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Inflation, a hawkish Fed, fears of a recession have all made 2022 a tough environment for investing. A traditional portfolio of stocks and bonds is deeply in the red, leaving investors to seek diversity elsewhere.
Ares Management, however, has been a beneficiary of the current environment. With hundreds of billions of dollars’ worth of floating rate credit and real assets, the firm’s $200B book has surprisingly held up well. CNBC’s Delivering Alpha newsletter sat down with Ares CEO Michael Arougheti who says that “when the markets get challenged, that’s when our investment opportunity becomes the most attractive.”
(The below has been edited for length and clarity. See above for full video.)
Leslie Picker: How long do you think these tailwinds for your business will last?
Michael Arougheti: I think we have to talk about secular tailwinds in alternatives, and then maybe some of the cyclical tailwinds that we’re seeing as well. So if you look over the last 20 years, we’re seeing a meaningful increase in allocations on the part of institutional and retail investors to alternatives. And to oversimplify what’s a complex series of global flows, it really comes down to a global desire for durable yield. Hence the demand that we see for private credit assets globally, and maybe a dissatisfaction with the performance of traditional 60/40 portfolios and what seems to be more consistent volatility in the traded markets. And so we’re also seeing increasing demand for things like real assets and private equity. I don’t think that will end anytime soon. If you look at institutional allocations to alternatives, they are predicted to double likely over the next five to 10 years at a compound annual growth rate of about 15%. And we’re now seeing the retail investor really take hold as well.
Picker: As you think about the inflationary environment, in particular, and in planning for your own business in conversations with LPs, what’s your take for how long we will be in a current situation like we’re in right now?
Arougheti: Well, this is like something we haven’t seen before. So you know, each cycle is different. But there are echoes of the past. And I think one of the key jobs that we have at Ares is to mine our historical experience and recognize patterns. For the last almost 10 years, it seems like almost every market has been correlated and performing well. We obviously navigated the pandemic with a significant amount of government and central bank intervention. But today, as we sit here, there’s a particularly interesting set of crosscurrents, that’s now starting to see a divergence of opportunity around the globe. So we’re not only dealing with inflation, but we’re now dealing with the impacts of a strong dollar globally, we still haven’t quite gotten through the supply chain constraints that we’re dealing with, and then overlay just for good measure of global, global conflict and energy crisis. So there’s a lot to digest.
Picker: As you digest all of that, do you think it’s possible to avoid a hard landing? And if so, do you think that the markets are already pricing that in?
Arougheti: I think, in the US market, we still have a shot, I think the Fed is on the task, if you look at the strength of the market, and this what makes it particularly challenging to invest in, all of the data that we see, up until this point in our significant private portfolios, we tell you that the economy is still quite strong, corporate balance sheets are well positioned, the consumer is still relatively underleveraged. So we have a ways to go. If you turn your attention to Europe, in certain parts of Asia, the story might be different. I think they’ve got, you know, the increased challenge of the energy crisis and the strong dollar exacerbating the inflation picture for them.
Picker: So how would you characterize the credit quality within your portfolio right now?
Arougheti: For us and others that look like us, it’s been as good as we’ve seen in quite some time. So if there is a silver lining to all the challenges globally, right now, we’re going into this period of volatility with real strong underpinnings.
Picker: Are you surprised by that? Are you surprised that the credit quality has been able to withstand some of the pressures of a rising interest rate environment and lack of liquidity in the system? Inflation?
Arougheti: Yes and no. The reason I say ‘no’ is we’ve, despite the pandemic, we’ve had so much stimulus come into the market that people have had time to prepare. So if you look at the amount of issuance that we saw in the high grade market, if you look at the amount of liquidity that’s been in the system, companies have built up a pretty substantial war chest of liquidity, and the consumer is coming off of a pretty significant amount of government assistance globally. So that in and of itself is not surprising. What I’ve been pleased with is in our portfolios, inflation is present, it has shifted from cost of goods to cost of labor, at least in our US portfolios, but the margins are still at or near all time highs. And I think that’s true for the publicly traded markets as well. So we’re going in with more health than we typically would have when we’re talking about recession risk, the order of magnitude that some people are anxious about.
Picker: So you’ve seen a full transition from the cost of goods we’ve seen, and things like fuel costs go down, lumber go down, other raw materials go down, shift to the cost of wages, which have, of course gone up, not keeping pace with inflation. How is that easier than to digest? What does that mean for margins and kind of the stickiness of these high prices?
Arougheti: So this is – we’re talking about the US specifically.
Picker: US specifically.
Arougheti: So what it really means is one of the ways to think about this credit cycle, or this potential recessionary environment in the US is that it may likely be sector specific. And it’s moving around a little bit, right. So if you say, cost of goods, inflation, that had an impact on retail, hospitality, consumer facing businesses, as you now shift, and you see easing in that now, maybe you’re seeing some pressure on service oriented businesses, you know, that are either facing off with a consumer or trying to navigate a tightening labor market. So I don’t want to say that that’s good. But it’s been a little bit easier to navigate in the sense that there’s not one sector that’s getting consistently challenged by the current environment, it’s giving people a little bit of a reprieve, now and again.
Picker: It’s shifting. So given all that, and given just where you see opportunity, are there certain sectors that you’re putting more capital to work, say, than others, just given kind of the macro backdrop you just outlined?
Arougheti: Yeah, so the good news is about being an alternative manager is we don’t have to invest the dollars that our clients give us. So there are a lot of structural competitive advantages that we have as an alt manager, one of the largest is just the structure of our funds. So if you look at our $340 billion of assets, over $90 billion of it is unvested. So one of the ways we can express a view on the market is by not investing. That’s not necessarily true for traditional 60/40 portfolios, when you have money, you have to express a view on what you think is the best opportunity in the market. So there’s a fundamentally different positioning when you manage private capital versus liquid capital. All that being said, you also have to be measured in the way that you deploy through a cycle. Because if our experience has taught us anything, things can change to the positive as quickly as they change to the negative. So if you look at recent memory, going through the early days of COVID, in 2020, that felt like it was going to be a severely disrupted market for quite some time. And that opportunity to deploy lasted maybe three weeks. So the way that we’re approaching it is we’re obviously looking for what we think is the best risk adjusted return globally. But most of our portfolio managers and investors are investing at a slower pace than they normally would as they wait to see how these markets develop.
Picker: And you are not, is this typical for you? Or is it faster or slower?
Arougheti: Ares has a history of navigating volatile markets well, so if you look at the history of the firm, the period of growth for us it was the largest was through the global financial crisis and through COVID. So we actually tend to see a consolidation of share and maybe counterintuitive and acceleration of capital that comes onto our platform to help navigate. One of the reasons is we’re one of the largest private credit managers 90% of our private credit exposures are floating rate. So if all we do is continue to invest at the top end of a company’s capital structure, or lend against a real asset, with rates going up the way that they are, there’s significant embedded profit potential. And that’s pretty attractive to most investors right now.
Picker: What about on the supply side of the equation? What about the companies that are seeking that type of financing? Are you still seeing that as active?
Arougheti: It’s slowing, anytime the market goes through this type of a transition or a reset, transaction volumes will naturally slow in the private market. And the simple answer for that is buyers and sellers need to take time to re agree on what the appropriate price for a company or an asset are. My experience would tell you that that’s usually a six to 12 month process, that has to take into account a shared view of what the economy is going to look like, and take into account what the new financing markets look like. So when you’re in an environment now, where the cost of financing is going up, maybe the availability of financing is going down, and rates are rising, putting pressure on discount rates, the markets will pause to try to evaluate where assets will clear. And then it will, it will pick back up again.
Picker: So six to 12 months puts us at what, January?
Arougheti: Yeah, we’re already seeing the pipeline start to build into the end of the year. So I’ve been encouraged by that from an activity and deployment level. And then surprisingly, when the private markets slow, you usually see public markets challenged as well. So we’re giving a little bit back in the private flow. But now there are things like take privates that are being talked about, again, where we’re now mining flow in the public market, or rescue financing as some of the distressed strategies that we operate in are starting to be a liquidity provider, given that the liquid markets are effectively closed right now.
Picker: So in recent months and we’ve spoken, private equity has been essentially the kind of the laggard in terms of dealmaking. It’s just waiting for the market to really open up to be more aggressive. Would you say that’s coming back then?
Arougheti: Yes, and no. And it’s hard to generalize about a market that’s trillions of dollars deep and, and is global, I would say the following, private equity enjoyed a wonderful rebound coming out of COVID. So if you look at the positioning of most portfolios, they were, if not fully invested in moving towards full investment, and enjoyed great performance in 2021. So that was the good news. The challenge right now is in 2022, given how well the portfolio’s performed and how deployed, they were given the significant amount of volume in 2021, the market now is digesting the need for more capital against the backdrop of a lack of capital. And that’s a function of great performance, but it’s also a function of what they call the denominator effect, which is as public market valuations come down, traditional fixed income valuations come down, those allocators of capital that are managing to a model have less capital to deploy into private equity. So I think with private equity specifically, and I wouldn’t say the same right now for private credit, and real assets, there’s a little bit of a rebalancing that needs to take place just because we’re not seeing as many exits. And therefore you’re not going to see as much transaction volume as people manage their liquidity.
Picker: So that would imply that fundraising is a bit more challenging as well in PE?
Arougheti: I think, for traditional private equity for many it likely will be. I think that capital will get raised, I think it will just take a little bit longer. I think many managers got accustomed to very quick fundraisers and I think they got accustomed to fundraisers happening prior to return of money. And I think now we’re back to kind of what it used to be, which is to invest my money well, return it, and it could take 12 to 18 months. But ultimately, the market is there, and the demand for the product is there. We’re not having that experience. And I also think that some of the large public platforms similarly continue to raise money. Despite that, that issue and I think that’s a reflection of, of a consolidation of LP dollars with fewer GPS.
Picker: So given all of this Ares’ stock price is basically flat on the year which is outperforming the S&P, it’s outperforming your peers, but still flat. Why do you think that is?
Arougheti: You have to look at it on a relative basis. So, Ares, I think we’ve been fortunate that we’re outperforming not just the public asset management peers, but the markets generally. I think that’s a reflection of the nature of our business. It’s somewhat counter cyclical. So when the markets get challenged, that’s when our investment opportunity becomes the most attractive. It’s also a reflection, I think of the investors understanding that embedded value that sits in our private credit portfolios. So we have some publicly traded credit companies, ARCC, ACRE, that largely manage floating rate assets. And we’ve been pretty vocal that again, if all we do is sit on our existing exposures, we can see core earnings growing, you know, in the double digit range just because of the rise in base rates. And that’s obviously pretty attractive to an investor who’s looking for certainty of yield. When the markets are so uncertain.
