Ares: Industry specialisation within direct lending

Dedicating teams and resources to key sectors has multiple benefits for managers, borrowers and investors, say Ares Management’s Mark Affolter, Jana Markowicz, Jim Miller and Kort Schnabel.

This article is sponsored by Ares Management

With market leading capabilities across North America, Europe and Asia-Pacific, Ares Management is one of the world’s largest originators of private credit. Ares’ US direct lending team has nearly 150 investment professionals across six originating offices and oversees $69 billion of assets under management as of 30 June 2021. Private Debt Investor sat down with Ares US direct lending co-heads Jim Miller, Mark Affolter and Kort Schnabel and head of product management and investor relations for US direct lending, Jana Markowicz, to learn why targeting specific key sectors can benefit investors, lenders and borrowers alike.

How do you define industry specialisation at Ares? How has sector expertise evolved at Ares since you began investing in private credit over 17 years ago?

Jim Miller, partner, co-head of US direct lending

Jim Miller: We have been investing in direct lending since 2004 and that experience and track record drove us toward investing more in sectors where we already have had strong performance. While our focus was informal in the beginning, we recognised certain industries provided better private credit investment opportunities, and we organically built industry expertise within our deal teams. In addition, we could leverage our in-house credit research in many of these sectors. Over time, we decided to formalise our industry specialisation with dedicated teams and resources.

Mark Affolter: The industries in which we have chosen to invest have large total addressable markets and are ones where there are opportunities for us to establish strong shares of those markets.

These industries have unique market attributes that require specialisation in order to optimise risk-adjusted returns. Often, these industries operate within unique channels, teams or networks, and they are generally where Ares can bring differentiated industry experience. We also see strong credit attributes in these specialty sectors.

Kort Schnabel: We look for industries that are defensive and non-cyclical and that also benefit from strong industry tailwinds. They typically exhibit high organic growth characteristics and low capital intensity – a nice combination of attributes from an investor perspective.

Kort Schnabel, partner, co-head of US direct lending

Why do you think specialisation is so important in the direct lending space?

MA: First, having a team of specialists means that you can build a strong brand for your organisation within a specific industry vertical. By strengthening our specialisation, we can originate a greater quantity of high-quality investment opportunities and become more selective. At Ares, we believe asset selectivity leads to improved performance.

We believe that having in-house dedicated expertise helps strengthen our private credit business, benefitting from the industry-specific knowledge and relationships. We see this both in specific sectors as well as in the non-sponsored space. Notwithstanding the fact that we have a core market leadership position in sponsored deals, we believe Ares is now one of the leading providers of non-sponsored transactions. Sector expertise is a particularly impactful way to originate in the non-sponsored world and we believe that it is a key competitive advantage as we grow that side of our business.

We have built significant portfolios in each of our areas of industry specialisation, which we believe gives us an incumbency advantage, generating dealflow while also increasing our selectivity rate since we can lend to our best borrowers again and again.

Jana Markowicz, head of product management and investor relations for US direct lending

KS: Another reason why we believe that specialisation creates a competitive advantage is because borrowers want their lenders to understand their business and all the characteristics unique to their sector. We can be better partners, add more value and help borrowers navigate challenging situations because of our depth of experience and knowledge in that sector.

Understanding the industry also allows us to structure our investments with better protections against industry-specific risks that may unfold. For example, we would take into account risks related to the Federal Drug Administration in healthcare, or technology risks in the software space.

Ares identifies specialty healthcare, financial services, software, sports, media and entertainment, and non-sponsored as important sectors within its direct lending strategy. Can you start by telling us a bit more about the opportunities you see in specialty healthcare?

KS: Nearly all lenders now invest in the healthcare space because of its defensive and non-cyclical characteristics and the growth tailwinds associated with an ageing population. However, most competitors focus more narrowly in areas like healthcare services, but we have invested in a dedicated team to develop a much broader and deeper expertise that also includes specialty markets like biotech, pharmaceuticals and medical devices. We believe that those are more difficult for banks and other lenders to understand, and therefore have higher barriers to entry and less competition for lenders like Ares.

Mark Affolter, partner, co-head of US direct lending

We are seeing the biggest opportunities in companies that have developed protected and sustainable revenue streams from existing products but are making substantial investments in R&D for new product growth. This can hamper cashflows and make it difficult for banks and other direct lenders to get their heads around using traditional lending metrics. We are able to use our industry-specific expertise to underwrite these deals, seeking to gain comfort with the downside protection from existing revenue streams and intellectual property, which, we believe, have value for strategic buyers in excess of our loan amounts.

What themes are you currently observing around direct lending in the software space?

KS: Software is a unique space because it is used by all different kinds of end markets, so you need to understand the dynamics of those end markets as well as the software market itself. The benefit of having a dedicated team in this space is that there are many characteristics that lead to software investing success, and over time our team has become adept at identifying themes like licence retention rates, upsell rates, pricing trends and other elements that govern future recurring revenue streams.

The intrigue of software businesses, when they are operating well, is that they are highly integrated into end customers’ workstreams and are therefore typically very difficult to supplant. We look at hundreds of businesses in this area every year against a very specific set of metrics to identify these opportunities. Non-sponsored origination has been a key focus area in software, and we find that these transactions are generally less competitive than private equity-backed deals.

What about financial services? Where are the challenges and opportunities there?

JM: Financial services, like healthcare, is a big subsector where we believe that our industry expertise gives us an advantage. We have a particular interest in insurance brokerage and wealth management, two sectors that have demonstrated solid organic growth and recurring revenues with attractive credit metrics thanks to a growing and ageing population. We also believe those subsectors are less cyclical and outperform in difficult economic cycles. We have developed a real expertise in financial services and have demonstrated strong performance lending to companies in this sector.

What are the benefits for lenders of specialisation in sport, media and entertainment?

JM: We believe that certain subsegments within the sports, media and entertainment area are particularly attractive given the strong end market trends. For example, demand for live unscripted content is increasing along with the desire for media companies to acquire subscribers. We believe that one common theme across these investments is that the covid-19 pandemic has accelerated an existing trend where companies in these markets are increasingly more open to innovative and institutional solutions. We expect this trend will continue.

In addition, we believe investments in this area have high barriers to entry and are not as competitive as other parts of the private credit market. Companies in this area have been historically funded through rigid bank lending and ultra-high-net-worth individuals. We believe that this area is ripe for direct lending and equity investment that delivers creativity and flexibility and presents significant opportunities to deploy capital. We also believe that company performance in this area is uncorrelated to the broader economy.

How has your approach to non-sponsored deals evolved over time, and why does it make sense to have a different focus around that?

MA: This is a channel that complements our core sponsor business, and benefits from some of the same underwriting processes and approaches. It does not have the benefit of a financial sponsor in the underwriting and structuring discussions, which makes negotiations more nuanced. On the other hand, this dynamic may result in favourable relative value compared to the sponsored deals.

When you look at direct lending and the growth of capital in the space, the vast majority is targeting the sponsored business, so we believe that we can find a competitive edge in the non-sponsored space. This is a channel we have been active in since inception and in the last five years we have decided to dedicate a specialist team and resources, allowing us to reap the benefits in origination.

The amount of heavy lifting and due diligence required on non-sponsored transactions demands an investment in infrastructure, and the deal gestation period tends to be longer. For a large platform like Ares that is evaluating so many companies across our verticals all the time, we believe that it underscores the benefits of scale.

JM: The dedicated teams we have for non-sponsored deals liaise with the rest of the platform. We have dedicated pools of capital for our Credit, Private Equity, Real Estate, Secondary Solutions and Strategic Initiatives groups, and these dedicated resources cut across all of those pools of capital in a meaningful way. As Mark mentioned, this further underscores the collective power of the combined Ares platform.

Finally, what is most exciting about Ares industry specialisation?

Jana Markowicz: The key thing is we are increasing dealflow, increasing our market penetration, and as a result, we are more selective and thoughtful in how we deploy capital.

We look to provide access to opportunities that other lenders may not be able to access and believe that this competitive edge enhances our ability to source investments. Ares’ flexible capital approach targets investments at every level of the capital structure and we believe that this further enhances our competitiveness.