is new, I don't really have any confirmation beyond that, Fin.

Thank you for your understanding. I have a follow-up question. Does Ares BDC receive or have any interest in allocations from the Ares alternative credit line?

From that business, for sure. I mean, as we say all the time, we think we are real beneficiaries at the BDC of the breadth of our credit platform here. So what we have typically excluded has been what we are doing in Europe. For the most part we really run that standalone. But everything else that we are doing in U.S. credit benefits the BDC and alternative credit for sure can be part of that.

Very good. Thanks so much.

Our next question comes from the line of Arren Cyganovich with Citi. Please proceed with your question.

Thanks. It sounds like structures and leverage levels are attractive here. Are you seeing any kind of opening up yet of sponsors' willingness to invest in? What do you think the timeframe would be to till you start to see deal activity start to increase?

That's probably the hardest one, Arren. And if you actually ask the senior folks here, I think you have got a range of different responses in terms of optimism, pessimism, whatever it may be. I probably sit somewhere in the middle. I mean, look, we have seen the pipeline pick up a little bit. Specifically, we actually saw the number of deals that we review increase each month during the second quarter if that's any indication it's picking up a little bit. But as I said in the prepared remarks, I think different folks have a very different view or at least there has not consensus perhaps around the direction of the economy or the trajectory for rates. Are they going to stay higher for longer? Are there going to be rate cuts this year, which I don't think we see on the table anymore? Early into next year if the economy weakens? So look, I mean, anecdotally, we are starting to see things pick up, but it's the middle of the summer, it's a really difficult time to gauge that.

Fair answer. The other question I had was just in terms of funding. You have always had a nice balance between secured and unsecured funding. I mean, how are you thinking about funding going forward? You don't really have anything on the unsecured side, I guess, coming due until next year.

I'll turn it to Penni, but I think the answer is, we don't really have a change in our view of how we are going to do things. But, Penni, you should pile on to that general comment if you'd like to.

Yes. I would just say that our situation remains stable. We maintain a strong balance sheet with a well-structured liability profile that features a range of maturities and a good mix of secured and unsecured obligations. As for the maturities in 2024, they are effectively settled at this stage. We have $4.7 billion in available liquidity. We have made significant efforts to enhance our existing capacities, so I believe there is no refinancing risk as we enter next year. However, we will keep an eye on the markets and, as we have done previously, we will remain opportunistic in exploring ways to access those markets to progressively manage our maturities.

Next question comes from the line of Ryan Lynch with KBW.

Following up on the previous question regarding credit market activity, I'm curious about the recent decline in LBO sponsor activity. You mentioned seeing some improvement, but it comes from very low levels. Do you believe we can expect a significant increase in LBO sponsor activity if base rates stabilize around their current levels or slightly higher? Is that clarity enough to attract sponsors, or is it necessary for the Fed to lower base rates to make the cost of capital cheaper for these deals?

Yes. I mean, again, I'm not sure. I mean that's a hard question. Appreciate the question, Ryan. I mean, I think if seller expectations for where they hope to sell companies to sponsors go down, the current level of rates is probably fine. And then the counterpoint is, decreases in rates in 2024 perhaps and beyond, I think should loosen activity levels up and make it a bit busier. But we're seeing folks try to put capital structures together with the current base rates, right? And again, activity is going up from here. But yes, the cost of debt is much, much higher, and you just have to factor that into the model in terms of how you think about buying something right now. And I think that's why everything's sort of slow, right? You're in a period of just feeling things out.

Yes. I don't think it's an unwillingness on the part of sponsors to invest. I think it's just the uncertainty creating a difficult environment to transact between buyers and sellers. So I do think that the more certainty there is, the higher the likelihood that we're going to see a pickup in transaction activity.

Okay. Understood. It seems that the economy has proven to be more resilient than anticipated, especially considering the predictions made six to nine months ago about a recession in 2023. However, even though the overall economy appears strong, I would assume there are specific sectors—whether in your portfolio or in general—that may be experiencing some weakness. Are there any sectors that you find more concerning or challenging in what is otherwise seen as a resilient economy?

Not really, Ryan. I mean, as you know, and many others probably on the call know, we try to position the portfolio defensively in terms of industry mix. So I think the places where you're likely to see real spikes in defaults are places where we try to have very little or no exposure. I too agree with your comment that the economy is actually performing materially better than I might have expected, even 12 months ago if you had asked me in terms of where we'd be in the summer of '23. So I don't know if the soft landing is really in the cards. Obviously, the newspapers seem to imply that there is a chance of that now. But look for the back half of the year, borrowers just, as I said in the prepared remarks, have less cash flow, right? They are deleveraging less quickly, and we need to be focused on every company in every industry to make sure that we are doing what we need to do from a risk management perspective. But when we look across our industry mix, there has been one particular place where we feel more concerned rather than in the aggregate.

Okay. Thanks, Kipp. I appreciate the time for that.

Our next question comes from the line of Kenneth Lee with RBC Capital Markets. Please proceed with your question.

Hi, good morning. Thanks for taking my question. Just in terms of any potential future capital raising needs, wondering if utilization of the ATM equity program is still the preferred method here, or would you be open to any sort of block transaction? Thanks.

I mean, I think the simple answer to that is, we felt like we have been able to grow the company modestly through the ATM program and the accretive cost effective ways, so we will probably stick to that as the primary source of where we go from here. The leverage level is in a very reasonable level at the end of this quarter. So we feel confident that we have dry powder enough to take advantage of what we think is a compelling environment. So for now I think the ATM program is going to prove to be sufficient.

Got you. Very helpful there. And that's all I had. Thanks again.

Our next question comes from the line of Casey Alexander with Compass Point. Please proceed with your question.

Yes. Thank you. And sort of given your comments about the economy performing better than you would expect, can you give us some color on the pace of amendments and modifications in the portfolio? And are you actually doing less of that than you also might have expected at this point in time?

Yes, it's certainly less than what it was, though there is still some activity. I would consider it somewhat average; it's not very active. However, it's a topic we are discussing with owners of these companies, who may not be meeting their plans or achieving the cash flows they anticipated, but I would classify that as just part of ordinary operations.

Okay. Thank you. And secondly, did Penni mention how much spillover there is on a per share basis?

I did not. But it was the same as last quarter. So if you look at what we estimate to be carrying forward from 2022 into '23, it's stable at $650 million or $1.19 a share.

Terrific. Thank you very much. Appreciate it.

Our next question comes from the line of Robert Dodd with Raymond James. Please proceed with your question.

Hi, and thank you for the question. Kipp, your comments indicate a decrease in cash flow across the portfolio, but EBITDA continues to grow, and overall interest coverage is quite solid. Can you provide insight into how much of the portfolio has interest coverage below 1 when peaks exceed 5.50? Additionally, for those that are struggling, what is the rate at which sponsors are stepping up to provide additional capital for that portion of the portfolio?

Yes. We tend to guide people to focus on companies that have lower cash flow, particularly those classified as 1s and 2s in our portfolios, which are our underperformers. The significantly underperforming assets fall into these categories, and I consider them to be on our watch list. Currently, that portion represents less than 10% of our total. I apologize for the follow-up; I was just stumbling through some…

What proportion? For those businesses, are the sponsors stepping up, 100% incidence rate or 90% or 80%. I mean, how are the negotiations coming? Are they coming through and supporting those businesses, or are you having to do more of that?

I believe they generally have. Looking at our portfolio's pick percentage, it is at a three-year low currently. The strategy we employed during COVID, where we provided minimal cash interest, isn't applicable today. We have observed strong sponsorship support in situations that needed it. To provide further detail, even if a company has long-term issues with its capital structure, such as high interest payments due to elevated base rates, most of these companies still have substantial cash reserves. They also have access to undrawn revolving credit facilities. Thus, there are several interim solutions available before a sponsor needs to step in and provide additional support for a company that requires more capital. This factor contributes to the current low levels of activity. Many private equity firms are primarily focused on managing their existing portfolios and addressing these challenges rather than pursuing new deals. I hope this clarifies things for you.

Yes. To highlight the initial point Kipp made and to directly address your question, we are not observing any change in sponsor behavior regarding their readiness to support companies when liquidity is required. We discussed at length the loan to values in our remarks, and based on those loan to values in our portfolio moving forward, we certainly anticipate seeing the same trend.

Thank you for your question. Ivy Hill has been a highly successful business for us and now represents 10% of our portfolio. We've discussed this in previous calls, but I'm curious if there is still potential for growth in that area or if we have reached a limit with that percentage.

Yes. I mean, we don't really have a cap particularly on things that have been that successful. I have acknowledged in a different setting, so I will acknowledge it now that having a 10% exposure to a single name even though we don't really think about it as a single name, because there are a host of underlying funds and cash flows to deliver the return, is probably near the upper limit at least for me personally. So I wouldn't expect it to grow materially from here.

Our next question comes from the line of Mark Hughes with Truist Securities. Please proceed with your question.

Thank you. Good morning. The non-accruals improved this quarter after stepping up for a bit for a quarter or two. Was there anything common to that improvement? Was it one off? You talked about inflationary pressure easing, was that a driver perhaps?

When you go into more detail, what actually happened is we resolved one of the non-accruals by restructuring a specific portfolio company. Removing that non-accrual is what lowered the number from a mathematical standpoint. To clarify, we didn't see any significant addition of other companies. So, the decrease was primarily due to one major restructuring we implemented at the portfolio company.

Understood. And then with the potential for deal activity to pick up if interest rates improved, do you see maybe some pause as the expectation is for interest rates to decline further? And then the question is, when do you transact? How does it work at this point in the interest rate cycle?

I mean, I think it's very hard to tell. Again, I think if you have stability in rates, it makes it easier, back to one of the earlier questions, for buyers to at least understand what their maximum cost of debt financing may be when you set up a model to do a transaction. Obviously more compelling for transaction activity would be a decline in rates, right? Where you actually had the expectation for cuts to start coming through. But your guess is as good as mine as to when that actually happens, if at all. So I think we kind of are where we are for the time being.

Our next question comes from the line of Bryce Rowe with B. Riley.

Maybe first one is around balance sheet leverage. You all delevered a bit in the first quarter and maybe even a little bit more here in the second quarter. Can you talk about kind of your view on maybe relevering or maintaining at these levels? Just kind of curious where your comfort level is at this point?

Thanks for the question. I mean, it's the same answer I think as it's been in the past, maybe with a modest footnote. We tend to run kind of between 1x and 1.25x. The leverage helps drive earnings a little bit. But again, just as a reminder, the BDCs are really not particularly leveraged companies, right? So going from 1.05x to 1.17x doesn't have a huge impact. We, I think at this point in the cycle though, would like to have a lot of liquidity both to pursue new investing and also to make sure that we can invest in portfolio companies to the extent we want to or need to. So I think it's really just driven quarter-to-quarter by how active we are and what the repayment calendar looks like. That's hard to predict. But we feel comfortable with where it is today. If it went up a little bit, that would be fine. If it went down a little bit, that would be fine. So the earnings are more than supporting the dividend, and we felt good about the trajectory here. So we don't feel any need to lever back up in the way that you referred to it. We're happy with where we are today.

Okay. That's helpful. Maybe a follow-up to those comments, Kipp. No view of imminent recession based on your prepared remarks. Obviously, dividend coverage is extremely strong here, 20% plus. I mean at what point do you kind of take it up another notch in terms of dividend increases? I mean, obviously, you have seen some great dividend increases over the last year. But with that view of no imminent recession, just how are you thinking about dividend levels given that level of dividend coverage?

I think the discussion that we had when we raised the dividend, obviously, was, the earnings are well in excess of given the raised dividend level, what's prudent, right? And the discussion that was much more about the direction of interest rates than it was about portfolio credit quality, right? So if we pull a couple of the different levers that could allow us to have a higher dividend or a lower dividend, the one that's the most impactful would be a significant decrease in base rates. You'd have to model non-accruals up a lot to have it to have any real impact on how we thought about the dividend today.

Our next question comes from the line of Erik Zwick with Hovde Group. Please proceed with your question.

Thank you. Good morning all. I wanted to start, I guess, just first with a follow-up to something I inquired about last quarter. So in terms of your new commitments, 92% had head floors this quarter, I'm curious if the borrower is accepting your maybe request to move that floor up a little bit from kind of the 1% level that you have been operating for a while or is that still kind of…?

We've been trying and we haven't had a lot of luck.

Okay. Fair enough. And then my second question is, maybe similar to some prior questions, but maybe just thinking about it a slightly different way. So looking at new commitments in the quarter, up noticeably from 1Q, but still running well below the level that we've seen in prior years. So curious, how much of that is just to reflection of the market, is it slower deal activity versus maybe caution on your part, just given that there is still uncertain economic environment at this point?

No. I mean, we wish there was more activity. We are not particularly cautious. I think we are thoughtful about the existing portfolio, but we would love a busier environment. The reality is there are not a lot of opportunistic recaps getting done because people have pretty good balance sheets in place. What's really going to drive a pickup from here is just going to be more M&A activity. And as we mentioned, we have got the benefit of having a large diverse portfolio that contributes to a lot of follow-on capital opportunities for us. But, yes, to be materially busier, we just need the M&A environment to pick up.

The downside is that the repayment activity is lower than usual. As a result, we are experiencing longer durations on our existing loans. However, this isn't entirely negative as it balances out.

Yes. It's a good point.

And our next question comes from the line of John Rowan with Janney. Please proceed with your question.

Good morning. So just to talk a little bit about the interest coverage and specifically kind of the 1s and 2s. And I appreciate the information you gave on how it's calculated. And particularly, the loan to value rates and which would seem to be compelling for sponsors to step-up and help a struggling investment. But I'm just curious, is there a difference in kind of the LTVs across the portfolio relative to what would be in the 1s and 2s? I'm just trying to gauge, if that same reason to step-up and support a company is the same in the 1s and 2s, as it is for the rest of the portfolio?

Yes, I believe the loan to value ratios will be significantly higher for the underperforming assets.

We are marking the equity value to market every quarter. And so as there is underperformance, we are marking the equity value down. There still might be significant cash equity there, which would incentivize support, but obviously sponsors are going to evaluate performance of the company and lower performance might be harder for them to support.

Okay. And then just one kind of housekeeping question. Obviously, non-accruals came down, you did restructure one large loan. Is that what drove the realized loss in the quarter?

Yes. Primarily.

And this concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Kipp DeVeer for any closing remarks.

I just thank everybody for participating and the good questions. And I hope everyone enjoys the rest of the summer. We'll be in touch soon. Thanks.

And ladies and gentlemen, this concludes our conference call for today. If you miss 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 August 22nd at 5:00 PM Eastern Time to domestic callers by dialing 877-660-6853 and to international callers by dialing 201-612-7415. For all replays, please reference conference number 1373-8840. An archived replay will also be available on the webcast link located on the homepage of the Investor Resources section of Ares Capital’s website.