Correction: Fitch Affirms Ares Management Entities at 'BBB '; Outlook Stable
Fitch Ratings has affirmed the Long-term Issuer Default Ratings (IDRs) of various subsidiaries of Ares Management, L.P. (collectively Ares) at 'BBB+'. The Rating Outlook is Stable. Approximately \\$300 million of unsecured debt is affected by these actions. A complete list of ratings follows at the end of this release.
Today's rating actions have been taken as part of a periodic peer review of the Alternative Investment Manager (IM) industry, which comprises seven publicly rated global firms. Fitch's outlook for the sector is stable, reflecting the relative stability of core operating fundamentals, given the locked-in nature of a large portion of fee revenue, modest but increased leverage levels, manageable near term obligations relative to available liquidity resources, increasing asset under management (AUM) diversity and investors' increasing allocation to alternative investments, particularly those managed by alternative IMs with strong franchises such as those included in Fitch's peer review. While fund realization activity has increased significantly over the last three years, leading to the amortization of existing AUM, managers have continued to replace capital, and therefore fees, with follow-on funds and expansion into other product categories through step-out strategies, seed investments, and/or acquisitions.
The variable cost structure of the alternative IMs has contributed to relatively steady cash flows through cycles. Fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins had been trending down in recent years, given lower fee rates on new product categories, higher fundraising costs, and because the cost of doing business has risen with increased regulation and administrative costs associated with operating as public companies. However, FEBITDA margins have turned a corner more recently as many alternative IMs have begun to raise follow-on funds for newer strategies, which adds scale to the platform. The FEBITDA margin for 'A' category alternative IMs averaged 35.5% for the trailing 12 months (TTM) ended Sept. 30, 2015, which compared to a 34.9% average for 2012.
Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long duration funding and have also used debt financing for acquisition purposes. Average leverage, defined as debt divided by FEBITDA, was 3.54x for 'A' category firms for the TTM ending Sept. 30, 2015, which compared to an average of 2.55x at year-end 2012. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to migrate toward historical averages, as cash proceeds are deployed into FEBITDA-generating opportunities and recent acquisitions begin to contribute to consolidated results.
While core issuer fundamentals remain solid, alternative IMs continue to have record levels of capital to invest at a time when conditions are increasingly challenging. Therefore, there is more capital chasing fewer deals, which could lead to significant fund underperformance if competition bids prices up further. Outsized vintage concentration could potentially exacerbate this issue. While most of the large managers have operated through a variety of market cycles, and have demonstrated investment restraint, pressure for returns from limited partners remains high, given the length of time that interest rates have been at low absolute levels. However, a meaningful portion of the industry's uncalled capital is not-yet-earning fees, often referred to as shadow AUM, which could provide some material upside to alternative IM FEBITDA as the capital is deployed.
KEY RATING DRIVERS
IDRs AND SENIOR DEBT
The ratings affirmations reflect the firm's solid competitive position as a global alternative investment manager, its experienced management team, solid investment track record, strong and predictable fee-related earnings (FRE), given meaningful fee-earning assets under management (FAUM), relatively stable distributable earnings compared to peers, due to the significant FRE component, and the subordination of general partner interests to outstanding indebtedness.
Rating constraints for the sector include 'key man' risk, which is institutionalized throughout many limited partnership agreements, reputational risk, which can impact the company's ability to raise future funds, and legal and regulatory risk, which could alter the alternative investment management space. Risks to the ratings more specific to Ares include lower FEBTIDA margins than peers, weaker revenue diversity given a heavier credit concentration, more limited upside from incentive income, higher leverage, and a relatively low level of on-balance sheet liquidity, as measured by cash or liquid securities relative to debt outstanding.
The cancellation of Ares' announced merger with Kayne Anderson on Oct. 27, 2105 was highly unexpected in Fitch's view, particularly since Ares had already raised \\$325 million of debt capital to fund a portion of the transaction. While Fitch believed there was execution risk associated with the merger, the agency did believe the merger could have provided Ares with a number of potential benefits, such as: a broader investment base, with cross-sell opportunities; enhanced predictability of fees over time, given the locked-in nature of the majority of investor capital; and upside potential to the firm's FEBITDA margins, given increased economies of scale and a lower blended compensation ratio. The termination of the merger raises questions about Ares' strategic planning and heightens Fitch's focus on the firm's ability to produce positive operating leverage in order to yield margin expansion.
At June 30, 2015, Ares' total debt amounted to \\$375 million, consisting of \\$250 million of public unsecured notes, \\$50 million of corporate revolver draws and a \\$75 million guarantee on the credit facility borrowings of Ares Commercial Real Estate Corporation (ACRE), a publicly traded commercial mortgage real estate investment trust managed by Ares. Based on this debt balance, Fitch calculates the firm's leverage (debt/FEBITDA) was 2.97x on a trailing 12 month (TTM) basis at June 30, 2105. This baseline calculation excludes the Part I incentive fees Ares earned from Ares Capital Corporation, a publicly traded business development company managed by the firm, and assumes a 60% compensation ratio on that revenue. If the net Part I incentive fees were included in FEBITDA, leverage would be closer to 1.51x, which is below the peer average.
Subsequent to quarter close, Ares accessed the public debt markets for the second time, issuing \\$325 million of 10-year notes, with a 5.25% coupon. Proceeds from this issuance were expected to go toward the funding of the Kayne Anderson acquisition. However, with the termination of the transaction, Ares will be required to redeem all of the notes at a price equal to 101% of the principal amount plus accrued and unpaid interest. While the redemption premium and administrative costs of the debt raise are deemed manageable, they do not create long-term value for the firm.
At June 30, 2015, Ares' FEBITDA margin (FEBTDA/fee revenue) was 23.2% on a TTM basis, which compares to a peer average that is closer to 32%. The lower margin reflects the firm's higher compensation ratio as compared to peers, on both a base and incentive income basis. Fitch does not expect the firm to adjust its compensation policy; therefore, FEBITDA margin expansion will be heavily dependent upon Ares' ability to scale its operating segments more effectively. Fitch believes positive rating momentum could result from a combination of a sustained decrease in leverage and an improvement in FEBITDA margins, both of which would provide the firm with more operating flexibility through market cycles.
Ares' liquidity profile is sound, but weaker than many higher-rated peers that operate in negative net debt positions. At June 30, 2015, Ares had about \\$101.5 million of balance sheet cash and \\$980 million of borrowing capacity on the corporate revolver, which compared to \\$250 million of long-term debt, \\$50 million of revolver draws, \\$75 million of debt guarantees, and \\$396 million of unfunded commitments. Additionally, in concert with the termination of the merger transaction, Ares announced its intention to invest \\$75 million into Kayne Anderson's energy activities. The use of leverage to fund Kayne commitments along with pre-existing co-investment commitments, at current leverage levels, is viewed unfavorably, as the use of proceeds generate more volatile investment income, not FEBITDA. Fitch is also mindful of the increased energy exposure on the balance sheet.
At June 30, 2015, Ares had \\$87.5 billion of AUM; \\$66 billion of which was fee-earning. FAUM has expanded at a compound annual rate of approximately 15.2% since 2011 and is up 7.6% in 1H15 due largely to the acquisition of EIF Management, LLC, an energy infrastructure manager, which added about \\$4 billion of FAUM. Approximately 15% of the firm's AUM is invested in permanent capital vehicles, while 55% of AUM has an investment tenor of seven or more years. The locked-in nature of the firm's capital compares favorably to peers and provides for more predictability of fees and cash flows over time.
The Stable Outlook reflects Fitch's expectations that management will continue to generate stable management and advisory fees, grow/retain FAUM through the raising of new and expansion of existing funds, sustain operating margins, operate with relatively low leverage, and retain an adequate liquidity profile in order to meet debt service obligations and co-investment commitments to its funds
RATING SENSITIVITIES
IDRs AND SENIOR DEBT
Positive rating momentum may be slowed by the termination of the Kayne Anderson merger, but could be driven by improved FEBITDA margins, increased fee revenue diversity, stronger balance sheet liquidity levels, and the sustained maintenance of leverage below 2.5x.
Negative rating actions could result from material declines in investment performance, a key man event, and/or legislative risk which negatively impact the company's ability to raise FAUM and generate fees, meaningful increases in leverage, and/or further weakening of the liquidity profile.
Headquartered in Los Angeles, CA, Ares is a global alternative IM offering funds across a variety of strategies, including credit, PE and RE. At June 30, 2015, Ares had \\$66 billion of FAUM, largely across its liquid and illiquid credit strategies. Ares was founded in 1997 and completed its initial public offering on May 7, 2014. The stock is listed on the NYSE under the ticker symbol ARES.
Fitch has affirmed the following ratings:
Ares Management LLC
Ares Investments Holding LLC
Ares Offshore Holdings, L.P.
--Long-term Issuer Default Rating (IDR) at 'BBB+'.
Ares Holdings LP
Ares Domestic Holdings LP
Ares Investments LP
Ares Real Estate Holdings LP
--Long-term IDR at 'BBB+';
--Bank Credit Facility at 'BBB+'.
Ares Finance Co. LLC
--Long-term IDR at 'BBB+';
--Senior Unsecured Debt at 'BBB+'.
The Rating Outlook is Stable.
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