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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good afternoon. Welcome to Ares Capital Corporation Second Quarter Ended June 30, 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Wednesday, August 1, 2018.
I’ll now turn the call over to Mr. John Stilmar of Investor Relations.
Great. Thank you, Brian, and good afternoon, everybody. Let me start with some important reminders. Comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar such expressions.
The Company’s actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in its SEC filings. Ares Capital Corporation assumes no obligation to update 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 measure 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 the financial performance, because it is one method the company uses to financial condition and results of operation.
A reconciliation of core EPS to the net per share increase or decrease in stockholders’ equity resulting from operations which is the most directly comparable GAAP financial measure can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures may also be found in our earnings released, filed this morning with the SEC on Form 8-K.
Certain information discussed in this presentation, including information related to portfolio companies, was derived from third-party sources and has not been independently verified and accordingly, the Company makes no representation or warranty in respect to this information.
The Company’s second quarter ended June 30, 2018 earnings presentation can be found on the Company's website at www.arescapitalcorp.com by clicking on the Q2 2018 Earnings Presentation link on the homepage of the Investor Resources section. Ares Capital Corporation’s earnings release and 10-Q are also available on the Company’s website.
I will now turn the call over to Mr. Kipp deVeer, Ares Capital Corporation’s Chief Executive Officer.
Thanks John. Good afternoon and thanks to everyone for being with us today. I’m joined by members of our management team, including our Co-President, Mitchell Goldstein, our Chief Financial Officer, Penni Roll, and other members of the Finance, Investment and Investor Relations teams. You will hear from Penni and Mitch later on the call.
I’ll start by reviewing our second quarter results and providing an update on our current market conditions. I'll then discuss our plan to take advantage of the flexibility provided by the Small Business Credit Availability Act, which we detailed on a presentation posted to our website in late June. And finally, I'll leave you with some thoughts on our progress in the American Capital deal, as the sale of non-core assets is now largely behind us.
This morning, we reported strong second quarter core earnings of $0.39 per share, an increase of 15% from the same period a year-ago. Improved earnings were driven by higher portfolio yields as we benefited from continued portfolio rotation initiatives and increases in LIBOR. We also generated another quarter of strong GAAP earnings, which totaled $0.60 per share, reflecting significant portfolio appreciation primarily from the remaining acquired American Capital portfolio.
Over the last four quarters, we generated a GAAP return on equity of approximately 12%, above our long-term average since inception of roughly 11%. And we also ended the quarter in a conservative financial position, with a modest debt equity ratio of only 0.57 times. This is below our current target leverage range of 0.65 to 0.75 times. We feel we feel we're well-positioned today and have significant near-term opportunity to deploy capital.
But it's a good transition as there in lies the challenge today. Overall market conditions remain highly competitive. We continue to differentiate ourselves from the competition with our large-scale commitment and hold capability, long-standing relationships, ability to take advantage of incumbency and the flexibility of our capital.
We remain very selective our new deals as evidenced by the fact that we closed less than 4% of the transactions that we review from new companies. And as Mitch will discuss later in more detail, the vast majority of our investments today are backing our strongest existing borrowers where we believe we take the least risk of deploying capital. Despite these challenging conditions for investing, we did see evidence of increasing market volatility in the liquid credit market beginning in late June, and has continued.
Under the weight of strong new supply and deal activity, investors began to push back on both pricing and terms in the liquid loan markets. As supply and demand dynamics in the market become more balanced, the syndicated loan market seems spread widening of approximately 25 basis points to 50 basis points. Marginally improved credit protections and tightening risk parameters from the syndication desk from liquid loan executions. This increased volatility from more capital market oriented execution should be a positive for us, since it provides additional opportunity for ARCC on the upper end of the market, with potential improved pricing on larger transactions.
These are early signs of improved terms for investors developed we remain patient, as we know that the middle market typically lags the liquid market. And in our opinion, it's a good time to take the wait and see approach in many situations, we feel good about having significant dry powder as we move forward.
I would like to turn now to our previously announced plan regarding the adoption of certain provisions of the Small Business Credit Availability Act. Prior to our board approving the reduced asset coverage test under the SBCAA on June 21, 2018, we spent significant time engaged with our Board of Directors, lending partners, rating agencies and other key constituents in examining our options.
As we described in the presentation filed on June 25, we believe the adoption of the 150% asset coverage requirement and our corresponding plan will result in enhanced profitability for our company, while maintaining our conservative investment grade profile. We also believe the greater flexibility offered by the act allows us to operate with an increased cushion to the regulatory leverage threshold, which should benefit us in more volatile markets.
We have provided a clear and simple plan to gradually increase leverage to a range of 0.9 times to 1.25 times debt-to-equity over the 12 to 36 months following the effective date next June. We have no desire to change our investment strategy, which has proven to be very effective through our credit cycles and through the last 14 years. We also maintained our investment grade ratings with both Fitch and S&P, while Moody's placed our ratings on watch for a possible upgrade.
All in all, we think our plan allows for the possibility of higher returns for shareholders, while maintaining our conservative balance sheet and investment positioning. Our leverage of the company will remain modest, especially compared with other financial services companies or financial vehicles.
Finally, in connection with the plan, our investment adviser has reduced the base management fee from 1.5% to 1% on all assets financed using leverage over one-time debt to equity. This fee concession is meant as an additional benefit of our plan to shareholders in support of potentially higher future earnings.
Before I turn it over to Penni, I will finish with a brief update on the American Capital Acquisition. I am pleased to announce that we've completed the sale of the largest portfolio company that we acquired from American Capital, and we realized a sizable gain. Post-quarter-end in July, we sold our investment in Alcami, which was a controlled portfolio company and a leading outsourced drug development and manufacturing business.
With the sale, we recognized the $324 million realized gain, generating proceeds that were more than double the investment that we acquired. Since our initial acquisition of the $2.5 billion American Capital portfolio in January of 2017, and pro forma for the exit of Alcami, we received more than $2.3 billion of proceeds from exits and repayments, including gains on a realized basis of $420 million. We continue to hold approximately $900 million of ACAS investments using our June 30 fair value, and that does still include the Alcami investment.
Of this remaining amount, approximately $400 million is in lower yielding non-core assets. As of June 30, and pro forma for the Alcami sale, the gross realized asset level IRR on our acquisition of ACAS is an excess of 40%. We believe it's a great reminder that our company has the ability to opportunistically make accretive acquisitions that can generate these very, very attractive returns.
Now let me turn the call over to Penni to provide more detail on the financials and to deliver some good news regarding our quarterly dividend.
Thank you, Kipp and good afternoon. As Kipp stated, our basic and diluted core earnings per share were $0.39 for the second quarter of 2018 as compared to $0.39 for the first quarter of 2018, and $0.34 for the second quarter of 2017.
Our basic and diluted GAAP earnings per share for the second quarter of 2018 were $0.60, including net gains for the quarter of $0.22 per share. This is compared to GAAP net income of $0.57 per share for the first quarter of 2018, and GAAP net income $0.42 per share for the second quarter of 2017.
In total, we reported net realized and unrealized gains on investments and other transactions for the second quarter of $92 million. This included net unrealized gains on our investments of $54 million, primarily supported by the further appreciation of our investment in Alcami that was driven by the exit value ultimately realized in July.
As of June 30, our investment portfolio totaled $11.5 billion at fair value and we had total assets of $12.3 billion. At the end of the second quarter, the weighted average yield on our debt and other income producing securities at amortized costs increased to 10.4% and the weighted average yield on total investments at amortized costs increased to 9.1% as compared to 10.1% and 8.9% respectively at March 31, 2018. The total portfolio yield increased since the end of the first quarter, primarily due to the continued increase in LIBOR.
Due to the strong performance in the portfolio, the continued upward progression in our earnings and what we believe to be multiple drivers for future earnings growth, our Board of Directors approved an increase in the quarterly dividend to $0.39 per share from $0.38 per share.
In addition, we currently estimate that undistributed taxable income carried forward from 2017 into 2018 will be approximately $346 million or $0.81 per share. The third quarter dividend of $0.39 per share is payable on September 28, 2018 to stockholders of record on September 14.
Moving to the right hand side of the balance sheet, our stockholders’ equity at June 30 was $7.3 billion, resulting in net asset value per share of $17.05, an increase compared to $16.84 a quarter ago and $16.54 per share, a year-ago.
As of June 30, our debt to equity ratio was 0.64 times and our debt to equity ratio net of available cash of $475 million was 0.57 times compared to 0.73 times and 0.69 times respectively at March 31, 2018. Our total available liquidity at the end of the second quarter was approximately $3.5 billion.
Our balance sheet continues to be asset sensitive and a further rise in short-term rates should continue to benefit our earnings. For example, using our balance sheet at June 30 and assuming an up to 100 basis point increase in LIBOR, our annual earnings after including the impact of income based fees are positioned to increase by up to approximately $0.17 per share.
With that, I will turn the call over to Mitch.
Thanks, Penni. I'd like to spend a few minutes reviewing our second quarter investment activity and portfolio performance. I will then provide an update on post-quarter-end activity in our backlog and pipeline. As Mike Smith and I often mentioned, we focus on originating a very broad set of middle market opportunities with the goal of investing in the best credits where we'll find compelling risk-adjusted returns.
During the second quarter, we made 46 commitments totaling $1.6 billion, of which, over 65% of these commitments were first lien, and 90% were senior secured positions reflecting our conservative approach in this market. The sheer size of our portfolio along with growing financing needs of our portfolio companies offers a significant differentiated deal flow from our existing borrowers, which represent nearly 75% of our second quarter investment activity.
For example, in the second quarter, we let a $340 million incremental senior secured financing for our portfolio company community brands, in support of a strategic acquisition. This transaction serves as a good example of how we evaluate the software businesses. We seek software businesses with strong free cash flows and large embedded customer basis with high switching costs.
Community brands is a preeminent provider of integrated cloud-based software to over 100,000 faith-based institutions and not-for-profit organizations. Our first investment in this company was made in 2015, and over the past three years, we have raised a total of $2.0 billion to seven transactions for the company.
Shifting with repayments. During the second quarter, we exited or repaid on $2.2 billion of commitments as we used strong market conditions throughout most of the quarter to refine our portfolio. The strong repayments we experienced included exits of a lower-performing credits and companies with investment terms where we were happy to be repaid at par or premium at par.
At quarter end, our portfolio was $11.5 billion, consisting of 346 different portfolio companies, resulting in a highly diversified portfolio, where our average hold position per name at fair value is only 0.3% of the portfolio. Performance continues to be strong in our underlying portfolio companies. As of June 30, these companies continue to generate solid growth in their aggregate earnings, as weighted average EBITDA grew over the past 12 months by approximately 7%, consistent with last quarter, and up from 5% in the second quarter of 2017.
We also saw a decrease in the number of companies on non-accrual during the quarter as two companies came off non-accrual and no new non-accruals during the quarter. At the end of the quarter, non-accruals as a percent of the total portfolio at cost were stable quarter-over-quarter at 2.7%. Non-accruals at fair value decreased to 0.8% in Q2 2018 from 1% in Q1 2018.
Looking forward, we remain defensive with a continued focus on lending to franchise businesses with high free cash flows and strong margins. We continue to seek investments in industries such as business services; healthcare and software services and we continue to be underweight in sectors where we see volatility or weakening trends such as retail and media/communications.
Underscoring the importance of industry selections, retail, media/communications and energy/oil and gas sectors accounted for nearly 9% of broadly syndicated leverage loan fall since the beginning of the second quarter 2017. All sectors that are either non-existent or materially underweight in our portfolio. We also made good progress this quarter and utilizing our availability under our 30% basket.
Our FTLP joint venture made five new commitments totaling $500 million, bringing the aggregate capital funded in this program to $2.9 billion. ARCC invested $111 million in the subordinated certificates during the quarter, bringing ARCC's total investment in the SDLP to $589 million. The subordinate certificates of the program provide ARCC an attractive risk-adjusted return with a yield of 15% as of June 30, 2018.
Before I turn it over to Kipp, I would like to provide some brief comments on our post-quarter investment activity. From July 1 through July 25, we made new investment commitments totaling $895 million and exited or were repaid $629 million of investment commitments, generating approximately $326 million of net realized gains.
The significant net realized gains primarily reflect the successful exit of Alcami. Since ARCC's inception through June 30, 2018, and pro forma for the Alcami exit, we have generated over $950 million of net realized gains for an average annualize net realized gain of 1.2%. It is our belief that this metric compares favorably with most banks and other BDC's. The Alcami transaction also demonstrates how our scale and position of incumbency supports attractive investment opportunities.
As part of Madison Dearborn acquisition of Alcami, we were selected to lead a $390 million First and Second Lien financing, allowing us to stay invested in the company. Our scale and knowledge allowed us to create a customized financing solution that we continue to view as an attractive credit.
And finally, as of July 25, our backlog and pipeline stood at roughly $710 million and $660 million respectively. As always these potential investments are subject to approvals and documentation and we may sell or syndicate post-closing. please note that there is no certainty that these transactions will close.
I will now turn the call back over to Kipp for some closing remarks.
Thanks a lot Mitch. So we're really pleased with our second quarter results and the continued execution against our goals for 2018. Our core earnings have increased significantly over the last five quarters. We believe our future earnings are positioned to further benefit from additional increases in LIBOR, releveraging back to our current target range of 0.65 to 0.75 times debt-to-equity, and increased utilization of our 30% basket. The growth in earnings has allowed us to increase our quarterly dividend of $0.39 per share. We feel well positioned to deliver attractive returns for shareholders moving forward.
Looking longer term, we believe the flexibility we gained with the passage of the SBCAA and the plan we laid out will enable us to improve returns for shareholders going forward, while maintaining our investment grade profile, and our conservative balance sheet. We intend to go slowly if the current market continues as it is. And as we implement our plan, we will be sure to keep all of our stakeholders updated.
That concludes our prepared remarks. Brian would you open the line for questions please.
[Operator Instructions] And our first question today comes from Rick Shane with JPMorgan. Please go ahead.
Hey guys. Two questions this morning. First, Kipp you talked about widening and spreads and that’s obviously a dynamic we have not seen in a very long time. I’d be curious given that the portfolio is basically been bounded by par in terms of marks and spreads have tightened, as spreads widen, there's substantial cushion, so we wouldn't expect NAV decreases or NAV compression associated with a little bit of movement in spread?
Thanks for the question Rick. I mean, look when spreads widened, generally we see modest markdowns is the way that the math works just on the portfolio on a mark-to-market basis, but I think that we do have enough yield in the portfolio that based on the way we think about valuations today. We didn't see anything material in Q2. I’d just make the point to as it relates to valuation.
This is sort of very late quarter-end and then continuing, let's say, as much into July as it is anything else ongoing, but it's very dependent on supply of outstanding loan transactions, some of the things that got a little choppy there in late June and early July seemed to have cleared with a slight tweak to pricing. And that supply/demand imbalance isn’t quite as bad as it was maybe six weeks ago, but it's something that we're monitoring. And if there's more caution on the sort of loan syndicates desks these days relative to underwriting large cap transactions vis-a-vis what's coming in the fall and beyond that.
Got it. And then I just wanted to follow-up on a comment that Mitch had made. Am I correct – so in the slide you know, $326 million of net realized gains that are coming in the third quarter, and that was in the context including, basically the history of $900 million gains. Are you going to realize almost one third of the gains, lifetime gains in the third quarter?
Yes.
Okay. Got it. Thank you.
Thank you.
Our next question comes from Fin O'Shea with Wells Fargo Securities. Please go ahead.
Hi guys. Good afternoon. Thanks for taking my question and congratulations on the strong quarter on all fronts.
Thanks.
First question on Ivy Hill. You stated that – recently you hope that keeps growing. Underneath we saw investments come down a little bit, but are still above risk retention requirements. Is this still a lump based on the Pac West deal or should we see more underlying CLO investment exposure there?
I'm glad Mitch is here, because he can probably answer. I want to make sure, I'm clear on the questions and we appreciate it. So there was a modest write-down in Ivy Hill in the quarter simply as part of our regular evaluation exercise, I wouldn't call material in any way. The risk retention requirements don't really have any impact on Ivy Hill, right. I mean we’re an equity investor, through Ares Capital. We have third-party investors. But there's no risk retention sort of element to it. The only thing that really is material is obviously that we have increased the ongoing dividend there to represent a larger size of the company, post the transaction that we've talked about, that recalled project jump with the Pacific West. Did I answer your question? I want to be sure the answer…
Yes, just basically, it used to be a more even split between the fee income and the investment income and that vehicles are just seeing if there's going to be an increase in investment income going forward?
I don't think – this is Mitch, I appreciate the question. I don't think you'll see a material change in Ivy Hill going forward. Obviously, the back Western was a very large transaction that we closed at the beginning of this year. But I don't see a lot of changes in Ivy Hill going forward, certainly not in the near-term.
In fact, part of the write-down in Ivy Hill was the abundance of cash we have in some of the vehicles given the slower deployment that we have to stop before we can consider more Ivy Hill transactions.
Okay, that makes sense. And just for my follow-up, seeing they're gone a little more active in leading middle market deals, are you familiar as to if these are smaller market or are they able to build around there would be SDLP funnel parameters?
I think they're mostly smaller deals, from what at least I have observed. Anybody here can chime in. Look, we're still happy with the partnership and we both of them originate for our joint ventures sort of the extent that they're growing and getting to be larger, it's probably a good thing for us. And we're happy from them do for them on that front. But I think a couple of the recently disclosed transactions that maybe I come across and you did do, I think we’re in some smaller companies.
Okay, thanks so much.
Sure, thanks.
Our next question comes from Chris York with JMP Securities. Please go ahead.
Good afternoon guys and thanks for taking my questions. So as I adjust the quarter, I think investors will try to make sense in the dividend increase with the decline in your portfolio and the leverage, and then as we look out, combined with a few waivers that were set to expire in 2019.
So obviously returning to target leverage will help expand net investment income. So could you help us understand why the decision was made to declare this good news today as opposed to maybe waiting to rebuild the portfolio in a quarter to ensure we've dealt with coverage?
Sure, well, obviously we thought the timing was right. I think if we look back six quarters, we've been telling, what I hope people have observed to be a pretty consistent story of using our existing capital to generate higher core and certainly it’s been spend GAAP earnings with all the gains that we've realized, but higher core earnings that meet or exceed our dividend, which we've done now two quarters in a row and feel quite good where we position and continue to do that for the foreseeable future.
As we've evaluated the dividend policy, we've always said that we wanted to pursue a dividend increase and we thought the earnings momentum of the company allowed for it that we think that it does today.
So being modestly under invested where we have dry powder and seeing earnings that meaningfully exceed the dividend is a little bit of a Goldilocks situation for us today. We feel very fortunate and feel very confident looking forward that whether it's a challenging investment environment, which we do see, or lower leverage on the company or even the rolling off of few way where we have a lot of confidence in earnings power of the company and we felt good about raising the dividend in this quarter.
Great, helpful color. Thanks, Kipp. And then as Mitch pointed out, post-quarter-end activity is strong, again provided, I think I get about $0.75 per share on realized gains. And you have the ample spillover to cover the core. So what inputs are going into your thoughts about distributing versus retaining this future income, or I guess, that's already occurred today?
Yes. So we’ve had – obviously, we kind of disclose and test our spillover income on an annual basis, right? So as of the end of last year, it's about $0.81 a share. The significant gains that we've generated now particularly through the end of July will increase that, but until we get to year-end, we're not going to have a firm view as to what the spillover income is, because our GAAP in our tax positioning can vary a little bit.
But it's safe to say that with the amount of the spillover that we've had, and what we assume will be an increase in that spillover income at the end of the year, everything is very much being discussed today with the board, whether it's special dividend, whether it's a modest tweak to the way we think about paying out earnings in excess of the regular dividend, which I know a couple of the other BDCs in the space have done, they've been well received. So a lot of time being spent on that right now, but – I think we'll have more the report probably as we progress through the year.
Awesome. Great, color again. Last one for me and then I'll hop back in queue. So Mitch, you said exits were robust, I calculate a record this quarter, and some of it was a strategic. So could you help me or us receive a little bit color – more color on the level of exits repayments that are in your control versus maybe not? And whether this level of portfolio churn may continue?
Mitch will chime if you – certainly if you wants some – to add something I think that most of exits that we're seeing probably fall into three camps: it's something like Alcami, where we're pursuing sale at a reasonable or a pretty significant gain.
It is repayments that are coming in situations where we sort of regrettably lose one of our larger company transactions, typically to a syndicated deal where a borrower can reduce their cost of capital with ratings and syndication, which happens in an environment like this, it definitely a little higher regrettable repayment.
I think importantly also, some opportunistic exits of debt position situations. That I would tell you I don't think we're all that excited about where companies were necessarily going, but were still able to get pretty attractive refinancing packages that we probably wouldn't have come close to meeting.
So part of what you do late in the credit cycle, and we do think late in the credit cycle is, you try to get your portfolio to be as clean as possible. You use liquidity in the market to get your refinance out of situations that you're not thrilled about and there are a couple of examples as for sure in Q2, and frankly, over the last 18 to 24 months where we've been doing that.
Got it. That’s it for me. Thanks Kipp.
Okay. Thanks.
The next question comes from John Hecht with Jefferies. Please go ahead.
Good afternoon, guys and thanks congratulations on the dividend. Thanks for the taking the questions. Actually, I had the same question as the last one Chris I guess maybe the only thing I'd add to that is based on what you're seen this quarter, do you expect that the lumpiness of repayments to persist for the near term, basically and if you look at the pipeline, it's just that you see further contraction of portfolio? Or do think that will – the tides will turn a little bit in this investing environment?
Yes, John. Thanks for the question. We don't see anything unusual in terms of inflows and outflows. I think Q2 touched a little bit unusual we're just looking-forward into Q3 it looks a bit more balanced. I'm hoping with a target leverage ratio below where we'd like it to be that we find ways to increase the leverage, because it will obviously help us to even improve earnings from here. But I think we're going to – as I mentioned in the prepared remarks continue to take a little bit of a wait and see approach right I mean it's August 1, we'll see what happens when backlog in pipeline gets rolled out in September.
It's sort of how the first couple of weeks goes, see if the markets are volatile, see if the transaction launch and the larger markets are well received, moderately received, poorly received, et cetera, and then we'll kind of give us guidance as to what we think September and the balance of the year looks like. But I guess, to get to what I think, Q2 is unusual in that we just saw that significant shrinkage in the portfolio. I think we're okay with that for the time being. We're pretty sure with the origination team and the relationships we have, et cetera et cetera, that, that will recover.
Okay. And then a different question. I know we're only a couple of quarters into the Tax Reform, but I'm wondering are you guys – is there any behavioral change in the market either from borrowing customers or your private equity counterparts that you guys have observed as a result of the Tax Reform at this point?
Yes. I need to give you a short answer, but not really. Everybody is kind of shaking their heads around our ballroom here. So it seems like the consensus in the room.
Okay. Appreciate that. Thanks guys.
Thanks for your questions John.
Next question comes from Allison Rudary with Oppenheimer. Please go ahead.
Hi. Good afternoon, everyone. A lot of my questions have been asked and answered, but I wanted to ask, one of your peers recently called out the direct lending space is an area and asset class “is being primed for having real issues over the next couple of years.” And I think it's obvious that the opportunity for more like [indiscernible] transactions seems pretty apparent in that, but would you guys agree with that? And how do you think about both the opportunities and the risks, especially in sectors that you perhaps you didn't call out as long as that you avoid?
Yes. Thanks for the question. We have great respect for our friends based out on the West Coast. All I say that continued, but quite a lot of energy and building their own direct lending business. I'm sure being opportunistic investors as we are today look to the prospect of consolidation in the space. We love the idea. There is no changes at our company right and we’ve done two very large acquisitions of two troubled companies in our space.
We certainly don't wish trouble on anyone, but we do expect that trouble will come at some point and we're doing our best to stay out of trouble for the time being, so that we're well positioned to potentially engage in those kind of discussions if and when they come. So again, I think we are late in the cycle. I think there's a lot of not so great underwriting going on. I think there are a lot of mistakes being made. We're trying not to make them, but we’ll see. I don't have my crystal ball here with me today to know when that all come and if it does.
Great. Thanks. I have my follow-up, with tariff coming on line in the United States in our domestic economy and starting to see some of the flow through in larger company reporting, do you guys have pockets that where I guess sustained tariff or price increase situation with your companies could cause problems?
Yes. I think – look the good news is a lot of our investing is focused kind of in the services area, whether it's business services, healthcare, software et cetera. The places that we've spent time starting to worry about or probably in the consumer and manufacturing sectors where we think that some of the early pain points may get delivered from the tariffs. But again, what's really been rolled out at least to my understanding is a program that's pretty small scale relative to obviously the overall U.S. GDP and size of the economy and all that. So certainly doing work, our portfolio management team spending time there, but I’m not particularly worried yet. You know without talking politics certainly don't view it as a positive for the U.S. economy.
Fair enough. That’s it for me guys. Thanks for taking my questions.
Next question comes from Terry Ma with Barclays. Please go ahead.
Hey guys. You guys have now highlighted additional investment opportunities that could be available with expanded leverage, so can you just maybe talk about the types of investments you will be able to do and how they differ from what you're doing right now?
Thanks for the question Terry. I said this in the prepared remarks and we said it as well. And we hope to say it pretty clearly in the presentation that we posted in June, but we don't expect to see any change in our investment strategy at all. I think there are other BDCs that have said we're going to make some changes to the way that we do things, we're going to orient ourselves more toward senior loans or increase our financial leverage and use leverage up to 1.5 or whatever folks have said. We really don't intend to do anything differently. We have a long cycle tested investment track record and a fantastic investment team as well as a whole lot of relationships and clients that come to us for flexible solutions to their capital needs. So we don't really see any changes at all.
Okay, great. Thanks for being clear on that. Follow-up question, can you just maybe give us a sense of how spread tightening has trended in the first half? And whether or not you think there is some widening is more transitory or do you think that just going to hold steady from here?
Spreads have been pretty consistent – maybe grant came in a little bit in the first quarter – end of the first quarter and then back out, again a little bit at the second quarter such that that really started the year. I do think it's transitory. I don't mean, based on our prepared remarks, say, we saw a big crack in the armor, so to speak, in June and it's continuing. We're going to have all this opportunity, but we saw the markets a little bit unsettled towards of the back half of Q2 because despite flows in the direct lending, flows in the CLOs, there's just a huge, huge backlog of transactions trying to clear.
And for the most part, they cleared. They just cleared a little bit wide, and I think we'll have the same type of situation to observe, which I mentioned in an earlier response in September. That's meant to be a busy month. I think we'll have to see what the climate is again, when everyone kind of is generally back from vacation and focus on doing the deals again. But I think the fall will be important for all of us to watch to see where we go from here.
Okay, got it. Thank you.
You’re welcome.
The next question comes from David Miyazaki with Confluence. Please go ahead.
Thank you. Congratulations on a good quarter and we certainly to appreciate your efforts in staying out of trouble and any success in doing so.
Thanks, David.
Just a couple of questions, first one, actually for Penni. My recollection when you did the Allied acquisition. But obviously, pretty well, that there were instances when you realized gains above the acquisition types of certain assets that they were below the tax basis of the original investment. So you could realize gains that wouldn't necessarily have to be distributed because relative to the tax basis, they were losses. Is that the case in Alcami or any of the other realized gains that you might be having in the third quarter?
There was a tax difference on the way. The two acquisitions are treated. With Allied, we did a tax rate change, which ultimately had carryover basis of the Allied cost basis of deals, which resulted on us exiting things on a book basis that had a different tax basis. But what that did do, was it did build up some capital losses that we could use and carryforward over time as we realized gains.
For the ACAS acquisition, it was a taxable transaction. So our tax cost basis for any deal is the same as our book cost basis. We don't have those timing difference recurring. But we do have some tax planning that we can do and there are some accumulated tax losses in the book that can shelter some of the realized gains that we have and that something that will be looking at as we move into the end of the year that will determine the ultimate level of spillover that we have going into 2019. To the extent we can use those losses that does allow us to effectively retain those gains and that has to distribute them.
Okay, great. Thank you. And then, Kipp, just a follow-up on the comments that I think you've made in the past, that you didn't – I think, last year, we talked, you didn't see any immediate need to raise equity, and I guess with having a higher leverage target range now that, that would continue to be the case for the near-term.
But as we think about ARCC more in the intermediate longer-term and then presumably getting to your target leverage and then raising more equity, not changing your investment philosophy, is there room in your existing business to grow and become a $20 billion asset BDC. And so as you're doing or do you anticipate adding different verticals or changing the nature of your focus because you have a larger asset base?
It’s a great question. And we talk a lot about things like that. It’s a hard question to answer on an earnings call, frankly, because it could go on and on, and this is obviously the kind of stuff that we talk about at a very high level with our management team and with our board.
I mean look, I think that we – when we layout our presentation vis-a-vis higher leverage, we laid out a more or less three-year plan when we increased the assets to the company continue to grow and continue to grow earnings all without relying on any equity issuance.
I think for the foreseeable future, we don't really see that as part of the plan as we modestly increased leverage at the company, I think that question that you're asking, which is again David, a great question. And we’ll be honest, more in two or three years than it is today, right?
So we've a lot of changes vis-a-vis the SPCAA. We've been trying to evaluate those, and we've been working through again a challenging investment environment. It's easier to grow when investing is easy, right? And investing today is not that easy. So what we've laid out in that presentation as or three-year plan which is a measured and you know slow going plan to improve returns for shareholders as we've mentioned is sort of as far as we've gotten.
That being said back to the point about I think it was Allison and you mentioned you know things to buy portfolios to buy, assets to buy, companies to buy, that can changed reasonably quickly and we participate in a very large market where despite our market leadership you know our market share is low, is below 10% in terms of the available universe and we typically will consolidate market share and grow during again easier time to invest, times when things are more opportunistic and frankly not as expensive as they are today. So I hope that gives you some thoughts as to – we could talk for a long time about that question and we do around here, but hopefully that gives you some color.
Yes, that’s helpful. I obviously thinking that far down the road, you can't have specifics, I'm just wondering what the thought process around the intermediate- and longer-term. So thank you very much for time.
Yes. We've got a big team here and they and they're busy I mean we originated north of 10 billion in capital most business last year we continue to add people we're always pursuing the idea of new verticals and new specialties and all of that and branching out. So for sure that’s all part of what we do here day today.
Great thanks.
Yes. Thank you.
Next question comes from Robert Dodd with Raymond James. Please go ahead.
Hi, follow up for pending on tax planning, obviously I mean Alcami is an LLC, so I presume it was held in a taxable [Brokaw], right? The question to the point of raising the potential for special much higher spillover, et cetera. I mean is it you intend to distribute more to upstream from the Brokaw to the BDC and great a spillover event? Or to retain as much capital as you can, either in the Brokaw for some other vehicle and i.e. minimize the spillover growth as a result of the Alcami gain? I mean, is that the plan? And if that's the case, obviously, the potential – the necessity of a special dividend would be significantly reduced?
Yes, I think just from a technical aspect the Alcami exist is tax or gain to us just to be clear from that exit of that position. So like with any year when we look at our taxable income because distributions both play are paid out of taxable earnings. We look at all of our book tax timing differences. So when you put that on a blender affectively we do have you know some losses we could take.
But at the end of the day the earnings of the company being in excess of our distributions and the significant net gains that we are realizing this year. We have some expectation that we would grow the spillover income vis-a-vis compared to what we did from 2017 to 2018.
So and then back to you know Kipp’s earlier comment we are continuing to look at how we could think about dividends in light of the earnings being in access our distributions both from current income and capital gains and that's something we would expect to continue to discuss internally and come back with a more a better view around that as we go through the end of this year.
Got it. I appreciate that Penni. If I can have a CapEx question for you, obviously, if we look back at the end of 2015, beginning of 2016, the BSL market was also very choppy. Obviously, a lot of different dynamics going on then with risk potential, rules changing, et cetera, et cetera. But now, you indicated some choppiness and maybe it's just supply/demand rather than something else.
So for lack of a better term, can we get – what's your gut feel whether, obviously in 2016, that choppiness got completed away very rapidly. Do you think that that's the same kind of scenario we're looking at given may be no regulatory changes going on to elongate that choppiness? Or do you feel it's different now because rates are higher, that the markets shifted?
I don't think it's different. I think there's still a lot of interest in probably syndicated loans. And I think there's a lot of interest in U.S. mail markets, direct funding product. So my feel would be that nothing particularly funny happens in September, and then lot of these transactions clear. You had a huge year of CLO issuance. That's going to – if this continues to be a record year. You continue to have inflows in the floating rate fund that's largely at the expensive high yield. People are looking at a flatter yield curve and all of that, but despite that you've got a $40 billion plus for calendar sitting on the desks of a lot of the banks that when they get back from vacation, they're going to have bank meetings for in sale, right.
So that doesn't mean that's not doable, it's just going to be a question of is there a little bit more price discovery that investors push back in terms a little bit, which I think most investors have felt that have swung too far perhaps the other way. And I think there's some push back and I think it will continue. I don’t expect anything too terrible, but just a little bit of a…
Okay. I appreciate that. One quick follow-on if I can or housekeeping one. Other income was $20 million from the non-affiliate side of the portfolio this quarter pretty high, I mean is that a normal occurring event or is something structurally changed in terms of more fees or things coming out of the non-affiliate side that that's going to run higher going forward?
Yes. There was actually – there's an extraordinary item on top of which usually $5 million to $10 million of other income in there. Put some disclosure in the 10-Q if you want to give it a read. It’s on page 117 by the way, but for the second quarter it was about a $0.5 million item, but now just part of our regular and kind of continuous review of all of our processes here, including allocation of fund expenses and reimbursement and all of that. Ares actually made a reimbursement to Ares Capital Corporation in the quarter, but there's disclosure on in the Q.
Okay. So that reimbursement is in the other income line is income…
That’s in the other income line.
Okay, got it. Appreciated.
Next question comes from Derek Hewett with Bank of America Merrill Lynch. Please go ahead.
Good afternoon, everyone. Kipp or Mitch, could you talk about growth in the SDLP kind of given the accelerating trends, what's driving the optimism for this more liquid strategy when at least one kind of well respected BDC competitor has been shrink – actually been shrinking their joint venture over the last year or so, including a preannouncement for this current quarter?
Yes, interesting. So if you look at our prior JV that was at its peak on $11 billion plus program that we grew over a number of years. So I'm not sure we agree that the acceleration of the investment in SDLP is an appropriate way to describe it. We are trying to find the best investments we can make in the unitranche product. And I think we've been pretty consistent over the last three or four years in growing that product. I expect that to continue to grow as we have in the last couple of quarters. It's a great product for our client. They find a lot of value in it, but it's not for all of our investments given the market that we're in.
Okay, great. Thank you.
Thanks Derek.
Next question comes from Christopher Testa with National Securities Corporation. Please go ahead.
Hi, good afternoon. Thank you for taking my questions. Kipp you had mentioned about, obviously the spread widening a little bit in the BSL market and some terms getting better, obviously the opposite that trickle down through the upper and core middle market pretty quickly. As you expect the lag to be maybe longer than normal before these favorable trends hit the middle market given that there is still a lot of money sloshing around and it's still a borrower's market or do you think that this is something that could pretty much manifest itself in a positive way as quick as it did in a negative?
Yes. I mean, I think it always takes a little bit of time. I mean we’re chatting before the call little bit, but look at a middle market sort of large cabinet market deal that actually had a rating was probably clearing 350 to 375 well back and now it's 400, 450. The unrated stuff would be a little bit wide of that, so we're really talking about here is I'd call it a modest 50 basis point pullback. Will it continue? I think it depends on again what happens in the broadly syndicated mark in September vis-a-vis a reasonably large backlog of stuff needing to clear investor enthusiasm for that or lack of enthusiasm for that et cetera, et cetera, but I don't have a lot more to add on this one.
Okay. That's fair. And I'd be curious there's – obviously scale is becoming increasingly important in this industry and there's obviously been consolidation to reflect that. Just wondering, you guys obviously have a large balance sheet, but there's not a lot of co-investment done, to my knowledge, at least across other Ares funds.
And there's been a lot of players in the market was not nearly is kind of a track record as yourselves that have raised a significant amount of private AUM. I’m just wondering what you’re thoughts are as Ares has a platform raising more private AUMs to kind of reduce indication risks – reduce indication and concentration risk and permit you guys the kind of take in even larger bite size than you already do?
So I think you might have that one a little off in that we've actually raised a fair amount of non-BDC or any capital here in the last five years. Just to keep it broad. So both in commingled funds and in separate accounts that are focused on what I call more traditional bank loan investing. LIBOR 400 kind of paper that for us hasn’t been a particularly good fit in the BDC, and also focused on what I call larger transactions covenant-like deals, private high-yield transactions that sort of things, we disclosed that we raised a fund there.
And the good news is those funds can freely co-invest with the BDC and they do. So we think that capital raising that we’ve done away from the public company. It’s been a huge benefit to ARCC over the last five years.
Got it, and but out of those funds, I know you have mentioned a multitude of different one wit some strategies that may not be – might not fit with the BDC does. How much of the AUMs, just roughly speaking, do you think is really doing almost exactly what ARCC itself is doing?
The separate raising away from the BDC is focused on doing things that we frankly thought the BDC wasn't as good at, sort of the architecture for the how we have done things. And again, they do freely co-invest. We do have some LIBOR 400 and LIBOR 500, bank loans that are at the BDC and then elsewhere, and we do have like in your medical field that we closed last quarter, and we do have some very large covenant life junior capital financing that are at the BDC at that or elsewhere too and on our platform, so – hopefully that answers you question.
Okay. Yes, that’s fair. That’s all from me. Thank you.
You’re welcome. Thanks for the questions.
Next question comes from Casey Alexander with Compass Point. Please go ahead.
Hi, good afternoon. This is just maintenance. I think we've found out every reasonable question that could ask. The $325 million – $326 million in realize gains that are being taken here in the third quarter. That was all within unrealized gains as of the end of the second quarter. Is that correct?
Yes.
Yes.
Secondly, just polish the language. You said you've led the $390 million First and Second Lien package for Alcami. Did you retain all of it with the BDC?
No. But you’ll see more about it in Q3. And we talked about the deals that we closed, I think Mitch mentioned the $900 million something that we closed. What we retained in Alcami is certainly in there. We love the company. We're a big supporter and remain a reasonably sized position, which is very different obviously and make sure on that. We used our own and control the business now or just primarily a lender.
Okay, great. That’s very helpful. Thank you.
You’re welcome.
End of Q&A
At this time, this will conclude today’s question-and-answer session. I’d like to turn the conference back over to Mr. Kipp deVeer for any closing remarks.
I think we're all set, and just appreciate everyone taking the time, all the great questions. Have a great finish to your finish to your summer.
Ladies and gentlemen, this concludes our conference call for today. If you've missed any part of today's call, an archived replay of this conference call will be available approximately one-hour after the end of the call through August 15, 2018 at 5 PM Easter 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 10121377. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital’s web site.
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