Ares' Focus on Credit Should Pay Off

We'd define the credit opportunity for Ares in two ways. First, banks are divesting themselves of risky and complex credit instruments to buyers like Ares because of tougher regulatory rules. Ares, as a result of its deep expertise and extensive relationships, is better positioned than most investors to acquire these difficult-to-value instruments at a reasonable price from forced sellers, generating excess returns for its investors. We see the total opportunity here as sizable; potentially more than a trillion dollars' worth of assets could be divested over the next decade.

Second, banks are stepping back from lending to certain middle-market and non-investment-grade companies in another effort to shed risk. We expect continued pressure on the banks here, particularly as regulators are asking banks to carefully scrutinize highly leveraged lending practices. Ares has filled this niche through Ares Capital, its business development company, which is one of the industry's most experienced and largest middle-market lenders. Ares' direct lending vehicles have a pool of $28 billion in AUM with operations throughout the United States and Europe. The business development company model can be risky--former industry giant Allied Capital, which Ares Capital acquired in 2010, struggled mightily after one of its large investments declared bankruptcy and Allied had guaranteed the firm's obligations. However, Ares Capital is focused on lending rather than purchasing entire companies, and the lower-risk model instead generates more than $200 million in fees to parent Ares Management annually. Ares Capital benefits from its relationship with Ares Management, as the parent provides a steady source of strong deal flow.

Our Fair Value Estimate Is $24 per Unit After Ares' solid third quarter, we maintained our fair value estimate of $24 per unit. Our fair value estimate implies a 2015 price/economic net income multiple (the industry's preferred metric) of 12 times, a 2015 price/distributable net income of 15 times (our preferred metric because it removes unrealized incentive income and is thus closer to cash earnings), and a dividend yield of 6.3%. Economic net income was affected negatively by lower performance fees, as fund fair values declined due to market volatility, but we think the third-quarter report did help highlight the stability and quality of Ares' earnings relative to peers. Management fees of $154 million were essentially flat from last year's levels, and the fees now make up more than 90% of Ares' revenue base, much higher than the roughly 50/50 split we see at peers. Ares Capital, which generated 20% of Ares' management fees, looks well positioned, with $1.3 billion in lending commitments during the quarter. We remain optimistic about further lending opportunities in Europe due to stretched bank balance sheets. AUM inflows for the quarter were respectable at $3.6 billion and mainly driven by alternative credit and real estate funds, while being offset by $1.4 billion in distributions and $1 billion in capital reductions.

We're fans of the alternative asset manager business model versus traditional asset managers. The alternative asset manager model includes higher profitability and secular tailwinds (increasing allocations from institutions), and we could see multiple expansion over time as investors reach greater levels of comfort with the lumpier, but recurring, nature of performance fees over long time horizons. That said, we expect that the industry's use of the partnership rather than the traditional corporate structure means that the alternative asset managers will still trade at a discount to their traditional peers, probably because of potential tax ramifications, thanks to the industry's use of K-1s, which creates tax complexity and the carried interest tax issue. We also assume that carried interest tax reform eventually passes in some fashion and our long-term tax rate is 35%, although we do not see any near-term threats to the industry at this stage.

Alternative Asset Managers Enjoy Reputation Benefits and Sticky Assets We believe Ares has earned a narrow moat. Traditional asset managers typically benefit from intangible assets and switching costs as moat sources, in the form of substantial reputation benefits as well as sticky assets. We think alternative asset managers like Ares benefit even more than the traditional asset managers from these sources, given the less transparent nature of the lucrative returns they earn. In late 2014, Ares acquired Energy Fund Investors, which added another $4 billion in energy-infrastructure-focused investments and four additional funds. Ares now manages about $14 billion in private equity AUM, with more than $7 billion in energy-related investments. Out of the major asset classes of the alternative asset industry managers, we consider private equity to have the strongest competitive advantages, primarily because a firm needs to attract and hire ex-industry executives to turn around the acquired companies, but also because of the lengthy record required by investors and the deep relationships required to source deal flow and attract new limited partners on a global scale. Funds tend to have 10- to 11-year lockup periods as well, meaning investors see a return of capital only when an investment is realized, which is at Ares' discretion.

The bulk of Ares' AUM is credit, and we think many of the advantages from private equity transfer over. The average management contract terms for the credit strategies (tradable credit and direct lending) range from nine to 12 years, and we still believe the space requires a substantial investment in investment talent, compliance, disclosure, deal sourcing, and fund-raising efforts. About 15% of Ares' AUM is considered permanent capital, as the publicly traded credit funds held within Ares Capital and several other vehicles are not required to return capital to investors upon exiting the investments, which provides substantial switching costs for Ares. We believe Ares is ahead of its peers through its deep relationship with Ares Capital, which was formed in 2004. With regulators putting pressure on traditional banks to more carefully scrutinize highly leveraged lending activity, Ares Management can direct deal flow toward Ares Capital to fund the required loans, letting it pursue deals that competitors might otherwise struggle to obtain funding for. We believe Ares Capital has one of the largest direct lending platforms in the industry, though we note that

Overall, the ability to invest globally across multiple strategies with offices, investment professionals, and fund-raising teams located globally demands a certain level of scale across multiple channels. In fact, we believe the number of marketing channels is fragmented across the industry, as inflows from pension funds and fund of funds are increasingly stagnating, while sovereign wealth funds and retail investor channels are growing in importance, demanding higher levels of marketing investment than in the recent past. In addition, investors are looking to consolidate the number of managers they invest with to reduce monitoring and fee costs, with a focus on managers that can meet increasingly tougher compliance and transparency requirements, which requires substantial investments. As a result, in recent years, institutional investors (nearly 80% of industry AUM) have typically directed an estimated 90% of industry asset flows to funds with assets over $1 billion. We believe the alternative asset management industry asset flows will increasingly consolidate around a few select global managers, and Ares, due to its size, will be one of the beneficiaries.

Majority of Distributed Earnings to Benefit Insiders We give Ares a Standard stewardship rating. Ares was established in 1997 by its five cofounders: Michael Arougheti, David Kaplan, John Kissick, Antony Ressler, and Bennett Rosenthal. With four out of five cofounders in their 40s and 50s, we consider the succession issue a critical topic, given the importance of a consistent investment process and the founders' typically outsize role in attracting new AUM. The founders as a group own about 40% of the company, and Ares insiders overall own about 70%. As a result, while we expect Ares to pay out 80%-90% of its distributable earnings, in line with peers and a positive from a capital allocation standpoint typically, the vast majority of the cash will be returned to insiders versus common unitholders.

The other major capital allocation decisions in recent years for Ares were the acquisition of Allied Capital in 2010 (through Ares Capital) and the purchase of AREA Property Partners in 2013. The acquisition of Allied Capital was a classic distressed purchase by Ares, and as portfolio yields, realized losses, and core earnings have remained stable or improved since the deal (Ares Capital's stock has returned about 100% since the merger as well), we consider it a highly successful deal. However, we see this as a one-time opportunity and a unique situation, so we'd look for a longer record of smart capital allocation before awarding an Exemplary stewardship rating. AREA added about $6 billion in real estate AUM to Ares, but the overall segment is still less than $10 billion in AUM and profitability is limited at this stage. We consider the move smart, as it adds a new strategy to Ares' portfolio, but we don't consider the move particularly exceptional versus similar acquisitions made by peers.