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ARES on GE Opportunity

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Topic: BDCs — ARCC
May. 13 2015, 10:50 AM ET - by VF member NAL (1040 gold star (click for information on feedback))

ARES on GE Opportunity --

One of the most interesting recent developments in the BDC sector is the announcement by General Electric (GE) that its middle market lending business is up for sale. We already saw this specifically impact business plans at ACAS, with GE's announcement cited as one of the recent developments prompting a change to their spin-off strategy to now spin out just the one large BDC with a plan to "tackle this opportunity." Another important player just mentioned GE on their earnings call this week, that player being ARES (manager of ARCC). I also tuned in to the NewStar (NEWS) call where GE came up as well. I thought the following conference call transcript snippets would be worth posting (my emphasis added in underline/bold):

From the ARES call Q&A:

Doug Mewhirter - SunTrust

This was partially addressed from ARCC’s view point week or two ago, but I just wanted to see – get your comments on the uncertainties surrounding GE Capital. And, obviously, it may or not affect ARCC directly, but also how it would affect the other markets in which you participate in? Because obviously they are a very broadly diversified platform sort of the good and the bad from what is happening now.

Michael Arougheti

Sure. Again, as I often do, I will try to take this high level and then maybe get specific on some of the markets that we play in. To start, as I – and I mentioned this in our prepared remarks, generally speaking, Ares’ position to take advantage of market dislocation; probably the biggest singular trend driving our business right now is changing bank behavior both in the U.S. and Europe.

It is having a meaningful positive impact on the opportunity in U.S. and European Direct Lending as well as our Tradable Credit business. I view the GE announcement of, a couple of weeks ago, really as just the continuation of this trend of banks and regulated institutions exiting attractive markets to our benefit just because of regulatory cost of capital, regulatory burdens, et cetera, et cetera.

So, at a high level, GE exciting the business is a very, very good thing for Ares. We expect that it will create opportunities within direct lending both in the U.S. and Europe. We think that it will create opportunities in our commercial real estate lending businesses in both the U.S. and Europe. We think that it will drive growth in our commercial finance platform, which as we’ve talked about is still in its infancy as a business here, but has been growing quite dramatically.

So, I would expect increased share because of GE leaving for Ares. I would also expect that the ROA and ROE on a lot of the businesses that GE used to participate in will become more attractive. As good as GE is at credit and investing in many of the markets where we would bump into them, they were effectively an unnatural competitor. They have the lowest cost of capital with the highest balance sheet leverage and, as a result, are able to compete on price in a way that other market participants aren’t.

So, it may take some time to work its way through the market, but my personal expectation is in many of the markets where we used to bump into GE we will see fees go up, margins widen and certain structural changes work the way through to the market to accommodate non-bank players and non-GE players in those markets. Vis-à-vis the corporate uncertainties you mentioned around GE maybe just to reiterate some of the things that Kipp talked about on the ARCC call, but GE has been a great partner of ours over the last 5.5 years in SSLP; and I think together we have introduced a wonderful product in the form of the unitranche that changed the direct lending landscape in the U.S. a little bit. That said, shouldn’t be lost on people that Ares’ direct lending business is, we believe the largest in the market.

We have 85 front facing investment professionals who are originating and executing on that business everyday with phenomenal credit performance. So, our hope is that through this process there will be a resolution that is good for the existing SSLP. However, I think that we are going to be very successful regardless of how this process plays out given our market position and given some of the strategic dialogue we are having with investors and financing sources around this sale process.

Personally I found this discussion to be very interesting. Over on the ARCC call they had used the phrase "seismic shift" (full quote was: "GE Capital's exit from our industry presents a seismic shift in the landscape of middle-market lending"). Another middle market lender, NewStar (NEWS) also talked about this development on their call. NewStar is not structured as a BDC and pays no dividend; they focus higher up in the capital structure but also target much higher leverage levels (their stated goal is to increase their leverage to 6x [gulp]).

Here is a snippet from the NewStar conference call, with the CEO talking about GE:

Tim Conway

I'd like to take a minute on market trends. In the first quarter, we saw increasing regulatory pressure on the banks, which discouraged leverage-lending activity, which has been going on for several quarters. As a result, banks are ceding market share to non-bank lenders like ourselves. More significantly and directly consequential to our markets was the recent announcement by GE that it intends to divest a vast majority of its capital business.

As you know, GE Capital is believed to be the largest middle market lender to private equity firms in the US through its sponsor finance business. Its exit from the industry is likely to result in lasting changes to the competitive landscape. While there is a significant degree of uncertainty about how the M&A process plays out and who might acquire the platform, I believe it's a positive development for us in any scenario that I can think of. As a result, I generally believe the pricing environment is likely to improve and there will be opportunities for us to continue to pick up market share.

NewStar, Ares, American Capital, and others are all making the same point about the expected impact on pricing: that it will be expected to improve. I thought the "unnatural competitor" quote from Arougheti summed it up well... With the GE parent at a market cap of 270+ Billion, they were able to step into the middle market lending arena with such size and such low cost of capital that it may very well be impossible to match in the future no matter who ends up acquiring that business line. This does sound like it presents an exciting opportunity for smaller firms including within the BDC sector.

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ARES on GE Opportunity