Critical mass

Mike Arougheti and Kipp deVeer, co-heads of Ares Management’s direct lending business, made a bold move in early 2007, approaching Mike Dennis and Eric Vimont, who ran Barclay’s mid-market leveraged finance business in London, about establishing a European presence for Ares. The credit crunch and wider global financial crisis hadn’t hit, but Arougheti was already certain that lending in Europe would evolve as in the US, with banks reducing lending and losing market share.

“Europe was bank-dominated at the time and their thesis was that, over time and through successive credit cycles, there would be an opportunity for institutions to build large, scaled direct lending businesses,” says Dennis, who agreed and came on board. He is now a managing director at Ares Management and the co-head of Ares Capital Europe.

“The people that they wanted to establish and run that kind of business were middle-market financiers, which Eric and I had been for over 10 years prior. So in early 2007, we jumped at the chance to leave Barclays and set up the direct lending business at Ares in Europe,” he adds.

They agreed with deVeer and Arougheti on which way the wind was blowing, seeing signs at Barclays. “I think prior to the credit crunch which started in earnest in July/August, 2007, there was certainly a feeling within Barclays that the leveraged finance book had gotten quite large in relation to the overall corporate book and we were starting to see signs of a very frothy market and some hesitation from Barclays to continue expanding leveraged finance,” Dennis says. While they were on gardening leave that year, news of structured credit losses at Bear Stearns surfaced, confirming for them both the move and the timing.

FAMILIAR FACES

Arougheti and deVeer have known each other since they were both at Yale. The pair, along with Mitch Goldstein and Mike Smith, senior partners in the direct lending group in New York, have worked together for about 18 years, first at Indosuez Capital and later at RBC.

Blair Jacobson, a partner in the direct lending group in Europe who came over in 2012 from private equity consulting firm StepStone Group, has also known Arougheti for a long time. One of their first jobs out of college was at Kidder Peabody, a securities firm acquired by GE in 1986.

Arougheti was one of the original founding members of Ares Management, along with David Kaplan, John Kissick, Antony Ressler and Bennett Rosenthal. The firm started its first private equity fund in 2003 and its first direct lending fund in 2004. Today, in addition to direct lending, Ares has private equity, tradable credit and real estate interests. Of the four, tradable credit is the largest at $33 billion, while Ares’ direct lending group handles about $28 billion in assets. Taken as a whole, Ares Management oversees $80 billion.

SCALING HEIGHTS

The move to Europe is just one example of a series of timely and shrewd expansion moves and acquisitions that Ares has made to facilitate growth. When the firm decides to conquer a new market, its strategy is to put weight behind the push and establish a strong presence. They don’t dabble.

The European business now has €4 billion invested across the continent. Arougheti, who is also the president of Ares Management and a senior partner of the direct lending business, thinks strategically about these initiatives. He says he’s frequently scouting for acquisitions, team lift-outs or office additions, to find lucrative and warranted expansion opportunities.

When it comes to opening up in a new region, he demands boots on the ground.

For acquisitions, he has a methodical approach to what the firm is acquiring and how to strip out the best assets to create more value for Ares. “In direct lending, you have to think about acquisitions in one of several ways: is it an acquisition of people, an acquisition of assets, or an acquisition of people with some assets? Or is it a whole company?,” says Arougheti.

PUBLIC MATTERS
  

For Ares, size matters, and the firm opted to publicly list because reputation and scale are important, according to Arougheti.

“We’re a very large and growing asset manager and there are still pockets in the investment universe that don’t really have a broad relationship with us. Being public has elevated the visibility of our brand and we’re already seeing that translate into capital raising and the ability to forge broader and deeper relationships with more investors, which ultimately is the lifeblood of the business,” he says.

Ares Management went public this spring while its business development company, Ares Capital Corporation (ARCC), has been publicly traded since 2004.

The extra capital and name recognition also puts the firm in a better position for acquisitions, Arougheti notes, adding that he wants the firm to grow and benefit from the anticipated consolidation across the industry.

LISTING LIFT

Energy Investors Funds, the $4 billion private equity power manager that Ares agreed to buy in October, is a good example of a deal the firm’s public listing helps enable, Arougheti contends, citing the real and perceived stability and capital that a stock exchange listing brings. “The number of opportunities that we are seeing to make acquisitions that are accretive and strategically relevant to us has increased dramatically since we went public,” he says.

ARCC, the firm’s listed BDC, manages about $10.2 billion making it the largest public BDC (GSO’s BDC partnership with Franklin Square Capital Management, runs about $13 billion but that’s across listed and unlisted vehicles). Of the older, prominent BDCs it is also, in terms of share price, one of the most successful. ARCC’s share price is one of the few that has actually risen since experiencing a dip in 2009 following the financial crisis.

Part of the reason for the valuation boost was its acquisition of Allied Capital in 2010. Allied ran one of the oldest BDCs in the country, but by 2009 the portfolio and performance had been pummelled by the financial crisis, poor investment decisions and a public spat with David Einhorn, the founder of activist hedge fund Greenlight Capital.

Einhorn shorted Allied Capital’s stock in the early to mid-2000s publicising his strategy and criticisms of the firm and encouraging other investors to do the same. He wrote a book and took on public speaking engagements to air his complaints about how Allied valued of its illiquid securities and accusing the firm of inflating those valuations.

Ares bought the firm’s portfolio and cherry picked through the rubble. “If you look at Allied, they did a lot of things wrong just from a management perspective. They financed themselves poorly. When we acquired them, we were able to do things with their portfolio that they couldn’t do, like bring new capital in where it was needed,” Arougheti says.

Most of the Allied team was not brought over to Ares.

“They were distressed, but they actually had a pretty good core of companies in which they couldn’t unlock the value because they didn’t have enough capital, or the right capabilities,” Arougheti says.

ASSET VALUE

Arougheti finds reaching a decent size is important when establishing the firm in new territories. Though he is also careful, Allied was a cheap buy.

More recently, Ares looked at Hayfin Capital Management in Europe but later decided to drop out of the auction (it is now reportedly going to Guggenheim Partners). Ares opted out of the race because Hayfin and other assets are expensive at the moment, says deVeer.

“We’re a value oriented firm. So going out and paying multiples of book value doesn’t make sense,” deVeer says.

“We think a lot about value and our ability to build teams and originate assets at book. It makes you reconsider paying 1.5 or 2 times book value for assets. Acquisitions for us are much easier during volatile markets than they are during times like these, but I’m sure they’ll come back, which will be a great opportunity,” he adds.

Ares also brought on board an asset-backed lending team from Keltic Financial Services to build out its new Ares Commercial Finance business in June and Arougheti says he’s always looking for acquisitions and talking to teams to see where else the firm can expand.

EUROPE GROWS UP

After founding the European unit towards the end of 2007, Ares began investing in earnest in 2008. Unlike many of its competitors, who went to the area to wait for banks to start shedding loan portfolios, Ares went straight into lending directly to private companies and working with private equity sponsors.

But in bank-dominated Europe, the trick is to convince borrowers to take non-bank money.

Arougheti describes how Ares aims to be more creative in structuring, more flexible and more closely aligned with borrowers in terms of their own behaviour through the cycle.

“We want to fund growth and when the markets turn, we don’t want to put companies into work-out and get 20 cents on the dollar,” he explains. “If you look at the banks in the downturn, you have a lot of behaviour like that. That’s when the switch flipped, the banks froze, they were paralyzed, they didn’t know how to restructure companies and there was a lot of value destruction because of that.”

The firm has so far raised two European funds, Ares Capital Europe and Ares Capital Europe II, which closed in 2009 and 2013. ACE I raised €440 million and ACE II raised €1.1 billion. Some of the money from the Ares Capital funds went to the European Senior Secured Loan Program (ESSLP), a partnership with GE Capital to invest in mid-market companies, mirroring its US Senior Secured Loan Program. The European was established just over a year ago has invested €1 billion so far.

The firm also got a nod from the UK Treasury. The government set up Business Finance Partnership to invest £1.2 billion in lending to small and mid-size business via alternative lenders. The government lending was designed to be matched by equal amounts from private sector managers. It selected six firms, including Ares, to manage this pool.

Dennis and Vimont say they continue to staff up and hire people in Europe but the market differences with the US remain. deVeer says it will remain distinct from the more consolidated US model. “Banks in France want to be French banks and lend to French companies. There are some other nuances there that don’t exist in the US,” deVeer explains.

Arougheti and deVeer say that lending in Europe is at a 20/80 percent split between alternative lenders and banks and that market share division will reach a 50/50 split in the next several years.

ALL-ROUNDERS

Ares’ approach to what it demands from the talent is interesting. Geographical expertise is essential but otherwise roles are not placed in silos.

The firm has offices across Europe and one of Dennis and Vimont’s first tasks was to quickly ramp up the firm’s presence on the continent by opening additional offices in Paris, Frankfurt and Stockholm, which were all staffed with local mid-market financiers. “They were people with a long track record of providing finance to middle market borrowers, had deep networks and were very well respected in their chosen markets,” Dennis notes.

This established the firm in Europe early and gave it a wider reach than many US lenders who settle on covering the whole continent from London.

The firm’s investment professionals are not assigned to specific industries, nor are they separated by function. Deals are sourced locally and the person that originated the deal, will also underwrite the risk and close the transaction. DeVeer and Arougheti argue it gives people more accountability, attachment and ownership over facilities, and helps them learn from mistakes.

“At a lot of finance companies and private lenders, you’ll find people have originators, underwriters and portfolio managers. I think we’re one of the few holdouts in the space in that don’t do it that way and we never will,” deVeer says.

At Ares, everybody does everything. “You originate a deal, you underwrite it, you close it, and you remain with that company the entire way. It teaches a principal orientation to the business that doesn’t exist otherwise,” deVeer explains.

The firm’s clients and competitors often credit Ares for having one of the deepest and largest origination teams in direct lending and a very low default rate. DeVeer says their default rate is around 20 to 30 basis points.

Some of the firm’s private debt competitors even invest in ARCC’s BDC. “Mike [Arougheti] and Kipp are the real deal,” says one shareholder, “they don’t do the stupid deals.”

EYEING ASIA

Ares sets out to achieve a decent size when it opens a new platform or expands to a new region. Part of maintaining scale is continuing to grow and the management team already have some destinations in mind. They are looking east.

For Arougheti areas like China and India will be attractive for lending opportunities in a few years, as well as parts of Latin and South America, but there remain a lot of issues in those regions. “The ingredients you need to have these markets form are a functioning bank market, with a developing capital markets around it. You need a real rule of law,” Arougheti says. He expects Ares to make an entrance into one of these markets in five years or less.

Blair Jacobson in London, says that given the location of Ares’ four offices in Europe, the firm has tended to focus on the continent’s northwest, but it continues to evaluate Spain and Italy, as well as Central and Eastern Europe for investment opportunities. Those might not be quite ready yet for lending expansion, but when and if they are, Ares would open offices in those regions and staff them with local experts as well.

“What really drives our business is sourcing. If we’re going to make an investment in any of those other jurisdictions, how does it stack up in terms of what we’re seeing in our core geographies as far as risk, return, the legal system, the sovereign risk, etc.? I’d say, when we weigh all of those parameters, it makes us very cautious in those areas so far. We’re finding lots of great risk-adjusted returns in our backyard,” says Jacobson.

HOME AND AWAY

The four senior lending executives in the Big Apple have deep connections there. All four are originally from New York or New Jersey and still live in the tri-state area. The lender’s leadership are deeply connected to their base, and that connectedness has led them to make firmly local expertise and expansion key to their business.

Travelling the world to recruit new local lending experts, Ares has shown that private firms can and will play an increasing role in lending across the world and they’re committed to staying at the top.

Arougheti rounds off the market trajectory succinctly: “Before it was this unique cottage opportunity where people were trying to nibble around the edges, but now it has become an investible asset class.”