Ares Management Corp. faces the sort of quandary that other financial firms might find enviable.
It has vaulted to the top rungs of the alternative-asset management world by focusing on what it does best: private credit. Yet, like its peers, Ares feels compelled to diversify into other asset classes, such as real estate, infrastructure, and private equity.
Question is: Can it become a one-stop shop for pension funds, endowments, insurers, and sovereign wealth funds eager for exposure to every major alternative-asset class — without diminishing its private credit franchise?
The attractions of sticking with private credit are obvious. It’s the alts strategy that’s been the most in demand during this unsettled economy. And Ares’ greatest growth spurts have come during tough times like the 2008 financial crisis and the height of the Covid-19 pandemic. So the current business climate — bedeviled by climbing interest rates and tighter access to bank loans — has Ares Management CEO Michael Arougheti champing at the bit.
“We see current liquidity constraints as an opportunity right now,” he says. “The returns that we are able to generate in this kind of market are about as good as we have seen in 15 years.”
But Ares executives insist their firm remains steadfast in its goal of offering institutional investors more than just private debt.
Thus far, Ares has diversified farthest into real estate. Yet even there, private credit plays an outsize role. William Benjamin, head of Ares’ real estate group, describes the parent company’s prowess in private debt as an invaluable fundraising tool.
“Because we are so successful on the private debt side, when we go to institutional investors across the globe and pitch real estate, chances are they are already in an Ares product,” he says.
Even the language spoken by Ares executives suggests this is a firm where private credit is the prime mover. Phrases like “credit mindset,” “protect your principal,” and “better credit metrics” get bandied about in every Ares asset class — whether private debt, real estate, private equity, or infrastructure.
No matter how ambitious Ares’ diversification plans are, Arougheti leaves no doubt that private credit will always define the firm. At Investor Day in 2021, the firm set a target of a half-trillion dollars in assets under management by the end of 2025. But private credit will continue to claim about a 60 percent share of the total, Arougheti predicted.
The fact is, with rivals like Blackstone surging ahead with their own impressive private debt businesses, Ares can’t afford to take its foot off the accelerator.
Headquartered in Los Angeles, Ares began in 1997 as a pioneer in the private credit space. At the time, other future giants of alternative-asset management — KKR & Co., the Carlyle Group, and Blackstone — were making private equity synonymous with a buy it/fix it/sell it strategy. Despite staying with private debt, Ares had no trouble keeping pace with the rest of the industry.
But its greatest growth has come over the past five years, coinciding with Arougheti’s tenure as chief executive. Since 2018, profits have compounded at an annual 35 percent clip, exceeding $1.1 billion last year. And assets under management have tripled, with private credit accounting for the lion’s share. Those strategies have expanded to include direct lending, syndicated loans, high-yield bonds, and real estate and infrastructure credit.
Lately, much attention has been lavished on Ares Capital, the unit created in 2004 to provide financing for middle-market acquisitions, recapitalizations, and leveraged buyouts. It has become the largest publicly traded business development company, with a market capitalization of more than $10 billion and assets under management of $22 billion.
The Ares portfolio is diversified across 466 borrowers backed by 222 private equity sponsors that invest in those borrowers’ equity. Because its parent, Ares Management, is one of the largest alternative-asset managers, Ares Capital has more financial weight than its borrowers or their private equity sponsors — with the exceptions of Blackstone, Brookfield Corp., Apollo Global Management, and KKR. And this sort of clout allows Ares Cap to be a demanding debt collector.
It expects an increase in missed loan repayments by borrowers as the result of an economic slowdown in 2023, but thus far, delinquency has been minimal. In the last two quarters of 2022, the non-accrual rate — the percentage of companies that missed payments — in Ares Cap’s portfolio was 1.7 percent, less than the firm’s industry-low ten-year average of 2.4 percent. And even when a default occurred during that decade, the firm managed to recover about 90 percent of principal.
Ares Cap goes to unusual lengths to reduce the risk that some portfolio companies will fall behind on their debt payments. Its underwriting strategy focuses on middle-market companies with high free cash flows in industries such as software and health care services, which tend to be resilient during periods of recession, inflation, and rising interest rates. Its exposure to cyclical industries is low — a mere 2 percent in energy, for example.
Almost two thirds of Ares Cap credit allocations are for first- and second-lien senior secured loans — the safest loan types. The remaining third are mostly higher-risk subordinate loans with more upside. And whenever possible, the firm prefers borrowers that are previous clients with problem-free repayment records. Last year, more than half of new loan commitments went to such borrowers.
As the Federal Reserve Bank ratchets up interest rates, Ares Cap monitors borrowers’ balance sheets for any signs of stress. It shares information with the borrowers and their sponsors on how other Ares Cap clients in their sector are being affected.
Still, Ares Cap executives wish that portfolio companies would hedge more of their debts. Fewer than half of them hedge even 50 percent of their outstanding exposure because they became complacent during the long era of low interest rates.
“We try not to be surprised when we come across underperformance in a portfolio company,” says Kipp deVeer, Ares Capital CEO and head of Ares’ credit group.
If a portfolio company veers toward non-accrual, Ares Cap removes the kid gloves. It will point out to the borrower and the sponsor how much more a loan would cost today than when it was issued two or three years before — and then it will demand a higher fee and interest rate to cover the increased risk.
For now, the uncertain economic outlook is mostly working to the advantage of private credit firms. The market spreads on new Ares Cap deals in the fourth quarter of last year were at least 1 to 1.5 percent higher than during the same period in 2021.
There has also been a dramatic increase in large corporate borrowers in the firm’s portfolio as banks continue to pull back from buyouts and other business financing. At the end of 2022, the weighted average EBITDA of Ares Capital’s portfolio companies reached $275 million. That was six times the weighted average a decade before.
It’s easy enough to understand why Ares Cap would prefer to lend to a big firm than to a small- or middle-market one. Larger corporates have higher profits and more revenue streams that are more diverse. They tend to be owned by private equity firms with stronger capitalizations. And almost always, their management teams are more experienced than those of small-cap companies.
But the shift toward deeper-pocketed corporate borrowers by Ares and other alternative-asset managers is raising hackles on Wall Street. Banks complain that tightened restrictions and capital requirements imposed on them by the Securities and Exchange Commission in the aftermath of the 2008 financial crisis put them at a growing disadvantage.
Charles Scharf, the CEO of Wells Fargo & Co., insists banks have lost market share because alternative-asset managers and other nonbank lenders have fewer regulatory constraints. “It’s not because we have purposely deemphasized the business,” he testified to Congress last September. “Regulations are inconsistent between banks and nonbanks, and cost structures are different.”
The banks’ retreat from corporate lending could accelerate in an economic slowdown because a likely rise in nonperforming loans would impair the banks’ capital adequacy.
“In order to keep their capital ratios high enough to keep the regulators happy, the banks would have to shrink their lending,” says James Angel, a Georgetown University business professor specializing in the regulation of financial markets.
Ares CEO Arougheti holds a more jaundiced view, blaming consolidation for the banks’ pullback in lending. Thirty years ago, when there were twice as many U.S. banks as today, banks accounted for more than 70 percent of middle-market loans. Today the figure is less than 10 percent.
Bulge-bracket banks like JPMorgan Chase and Bank of America find it more profitable and cost-efficient to make investment loans and offer syndications for deals to a reduced number of large corporates rather than underwrite a multitude of middle-market firms. “It’s just the economics of being a large bank versus a small bank,” says Arougheti.
And the banks continue to be big-time lenders to Ares clients. “Rather than competing with one another, it’s really more of a symbiotic relationship,” Arougheti insists. “The amount of business that banks do with us now is more than it has ever been.”
Perhaps so, but resentment among banks is bound to increase as Ares pushes into another lucrative domain of theirs — funding of leveraged buyouts. In 2022, Ares’ direct lending tied to such buyouts totaled $26.4 billion.
For example, last year, Elliott Investment Management and Brookfield Asset Management needed more than $11 billion in debt financing to acquire Nielsen Holdings, the television ratings firm. Normally, Elliott and BAM might have turned to a syndicate of banks for leveraged loans to cover their entire financing needs.
Instead, an Ares-led consortium of lenders provided a $2.15 billion second-lien loan to cover the unsecured portion of the buyout debt.
Ares’ desire to expand beyond private credit follows an industrywide pattern. Each of the major alternative-asset managers was initially identified with a single strategy: Blackstone with real estate, Brookfield with infrastructure, KKR and Apollo with buyouts, and Ares with private debt.
But to raise more funds and increase their AUM — a key driver of their share prices — these firms spread into other alternative assets.
In general, the pension funds, endowments, insurance firms, and sovereign wealth funds that make up their limited partners prefer dealing with a large, diversified alternative-asset manager.
“If an LP likes you in private credit, they will think about you in private equity and real estate as well,” says Steven Kaplan, a private equity specialist at the University of Chicago Booth School of Business. “They prefer writing a few big checks to writing many smaller ones.”
And for alternative-asset managers, such one-stop shopping reduces the time-consuming annoyance of wooing new LPs for funds every few years.
Economies of scale provide the large alternative-asset managers with meaningful competitive advantages in data collection, too. By investing across different industries, they accumulate market insights that are inaccessible to smaller firms. Ares, for example, is well positioned to expand its real estate investments because it already has a deep understanding of the business from its private credit side.
And real estate has become the biggest alternative-asset class in Ares’ strategy to diversify beyond the credit business. But with $51 billion in assets under management — about a seventh of the firm’s total AUM — the strategy still leans heavily on the private credit franchise to drum up new business.
Real estate head Benjamin calls it the “halo effect.” Whenever he approaches a U.S. or European pension fund, it will likely already have used Ares for a transitional mortgage loan or common equity or something in between.
“The Ares brand is so well known that when we make our pitch, the doors open and it’s often ours to lose,” he says.
That kind of dependency has existed since the beginning of Ares’ involvement with real estate in 2011, when the firm acquired Wrightwood Capital, a Chicago-based provider of debt capital for commercial real estate, for an undisclosed amount. “Our DNA was debt-oriented, so we thought it natural to acquire a real estate credit business,” explains Benjamin.
A decade later, though, Ares bought Denver-based Black Creek Group, a holder of real assets rather than a credit operation. (The purchase price was not disclosed.) With 80 percent of its $11.6 billion AUM in e-commerce warehouses, Black Creek instantly gave Ares a large footprint in the most profitable real estate sector.
Until the acquisition, Ares ran its real estate business on a private equity model, turning to experienced operators for assistance. Black Creek, on the other hand, was vertically integrated — buying acreage, zoning it, overseeing warehouse development, and leasing and managing it. This allowed Ares to take a more hands-on approach to its real estate business.
Warehouses now account for half of the Ares real estate group’s assets under management. In a typical recent expansion, the firm broke ground on a 361,000-square-foot warehouse spread over 16 acres in El Monte, a city less than an hour away from the ports of Los Angeles and Long Beach and five minutes from Interstate 10, the transcontinental highway connecting Southern California to Florida.
The $90 million project is being built on speculation. But it’s not much of a risk: The 18 million square feet of warehouses that Ares already owns in the area are fully occupied, and rents have doubled in the past two years.
Multifamily rental housing is Ares’ second-most-important property investment, accounting for 20 percent of the real estate group’s assets under management.
In Madrid, Ares has teamed up with the city government to build 3,600 affordable rental housing units across 13 locations in the Spanish capital. Ares gets the land free on a 50-year lease and is spending €400 million ($430 million) on apartments that will be rented out at 80 percent of the market rate, or an average $700 monthly charge, when they are ready for occupancy next year.
Despite its determination to diversify, Ares must still defend its private credit franchise against other alternative-asset managers.
The biggest of these rivals is Blackstone. Its $246 billion AUM in credit easily surpasses Ares’ $214 billion. “We’re seeing the greatest demand today for private credit strategies,” Blackstone president Jonathan Gray told analysts at the fourth-quarter 2022 earnings conference.
Although most of its private credit offerings are aimed at institutional investors, Blackstone is far ahead of Ares and other asset managers in its outreach to retail investors. Its BCRED private credit fund, targeting wealthy individuals, has reached $50 billion in AUM — more than the combined total assets of similar funds managed by Blackstone’s competitors.
“Private credit is a more user-friendly product for retail investors than more traditional private equity because the minimum investment is lower and the liquidity is better,” notes Lawrence Glazer, co-founder and managing partner of Mayflower Advisors, a Boston-based registered investment adviser whose clients include investors with less than $5 million in liquid assets. “Also, while investors should not expect a return on capital or distributions for years in private equity, with private credit, income starts immediately.”
But the clamor for private credit from Ares and other alternative-asset managers is strongest among public pensions. The retirement funds for public employees remain their largest LPs — outpacing other institutional investors like insurers, endowments, and sovereign wealth funds.
Unable to maintain their needed annual investment returns of about 7 percent, pension funds have ditched the traditional 60-40 portfolios of stocks and bonds and have increasingly invested in alternative assets.
The largest public retirement funds — the California Public Employees’ Retirement System and the New York State Common Retirement Fund — have raised their private credit allocations to 5 and 4 percent, respectively.
Among the more enthusiastic investors in private credit is the Arizona State Retirement System, a $49.3 billion fund for teachers and government employees. Five years ago, it invested 16 percent of its portfolio in private credit. Today private credit accounts for 23 percent of investments.
“We expect to stay at approximately this level or slightly higher for the foreseeable future,” says Michael Viteri, chief investment officer for the state pension fund.
Arougheti isn’t the least bit concerned that such fervor is leading to portfolio imbalances.
“Most institutional investors we talk to are likely to be underallocated to alternatives,” he says. And as long as pension funds struggle to cover payouts for their retirees, Arougheti is convinced the appeal of private credit and other alternatives will only strengthen. “I don’t expect that to change.”
