A bet that paid off

Ares Management, which is based in Los Angeles but runs much of its credit practice out of New York, has built a substantial credit platform over the past 20 years that makes up by far the largest portion of its business, including the Ares Capital Corporation BDC, the firm’s main US direct lending platform.

“We had come from a bank platform and another bank platform before that and we saw how the markets were consolidating behind the backdrop of bank consolidation.”

Mike Arougheti

“I think when the core of our team started at Ares in 2004, we all challenged one another to say, ‘How big do you think our direct lending or private credit business could be?’” head of Ares Management’s Credit Group and Ares Capital chief executive Kipp deVeer tells PDI. “And our aspirations in 2004 were to build a diversified portfolio of, call it, $5 billion or so in capital.”

The numbers put that aspiration in perspective. Of its $105.6 billion in managed assets, some $70.5 billion was in credit, as of 30 September 2017. Some $1.9 billion of the $5.23 billion raised in the third quarter was split almost evenly between Ares Capital and other US direct lending vehicles, including separately managed accounts.

Ares Capital was one of the earlier mid-market lenders to float when it debuted on NASDAQ in October 2005, and the business development company market as a whole has blossomed since. Since the global financial crisis, over 25 BDCs have gone public. In 2005, though, BDCs were still relatively novel. The industry was “much more fragmented, a bit more of a one-off deal business”, DeVeer says.

Much of Ares’ top credit brass, including chief executive Mike Arougheti, came from Royal Bank of Canada, a prescient move that presaged private credit’s growth and put the firm in a position to take advantage of surging investor interest.

“We had come from a bank platform and another bank platform before that,” Arougheti says, “and we saw how the markets were consolidating behind the backdrop of bank consolidation and changing risk appetite within the banks. We voted with our feet by building the business at Ares.”

In the early days, limited partners weren’t sure what to make of firms like Ares. If the investor had even heard of the private credit asset class, trying to fit it in a portfolio was like putting a square peg into a round hole.

“If there was any awareness of the asset class, they really didn’t know where it should go because the classic structure within institutional investor firms was global equity, traditional fixed income and alternatives,” Arougheti adds.

Today, many LPs have come to grips with private debt and gained a sophistication not there a decade ago, but the newer investors now have even more fund managers and complexity to sort through.

“The new LPs are asking, ‘Should I come into an SMA, a commingled fund, or buy shares in a BDC?’” deVeer says. “Choosing a quality manager with a proven track record is the most important factor, especially as new investors gain experience in the asset class.”

Onward to $12bn

In 2010, Ares Capital made its first large acquisition, closing the $648 million purchase of Allied Capital, the largest BDC deal at the time and which brought Ares Capital its current chief financial officer, Penni Roll. Ares, as a firm, in July 2015 embarked on an even larger merger: the proposed $2.55 billion acquisition of Kayne Anderson, which fell apart in October of that year over diverging opinions on energy investing.

The next year Ares Capital would ultimately close an even larger transaction: its $3.62 billion merger with American Capital. The deal wrapped up in January of last year and was a transaction that came about in large part thanks to agitated activist shareholder Elliot Management.

“When American Capital presented itself, we literally had an M&A playbook that we had developed across the entire Ares Management platform,” Arougheti told PDI last year, referring to Ares’ strategy in acquiring Allied.

With scale also came the ability to lead deal sizes that turned heads – at $9 billion in assets, Ares was already the largest BDC before the American Capital deal.

When Ares Capital led the $1.08 billion unitranche deal in June 2016 for the multibillion-dollar buyout of Qlik, a Bloomberg headline trumpeted: “This $3 billion buyout doesn’t need banks.” When Ares was refinanced out by Goldman Sachs and Morgan Stanley in April 2017, the news outlet proclaimed in another headline: “In hot debt markets, Wall Street shows it can beat shadow banks.”

As is often the case, the reality lies somewhere in the middle. While Qlik cut its borrowing costs with the refinancing, Ares did another 10-figure deal. It backed a $1 billion first lien-second lien deal in the buyout of Ministry Brands, a software programme provider to churches and other faith-based institutions, a firm that’s still in its books.

“The liquid leveraged finance markets drive the need for further liquidity,” Arougheti says. “The opportunity for private capital to come in and displace the smaller end of those markets has been a real growth engine for the development of the asset class.”

Having established itself in the US, the next frontier for Ares was the ‘old world’ of Europe. Mike Dennis, partner and co-head of European credit, recalls that it was 2006-07 when the firm decided to “put its toes in the water” in the region. The initial breakthrough was raising a couple of CLOs, but the firm always had it in mind to bring its direct lending expertise to bear as quickly as possible.

“In 2007, the US direct lending team came to London, and it was very evident to them that it was a bank-dominated landscape that looked very much like the US 10 years earlier,” says Dennis. “There was a lot of conviction around the opportunity set.”

Dennis, who was head of the London-based financial sponsor group at Barclays at the time, was invited to discuss the opportunity with deVeer and Arougheti. “They were absolutely sure the market would evolve, and that the institutionalisation of the asset class would inevitably follow as the banks retrenched and consolidated,” he says.

As a senior executive within a major bank, Dennis says the argument was particularly persuasive to him – because it confirmed what he was seeing happening around him. “The Barclays portfolio was very large, but the appetite for mid-market lending was accelerating, so what Kipp was saying about the future of the European direct lending market really resonated,” he reflects. While the run on Northern Rock and collapse of Lehman Brothers sent shockwaves around the world, the unfolding financial crisis – while deeply troubling for many – was undeniably a game-changer in a positive way for Ares. “What a fantastic time to be bringing an alternative mid-market lending strategy to Europe,” notes Dennis.

Working alongside Dennis in London is fellow partner and co-head of European credit, Blair Jacobson, who joined in 2012 having previously spearheaded StepStone Group’s European operations. He says the global financial crisis “turbo-charged direct lending in Europe. However, the core Ares thesis about providing differentiated and flexible credit to businesses would have been correct even if the crisis hadn’t happened”.

Jacobson says proof of concept has been provided by the fact Ares has, since launching in the region, done deals with around 90 private equity sponsors out of about 150 it has some kind of relationship with. The broader development of the market is evidenced, he suggests, by the regular market surveys conducted by Deloitte, which indicate that around 300 deals a year are now being done in Europe by non-bank lenders.

Having launched in the UK, Europe’s largest private debt market, Ares began to spread its wings onto the continent two to three years later and now has what it describes as “principal and originating offices” in Paris, Frankfurt and Stockholm, as well as “additional offices” in Amsterdam and Luxembourg.

Ares this year has reportedly completed around €1 billion of deals from Frankfurt and €500 million each from Stockholm and in the Benelux region. Jacobson says the continent has “probably” taken longer to warm up than originally thought, but this year marks the first in which the firm has written more European business outside the UK than inside. The firm has also made its first forays into the Spanish market. Aside from geographic reach, Jacobson believes the size and quality of the team is also a key factor. He says that with 40 investment pros in Europe the firm is much bigger than most of its peers. He also thinks recruiting the right people is increasingly difficult, so it’s hard for others to play catch-up with what the likes of Ares already has.

“Talent is a big question mark if banks want to refocus on middle-market lending, because many of the best people have already left the banks,” he says. “That’s a real barrier to entry for them, which favours Ares and our peer set.”

Moreover, hiring the right people is just part of the long-term commitment required to be successful. Jacobson feels that some lack the necessary staying power. “While raising capital in direct lending has become a hot story, it is far from the whole story. You can’t build a successful business around two or three people and a Bloomberg screen. Investors are questioning whether new entrants are sufficiently committed and asking if they will be forced to pull out of the market before launching a second fund.”

Despite there being much background talk about growing levels of competition within private debt, Jacobson says the list of firms competitive to Ares – including the likes of BlueBay, Hayfin and ICG – has remained “quite stable” over the years. “We bump into our core competitors less now than four or five years ago, when there were fewer deals to review,” he says. “Investors often think we must bash heads with the same firms, but the market has grown significantly relative to the amount of capital for investment.”

Smaller and tougher

He also thinks that while “competing at the smaller end of the market is really tough” and Ares has gained the ability to underwrite transaction sizes that few other debt fund managers can match, they continue to see value in underwriting transactions as small as €5 million-€10 million where they can back existing relationships and grow with borrowers over time.

Dennis takes up the point: “For us and others, we couldn’t have hoped to be relevant to the upper mid-market two to three years ago, but the average EBITDA of businesses in which we invest has gone up from €20 million in our first couple of years to €40 million today as our capital base has increased, with Ares’ direct lending strategy in Europe now exceeding more than €10 billion in AUM.”

Jacobson describes current work in progress as “robust” and isn’t too worried about the volatile world events making the headlines. “Of course, we have an eye on geopolitics, and we have adopted a more defensive, first lien bias. As the cycle comes to an eventual end, we need to have selected our businesses carefully, but we think where we are is a pretty good place.”