Ares Management Corporation (ARES) Q3 2015 Earnings Report, Transcript and Summary

Welcome to Ares Management L.P.’s Third Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded on Tuesday, November 10, 2015. I will now turn the call over to Carl Drake, Head of Ares Management Public Investor Relations. Please go ahead.

Good morning and thank you for joining us today for our third quarter earnings conference call. I’m joined today by Michael Arougheti, our President; and Michael McFerran, our Chief Financial Officer. In addition, Greg Margolies, our Head of Tradable Credit, will also be available for questions. Before we begin, I want to remind you that comments made during the course of this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in our SEC filings. We assume no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results. Moreover, please note that the performance of and investment in our funds is discrete from the performance of and investment in Ares Management L.P. During this conference call, we will refer to certain non-GAAP financial measures. We use these as measures of operating performance not as measures of liquidity. These measures should not be considered in isolation from, or as a substitute for, measures prepared in accordance with Generally Accepted Accounting Principles. These measures may not be comparable to like-titled measures used by other companies. In addition, please note that our management fees include ARCC Part I fees. Please refer to our earnings release and Form 10-Q for definitions and reconciliations of these measures to the most directly comparable GAAP measures. I would like to remind you that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase an interest in any securities of Ares or any other person, including any interest in any fund. We’ve also posted a third quarter earnings presentation under the Investor Resources section of our website at aresmgmt.com, which can be used as a reference for today’s call. I will now turn the call over to Mike Arougheti.

Great, thanks, Carl. Good morning, everyone. I’d like to start off with the business performance update and then put our third quarter results into context, given the current market environment. I’ll then update you on several important business drivers for us before turning the call back over to Mike McFerran, who will provide an update on our third quarter financial results in greater detail. During the third quarter, fears of slowing global economic growth, declining commodity prices and uncertain Federal reserve policy all contributed to increased volatility for risk assets. These market fluctuations not surprisingly had an impact on our performance related earnings in certain business segments as the unrealized lower marks on our assets impact our balance sheet investments and our net performance fees. Importantly, we don’t believe that these fluctuations had much to do with the fundamental performance of our funds and portfolio investments during the third quarter as the underwriting aggregate performance of these investments continues to be very strong. While the contribution of for performance-related earnings to our ENI is important, the short-term unrealized impact is less relevant until investment outcomes are ultimately realized. Instead, we believe that our more stable fee-related earnings are a better metric to evaluate the core strength of our business. As we’ve talked about in the past, our focus continues to be on growing our fee-related earnings which were up 28% for the first nine months of this year compared to the same period in 2014. This past quarter, our fee-related earnings were slightly lower quarter over quarter as we continue to make infrastructure investments in personnel and technology in advance of the commensurate step up in management fees that we expect from our current fundraising cycle. However, we do expect a meaningful improvement in our fee-related earnings and margins during 2016 as we deploy funds where fees are paid on invested capital and as we raise several large successor funds on which the substantial majority of capital raised pays fees based on committed capital and each with targets larger than their predecessor funds. Now, just a few highlights on the key business drivers for us starting with our fundraising, for the third quarter, we had significant success with $6.5 billion in gross new capital raised. There were three strategies in particular that drove these results. First, we raised $3.6 billion in direct lending funds, including $2.4 billion in our third European direct lending commingled fund which was comprised of $1.5 billion in equity and $900 million in debt commitments, $400 million in other European direct lending mandates and another approximately $400 million in a new US separately managed account. As many of you recall, the sale of GE’s middle market private debt assets earlier this year created a lot of institutional investor interest in in direct lending and as a market leader we are now benefiting directly through new separately managed accounts. Second, our tradable credit group continues to be a leading market player in the CLO sector and during the quarter we closed two new US CLOs and price the third totaling $1.9 billion in aggregate. And finally, our real estate group closed approximately $700 million in real estate private equity funds primarily through first closings on our two new equity funds in our US opportunistic and Europe value-added services. We continue to have success attracting funds directly from existing and new institutional investors. This past quarter, 75% of direct new funds raised came from existing investors and 25% was from new institutional investors. Approximately 45% of the investors were European, about a third were North American, with the remainder from the Middle East, Asia and Australia. So looking back over the past 12 months, we’ve raised approximately $15.5 billion in gross capital with two thirds coming from existing investors and one third coming from investors new to the Ares platform. The two largest investor types are pension investors and insurance companies, followed by our continuing penetration of the private bank wealth management channel. We believe that the high percentage of existing investors adding capital to our platform validates our strong performance and our ability to serve our clients needs with an expanding array of investment strategies. However, it’s important to point out that more than half of this $15.5 billion of capital is not yet earning management fee. There are two main reasons for this. First, about 20% of this capital was primarily in the form of long-term fund level leverage and is not eligible for fees. And secondly, about 37% of the capital is comprised primarily of drawdown direct lending and special situations funds where fees are paid on invested capital rather than commitments and that capital has not yet been deployed. Let me now provide a further update on our perspective fundraising in progress which we expect will meaningfully enhance our 2016 FRE. Most importantly, we are experiencing strong demand for our fifth US and European private equity fund with a target of $6.5 billion compared to our fourth fund of $4.7 billion. We expect a substantial first closing in the fourth quarter with the final closing expected during the first half of next year and initial investing to begin later in the year. We are also raising our fifth power private equity fund with a target of $2 billion. We continue to expect a first closing during the fourth quarter in this fund strategy as well. Once we begin investing in these two points, we will begin to earnings fees on committed capital. Within direct lending, we are also experiencing significant demand having held two closings already for our third European comingled fund that we launched this summer. Our first closing was comprised of €1.4 billion in equity in the third quarter and during the fourth quarter we just had another closing on €400 million of equity commitments bringing total equity commitments to €1.8 billion. We expect the final closing of equity commitments for this fund above our €2 billion target early next year. We’ve also added long-term fund level leverage of $800 million of Euro associated with this direct lending fund. Also during the third quarter, we held the first closing of approximately €300 million in our second European value add real estate private equity fund, well on its way to a target of €600 million and a first closing approximately $200 million for our US opportunistic real estate PE fund with a target of $500 million. We’ve raised additional capital during the fourth quarter and we expect final closings for two of these funds early next year. Importantly, in addition to the $12 billion in commingled fund raising plans that I just described, we continue to make progress on additional separate account mandates, commingled fundraisers for new strategies and additional commitments to existing accounts. So now maybe turning to our investing activities, we continue to find attractive investment opportunities across our diverse global platform with relatively consistent deployment. We remain focused on leveraging the power of our platform to invest in high-quality assets where we have a sourcing advantage and where we can add our expertise to create meaningful value. In the aggregate, we deployed $5 billion in gross capital during the third quarter, balanced across our various strategies, with a focus on US and European direct lending, liquid securities and tradable credit as well as a few private equity platform investments in both the power and corporate sectors. Looking forward, we believe continued volatile markets should create attractive new investment opportunities, driven in part by energy and commodity-related securities the distressed ratio in the high yield market is elevated recently reaching levels last seen in the fall of 2011. In addition, liquidities declined as banks are hampered in their ability to commit capital and maintain liquid markets in many of these lower rated issues. While technical factors have absolutely contributed to volatility and wider investment trends in both the high yield and leverage loan markets, we believe that the corporate performance remains generally sound, although we are seeing a few cracks in certain non-energy and commodity related sectors. As the cycle evolves, we expect individual security selection will become ever more critical playing into our strength as an in-depth basis intensive and flexible investor. These market dynamics haven’t materially impacted other less liquid asset classes in which we invest, but we are encouraged that volatility may eventually lead to improved investment environment for firms like us that can deploy capital flexibly in a wide range of opportunities. We feel well positioned with significant dry powder to invest. From an investment performance standpoint, our intermediate to long-term performance remains strong. In other liquid credit strategies, we continue to add outperform for both the third quarter and year-to-date periods. While our loan and high yield composites third quarter returns were negative 0.8% and 3.6%, respectively, we did outperform our benchmarks by 40 basis points and 130 basis points respectively. As one might expect, certain of our special situations strategies experienced unrealized depreciation and negative third quarter returns, but our new commingled fund takes a very long term investment approach and remains largely uninvested. Our direct lending strategies generated 2% or better quarterly returns on net asset value and were largely unaffected by volatility during the third quarter. Both of our largest US and European direct lending funds have generated net asset value and dividend returns of approximately 10% and 12% over the last 12 months. Similarly, our real estate private equity funds have also not been adversely impacted to date. For example, our two latest US real estate value add funds both increased over 5% during the third quarter. Within corporate private equity, our fund investors tend to look at much longer term IRRs which remain strong. For the third quarter, our corporate private equity funds outperformed the public equity markets by a wide margin with a net asset value return of approximately negative 1% during the quarter in which the S&P 500 declined 6.4%. And lastly, before I turn the call over to Mike, I thought it would be appropriate to close the loop on our mutual decision to terminate our merger with our friends at Kayne Anderson. As we disclosed in our press release, our two firms had different views on how to proceed with the merger in light of the heightened volatility in the energy markets. So after carefully considering various alternatives, we both determined that not moving forward with the transaction was in the best interest of our respective stakeholders. We are pleased that we continuing to collaborate on certain opportunities with Kayne and we look forward to investing in certain of their energy investment funds. And now with that, I’d turn the call over to Michael McFerran, our CFO.

Thanks, Mike. I’ll start with a quick summary of our results and key metrics and then follow up with a review of our upcoming distribution. As Mike stated, we believe our third quarter earnings performance may not be the best reflection of our actual underlying business performance due to the market impact in our performance-related earnings or PRE. Measuring performance related earnings is a useful gauge, but price movements up or down driven primarily by technical market factors don’t necessarily reflect the outcome of our investment. We are patient and disciplined investors. And ultimately, outcomes are driven by realizations. Bearing this in mind, we have more opportunities for value creation during periods of increased market volatility, even though such volatility may adversely impact our short-term performance related earnings. We benefit from managing capital that is well matched to investment strategies across our businesses and affords us the ability to focus on long-term value creation and not to be overly focused on short-term market value fluctuations. So with those opening comments, let’s dig into the numbers. For the third quarter, our AUM increased by about $4 billion to approximately $92 billion, a year-over-year increase of our approximately 15%. Our total fee earning AUM also increased about $67 billion, up 11% year-over-year. For the third quarter, we generated modestly higher management fees of $162.2 million and fee related earnings of $43.1 million, a growth rate of 6% and 5% over the prior year period, in each case including ARCC Part I fees. The growth was primarily attributable to deployment and new capital in our direct lending group as well as the contribution from EIF within private equity. Compared to the second quarter of 2015, the third quarter’s fee related earnings were lower by a few million dollars, reflecting some ramp up in expenses and other timing differences. Our year-to-date growth in fee related earnings continues to be strong at approximately 28% compared to the same period in 2014. Of our total $21.7 billion in available capital at the end of the third quarter, we had $13.3 billion in shadow AUM, not yet earning fees. We expect to receive incremental fees paid on these funds as we invest capital. In addition, as we expect a meaningful contribution next year, from our current fundraising cycles Mike discussed, as these funds are weighted towards our higher average returning and higher fee generating strategies. When we combine the expected fees from new fundraising and the deployment of our available capital, we anticipate achieving higher fee related earnings margins of over 30% on a run rate basis during the course of 2016. Moving to our performance related earnings, we incurred an unrealized loss of $37.1 million compared to an unrealized gain of $30.8 million for the same period a year ago, primarily due to unrealized depreciation from our balance sheet investments and private equity and tradable credit funds and to a lesser extent the reversals of net performance fees for funds in these groups. The two primary contributors to the unrealized losses were first a reversal of previous unrealized gains in our Asian private equity portfolio and second unrealized depreciation and alternative credit funds. Our third quarter pre-tax economic net income of $6 million was substantially lower quarter-over-quarter due to the volatile asset pricing environment. Our third quarter distributable earnings declined to $39.6 million compared to $65.3 million a year ago. We had very light realizations during the quarter and accordingly our fee related earnings comprised essentially all of our distributable earnings. Our current view is that fourth quarter realizations may also be modest based upon current plan to exit activity across all funds. As disclosed in our press release, we agreed to reimburse Kayne Anderson for their estimated out-of-pocket merger expenses of $30 million. Consistent with past practice, we expect that these and other one-time merger-related expenses will be accounted for as unusual items and therefore not deducted from our fourth quarter non-GAAP measures like economic net income or distributable earnings. Moving to distributions, third quarter distributable earnings distributable to common unit holders were $0.14 per common unit net of tax. This morning, we announced a distribution of $0.13 per common unit for the third quarter. The distribution will be payable on December 8 to common unit holders of record as of November 24. Our distributions have generally been fairly stable and growing to the high competition of fee related earnings. However, it can be lumpy. This past quarter’s distribution will be low by historical standards and the fourth quarter’s distributable earnings are currently tracking to a similar level. For the reasons we described, we anticipate that improving our fee related earnings will contribute to a higher base level for our distributions as we progress throughout 2016. Next, turning to our balance sheet, on November 5, we used cash on hand to redeem our $325 million of 5.25% notes at [101 at par], which require to be repaid as part of the termination of the merger with Kayne Anderson. In addition to our $250 million of 4% not currently outstanding, we have a nominal amount of our $1.03 billion revolving credit facility currently drawn. Now I will turn it back to Mike for some closing thoughts.

Great, thank, Mile. In certain quarters or market environments, our business can be lumpy and appear complicated. But from what I said I think in fact it’s quite simple. We raise capital from a global investor base, we invest money well on behalf of our clients and when we perform well for our investors, our company grows along the long-term trend line. So to simplify it, alternative asset allocations are growing globally as investors continue to be frustrated with low interest rates and with the volatility in global equity markets. At Ares, we’re getting more than our fair share in these alternative allocations across our platform based on our product, our capabilities and our track record of performance. This is evidenced by the significant fundraising success that we are having in which we believe should provide meaningful growth in our 2016 FRE and FRE margins. And finally, markets are inherently volatile, particularly today, and while this shows up in PRE, net-net, volatility is a big opportunity for us given our down-market expertise, our flexible strategies and our significant by dry powder available to invest into these markets. And that concludes our prepared remarks. I’d like to thank everyone again for your time and support. And operator, we’d now like to open up the line for Q&A.

[Operator Instructions] Our first question is from Kenneth Worthington of JP Morgan.

Maybe first BDCs are generally trading below NAV [indiscernible] raising new capital, but we understand the private BDC market, they are raising capital more freely to take advantage of the opportunities in the marketplace. In your opinion, what are the issues here for the publicly traded BDCs and is it a near-term issue or is there a longer-term problem?

I am not a perfect predictor of the future; it feels to me like it is a near-term issue and not the secular long-term challenge for the BDCs. There are specific issues that are challenging specific publicly traded companies within the BDC sector either related to energy market exposure, structured products and CLO exposure over leverage poor performance et cetera, et cetera. So you have the first read out some of the company specific issues when you look at the sector. And when you pull some of those out, what you have is a BDC sector that’s trading somewhere in the 90% of NAV range. We’ve been running, as I think people know, what is now the largest BDC for over 11 years and we have had periods just like this where based on macro factors in volatile markets, stocks traded below NAV. But we’ve had the opportunity to access the equity market at 20 times at a weighted average multiple of 1.1 times book. So we’ve seen it before. We don’t read that much into it. Understand and it’s maybe a good segue into the question about the private markets, yield stocks in general is not just limited to BDCs, but we see it in mortgage REITs, we see it in closed end credit funds, we saw firsthand in the MLP space, for whatever reasons yield stocks are out of favor and as I think most people know, yield stocks are predominantly held by retail investors, retail investors can be a little bit more cyclical particularly as we go into year end and people managing their tax positions. So I don’t read into fundamentals here, because to your point when we look in the private market and we’ve seen here at Ares and our direct lending strategies where we raised $2.4 billion in direct lending assets in the private markets during the quarter, the fundamental opportunity in private credit is very strong. We’re seeing it coming from pension funds, insurance companies, endowments, sovereigns. And yes, we are also seeing a certain class of retail investors still have a willingness to invest equity into the BDC market in the private non-traded space, public non-traded space. So we will keep an eye on it. It hasn’t hindered our business. I think as people saw in our ARCC earnings call, we continue to grow the core earnings of the BDC even without having access to the equity capital markets over the last 18 months and private demand for private credit is as good as we’ve seen it.

And then just given the breakup of Kayne Anderson, how are you thinking about your own capabilities in energy today, how attractive is that asset class today and are you finding investment ideas or is it generally still too early in the asset class?

So maybe putting Kayne Anderson aside, just to talk about energy, we have very good energy capabilities here in our private equity tradable credit and private debt businesses. Kayne was an opportunity for us to supplement and augment those capabilities. With the termination of the Kayne Anderson transaction, we are absolutely still in the business of evaluating opportunities that are presenting themselves in the energy sector. We have made a very small handful of investments in the direct lending space as banks are readjusting their reserve based revolvers. We have been active investors in the energy space and some of our tradable credit and special situations funds. So we’re active. We are picking our spots. But I would say at least this management’s opinion is if it’s not too early, we believe that this opportunity will be presenting itself for quite some time. So we are being measured in the way that we are accessing the market. I would turn it over to Greg Margolies to get some perspectives on tradable credit.

Completely agree with that, Mike. I think this opportunity is going to be with us for a while to take advantage of it. I think the key here like so many other times you see distressed or stressed opportunities across sectors is being a credit picket within those sectors. So you can’t look at it as a buying opportunity across the whole sector, but rather picking the right opportunities within the sector. And keep in mind that energy has directed very differently depending upon where you are within exploration company or midstream company. All that goes into the credit selection process. And so we do see opportunities today, we are playing them special situations in credit opportunity funds, but very, very selectively.

Our next question is from Craig Sigenthaler of Credit Suisse.

First on the $22 billion dry powder, if you look at the composition of the available capital, with almost $10 billion direct lending and $5 billion credit, can you provide some commentary on your the ability to deploy this dry powder? How long it may take if the macro environment remains more or less consistent with today?

I will start off with the second part of that. I think we said on our last earnings call and the answer is consistent, when we think about undeployed capital based on the strategy, we say on average 18 to 24 months, however as we intentionally are heading in the periods of increased volatility where the opportunities widens on an accelerated pace, we think that to happen more quickly. When you think about the composition of our dry powder, I’d say it’s really just a mix between a fair amount of stuff that’s been ratably deployed over some funds and the recent fundraising. Most notably, the $2.5 billion that Mike made a reference to for our new European direct lending fund.

So bear in mind, Craig, as you think about that number, while it has grown quarter over quarter as we told people it would and obviously given the fundraising backlog that I describe in our prepared remarks, I would expect that number will continue to grow. Understand that this number is recycling itself. So we’re deploying raising new capital and then seeing that capital run-off, but when you look at the deployment numbers in Q3 alone with $5 million of gross capital deployed in what was a fairly choppy market, again, I think it gives you a pretty good sense for what the deployment capability is in our credit businesses with the bulk of that uninvested capital.

And then just as a follow-up here, on the product front, what are the key holes in your product offering today? And what are your plans in terms of filling the spaces between bolt-ons and M&A?

I don’t know if we have key holes. I think the nice thing about the Ares platform we’ve got very broad product capabilities in the liquid and illiquid markets in the US and in Europe. So as you talked about M&A in the past, you’ve heard me talk about the filter that we used to think about M&A in terms of cultural fit, strategic fit and financial impact. But if you also look at the history of M&A for us, it’s been a wide array of team acquisition, product acquisition, company acquisition and a distribution channel acquisition. But every time we’ve done it, it’s come off of a core competency of ours. So as an example, being one of the largest CLO managers, be moved into the CLO structured credit space in a meaningful way and now manage about $3.5 billion in structured credit. In our direct lending business, we had a direct market leading US direct lending franchise. We moved that franchise into Europe and now you can see the success we are having growing there. So the easiest and most achievable growth for us is to take a core competency that we have at a team all a new product or alongside it and then grow them by using our global distribution and information advantages to help them. So I don’t really perceive a lot of key product holes, but I do see some adjacencies that I think we could be more aggressive in. In direct lending, we are investing heavily in the growth of our commercial finance platform. In tradable credit, we are investing heavily in our structured credit business. In our global credit business, we are beginning to invest heavily in some larger market illiquid credit products. In our real estate business, you are seeing a start to fill in some of the gaps in the direct lending side as we aggregate capital in the private markets. I would say we do have a gap in core real estate, given the amount of products that we manufacture to core in our value add strategies. So that’s something that we spend a fair amount of time thinking about. But as we sit here, I wouldn’t perceive any key gaps. I think that they are all easily attainable adjacencies to what we already do very well.

Our next question is from Mike Carrier of Bank of America.

I guess two comments on the outlook for the fourth quarter and then for 2016. I think for 2016, just wanted to get a sense to – you mentioned fee related margin above 30%, just wanted to get a sense is that mostly on the fundraising commitments even then if you deploy capital faster, like there’ll be a benefit to the FRE, just wanted to get a sense on how much of the deployment versus just the commitment you are looking at in terms of projecting there? And then for the fourth quarter, you anything related to Kayne unlike the notes or the $30 million, just wanted to get [indiscernible] in the fourth quarter and then 2016 will be pretty clean in terms of anything related to that transaction?

So starting with next year, a significant amount – we mentioned the 30%. That is a combination of fundraising, both fundraising that happened to date, through the deployment of that capital as well as funds that are currently being raised where we have lot of conviction about the timing and at least around ranges where we think they will end up. So as we look at 2016, it will be a function of deploying capital we will call at a modest pace. But I think to the point you alluded to in the question, if we – the opportunity sets to deploy capital more rapidly, then I think seeing that 30% would come more quickly. But it really is from a function of the revenue side without any significant assumptions on the expense side.

And maybe before Mike jumps to Q4, just to reiterate, when you look at the fundraising pipeline, the bulk of those funds are coming in higher return, higher fee, higher margin products in corporate private equity, power private equity and real estate. And the bulk of those funds actually pay on committed capital in a much higher percentage than the current book. So the level of confidence we have going into 2016 is really rooted in those facts about the fundraising pipeline.

And then on the merger costs, we are expecting the majority of the expenses to be recorded in Q4 and when I say the majority, it will be the $30 million plus other expenses that we have related to terminating the transaction and putting the redemption of the bonds will all be in the fourth quarter. I think you mentioned in the comments, in the prepared remarks is that as these are unusual items consistent with how we dealt with merger cost in the past, we’re not going to include them in some of our key non-GAAP metrics, so they won’t be an impact on FRE ENI, it won’t be directly part of distributable earnings. However, they will impact our GAAP results as expenses. But they will all be completed in the fourth quarter and none of that is going to go into 2016.

Just as a follow-up, the realization outlook, the distributable earnings and distribution into 2016, I think because of the outlook on the FRE, we can kind of gauge that in terms of what that means for the distribution. But when you look at the overall portfolio and kind of look at an environment where maybe it’s not [indiscernible] the third quarter we get a little more bit more normalization. Is there any way to – I don’t know a standard range when you are thinking about the quarterly distribution that you hit in the third quarter versus what’s been more typical quarterly run rate. I know it’s a tough thing in a volatile environment, but just wanted to get a sense of the third quarter, is that more of an anomaly or should we be expecting something in the lower rate ex pick up in realizations?

So when you think about our distribution, it’s $0.14 this quarter and that effectively – all came from our core earnings which we call fee related earnings. And to our comments in this call, if you look at our capital raising pace of deployment, I think the message we are sending is pretty clear. We expect that number to increase next year by a meaningful amount. We expect to see a significant FRE expansion and as a result margin expansion. With that, as core base level of distributable earnings, we will move higher just off that core. And we think that’s really important because as we’ve talked about in the past, one thing that is really important to this model is that we have a fairly predictable amount of decent and growing distributable earnings. And if you look at our core contribution for example over the last couple of quarters, it was around 60%. This quarter, the core contribution is nearly 100%. And as the business continues to expand its core earnings base, that what we will call minimum level of earnings really is going to increase. We think you’re going to see that as we grow through the course of 2016. To the second point on realization, frankly it’s hard to predict. We can’t – Mike made the comment earlier about the crystal ball, we have over $150 million of our accrued net performance fees at quarter end. It is going to be a function of the markets, it’s going to be a function of – want to make sense to exit things. The nature of our capital affords us the flexibility to be thoughtful and opportunistic and realizations for the sake of generating short-term outcomes. But we are very long-term focused and there will be times when certain opportunities will be there for higher realizations. But I think when we think about this business and looking ahead to 2016, the most important thing is going to be that core earnings expansion.

Our next question is from Chris Harris of Wells Fargo.

Can you guys give us a little bit of detail on what drove the investment write-downs in ACOF Asia, I know the markets generally were weak there and you guys have hinted that most of the write-downs were technically driven. I just want to make sure that that was the case in that fund or whether there was any fundamental issues that have prompted that?

One thing is a backup that should appreciate, Chris, and this goes back to sometime between fundamental performance and technical performance, but also short-term versus long-term. If you actually look at ACOF Asia which is our primary investment vehicle for growth equity in China, that fund is currently running at about 1.3 times cost. Obviously, when you look at it in any given quarter, you may see significant volatility, but I think it’s important to people get anchored that when you look at that from private market perspective through the lens of the investors in that fund, the fund is actually performing quite well and I think it’s important we also remind ourselves of that base line performance even when we are in volatile public to markets, 8% IRR since inception for that fund, despite everything that’s going on in the market. So when you look at what’s been happening this quarter, it’s really the reversal of prior gains, particularly in two companies, one is a dairy producer and other is a purified water company. Our strategy in China tends to be investing in consumer facing growth equity businesses. The fundamental performance of that company continues to be very good. But obviously, there has been a significant amount of volatility in the Hong Kong market and we’ve seen just dramatic reversals of previously realized gains. That said, when you look at those two companies in particular, dairy and water, we’ve seen a pretty significant rebound again highlighting the volatility in Q4 in both of those companies.

Just a quick follow-up on credit quality more broadly, across the Ares enterprise. I mean, you guys have a great line of sight into that and Mike you did mention you are seeing a little bit of cracks in some non-energy sectors. Can you expand on that a little bit, what sectors are you seeing a little bit of weakness in and what is Ares exposure there?

I will let Greg kick us off with the tradable perspective and I can provide a little bit of color from the private side.

We are definitely seeing the weakness of course in the commodity-related sectors, oil and gas as well as metal and mining. And as mentioned earlier, we are selectively playing those opportunities especially in the special situation funds. We are beginning to see cracks within the rest of the industries. Some of it is very company specific whereby we are seeing some healthcare names trade significantly lower than very company specific news, but we are also seeing it in some of the retail and consumer names. And most importantly, I think to give you a sense, in August of last year the distrust ratio in the high yield market which is measuring credits that traded 1000 basis points over Treasuries was around 6%, today that ratio is 18% to 19% of, about half of that is in commodity-related sectors. The other half is widely dispersed across all other industries. So there is no specific industry that begins to see, but you are beginning to see earnings misses in a number of industries and as is evidenced of the trading levels across these industries. And how do we take advantage of it, again, it’s very credit specific. In the long only funds, obviously we look to avoid those situations and look to take advantage of this volatility in those numbers for good companies that have stumbled in either special situations or credit opportunities funds.

I would just add, I think we are seeing similar type of outcomes in the direct lending space, obviously less indexed and more asset type business models. I would say there are early signs that some of the traditional manufacturing businesses may be slowing, if not recessing and certain parts of the retail market are probably underperforming as well. But again, when you look at our direct lending portfolio specifically and we talked about this on the ARCC earnings call, when you look at across those portfolios, we’re still seeing cash flow growth in excess of 10% year over year. So again, what we’re trying to do in how we play it is reconciled to what we see as good fundamental performance in our portfolios against what we know is technical challenges in the market that should create certain opportunities. But then looking at certain peer portfolios recognizing that we are in that part of the cycle where people are starting to see non-accruals go up, credit markets go up et cetera, et cetera.

Our next question is from [indiscernible] of KBW.

I wanted to touch back on the realizations really quickly, so understood that the market involved might not be a fantastic realization environment, but I would think there is some aspect of realization that should be tied to more recurring interest income or contractual repayment that we might see in any given period. So wondering if there is anything unusual around that and the dynamics you’re seeing that would really lead to very light realization in the third and fourth quarter?

I will just give a little bit of a qualitative comment and then we can talk about the composition of our PRE little bit more specifically and Mike can chime in. But one of the challenges I think of understanding the alternative assets managers is that historically there appears that have been PE centric. I think the market has conditioned to try to think about the timing of realization and harvesting, if you will, as they think about value. I think for the sector as a whole, that’s probably an oversimplification of the business model and doesn’t really give full benefit for some of the secular trends I’ve talked about earlier where we are seeing just a meaningful growth in alternative assets allocations globally into both PE centric strategies but also alternative credit strategies. So I think we are in the midst of a shift in the sector where you are seeing Ares and others change the composition of their business to be aligned as much to recurring revenue and credit oriented strategies as PE strategies. With that said, what we’ve always said as long as we’ve been a public company is we do believe that Ares is differentiated amongst this peer set, given the percentage of our earnings that comes from FRE and recurring management fee. And to your specific question and the percentage of our PRE that is coming from non-private equity strategies, and again it is lumpy because of some of the mark to market volatility we can see in our tradable credit strategies, but if you look over the last four of five quarters, 40% to 50% of our incentive fees are actually in credit oriented strategies. So even when we are involved in our markets, yes, I would agree with you that we would probably see a smoother realization pattern in some of our heavily PE centric or distressed centric peers. But that’s mitigated by inherent volatility in those markets that could constrain realization as well. So again, I can’t give you a specific number, but I think your point is well taken.

A quick question on the expenses, I know you mentioned the ramping up as you invest in the business and get ready to deploy a lot of the capital that you are raising. But is any aspect of those higher expenses related to the fundraising itself? And maybe something that we could see abate?

We are adding significant resources as we have been for the last number of years in our front-facing business development and marketing group. So part of it is adding people around the globe to help raise capital and also adding people internally in our investor relations function to manage those relationships as they come in.

Just to add, just outside of Mike’s comments, as you see us make acquisitions and integrate other businesses over the past year, which we have done, you have [indiscernible] non-compensation expenses of the those people that come forward. So on a year over year basis, as you can see for example EIF is included in our results from that team operating costs as well as the things we’ve done like ARES commercial finance.

And one more test very high level question, so there is been a lot of talk you guys have mentioned feeling like you are in the later innings of the credit cycle, there potentially being an opportunity to snap assets in more distressed or dislocation environments, and maybe not knowing when that is going to happen, you’re feeling like it might, so I guess I’m just curious how that plays into your current investment decision, you are definitely still putting money to work, but are you feeling like there is some scenarios where certain fund or strategy, it’s tougher to do a deal, it kind of looks like deal maybe you might have done a year or two ago, but now you’re thinking to retain capital, is there any change in the thinking around those investments?

I will give some qualitative stuff and then Greg can chime in here too, because of the focus that we have one special investing. But first of all, as an alternative manager, not lost on everybody on this call hopefully is that we are designed as a business to be able to benefit in periods of market volatility. And it’s as simple as if you are a high yield mutual fund and you get retail flows when you get inflows, you put the money in the market and when you get outflows, you pull the money out of the market. And at least a lot less discretion, if you will, to the portfolio manager to have the view on where they are and where they are growing. So the nature of our funds given the long-term nature of our capital and the flexibility of a lot of the strategies is regardless of where we are in the credit cycle, we are asking ourselves are we seeing good relative value in a given market relative to other markets and do we believe that the opportunity today is better than the opportunity that we expect to see six months, a year from now. And obviously when we make portfolio allocation decisions, that’s the wins that we think about investing through. What you will hear everybody at Ares talk about, I think even Greg mentioned it earlier, our private equity guys will tell you that right now they are in a stock pickers market given where valuations are, given how much cash is sitting with strategic buyers and you have to be laser focused on picking the best franchise businesses that you can add value to. I think Greg and this team is doing direct lending as they will call this a credit pickers market where you have to leverage all the information and all the sourcing advantages that we have to find the best investment in this market environment. There are certain funds therefore where we are actually slowing deployment because we believe that spreads widening and that we may have a better deployment opportunity six months from now. And there are other funds that are structured to be deploying more consistently that doesn’t really find the face of the view that the markets are actually improving from a spread widening perspective. So again, not to complicate, it depends on the nature of the fund. If we have a long only credit fund we maybe behave one very at special situation one, we may behave differently. But generally speaking, across all of our products, very, very focused on credit and equity selection. Our close rates are probably lower now than they have been in quite some time across the board which really supports the view that we are late in the credit cycle.

I think the only thing to add is that the credit cycle comment, it’s also being exacerbated by the regulatory changes that are going on and how it affects the banks that volatility in the marketplace on the tradable side is heightened because of the lack of the capital the banks are committing to actual making markets. So whether it would on the stressed [indiscernible] special situation side, or even on the performance side, we see pockets of opportunities to pick up high quality credits just because of the volatility in the marketplace because you are just not seeing orderly markets. So it really depends on the day and the week where – again, just to reiterate, what Mike said, take up very high quality credits which is the focus on both the performing and non-performing side because it’s what the market is offering you.

Our final question today is from Michael Cyprys of Morgan Stanley.

You mentioned earlier that you’re seeing a rebound so far in the fourth quarter in some of the ACOF Asia investments, just curious if you marked your books say as of yesterday, how much of the investment income would come back?

Most of our portfolio was to carry as well as our balance sheet level III, so we are not marking it daily. I would say to Mike’s point for the some of the observable equity traded positions we have in those portfolios, I think the two companies Mike referred to in Asia prices are up. One must of 5% and one is up 12.7%. And I think generally our liquid credit strategies have rebounded nicely through the month of October. And you think about the inputs to level III valuations, significant ones are going to be where credit prices have gone and correlated to the equity markets which clearly are up, but we don’t have an exact number to share with you. But directionally things have gone up since we closed the quarter.

And then just as a follow-up, could you talk to some of the trends that you are seeing from allocation changes by sovereign wealth funds and how you are thinking about the risk of these firms setting up internal asset management capabilities in sourcing some of that and then also some of the risk that these entities are geared more towards oil prices may look to bring some money back home over time?

There’s a couple of questions there. First, again, one of the benefits of the platform is we have a very well diversified investor base in the public markets and the private markets geographically diversed and then diversified by investor type. We do have very, very strong relationships with most of the global sovereigns, however, that only represents about 10% of our assets under management today. In terms of insourcing, insourcing has been something that the largest institutional investors have been doing for quite some time, both some of the large pension funds and the some of the sovereigns. We have not seen that change their behavior vis-a-vis our relationship and we haven’t seen them emerge as competitors or that the insourcing has changed the way they are allocating to third party managers. So maybe down the road that could impede the growth of that segment of the business for us, but it’s actually been a benefit as they have gotten better direct, they’ve actually grown more comfortable with a lot of the alternative assets that we manage and with that education we have seen larger flows. So it’s actually been a net positive for the most part. In terms of oil prices, we actually haven’t seen a change in investor behavior with volatility in oil. One could expect to see that if oil prices were low for longer, but we actually haven’t seen that yet. So it’s something that we’ve asked ourselves the same question, but hasn’t shown up in the way capital is getting allocated.

This concludes our question-and-answer session. I would like to turn the call conference back over to management for any closing remarks.

We really have nothing else. We really appreciate your time today and the great questions. And we look forward to speaking to everybody again next quarter. Thank you.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today’s call, an archived replay of this conference call will be available through December 9, 2015, by dialing 877-344-7529 and international callers by dialing 1-412-317-0088. For all replays, please reference conference number 10074377. An archived replay will also be available on a webcast link, located on the home page of the investor resources section of our website. Thank you for attending today’s presentation. You may now disconnect.