Ares Capital Corporation (ARCC) Q2 2020 Earnings Report, Transcript and Summary

Good morning. Welcome to Ares Capital Corporation's June 30, 2020 Earnings Conference Call. [Operator Instructions]. As a reminder this conference is being recorded on Tuesday, August 4, 2020. I will now turn the call over to Mr. John Stilmar, Managing Director of Investor Relations.

Thank you very much. Let me start with some important reminders. Comments made during the course of this conference call and webcast as well as the accompanying documents contain forward-looking statements and are subject to risks and uncertainties, including the impact of COVID-19, the related changes in base rates and significant market volatility on our businesses and our portfolio companies. 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 financial measures as defined by SEC Regulation G, such as core earnings per share, or core EPS. The company believes that core EPS provides useful information to investors regarding financial performance because it is one method the company uses to measure its financial and results of operations. A reconciliation of core EPS to the net per share increase or decrease in stockholders' equity resulting from operations, 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 release 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, 2020, earnings presentation can be found on the company's website at www.arescapitalcorp.com by clicking on the Q2-'20 Earnings Presentation link on the homepage of the Investor Resources section of the website. 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 Kipp DeVeer, Ares Capital Corporation's Chief Executive Officer.

Thanks, John. Hello to everyone, and thank you for joining us. I'm joined on the line by our Co Presidents, Michael Smith and Mitch Goldstein; our Chief Financial Officer, Penni Roll; and several other members of the management team. I will start by highlighting our second quarter results and then provide some thoughts on the company's position. This morning, we reported second quarter core earnings of $0.39 per share, which we believe is another strong result in light of the difficult economic conditions during this public health crisis. Our GAAP EPS of $0.65 rebounded this quarter and was supported by net gains in our investment portfolio. Our net asset value per share climbed to $15.83, a $0.25 per share increase, reflecting 2% growth from March 31. We also deleveraged our balance sheet, and we meaningfully enhanced our available liquidity to more than $4.2 billion as of quarter end, pro forma for a successful July notes offering. The second quarter gave us more visibility into the economic disruption caused by COVID-19. And with this, we've had more time to evaluate the health of our portfolio and understand how the duration of the economic recovery may affect our investments under a variety of potential scenarios. Overall, we are feeling more confident in the financial and liquidity position of our portfolio companies, despite the second quarter being a more difficult quarter for some of them. And I say all of this while acknowledging that this pandemic is creating a kind of uncertainty that we've never witnessed before. The good news is that our portfolio is highly diversified with the average investment representing just 0.3% of the total portfolio and remains weighted towards defensive sectors such as health care, software and business services. We're fortunate to be meaningfully underweight, many of the most impacted sectors like travel, entertainment, restaurants, retail, and oil and gas. And this was by design as we were more cautious in the new deal market over the last few years. We believe the portfolio remains a solid collection of defensive, upper middle market companies, which we believe have significant franchise value over the long haul. The weighted average EBITDA of our portfolio companies is over $140 million, and the weighted average enterprise value remains over $1 billion. Our weighted average loan-to-value for our portfolio is approximately 50% to 55%, which provides a significant capital cushion for our loan positions when we take a long-range view. These upper middle market businesses are very different from lower middle market businesses in terms of resiliency, access to capital and depth of management. The recent cross cower default study on the middle market corroborated this belief, illustrating the defaults amongst middle market companies above $50 million in EBITDA were 40% lower than those with less than $25 million in EBITDA. We're seeing this trend of larger company outperformance play out in our portfolio as well where borrowers EBITDA of $100 million or more are showing greater earnings stability or growth on average as compared to our companies with $25 million or less in EBITDA. For the second quarter as a whole, we saw a net increase in the fair value of our portfolio. We collected 98% of contractual interest due and witnessed a significant decline in outstanding revolver borrowings to our portfolio of companies. Indicating that the liquidity of a number of our borrowers has improved. On the other hand, two key metrics that we use to provide transparency and portfolio company performance, nonaccruing loans and portfolio grades trended modestly negative during the quarter, which is consistent with broader market credit trends and is not a surprise given the magnitude of the economic disruption in the second quarter. The recovery in the economy and those most impacted portfolio companies will certainly take time. However, we feel confident that we have the tools required to achieve good outcomes. Specifically, as it relates to our portfolio grades at the end of the second quarter, the weighted average grade of our investment portfolio at fair value was 2. 9, a slight decrease from the 3. 0 weighted average grade in the prior quarter. This modest aggregate change reflects an increase in Grade 2 rated names as the performance of certain companies have deviated from our original underwriting expectations, primarily due to the economic impact of COVID-19. Overall, we believe the companies will recover during more certain and predictable economic times, and we take comfort that the owners and management teams of these businesses agree. A significant number of these underperforming companies have already received additional sponsor equity capital injections that are subordinated to our loan positions, which we believe validates the long-term enterprise value of these companies beyond these challenging times. In situations where we have been asked to be part of a near-term solution portfolio of companies, we've executed amendments to address covenant breaches and liquidity needs. As a general matter, we've provided short-term concessions measured in months or quarters rather than years, and we have often been able to get some combination of enhanced pricing, improved terms, and tighter documents along with the sponsor equity. Shifting towards our new investment opportunities, it's been very quiet on the new deal front. However, due to the size of our portfolio and our wide range of relationships, we're still finding interesting opportunities to pursue, typically with much lower risk and higher returns. Our existing portfolio provides significant built in origination advantages, and most of our new investment activity has been focused on incumbent borrowers, either providing add on financing or buying loans in the secondary market. While new transaction flow has been slow, activity is beginning to pick back up in non COVID impacted sectors, and we're seeing compelling relative value in these situations. We believe there could be a long runway of attractive investment opportunities during what we expect to be a slow recovery. And importantly, the flexibility of our capital has enabled us to focus on follow-on transactions to reprice risk capture attractively priced and deeply discounted more liquid names that we believe we know well, and in a few instances, provide opportunistic rescue financing for more covet impacted names. Penni will spend some time in a moment on our capital and liquidity position, but I'll reiterate from our call last quarter, the balance sheet is in great shape, with our consistent earnings, strong balance sheet, in our portfolio positioning, we felt highly confident in declaring a $0.40 per share quarterly cash dividend for the third quarter of 2020, and we believe that we can continue to support a steady dividend level for the foreseeable future. I'll now turn it over to Penni to provide more details on our second quarter results.

Thanks, Kipp, and good morning. Our core earnings per share were $0.39 for the second quarter of 2020 compared to $0.41 for the first quarter and $0.49 for the second quarter of 2019. We had GAAP net income per share for the second quarter of 2020 of $0.65, which compares to a net loss per share of $1.42 for the first quarter of 2020 and net income of $0.47 per share for the second quarter of 2019. Our GAAP net income per share for the second quarter of 2020 of $0.65 includes net realized gains of $0.02 per share and net unrealized gains of $0.24 per share. The net unrealized gains primarily reflect some tightening of credit spreads relative to the end of the first quarter of 2020, offset by increased unrealized depreciation for certain investments, including from the continued impact of the COVID-19 pandemic. The $107 million of net unrealized gains on investment were approximately 1% of our total assets at fair value and 1.5% of our net asset value. Our total portfolio at fair value at the end of the quarter was $13.8 billion. As of June 30, 2020, the weighted average yield on our debt and other income-producing securities at amortized cost was 8.9%, and the weighted average yield on total investments at amortized cost was 7.7% as compared to 8.9% and 7.9%, respectively, at March 31, 2020. Despite significant declines in LIBOR, we were able to maintain the yield on our debt and income-producing securities at a steady level, primarily due to the benefits of LIBOR floors, along with the incremental spread on new investments, and from certain repricings within the existing portfolio. At June 30, 2020, 84% of our total portfolio at fair value was in floating rate investments. Additionally, excluding our investment in the SDLP certificates, 79% of the remaining floating rate investments had an average LIBOR floor of approximately 1.1%, which is well above today's current 3-month LIBOR rate. Now let's shift to discussing our shareholders' equity. At June 30, 2020, our stockholders' equity was $6.7 billion, resulting in a net asset value of $15.83 per share versus $6.6 billion or $15.58 per share at the end of the first quarter of 2020. The increase in our net asset value was primarily driven by the net unrealized gains that we recognized in the second quarter of 2020 that I mentioned earlier. As of June 30, our debt-to-equity ratio, net of available cash of $260 million was 1.08x which is in the midpoint of our stated target leverage range of 0.9x to 1.25x and down from 1.19x at March 31. The decline in leverage during the second quarter resulted primarily from net investment repayments as well as from the net unrealized gains on investments in the second quarter. Net repayments for the quarter were $702 million and included proceeds from sales of loans to funds managed by Ivy Hill Asset management, or IHAM. As Mitch described last quarter, IHAM sources middle-market loans from Ares Capital and other middle market credit managers to build new or maintain existing CLOs for its investors. Throughout our history, we have sold first lien senior loans in the ordinary course to IHAM at fair value on an arm's length basis. During the second quarter, we sold $747 million in loans to IHAM. To support the activity of IHAM and its managed funds during the quarter, ARCC made an incremental $175 million investment in IHAM. We believe our investment in IHAM remains highly attractive and provides a significant strategic and differentiated relationship that enhances the position of Ares Capital. Given the net repayments, along with the addition of new borrowing capacity, we ended the second quarter with available liquidity of $3.5 billion by approximately $900 million since March 31. We during the second quarter, we expanded ARCC's borrowing capacity with a new $300 million secured credit facility with BNP Paribas, which is very similar and structure to our existing revolving funding facilities. While we didn't close the BNP transaction until June, we had largely negotiated the new facility in the depths of the pandemic crisis in April when new secured financing was very hard to come by. We believe that the depth of Ares Capital's bank relationships was instrumental in procuring this facility and demonstrates the power of the Ares platform. Fourth quarter ended July, we further strengthened our capital position, created additional liquidity and effectively prefunded our next term debt maturities, which aren't due until 2022 by issuing $750 million of 3.78% unsecured notes due in January 2026. We believe that an important component of our capitalization is having a diversity of funding sources including a diverse mix of unsecured and secured debt capital to complement our permanent equity capital. Pro forma for the July unsecured notes transaction. Over 70% of our outstanding borrowings were from unsecured debt, which resulted in over 85% of our assets being supported by unsecured debt and equity. This approach to maintaining a largely unsecured capital structure provides us with significant overcollateralization of our secured credit facilities, which positions us well to fully access the total borrowing capacity available. The strength of our capital structure presents a clear competitive advantage for us in today's environment. Pro forma for the $750 million unsecured notes issuance in July, we increased our available liquidity at June 30, 2020, to more than $4.2 billion. Which equates to over 3.5x our unfunded loan commitments and gives us significant dry powder to capitalize on the improving investing environment. Before I conclude, I want to discuss our undistributed taxable income and our dividend. We currently estimate that our spillover income was $408 million or $0.96 per share at the end of 2019. As we've said many times in the past, we believe having a strong and meaningful level of undistributed spillover supports our goal of maintaining a starting dividend through varying market conditions. As Kippp mentioned, this morning, we declared a regular third quarter cash dividend of $0.40 per share, which is consistent with the regular quarterly dividend paid in the second quarter. This third quarter dividend is payable on September 30, 2020, to stockholders of record on September 15, 2020. Now I will turn over the call to Michael to discuss our second quarter investment activities and our portfolio positioning in more detail.

Thanks, Penni. During the second quarter, and excluding the $175 million investment in IHAM that Penni mentioned earlier, our team originated $692 million of new investment commitments across 21 transactions. 95% of the commitments issued were seen as secured and as highlighted by Kippp earlier, 76% of the transactions were to incumbent borrowers. We remain extremely focused on large borrowers and as the weighted average EBITDA of the companies to whom we issued commitments during the quarter exceeded $160 million. Specifically, in our first lien investments, the average EBITDA size of the companies we financed doubled as compared to the same quarter a year ago. For those new first lien commitments, we also achieved a higher spread over LIBOR and captured approximately 130 basis points of incremental fees. Going forward, the market for new investments should be meaningfully more attractive. Many of our competitors will be less active as they focus on portfolio issues and capital availability. Furthermore, while banks are in better financial position than they were during the great financial crisis, they have been less aggressive in seeking to make new loans. As a result, we believe terms, pricing and documentation will be very attractive, and we are optimistic that this shift in the competitive landscape will persist for some time during an uneven slow recovery period. Turning to the credit quality of our portfolio. As Kippp mentioned, one way we evaluate our portfolio performance is through the rating system with grades of 1 through 4, 1 being the lowest grade and 4 being the highest grade for investments that evolve the least amount of risk in our portfolio. It's important to note that our grading system, which has been in place since our IPO in 2004, may not be directly comparable to other BDC's investment ratings, and many of them have different criteria for how loans are graded. Based on our current assessment of the portfolio, approximately 80% of our portfolio at fair value is performing roughly in line with or above our original underwriting expectation, and about 20% of the portfolio is performing below our original underwriting expectations. This 20% segment of the portfolio who sees either a Grade 1 or Grade 2 using our rating system. The increase in the grade 2 investments this quarter is largely a result of the COVID-19 situation. It is not a surprise to see an uptick in underperforming names due to the unusual and broad impact this pandemic has had on all businesses, and we are seeing strong equity support for the subset of our portfolio that is more impacted by COVID-19. Furthermore, as we have demonstrated in the past, we have an experienced and cycle tested team with a strong track record of working through issues with underperforming portfolio companies. The other key metric to observe regarding credit quality is a nonaccrual rate, which includes those companies that are not currently able to make interest payments. During the second quarter, we added 3 new companies through our nonaccrual list with which increased nonaccruals to 4.4% at cost and 2.6% at fair value as compared to 3.1% at cost and 1.7% at fair value last quarter. It is important to note our differentiated approach to managing nonaccrual assets. Some managers are quick to exit their nonaccrual loans early by realizing losses and reporting lower nonaccrual rates. We typically take a different approach, which we believe allows us to achieve better recoveries. Our proactive portfolio management approach enables us to be very patient, allowing us to seek the most favorable outcomes to maximize our recovery. Much of our confidence in receiving favorable outcomes from struggling companies stems from our focus on large franchise businesses that we believe will ultimately be able to return to normal levels of profitability in a post coved world. In addition, our position in a significant number of these situations as a lead agent for having a controlling physician in the capital structure, often provides us the ability to positively influence our outcomes. With our deep sources of liquidity and the experience and size of our team, we believe that we have an opportunity to actively engage our borrowers and execute on this position of control, providing support for these businesses through challenging times and eventually benefiting from the recovery. As an example, this past quarter, our total net realized gains included gains on two previously underperforming investments that were graded 1 or 2, one of which was previously on nonaccrual status. Our ability to control and manage these investments over many years allowed us to convert what could have been a significant loss into the recoupment of our entire cost basis for these original physicians. We have a strong track record with respect to exits of restructured investments where we have taken control. Specifically, more than $250 million of the nearly $1 billion of cumulative net realized gains that we've realized since our IPO in 2004 are attributable to exits from restructured portfolio companies. While it is certainly not our goal or intention at the onset of an investment to take control of a portfolio company, we believe that our significant liquidity position of over $4 billion will give us the opportunity to selectively take ownership in companies as needed at a relatively low-cost basis, support the companies with new capital and capture the potential upside through recovery. Since ARCC's inception, we have realized total proceeds of investments on nonaccrual status, equal to more than 90% of the capital extended to these borrowers. Many of you have attended our investor days are familiar with our restructuring track record and our proactive approach to value creation and risk mitigation in these situations. Lastly, another way we are creating value in the portfolio today is by repricing the risk in our loans with incremental yield and tighter documentations. In more challenging situations, we can provide companies with flexibility, largely in the form of short-term covenant relief, and we have been benefiting from an improved position with additional sponsor equity enhanced pricing to tighter loan documents. I will now turn the call back over to Kipp for some closing remarks.

Thanks, Michael. In summary, we delivered another quarter of strong financial performance, and we remain optimistic despite the current challenges facing the economy and our country generally. Time has given us more clarity in our portfolio, and we feel confident that we have the playbook to navigate these uncertain times and work with the most impacted portfolio companies to help get them back to past levels of profitability. Our ability to support these borrowers during this period of volatility only serves to strengthen our relationships and our market presence, which we believe further positions Ares Capital as a market leader. Over the last several years, we positioned ourselves defensively in anticipation of weaker economic conditions. We have a strong liquidity position, no near-term debt maturities, a highly diversified portfolio, and a fabulous team with the capabilities required to deliver during uncertain times. We believe Ares Capital remains well positioned to navigate and prosper despite the challenging economic environment and to capitalize on today's attractive investment opportunities with a view to driving strong returns on equity at the company going forward. That concludes our prepared remarks. Operator, would you please open the line for questions.

[Operator Instructions]. Our first question comes from Chris York from JMP Securities.

So my question is a strategic question on active portfolio management and portfolio diversification. And Michael, I appreciate your prepared comments on restructurings. So obviously, the emergence of COVID was unexpected and unprecedented. It's disrupted business models. So I'm curious, Kipp or maybe even Michael, how is your approach to portfolio construction and/or diversification within the portfolio for new loans evolved as a result of a spike in default correlations or the likelihood that loans default at the same time?

Chris, it's Kipp. Can you hear me?

I got you.

Good. I think the easy answer to that is it hasn't changed much. I mean, the philosophy historically has been defensive industries less prone to default. So we've been positioned well in that regard. And it's also been to run a highly diversified. It's one of the benefits of us being a large company relative to some of the smaller BDCS. So that's always the way that we've run things, and I don't expect it will change much.

Got it. And then maybe just a follow-up. Does it -- in terms of portfolio management and product, does it cause you to maybe think about shifting towards growth lending or putting more ABL in the portfolio as opposed to more cash flow loans?

Look, I mean, we're always trying to diversify our origination strategy, right? So over the years, we've built industry teams in different verticals, whether it's software or health care. We do have an active ABL business at Ares. Most of the ABL lending that we've done outside the BDC at Ares has been in much, much smaller companies. And typically, with rates of return that maybe don't approach where we'd like to see assets coming into the BDC. For the point on growth, I mean, look, some of these companies are pretty growth-oriented businesses, right? So I'd say growth, for sure. And current portfolio as is, but I don't expect a real shift in what we're doing. We kind of like the way the portfolio is positioned, and I think we've got a lot of origination advantages.

The next question comes from John Hecht from Jefferies.

So you guys, during your prepared remarks, talked about expectations for an improving investment environment, you cited improving terms and so forth. How do you think that works through investment spreads over time? Is it going to be an opportunity despite the low rate environment to get some wider spreads in the portfolio?

Yes, I think for sure. I mean any time you see a downturn in credit, it doesn't have to be an economic contraction, it's severe. It's typically default start rising, spreads start widening. Folks feel like the environment is riskier and commands premium pricing. We've definitely been seeing that on anything that we've done since the middle of March, right? So -- and even in things that really have had no covent impact whatsoever. So software companies we closed the deal at the end of the first quarter that I think we talked about on the Q1 earnings call, where we actually took an existing name and lowered leverage type in the document and a sponsor to sponsor buyout and widen the pricing out on the overall capital structure by probably 300 basis points. The other thing that we're doing is looking at existing names where folks are looking for incremental capital, right? So the lag rods have expired, and they're saying, I've got an interesting acquisition to do. Again, a couple of hundred basis points wide, I think, of where we would have seen it back maybe in early March.

Okay. That's very good color. Also looking at the Page 8, it talks about the -- excuse me, you have an income based fee of $41 million that was deferred. Maybe can you talk about the circumstances around deferring that and kind of how does the look backs work?

Yes. So people, I think, know that we've got 2 different sort of performance fees. But I think the one you're referring to is what we typically call part one. It's the income based fee payment. It does have a hurdle associated with it of 7%. So actually, the fee was earned in Q1. So to be clear, the company expense for that fee because we expect it will be payable, and we're going to reserve liquidity to pay that. But it's a rolling four quarter test, right? So importantly, again, we expensed it. And our manager, Ares management is booking it as revenue because we view it as something that will get paid in the future. But what -- it sort of effect it's an old fee structure back to '04, it's a little clunky and it it actually deferred for a little while as people remember back in '09. What it does is it just -- it basically cash traps the fee for a little while. So it was put in place to pick up book value declines, so the reason for it is really that Q1 book value decline. As we roll forward the ROE test, it's in there to basically trap some cash. The concept way back when, and it's a little bit clunky, as I mentioned is, if a company is seeing continuous book value declines, they're probably not able to get to the equity markets. There were concerns around would the company have liquidity, and it became a deferral, right? So again, we think it will be paid down the line once the ROE test catches back up, but it's deferred on a cash basis this quarter.

The next question comes from Finian O'Shea from Wells Fargo.

To start with the market question, Kipp, I think it was now you're mostly focused on follow-ons and liquid opportunities. But you did anticipate a comeback in regular way deal flow. Can you add any color on the timing there? Is that happening right now? Or when do you see that return in regular activity?

Yes. It's kind of slowly happening right now, right? I'd say typically, the things that continued, even though they probably had the pause button hit throughout April into May, the things that were continuing, I'd say, were the things that were kind of well in process, right? So processes that again got paused, but were prospective buyers had actually met management teams and have the ability to go see plants and just the physical aspects, attendance aspects of trying to buy a company or are material, right? So the things where many of those boxes have already been checked, but it hadn't actually gotten to a sale or things that are back in process. And I'd say the interesting prospect maybe beyond that is there's certainly going to be folks looking for liquidity, particularly with so much that we do with private equity firms, they have finite lives. They're not going to hold companies forever. What we've seen is some of those businesses are actually getting sold or potentially being sold from a sponsor to another sponsor who may have had high familiarity with that company, right? So perhaps there was a process 4 years ago where biopharma ABC won over buyout firm XYZ. Well, certainly, XYZ was interested in buying that company. And if it becomes available for sale again, has the same management team. They understand the operations well. They've been tracking it. That's something that's easier to get done in this environment where folks. Still at home so much. So we see it picking up, but it's happening now and definitely hitting a little bit of a summer slowdown, too. So I think we'll all be interested to see what the fall brings.

Sure. That's very helpful. And just sort of natural follow-on there. Does that portend a drop? Any change of pace in your volume, assuming for a quarter or 2, you're doing follow-ons and liquid should we see a lesser clip of origination?

Yes, I think you will. I mean, you saw it this quarter, for sure. So we do have the ability to find some good stuff, as I mentioned in the prepared remarks, the incumbency in the portfolio helps follow-ons, et cetera. But it's certainly going to be a slower back half of the year than last year. At least that's my expectation. Yes.

Okay. Awesome. If I can wrap there. I think you mentioned rescue finance as well in some instances. Is that what would be sourced by your group in the -- given those opportunities in today's market? Or is that a mark of collaboration with, say, an op credit or another group in Ares?

Yes, we really have kind of a nice triangle form between a couple of the really strong opportunistic credit and private equity strategies today for corporates. It's really our special opportunities fund that we run out of private equity that does stressed and distressed investing on behalf of private equity, but certainly also in collaboration with credit. Direct lending, which is Ares Capital court and actually our alternative credit business, which has raised a fair bit of money to do deals more around asset-based type transactions to the prior question. So looking at things like mortgage REITs and others that may have needed to deleverage or look for some runway extending capital. So those three groups in our firm right now are focusing and are focusing together and collaborating really well on those types of deals.

Next question comes from Ryan Lynch from KBW.

First one, you obviously talked a bit about the new investments that you guys made in Ivy Hill and selling down some loans into that entity. Historically, you guys have paid about to $17.5 million dividend up from Ivy Hill. Do you guys have any guidance on the expectation for that going forward, given its stronger capital base and larger portfolio?

Yes. I mean, we don't really have any guidance, but typically, when we're making those investments, you're seeing increased dividend income. This one is a little bit different because we actually -- of the $175 million, $25 million, so a small portion was an equity investment; $150 million of the $175 million was actually a subordinated line down to the company that pays an interest rate of LIBOR plus 650. So it has seniority to everything else, but also has a cash coupon with it. So the income will start to get recognized a little bit differently. And if you want to follow-up or anyone wants to follow-up afterwards, right? We've typically seen dividend income and Ivy Hill come in in the dividend income line. It's going to change a little bit. But yes, look, I mean, with more investment, we're not lowering our return expectations for Ivy Hill at that. So I hope in time, we'll see commensurate income with a larger investment.

Okay. Yes, makes sense. And then I think you mentioned like 20% of your portfolio or so is performing below the expectations when you guys originally made that investment. But I think you also said that you were seeing strong equity support from some of those sponsors and some of those more COVID related names. Can you maybe just talk about how those conversations are going and why those equity sponsors are willing to continue to put more money and fresh new equity capital into a company that's having a downturn in clearly impacted by this COVID downturn and what's just the uncertainty of how this plays out being so great?

Yes. I mean, we tried to get it to this in the prepared remarks, right? I mean, there are a lot of these companies that are obviously experiencing very difficult conditions with COVID. I think it's improved, which is why our book value deterioration in Q1, I think, was worse than Q2, right? The prospects for where we were going March 31, at least in my mind, we're not as good about the prospects as to where we are now because at least we've had some partial reopenings. And I think private equity shares the view that they own and we lend to some really high-quality, long-term assets where despite depressed performance today, it's going to come back. The real question mark is when it comes back. But in a lot of these circumstances, the discussion is, look, you guys own the company. The company needs liquidity. We're happy to talk about amendments and modifications and be part of the solution. But it's not our responsibility to deal with liquidity challenges because we don't own the company. And we've seen more than a handful of equity infusions into these companies that obviously values below where we're sitting from a lending perspective, and that gives us confidence that they share our view that there's a recovery here. And a lot of these names that we've marked down aren't impairments down the line.

The next question comes from Kenneth Lee from RBC Capital Markets.

Just a follow-up on short-term concessions that you mentioned in the prepared remarks. I wonder if you could just share with us further details and as well perhaps how broad-based these concessions were either in terms of numbers of companies or percentage of the portfolio?

Yes. So in the quarter, we had 40 amendments on about $2 billion of fair value. And they typically look very similar. As I mentioned, they're short in nature, right? So not years but quarters. Sometimes they come with a partial deferral of cash interest and sometimes they don't, but in all circumstances, it allows us to reopen the documents and tighten our covenants up. A lot of discussions about minimum liquidity covenants, which should become the new thing in the market. Folks are obviously trying to make sure that companies can get through this while remaining liquid. And then we're just taking out a lot of the nonsense that crept its way into loan documentation over the last 5 years as the lawyers and private equity firms, in particular, push much harder on documentation. We're allowed to -- we're able to, sorry, reverse a lot of that. So that's the sort of the playbook and gives you a sense as to how active it's been. It's been really active on the amendment front.

Got it. Very helpful. And just one follow-up, if I may. And this is just related to the other question about seeing very attractive investment opportunities. Just wondering if you could just characterize how aggressive you could be in pursuing new investment opportunities in the current macro environment and also, especially given your comments around what you're seeing in the competitive landscape?

Sure. I mean, again, deal flows down, follow-on activity is down and all of that, but it's there. And I think I tried to give some color around wider pricing with materially lower leverage, right? So the 6.5x deal that used to exist with adjusted EBITDA is now probably more like a 5.5x deal without adjusted EBITDA and with higher pricing and a better document. But it's slower for Fin's question about new originations for the back half. I think it's going to take a while for everything to come back. So I get your whole question, I'm sorry if I missed one there.

The next question comes from Rick Shane from Jpmorgan.

Anyway, you guys to talk about rescue opportunities, and you'd also put that in the context of the broader platform distressed arm. I am curious how you think about the risk associated with that versus your core business and the framework that you're applying for loans that you're looking at?

Yes. I mean, because of the uncertainty of where we all are today, I'd tell you, the bar is unbelievably high, right? This is not necessarily an Ares Capital comment here for a second, but just an Ares comment around the collaboration of these groups that I mentioned. I think we and a whole host of other firms had very long list of these things back to the middle of March. And particularly the high-yield market, but the public markets really sort of you set some of it at what I'd call much, much lower pricing. We got a couple done for sure at the platform that we're thrilled about. And we still have a long list, but it is a little bit different, right, than the core middle market lending strategies that we always employ. But look, this is a time where you need to actually use your capital wisely. And if you can drive what you think are really exciting risk reward more opportunistic financings, that's the way that we can actually add value and ROE to the company over time, and you can't be afraid. You just have to be selective.

Got it. And are these generally speaking, financing transactions to companies that you might have looked at a year or 2 ago passed on and now you're in a position where you can look at how the how the company has performed versus plan and you see a more attractive return?

Yes, for sure. We talked about the small deal that we did with another part of Ares and outfront media, which is the public outdoor advertising business that I don't think it was rescue because they certainly are not a distressed company by any means of measure. But in those uncertain times, this is a company that you're talking to. Either about lending to or making an equity investment in and we've observed it and had met the management team and all of that. So felt knowledgeable about it. And I think the security that we were able to put into that company to give them extra liquidity to weather the storm is probably more expensive than they would have liked and certainly more expensive than they would have liked a little while back, right? But look, they made a smart decision and they shored up their situation. And I think it was a good outcome for everybody, and we're thrilled to have finally got invested in the company. So it's just one of the examples that we've referenced.

The next question comes from Terry Ma from Barclays. Terry M&A: I just wanted to follow-up on the concession question, that, can you maybe just talk about your appetite to grant additional concessions if this crisis drags on or even gets worse from here? And how you maybe think about the risk/reward of granting additional concessions?

So most of the concessions to date, again, have been short in nature and have come with equity investments. We think that we've positioned those concessions to allow for a pretty good runway for these companies. There are a few where the leases are a little shorter. And as we get towards year-end, we wanted to have another look or have another bite at the apple potentially with our equity owners and management teams. So it's really hard to generalize, Terry. It's kind of -- it's all over the map. But look, I think with additional concessions, and that's principal on a certain circumstance at year-end, I think unfortunately, we'd be looking for additional compensation in some regard.

The next question comes from Casey Alexander from Compass Point.

Most of my questions have already been asked, but I will ask, historically, the company has used a credit cycle to look for an accretive acquisition. I understand that you probably wouldn't want to execute on anything until 2021, but are you starting to see anything or smell anything out there that looks like an opportunity that you might want to take advantage of in the future?

Yes, Casey, the answer simply is, kind of, not yet. I think if you'd seen another material downdraft in book value across the BDC industry or elsewhere, you would have found some companies that really were not in wonderful positions from a leverage standpoint, you did see a couple of folks do rights offerings. You saw a couple of companies do what I'd characterize as reasonably expensive from a coupon perspective, bond deals to kind of shore up liquidity. So I think it's a little bit longer -- a little bit longer-range out, if at all, we'll see.

The next question comes from Matt Chaden [ph] from Raymond James.

Most of my questions have been answered. Just a quick follow-up, if I can, on the loan modifications. I know from 1Q, the count was around less than 10 modifications during the quarter. Is there any color you can give on the number in 2Q and kind of what type of composition were those modifications, specifically the number of PIK toggles, if any, would be of interest?

Yes. So I just said we did about -- we did 40 amendments in Q2 relative to the 10. I'm looking here to see if I've got that number. Handies were all sort of separate. I can't quite find that number. Certainly, some of it is some interest deferral. More often than not, it's a partial interest deferral, where we're actually increasing to say alone is paying 8% cash. It would turn into something that went 5% cash plus the 3% PIK, and then we would put a PIK ATTR on it, obviously, is additional compensation, and we typically do that for the life of the amendment or the loan depending on the situation. But I'm sorry, I'm flipping through my Q&A notes here, and I just can't quite sign that number off hand, but we'll follow-up with you.

The next question comes from Chris Kotowski from Oppenheimer.

Yes. And maybe your crystal ball isn't any better than anybody else's. But Fitch currently puts like the leveraged loan default rate at around 3.9%. And most of what you see is still in the obvious areas like energy and retail. I mean, if you had to look out 6 or 9 months, does this start impacting the nondirectly impacted borrowers? Are there second order effects? And do you have any speculative guesses where we may see that headline default rate be 6 or 9 months from now?

I appreciate the question. The crystal ball is not out today. It's very cloudy. But it's such a crazy time. The second order effect is kind of not where we're spending the most of our time, right? When we look at sort of the increase in watchlist names or the increase in Grade 2 names for Q2. It's really the obvious thoughts. As I think I said on the last quarter, it's businesses that require people to show up and attend whatever service or good they're providing or selling, right? So it was dentist office that was retail and all of that. But I mentioned in the prepared remarks, we're pretty underexposed to all of those sectors with the exception of things like consumer and certain health care services, where the lack of people being out of their house attending things and buying things and doing things in Q2 was pretty obvious, right? So those are the ones that are in the -- those are the ones that really are in the discussion and in that 20%.

[Operator Instructions]. Next question is from Cameron Baxter from Anfield Capital Management.

So first one to drill down a little more maybe into that 20% of the portfolio that's performing below expectations. Can you comment on if you've seen maybe a decline in trends just in July with the outbreaks and cases and how that fares maybe towards versus May and June?

Yes, that's an interesting question. I wouldn't say that it's materially different, right? Again, the point that I made on book value deterioration in Q1 versus Q2, I think, was trying to highlight that we thought things actually did improve with partial reopenings. Obviously, there have been some setbacks, but we haven't seen anything materially different in the last -- the companies that are having this COVID issue. We're very close to or daily or weekly conversations with management teams and owners. I wouldn't say there's a change in July versus, call it, the middle of May. It feels about the same.

Okay. That's helpful. And then just a follow-up. In terms of where you think the nonaccruals is going to go maybe for the back half of the year. How does additional government stimulus and support either fiscal or monetary factor into kind of your expectations of how maybe additional concessions, how the portfolio companies are going to do, how does that kind of factor into your thinking?

Yes. I mean, it factors in a bit. Obviously, when we looked at things like PPP, which helped some of the non-sponsored companies with government stimulus or the CARES Act that's had some impact on a few companies. But for the most part, a lot of this has been oriented to the public markets and our companies investing in private companies, right? So there's no it's very difficult for the fed to have an impact on driving consumer traffic in a mall, right, or getting people to go buy things in retail stores. Okay. So it's helpful, but I think there is this bit of a disconnect where the market seem to feel that the Fed can fix everything. And I don't think that's quite the case for most private companies that obviously have seen their business models in certain industries disrupted, and we're just going to have to unfortunately get the virus and the health crisis under control before things will return to normal. And I think that's more of a health and human interaction issue than it is a Fed issue. But look, any help from the Fed is helpful and stabilization in market, certainly, which we saw the retracement during Q2, it helped our book value, right? We saw some mark-to-market increases, purely on the backs of the loan and the high-yield market being stronger. So I guess that's -- it's a nice to have. But I think there are other issues out there that are not really issues that the Fed can handle head off.

We have time for one more question. And the next question is a follow-up from Chris York from JMP Securities.

It's on senior sowing. It's a sizable investment, and you did reference a positive recovery outcome for shareholders indirectly in your prepared remarks. So the term loan is now marked at a healthy premium to cost. So does that fair value reflect the receipt of any material fees that could hit the income statement? And then an expectation that it could be prepaid?

So we typically don't talk too much about a single portfolio company, but this maybe deserves a couple of seconds. So this is a company that we -- that had struggled, people probably know it then excelling machines. And was private equity owned, and we now own the company, didn't choose to, but sort of had 2, and that's a couple of years back. And look, this is testament to the portfolio management team. We've gone in. We've literally reengineered the entire business running it in terms of its board, its management team, its strategy and all of that. And the markup is simply reflection of the profits are up, and we think the value is higher than it was last quarter. And we think the prospects for the business are much, much better. So this is just going in and doing what we actually tell people that we do, which is roll up our sleeves and get involved in the underperformers and create value. So hopefully, we're on a path down the line to a realization, but I don't think there's anything happening tomorrow.

Okay. And then just the last one. I mean, the Class A comment that you do have on the SOI. So that 6.5 million units, that's 100% yours?

Do we own 100% of the company? I'd have to go look. I'm sure management owns a piece, and there are probably a few others. I don't think we own 100%, but we're the majority investor.

This concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Kipp DeVeer for any closing remarks.

No, just thanks for the great questions. Hopefully, people have continued confidence and support in the company, trust that we're hard at work. I hope you guys enjoy August a bit, but we'll catch up with you next go around on our call next quarter. Thanks.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of the call will be available approximately 1 hour after the end of the call through August 18, 2020, at 5 p.m. Eastern time to domestic callers by calling 877-344-7529 and to international callers by dialing 1 412 317-0088. For all replays please reference conference number 10145525. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital's website.