Ares Capital Corp (NASDAQ:ARCC) The Bank of America Securities 2023 Financial Services Conference February 15, 2023 3:20 PM ET
Company Participants
Robert DeVeer – CEO & Director
Conference Call Participants
Derek Hewett – Bank of America Merrill Lynch
Derek Hewett
Good afternoon, everyone. I’m Derek Hewett from Bank of America. I cover the specialty finance sector here at BofA, including business development companies. With us today is Kipp deVeer, CEO of Ares Capital Corporation. So Kipp, thank you for joining us.
Robert DeVeer
Thanks for having me.
Question-and-Answer Session
Q – Derek Hewett
So Kipp, could you start off by providing a brief history of Ares Capital, plus discuss maybe the investment strategy and competitive advantages of being a part of the Ares platform.
Robert DeVeer
I can do that. So our BDC, where I’m still the CEO here, I guess, 10 years later, we started back in ’04. We’re now about $22 billion of assets under management. The business has evolved a lot as it’s grown. It started years ago focusing on really only private equity oriented transactions. And we’ve grown the origination footprint to be about 170 people today in the U.S. And in doing that, we’ve expanded the geographic reach as well as the type of investing that we’re doing. So we’re playing off, obviously, long-standing relationships in the private equity space. But increasingly, we’ve been building with some of the strengths of the platform. So dedicated industry verticals and a whole host of areas where we think we can source better and we can really create that origination engine that’s differentiated.
So today, we’ve got a team focused on software and services. We have a team focused on health care and life sciences, oil and gas, power and project finance, which includes renewables and the energy transition piece, financial services, et cetera.
And that’s just dedicated to the BDC and the other U.S. direct lending investment vehicles to maybe pull it back to the platform a little bit. Ares manages about $225 billion of credit, which includes the BDC at $22-or-so billion. So we’re very active in leveraged loan space, manage a large CLO business, manage high-yield bonds, both in the U.S. and Europe, along with U.S., European direct lending and a business that we call alternative credit, which is sort of our noncorporate asset-oriented finance business. So all in all, our credit business has 375-or-so investment professionals. And look, I mean, I think that depth and geographic reach between the U.S., Europe and Asia, and all of the competencies that we have developed, I think, makes the BDC very, very advantaged from a competitive positioning perspective.
Derek Hewett
Okay. And then just from an origination perspective, following a record year driven by M&A and low rates in 2021, last year was a little bit more challenging given the wall of worry anywhere from for inflation to rising rates to geopolitical risk, et cetera. Could you comment on your outlook in terms of direct lending originations for the year? And then what would be some of the catalysts or risks to your base case in terms of volumes either being a little bit more positive or being a little bit more [indiscernible].
Robert DeVeer
We just had this discussion out in Denver around our budget meetings with one of my partners, who is the CEO of Ares Management. So we — ’21 was the busiest year in our history from a deployment standpoint in private credit both in the U.S. and Europe. I think that was a bit of the post-COVID hangover, a lot of capital waiting on the sidelines. ’22 was also busy, but, to your point, down a little bit because largely of the, I think, unexpected and quicker and more substantial rise in rates, right? If you think back to the summer of ’22, folks were not predicting that level of interest rate increases or how quickly they came along. The banks obviously found themselves in some not-so-great positions around leverage lending particularly, and that slowed things down. So my forecast for this year is, it should probably be in line with last year. There’s a chance that it’s lighter, I think, just because the risk that everyone is thinking about and dealing with is the markets have been impacted negatively by rising rates.
We haven’t seen company performance be impacted yet by the rising rates. So when rates go up, things are worth less, assets reprice. There’s a whole rediscovery of markets. What multiples do you lend at? What’s the pricing? What is private equity paper company specific to the direct lending business, and that’s happening right now. As a result as well as some of the hangover of the fourth quarter effects, I think everybody is just really trying to ascertain where rates go from here? Have we hit peak rates? There are the folks out there who are scared about a 7% base rate, which I don’t see in the forecast. And as that feeling out period is occurring, it’s just slowed the M&A market down.
I would expect once folks have a better consensus around that, that things will pick back up.
Derek Hewett
Okay. And then given recessionary concerns, although it seems like the recession continues to get pushed back further and further…
Robert DeVeer
If at all.
Derek Hewett
If at all, defaults and more importantly, severity are, to a certain extent, still somewhat topical. Now whether you look at defaults in the liquid credit markets or among the BDCs, they’re still trending near historic lows, although I suspect some of that just had to do with kind of the refi wave that we had in 2021. That being said, what is your outlook for defaults for the sector in 2023? And then…
Robert DeVeer
I think it would go up.
Derek Hewett
Yes. And then in terms of Ares performance or ARCC’s performance, what do you expect on a kind of an absolute and then maybe on an industry relative basis?
Robert DeVeer
I mean the good news for us is, I think, we know how to manage risk, and we also underwrite our portfolios pretty conservatively going into what we think are periods of credit weakness. So I’d say, even going into COVID, we weren’t expecting that, but we were feeling like the credit cycle was getting a bit long. So it’s even as far back as late ’19 and early ’20, we positioned our new underwriting pretty conservatively in terms of types of companies, focusing on larger businesses, certain industries that we wanted to play in or not play in. And that, I think, served us well during that strange period of 2020, which we needed a whole new playbook for, but obviously, I think, managed quite well through.
Today, we have the resources and the time to go in and do early monitoring and start thinking about portfolio companies that maybe aren’t performing to plan. To be honest, we’re seeing pretty good company performance at the BDC. We really described the portfolio in 2 ways in terms of quality for investors, right? So we publish a nonaccrual rate that usually averages around 3.5%, 4% through a credit cycle. Today, we’re at 1.7%, I think, 1.8% maybe, so that’s great news. And then we actually grade the BDC portfolio 1 through 4. So when you’re underwritten, you start as a 3. If you’re on plan, you remain at 3. If you’re outperforming plan, you become a 4. And if you’re at 2, that means you’re probably underperforming plan. If you’re 1, we think you’re probably a credit problem where we have the potential for an impairment on the loan.
We got the question during COVID a lot about how bad will the portfolio get, right? So the way that I describe it to people was we took really active monitoring to rescore the portfolio. 1s and 2s together at the peak of COVID added up to about 20% of the portfolio. I was getting the question all the time, is that number going to go to 50%? And our answer was, no. We think we have it pretty well under control. We know who the problem children are. Our goal was to identify the sick patients and get them less sick over the course of the next 12 to 24 months, and we did that. So from Q2 of ’20 on, we showed a really significant positive credit migration story that’s continued. And those 1s and 2s today, I think it depends if you look at cost or at fair value, it’s around 8% of the portfolio, and it hasn’t changed much in the last few quarters.
So right now, at this point in time, the credit quality in the BDC portfolio is excellent, but we did comment on the earnings call, we’re seeing an increase in amendment activity. It doesn’t give us a huge concern that we can’t handle it, but I think things will get a little bumpier. Companies still have the same operating pressure that they’ve been dealing with.
And with a period of slowing growth and maybe diminished margins because of all the things we read about in the newspaper, along with a higher base rate that’s introducing higher interest servicing costs, you have to expect that you’re going to see more amendment activity and more defaults.
Derek Hewett
Okay. And then well…
Robert DeVeer
It does mean you’re going to see more losses.
Derek Hewett
Okay. Okay. That’s helpful. And then — just looking at Ares portfolio companies that they are unrated, is there an analog to maybe some of the agency ratings in the liquid credit markets? Should the portfolio perform like equivalent to like a B credit?
Robert DeVeer
That’s probably a pretty good estimation, yes. I mean the only thing I’d say is part of the advantage that we have is — there are a couple, but — so our liquid credit business has a couple of constraints. Number one, it’s a benchmark investor. But it’s forced to invest in industries where it may not view them as particularly attractive. So if you’re managing a high-yield portfolio, you’re forced to have a pretty significant oil and gas portfolio, which is wildly cyclical because it’s part of the benchmark, and you need to — you can be slightly underweight or slightly overweight, but it can’t be in 0. So that’s actually a disadvantage. A disadvantage for liquid credit also is that you get very limited information. You tend to see a lot of surprises. You don’t have good lines into management. You didn’t have nearly as much information making a new investment.
Supposedly what you have to mitigate all that is daily liquidity. So if you manage that well, you have the ability to get in and out of positions. Our business works a little bit differently because we’re coming in, knowing that we’re underwriting for the long haul, that we’re taking the liquidity with companies, but what we get in exchange is all of the stuff you don’t get [indiscernible] market. So we get great access to information. We get great access to management. We get importance of relationship with the company on an ongoing basis. So we don’t get surprised a lot in our portfolio management process. It’s all for us about early mitigation, working with management teams and owners of companies to identify problems early and to fix things, to create solutions before you get defaults and certainly before you get losses.
So just the whole process of what we do from beginning to end, inherently, I think, at least for us, has led to materially better credit outcomes, i.e., fewer losses on these portfolios than we’ve seen from competitors, but also in liquid credit portfolios. So we’ve been able to achieve premium returns with fewer losses.
Derek Hewett
Yes. Okay. And then I guess, speaking of losses, kind of historically, you’ve had kind of a net cumulative negative realized credit loss. I think it’s like a 1% gain in the actual portfolio. So how has that been achieved? And then, more importantly, kind of what would be a more normalized loss rate on the ARCC portfolio going forward?
Robert DeVeer
So I mean we have 1 year of net charge-offs, right, which was not surprisingly, ’09, I think it was 1.2% or something on a net realized basis. The way you — there are not very many BDCs that actually understand how to pay a reliable dividends and also can build NAV, right? So the way that you do that is you actually consistently manage your dividend so that you’re out-earning your dividend, we’ve done for a very long period of time. That allows you to build modest amounts of retained earnings because we only need to pay out 90% of our income to preserve RIC status. You can make equity investments. Some BDCs don’t like to do that, or aren’t good at it. We like to do that, and we think we’re pretty good at it. You can buy companies, portfolios or assets at discounts to par and then obviously realize the loans. So as you know, and others, too, we bought 2 companies at pretty significant discounts to book value, Allied Capital in 2010 and American Capital in 2017. So we have gains from those.
We have gains some portfolios we bought. We have gains from single assets that we bought as well and then obviously minimize losses. And the way you minimize losses, in our opinion, is not to run away from bad situations, but it’s to actually put really active portfolio management against troubled situations and fix them if we have to. So we don’t like to own companies, but we will. And if we need to own them for 5 years and replace management and reposition the business so that we can achieve a good recovery, we’ll do that. But it takes a lot of people to do that.
Derek Hewett
Okay. And then circling back to the portfolio companies, base rates are up over, let’s say, 450 basis points in the last 12, 15 months. Are you seeing any signs of stress in your portfolio companies? I mean, on the fourth quarter earnings conference call, it looked like EBITDA was continuing to see growth, debt service coverage was still strong relative to the increase in rates.
Robert DeVeer
Yes. I mean the interest coverage ratio across the portfolio, we said is 1.8x. I’d say the phenomenon that you’re seeing is actually good underlying fundamental company performance burdened by substantial amounts of debt that have been put on these companies with much higher base rates to deal with. So it’s the first time in a while where we’ve actually seen companies that are doing well, that aren’t having problems as a company, but probably have the wrong capital structure with a 5% base rate.
So I described this in other settings. I think ’23 will be a little bit of a muddle through sort of year with lenders, equity owners and management teams all just sort of figuring out how to solve for that. And that’s rare, right? You usually have that interaction between lenders, equity and management when a company is not doing well. And I think we’re having more of those interactions with companies while they’re actually doing fine, they just have too much debt with materially higher base rates. And for me, that’s kind of an equity problem, right?
As the lender were supposed to go to management, I think, and to the owners of those companies and say, probably not a sustainable capital structure for you for the next 3 years, what should we do about that. And we can make some modifications. We can try to be part of the solution along the way, but that’s not a solution solely for us.
Derek Hewett
Okay. And then just in general, are any of your portfolio companies kind of benefiting from rate caps? Or is that just not a part of the business?
Robert DeVeer
Not really, no.
Derek Hewett
Okay.
Robert DeVeer
And probably not enough hedging versus historical advantage or maybe what they could have accomplished and now it’s gotten to be prohibitively expensive. Yes.
Derek Hewett
Yes. Okay. And then what about in terms of new entrants, — you’re seeing a lot of fundraising, both on the private and public BDCs have entered the space, seeing a lot of capital raising on the private side. Given…
Robert DeVeer
There was.
Derek Hewett
Well see, yes. What is the kind of the competitive environment, given just…
Robert DeVeer
To be honest, it’s actually, — we haven’t really seen any new entrants I think what we’ve seen — the only new entrant in our market over the last 10 years has been — well, maybe 3, KKR taking on all the assets from Blackstone and focusing on direct lending. Blackstone rebuilding their business with a different source of capital, but the only true new entrant is our Owl Rock, right? And It’s a truly new platform Blue Owl.
I think right now, what we’re seeing is increased reliance on private credit and direct lending to get anything done because the banks are not active and the syndicated loan markets are still not working. So that’s great for us. We’re seeing more and more capital wanting to come to us when we always say we consolidate market share during downturns during periods of bank weakness.
The other thing I would say is, the folks at the top of the heap are probably benefiting the most because they bring the most valuable solutions to the market. i.e., they’re the most flexible with their capital, they can write the largest checks, they’re the most experienced in terms of structuring. So I think we’re benefiting as are a handful of our other large alternative credit players, whether they’re public like Apollo and KKR, or not public like an HPS or Sixth Street. I think we’re all — I think that tide is lifting all boats and areas included right now.
Derek Hewett
Okay. And then just given higher rates, could you talk about kind of spreads on new investments that you’re seeing since competition is not as fierce as…
Robert DeVeer
Yes. I mean, to be honest, I mean, the markets reset to be what we kind of look at historically is wildly attractive. I mean, a new LBO is a 5x levered, unitranche at LIBOR plus 700. So I mean you’re talking about 12-ish percent with ease to make senior loans in what we think are great companies with very low LTV. So I’m excited about that. That being said, I don’t think that, that generates a ton of activity unless purchase prices come down. So that’s a fair amount of interest expense to have to pay until you stop working. Somebody said to me, it’s great except you can’t finance the American economy at 9%, right? So something is going to have to shift a little bit.
Derek Hewett
Okay. And just given the attractive spreads that you’re seeing in unitranche, the portfolio — ARCC portfolio is 18%. Second lien, Should we see a migration from second lien to unitranche just given the…
Robert DeVeer
We get asked that question a lot. I mean we kind of like the mix of the portfolio. It typically is SDLP, Ivy Hill, we have some components that are different than others. I think about the portfolio usually as being 60% or 70% senior, 30% junior and 10% equity. It’s just kind of what it’s always been for 20 years, and we’ll move that around a little bit. I think that the — the large unitranche business because the lack of syndicated financing out there is a very attractive place to play right now. So…
Derek Hewett
Okay. So then presumably, we would see more growth in the SDLP just given the attractive…
Robert DeVeer
More growth just in stretch senior lending, in either — so SDLP, for instance, and just on balance sheet unitranches for sure. I mean, that’s where we’re most active today. Again, it’s not super busy, yes.
Derek Hewett
Okay. And then just what about the growth in Ivy Hill, the last year or so. It’s doubled in size? you think it’s at the ideal size right now or…
Robert DeVeer
It’s about as large as we want it to be right now. So we are taking advantage of good financing there, good investing — it’s been an unbelievably successful investment for us. We made the initial formation of Ivy Hill 15 years ago, and we’ve generated a literally 15% return on our capital with increasing dollar amounts for 15 years. So sometimes you want to keep backing your winners. I’m a little bit tired of answering questions around, isn’t 10% of the portfolio high? And the answer to that is, yes, kind of is a little bit high, probably, and it’s about as large as we want to get for the time being.
Derek Hewett
Okay. And then what about fees. Fees have, over the last decade or so, have migrated lower either due to new entrants. BDC is coming into the sector…
Robert DeVeer
Deal fees or management fees?
Derek Hewett
Management fees. And one competitor basically cut the base management being half, although I would suspect part of that had to do with just that was more performance related more than anything else. So what is your…
Robert DeVeer
I didn’t even.
Derek Hewett
Apollo. Yes.
Robert DeVeer
Okay. Probably just from historic, not so great performance, yes.
Derek Hewett
So what do you think in terms of kind of the longer-term trajectory for just BCPs in general? do you…
Robert DeVeer
I think, to be honest, I don’t have a strong view. We don’t talk about our fees a whole lot with our investors. We talk about our fees every year as part of our process with our Board because we obviously have an external management agreement with Ares Management Corporation. But, look, my two cents on fees are because we negotiate fees in everything that we do as an asset manager, investors pay for good performance. I mean if your performance stinks, people look for lower management fees or they fire you. And if your performance is good, they tend not to complain that much about fees. It’s pretty consistent BDC or not BDC.
Derek Hewett
Okay. And then could you talk a little bit about underwriting just given it’s new originations are extremely attractive right now. Are you seeing any sort of pushback from portfolio companies in terms of covenants, EBITDA add-backs…
Robert DeVeer
Today, it’s about as lender-friendly as it can be for — particularly for [indiscernible] — the nonsponsor piece of it is always friendlier than the sponsored piece. I think sponsors that really want to get something done are understanding of the fact that it’s just not a borrower’s market today, right? It’s a much harder market for capital. So we’ve driven leverage ratios down, we have a laundry list of things that we’ve pulled out of loan documents.
And frankly, when they make their way in, we’ve actually passed on a couple of things that got done in the third and fourth quarter because of documents alone. It’s one of the benefits just of having such a big origination team and seeing so much deal flow as we can actually say no to more things than most people can’t because we know there’s a lot of deal flow coming behind it. But it’s quite lender-friendly today in terms of our ability to drive the outcomes that we want on the noneconomic side on the dock side.
Derek Hewett
Okay. And then could you talk a little bit about the significant growth in average EBITDA that we’ve seen in the portfolio from like pre-COVID to today? I think today, it’s nearly 100 — or $280 million versus pre-COVID it was $139 million…
Robert DeVeer
So someone asked me this earlier today and actually a caller reminded me. So that’s just a fourth quarter number. There are 2 numbers to look at because one is math-driven. So there’s no doubt we’ve been focusing on larger and larger companies, and I’ll come back to that. But the 2 numbers that we like or what’s your weighted average, that obviously gets skewed up by math, right? So if you’re involved with a bigger company, you tend to write a bigger check so the number goes up.
But we also remind people of the median EBITDA number, which I think is still below $100 million of EBITDA, I’ve lost track exactly where we are, but we want to make sure that we have people understand that we’re not deemphasizing doing smaller deals, right? It’s simply that the fairway for what we can do is broader for 2 reasons. Number one, we have more capital; and number two, our competition at the upper end of the middle market is severely disabled today, which is the syndicated loan and high-yield markets. So does that reverse? Not sure.
I mean I think the dynamic of syndicated lending and of high yield is the banks want to keep doing bigger deals, focus on larger borrowers, focus on larger sponsors and the buyers of those syndicated deals want them as big as possible because, back to my point about liquid credit markets, they value the aftermarket liquidity. Larger deal is, the more liquidity you have, the smaller deal is, the less liquidity you have. So I was saying in a meeting earlier, it used to be a lot of $100 million, $200 million high-yield deals. Those don’t exist anymore, right? Like the benchmark for a high-yield deal these days is $500 million. No [indiscernible]. PIMCO, BlackRock, et cetera, like don’t want to play in a $200 million high-yield [indiscernible]. So just that market continues to grow for private credit and continues to move away from the syndicated markets, whether it’s loans or high yield.
Derek Hewett
Okay. And then what do you think is some of the biggest risks for BDCs in the market today?
Robert DeVeer
So I really like describing BDCs as an industry, but I guess we have to hear since we’re at the Bank of America Financial Services Conference. And the problem is, it’s sort of — it’s sort of like saying every REIT is the same as well, which they’re not, right? Because people engage in really different business strategies, and I can’t compare a $22 billion BDC on top of $100 billion of direct lending capital with the BDC that has 12 origination people and 35 investments, right? So my quick answer is, I don’t see any massive risk in BDCs as a whole, right? BDCs actually benefited from regulatory relief 5 years ago where that cap was raised to . That gave us a lot more flexibility. It gave us what I always thought of as regulatory relief, but the one worst thing that could always happen in the BDC industry was you ran at , and all of a sudden, you saw fair value changes, and you blew your RIC test and you can’t pay a dividend anymore. Like that’s bad. That’s the [indiscernible] of horrible.
So that’s been taken off the table. Having lived through running this company with Mike through the financial crisis, the other really bad thing was financing 3- to 4-year liquid assets with 1 year secured facilities. Luckily, none of us have to do that anymore because all of these debt markets have opened, and we’ve diversified our financing sources and extended the duration of the liabilities. So the financing risk piece of it is sort of off the table. And I don’t see any changes in the regulatory environment that would be negative. But what I think you will see, again, saying that not every BDC is the same because I think you’re going to see significant dispersion in credit performance based on quality of team, quality of platform, experience with underwriting and risk management and all of that.
So we think we’re on the right side of all of those trades being large, being diversified, having a significant team and having an experience, having lived through some of the more challenging markets running this company.
Derek Hewett
Okay. And then just kind of speaking of liquidity risk, what is your — what are your thoughts on kind of longer term in terms of your funding mix? Although you don’t have any near-term debt maturities, or material near-term debt maturities, what is your — what is the policy in terms of unsecured versus secured funding for ARCC?
Robert DeVeer
Depends on what it costs, right? Today, our secured borrowing is based on just where the yield — we borrow at over so far, so call it 6-something percent. The unsecured bonds that we’ve issued, I think we’ve been a pretty thoughtful and quality issuer. We’ve done some bonds at, as you know, 2.5%, to 7%, 8% back when the markets allowed for that. Our bonds probably trade to a 6.5% to 7% yield today. So would I rather borrow unsecured at 7% or secured at 7%, I’d rather borrow unsecured at 7%, but that’s going to keep moving around when those markets open and close.
Historically, to keep the answer simple, we’ve been a roughly 50% mix of secured and unsecured. And just as a reminder, our secured financing tends to go up and down with investment activity, right? So if we make a new investment, we typically don’t have cash. We’ll just draw on our secured facility, make that investment. If we get a repayment, we’ll pay the secured facilities down. So those are sort of coming up and down. The unsecured issuance allows us to typically get more term at a favorable price. So there’s a good mix of both. But a good guideline for us is a 50-50 mix.
Derek Hewett
Okay. And then just given the rise in rates, do you think you’ll see, just from an industry’s perspective, more convert issuance or…
Robert DeVeer
I don’t know. The biggest issue for us with that market is it’s a pretty limited in depth. It’s just not a deep market for BDCs. And when you talk about our company, which has $10-plus billion of financing, we can do a $300 million convert deal. Is that useful? Maybe at the margin, but it’s not going to be a huge driver, I think, of what we do from a financing perspective.
Derek Hewett
Okay. And then just given the scale of the platform, although there are a lot of kind of subscale BDCs, does M&A, is that an interest to you? I mean you did 2 big deals previously. But…
Robert DeVeer
You know what, it usually takes something substantial to create that, right? Allied Capital actually trip their tests , and I would say, their bondholders fired them. That’s how we got involved with our company going into work with bondholders to buy assets from them to deleverage, so they could get back in RIC compliance. With ACAS, since it’s a long time ago now, I’ll say this, but it took substantial mismanagement for a long period of time to trigger a very significant activist campaign from some people who were not going to have the company not getting sold.
So look, if performance is really bad from certain smaller BDCs is where I would likely guess there might be opportunity, maybe, but it takes a while to get, at the end of the day, an entrepreneur or an owner operator who has a valuable external management contract to give it up. Something really bad has to happen. So we’ll see. No whispers of that yet.
Derek Hewett
Okay.
Robert DeVeer
And as I always joke around, I really doubt Blackstone or KKR are going to be selling me their BDC contracts anytime soon. So…
Derek Hewett
Okay. That’s all my questions. Maybe I’ll open it up for Q&A.
Unidentified Analyst
So, Kipp, a couple of years ago, portfolio yields unlevered were up 8%?
Robert DeVeer
Yes.
Unidentified Analyst
And so now they’re about 4% higher roughly?
Robert DeVeer
On a new deal, but if you look at the BDC, it hasn’t caught up that quickly. I think our stated yield on the portfolio is like 9.5% or 10%.
Unidentified Analyst
Even though it’s floating because there’s [indiscernible], right?
Robert DeVeer
Yes. Okay. And some of it doesn’t catch up all to current market today. So if you underwrote but you’re moving in the right direction.
Unidentified Analyst
Okay. And then you said interest coverage now lend is .
Robert DeVeer
Yes.
Unidentified Analyst
But how much — and you might think about this a different way, is close to , like on the low end. like is there significant between 1 and ?
Robert DeVeer
Significant enough to pay attention.
Unidentified Analyst
Okay.
Robert DeVeer
And the other question I get is what goes into that? We get what percentage is below 1, right? Everybody thinks that’s an immediate default, which is not because there are lots of other ways to cure that. And then the other question is what happens if rates go up 100 basis points, how much more goes into that bucket? So we haven’t quite gone there completely with people on that explicitly. We tried to be directional on the response. I would just say that the portfolio doesn’t have substantial from my perspective, weakness with another 50 to 100 basis points of rates, but I think with 150 to 200 basis points of rates, the percentage of the portfolio that you start to create cash flow problems in as it gets large.
Unidentified Analyst
And Kipp, you have lots of options, like you can take equity, you can extend duration like in those situations.
Robert DeVeer
Yes.
Unidentified Analyst
But you also have like a best-in-class private equity firm. So that manages equity. So how does that get involved with the BDC? And how often do you ever have to take the keys to the company?
Robert DeVeer
So when we do work out today at ARCC, we don’t get our private equity team involved. This is a simple answer. So we’ve got enough experience, frankly, at the senior level and on our workout team that we can do it ourselves. The benefit of having the private equity business, though, helps us do that, right? So it helps us source management teams. It helps us build boards. It helps us obviously have, if we have to go take the keys on a consumer products company. Private equity business owns a handful of consumer businesses, we can take the expertise there, but we don’t use that team — we don’t parachute in the private equity team to manage BDC investments just to keep it simple, but there’s a benefit to having all of this other stuff going on at Ares.
How often do we take the keys? I mean, look more often than we would like. I mean, when you’re in the sponsor finance business, you have to get the dialogue with private equity clients right, which is, we’re a lender, you own the company, right? Our goal is that you always own the company and that things go perfectly from start to finish, but we all know sometimes they don’t. And the way that you create your reputation for being a reasonable and difficult situations, but also keep that origination going is to realize that each portfolio interaction is not a onetime interaction, right?
So if we’ve done 15 deals with Blackstone or KKR’s private equity business, which we probably have, they understand our approach, which is, the last thing we want to do from a time resource, what our business is, is own your company. But if we have to, we will, right? I don’t have a good number, Craig, for how often. I mean we have 400 portfolio companies at the BDC rough numbers. Today, we probably have 10 to 15 lender-owned portfolio companies, something like that. Hopefully, that’s helpful. It goes up and down over time, but, yes.
Unidentified Analyst
How does it work when the PE is Ares itself?
Robert DeVeer
When there — I’m sorry?
Derek Hewett
So when the equity ownership is also with the Ares group and the debt is at the BDC level, but the equity is also owned at that Ares group somewhere, correct? So or you don’t have that scenario?
Robert DeVeer
so I mean the — so we — the equity investments that BDC makes tend to be equity co-investments alongside loans that we make.
Unidentified Analyst
No, no, not at the BDC level, but outside the BDC, within the Ares group, somewhere else, you have a PE business, correct?
Robert DeVeer
We don’t. Our debt business doesn’t finance our private equity business.
Unidentified Analyst
Okay. So the BDC does not have any portfolio company, which is owned by Ares?
Robert DeVeer
None. We prohibit it.
Derek Hewett
Any other questions? Okay. Thank you. It looks like we’re out of time. Thank you, Kipp. Appreciate it.
Robert DeVeer
Thanks.
Be the first to comment