Good afternoon. Welcome to the Ares Capital Corporation September 30th, 2020 earnings conference call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Tuesday, October 27th, 2020. I will now turn the call over to Mr. John Stilmar, Managing Director of Investor Relations.
Thank you. Let me start with some important reminders. Comments made during the course of this conference call and webcast, as well as accompanying documents, contain forward-looking statements and are subject to risks and uncertainties, including the impact of COVID-19, related changes in base rates, and significant market volatility on our business and our portfolio companies. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may, and similar such expressions. The company's actual results could differ materially from those expressed in such forward-looking statements for any reason, including those listed in its SEC filings. Ares Capital Corporation assumes no obligation to update any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results.
During this conference call, the company may discuss certain non-GAAP measures as identified by SEC Regulation G, such as core earnings per share or Core EPS. The company believes that Core EPS provides useful information to investors regarding financial performance because it is one method the company uses to measure its financial condition and results of its operations. A reconciliation of Core EPS to the net per share increase or decrease in stockholders' equity resulting from operation, the most directly comparable GAAP financial measure, can be found in the accompanying slide presentation for this call. In addition, reconciliation of these measures may also be found in our earnings release filed this morning with the SEC on Form 8-K. Certain information discussed in this presentation, including information relating to portfolio companies, was derived from third-party sources and has not been independently verified.
Accordingly, the company makes no representation or warranties with respect to this information. The company's third quarter ended September 30, 2020 earnings presentation can be found on the company's website at www.arescapitalcorp.com by clicking on the Q320 earnings presentation link on the homepage of the investor resources section of its website. Ares Capital Corporation's earnings release and 10-Q are also available on the company's website. I'll now turn the call over to Kipp deVeer, Ares Capital Corporation's Chief Executive Officer.
Thanks, John. Hello everyone, and thank you for joining us. I'm joined on the line by our Co-Presidents, Mitch Goldstein and Michael Smith, our Chief Financial Officer, Penni Roll, and several other members of the management team. I will start by highlighting our third quarter results and then provide some thoughts on the company's position. This morning, we reported third quarter Core EPS of $0.39 per share, consistent with our second quarter earnings, and we believe another strong result given the impact from COVID. Our Q3 GAAP EPS of $1.04 increased meaningfully, driven by strong net appreciation in our investment portfolio. Our net asset value per share climbed to $16.48, an increase of $0.90 per share, or approximately 6% since March 31st, 2020, when we registered the most significant impact from COVID on portfolio values.
During the third quarter, we also capitalized on strong market conditions to further extend the duration of our unsecured liabilities by raising over $1.1 billion of unsecured notes across two successful offerings. Our available liquidity now stands at more than $4.4 billion at quarter end, putting us in a good position to make investments in a more active market and to continue to support portfolio companies as needed. In terms of market conditions, investor risk appetite has improved due to some continuing signs of economic recovery, better than expected corporate earnings, and the positive effects of fiscal stimulus, all of which have been supportive of the broader liquid credit markets. With this firmer tone in the market and a slower new issue calendar, secondary market loan prices rose, and loan spreads on new deals began to decline.
These trends have flowed through to the middle market and have had a positive impact on the value of our portfolio. Observing these overall trends, we are generally seeing management teams and sponsors shifting their focus from risk management and value preservation to growth and value creation. We are also now seeing an acceleration of M&A activity and our deal flow. Businesses are increasingly seeking acquisitions to reposition their business models or to capitalize on new growth verticals in a post-COVID-19 world. In addition, there's pent-up demand from a very slow period this spring and summer. Many transactions that were being considered pre-COVID-19 are now returning to the foreground and seem actionable. Some sponsors are seeking to lock in gains for 2020, especially ahead of the upcoming elections.
With these dynamics, we would expect to see busier quarters in the future compared with what we saw in both the second and third quarters. One interesting trend that we're observing is that the average company that's seeking our financing solutions is increasing in size. The average EBITDA of companies in our new deal pipeline is roughly twice that of the companies that we were evaluating during the third quarter of last year. This trend reflects the expanding market opportunity and a growing desire by our clients to tap the increased certainty that direct lending solutions offer versus public syndicated alternatives. Given our long-term relationships, significant scale, and extensive positions of incumbency, we believe ARCC remains well-positioned to benefit from both the re-emergence of activity and the continued secular growth opportunity in direct lending. Shifting back to the portfolio.
As we mentioned at the outset, we saw a net increase in the fair value of our portfolio, driven largely by supportive market prices and stable to improving earnings across the portfolio as a whole. Underscoring the health of our overall portfolio during the third quarter, we collected 99% of contractual interest due, had a 60% drop in the amount of new amendments, and continued to see net revolver repayments from our portfolio companies. Revolver drawings are now back to drawing levels that are near pre-COVID-19. We believe this highlights the improving liquidity profile of a number of our portfolio companies. We also continue to see evidence that our focus on upper middle-market businesses results in a more resilient and stable portfolio of companies as compared to lower middle-market companies.
Across the portfolio companies with EBITDA of $100 million or more are showing greater earnings stability or growth on average compared to our companies with less than $25 million of EBITDA. Regarding the health of our portfolio, our weighted average portfolio grade of 2.9 remained stable versus last quarter, and less than 5% of our portfolio companies changed grades. The ratio of upgrades to downgrades was greater than three to one , which we believe highlights the steady to improving cash flows of our portfolio companies that has followed with partial or complete reopenings of many businesses. For the more COVID-impacted names, which we largely see in our grade one and grade two names, we believe we have an informed view of their path to recovery. We do think this recovery will take time and likely be quite uneven with the ever-evolving COVID health crisis.
We believe many of these companies are generally strong franchises with every reason to perform as they did pre-COVID, and that they will recover during more certain economic times. Our confidence is further supported by the fact that a significant number of them have already received additional sponsor equity beneath our loan positions, which provides cushion to our capital and a validation for the future of these companies. Given our stable earnings, our strong balance sheet, and the improving outlook for investment activity, we declared a 40-cent per share quarterly cash dividend for the fourth quarter of 2020. We believe we can continue to support a steady dividend level through varying market conditions. I'll now turn it over to Penni to provide more details on our third quarter results.
Thanks, Kipp, and good afternoon. Our core earnings per share were $0.39 for the third quarter of 2020, flat with $0.39 for the second quarter, and down from $0.48 for the third quarter of 2019. We had GAAP net income per share for the third quarter of 2020 of $1.04, which compares to $0.65 for the second quarter of 2020 and $0.41 for the third quarter of 2019. Our GAAP net income per share for the third quarter of 2020 of $1.04 per share includes net unrealized gains of $0.71 per share, partially offset by net realized losses of $0.06 per share. The net unrealized gains primarily reflect further tightening of credit spreads relative to the end of the first and second quarters of 2020 and some performance improvement in select names.
These unrealized gains were partially offset by increased unrealized depreciation for certain investments experiencing the continuing impact of the COVID-19 pandemic. The $306 million of net unrealized gains on investments for the third quarter of 2020 were approximately 2% of our total assets at fair value and 4.4% of net asset value. Our total portfolio at fair value at the end of the quarter was $14.4 billion. As of September 30, 2020, the weighted average yield on our debt and other income-producing securities at amortized cost was 9.1%, and the weighted average yield on total investments at amortized cost was 7.8%, as compared to 8.9% and 7.7%, respectively, at June 30, 2020. Our higher yields were primarily due to certain repricings within the existing portfolio, as well as an increase in the yield on the SDLP subordinated certificates.
At September 30, 2020, 83% of our total portfolio at fair value was in floating rate investments. Additionally, excluding our investment in the SDLP certificates, 84% of the remaining floating rate investments had an average LIBOR floor of approximately 1.1%, which is well above today's current three-month LIBOR rate. Now let's shift to discussing our shareholders' equity. At September 30, 2020, our stockholders' equity was $7 billion, resulting in a net asset value of $16.48 per share versus $6.7 billion, or $15.83 per share at the end of the second quarter of 2020. The increase in our net asset value was primarily driven by the net unrealized gains that we recognized in the third quarter of 2020 that I mentioned earlier.
As of September 30th, our debt-to-equity ratio, net of available cash of $213 million, was 1.07 times, which remains right in the midpoint of our stated target leverage range of 0.9-1.25 times and is essentially unchanged from 1.08 times at June 30th. Due to our successful investment grade bond issuances during the quarter, we ended the quarter with available liquidity of more than $4.4 billion, up by nearly $1 billion since June 30th. Specifically, we issued an aggregate $1.15 billion of three and seven eighths unsecured notes that mature in January 2026. The first $750 million was issued in July, and $400 million was later added through a follow-on offering in September as we took advantage of increasingly issuer-friendly market conditions. The follow-on was issued at a yield that was over 40 basis points lower than the original issuance yield.
Collectively, these 2026 notes represent the single largest aggregate principal issuance in our history, helping to lower the overall weighted average cost of our unsecured debt and significantly reducing any refinancing risk around our next unsecured note maturity, which isn't until 2022. We believe that the strength of our capital structure represents a clear competitive advantage for us in today's environment, and that an important component of our capitalization is having diverse funding sources, including a diverse mix of unsecured and secured debt capital to complement our permanent equity capital. As of September 30th, over 75% of our outstanding borrowings were from unsecured debt, which resulted in 85% of our assets being supported by unsecured debt and equity. This approach to maintaining a largely unsecured capital structure provides us with significant over-collateralization of our secured credit facilities, which positions us well to fully access the total borrowing capacity available.
Before I conclude, I want to discuss our undistributed taxable income and our dividend. Our spillover income from 2019 for distribution in 2020 was $410 million or $0.96 per share. As we've said many times in the past, we believe having a strong and meaningful level of undistributed spillover supports our goal of maintaining a steady dividend through varying market conditions. As Kipp mentioned, this morning we declared a regular third quarter cash dividend of $0.40 per share. Our fourth quarter dividend is payable on December 30th, 2020, to stockholders of record on December 15th, 2020. Now I will turn the call over to Mitch to discuss our third quarter investment activities and our portfolio positioning in more detail.
Thanks, Penni, and good afternoon. During the quarter, our team originated $706 million of new investment commitments across 24 transactions. 94% of the commitments issued were senior secured, and as typical for us, over 60% of the transactions were to incumbent borrowers. Consistent with our focus on non-cyclical industries, two-thirds of the newly issued commitments were to software, healthcare services, commercial services, and life science companies. With expanding M&A activity and favorable competitive dynamics, we are finding the market for new investments to be attractive. For new first lien commitments originated this quarter, we achieved about 100 basis points in higher yield than the senior loans originated back in the first quarter of 2020, the last full quarter before the COVID-19 crisis.
We have also found compelling fee opportunities in today's market as our senior loan structuring fees in the third quarter were nearly 20% higher than the fees on senior loans from the first quarter of 2020. Importantly, we were able to achieve these returns with more conservative leverage levels. For example, the senior loans we originated in the third quarter had a half a turn of lower leverage than existed in our senior loan portfolio at the end of 2019. Going forward, we expect the market to remain attractive as banks have tightened balance sheet lending standards this year, and the competitive environment remains favorable while greater M&A activity is creating a wider opportunity set in which to invest.
Shifting to our portfolio in terms of risk management, we remain focused on maintaining a highly diversified portfolio, which today includes 347 different companies with an average hold position at fair value of only 0.3%. We believe this diversity is a differentiator as it underscores the performance of any single investment is unlikely to have a material impact on the aggregate performance of our company. We also believe that it highlights the strength of our origination platform. The diverse portfolio supports more stability in our investment income, and with that, we anticipate our dividend. Furthermore, with a weighted average loan-to-value percentage across our loan portfolio in the low 50s, we believe our portfolio has significant value protection. We also believe that our portfolio, which is focused on high free cash flow, non-cyclical industries, is resilient and defensive.
As Kipp stated, our focus on upper middle market companies is benefiting our performance as our companies with over $100 million of EBITDA are experiencing better than the portfolio average EBITDA growth. Shifting to our non-accrual rate, during the third quarter, one net new company was added to non-accrual. This resulted in a modest increase to our non-accruals to 5.1% at cost and 3.2% at fair value as compared to 4.4% at cost and 2.6% at fair value last quarter. Based on where we are today with recovering corporate earnings and healthy financial markets, we believe that in future quarters, non-accrual levels may stabilize or could improve from these third quarter levels. Now, before I turn the call back over to Kipp for some closing remarks, let me provide a brief update on our post-quarter investment activity.
From October 1st through October 21st, 2020, we made new investment commitments totaling $419 million, of which $340 million were funded. As of October 21st, our backlog and pipeline stood at roughly $1.6 billion collectively. Note that our backlog contains investments that are still subject to approvals and documentation and may not close, or we may sell a portion of these investments post-closing. I'll turn the call back over to Kipp.
Thanks a lot, Mitch. In summary, we delivered another quarter of strong and consistent financial performance, including significant growth in our net asset value, and we did it during a challenging time. We believe market activity is improving heading into year-end, and that we're well-positioned to take advantage given our strong balance sheet and liquidity. Managing the portfolio and mitigating risk in our COVID-impacted names will remain the utmost focus. However, we feel that we've identified the situations that require this extra effort, and we have them under control. To conclude, let me remind everyone that our company is modestly leveraged and has the liquidity needed to support portfolio companies.
Ares Capital has a strong financial profile today, and even if the recovery from this health crisis is uneven and takes longer than expected, we believe that core earnings and net asset values are stabilizing or could improve from third quarter levels. Ultimately, we remain confident that our company will emerge stronger and likely in a better competitive position than ever before. That concludes our prepared remarks. We'd be happy to open the line for questions.
At this time, if you would like to ask a question, please press star then one on your touch-tone phone. If you would like to withdraw your question, please press star then two. Please note as a courtesy to those who may wish to ask a question, please limit yourself to one question and a single follow-up. If you have additional questions, you may reenter the queue. The investor relations team will be available to address any further questions at the conclusion of today's call. Our first question will come from John Hecht with Jefferies.
Morning, guys. Thanks very much. Congratulations on a good quarter. Kipp, you seemed a little bit more optimistic, constructive, I guess, just thinking about market trends and where your portfolio is going, and you talked about a pickup in opportunity as portfolio companies either invest in growth or transitioning business model. That seems like from a pipeline perspective, there may be more opportunity, but at the same time, it seems like there's still a lot of economic uncertainty about how this might unravel next year. I guess the question is, how do you guys internally balance those uncertainties and opportunities at the same time?
Yeah. Hey, John. It's Kipp. Can you hear me okay?
I can. Thanks.
All right, good. Yeah, it's a good question. That's obviously what we're talking about internally every day, thinking about the investing business, both new and managing risk. I would tell you, I think I am a little bit more optimistic. It's hard not to be versus seven months ago. I think the positives are we have a lot more certainty around the portfolio and the situations that we think are challenging. I mentioned in the prepared remarks that we feel we have much more control and more understanding of what's happening there. We don't see any negative migration. As we've mentioned in the past, we kind of think we have our arms around the situations that need extra attention. Yeah, in terms of optimism going forward, it's a much, much busier environment. It's much more constructive around getting new deals done.
I tried to lay out some comments, too, in what I said, but there was really not a lot of activity through, I'd say, July, and our pipeline's picked up substantially. As I look forward, I'm more optimistic on having some busier quarters and potentially with that, some continued good and maybe even better earnings from here, right? Look, I think that this recovery is going to be longer than we all expected, and I think it's going to be uneven, as I mentioned in the prepared remarks. I wouldn't say we're out running and gunning, so to speak, but we're a lot busier, and I definitely am more optimistic.
All right. Thanks. That's helpful. Then you also cited that the average size of company has materially increased over the past few quarters in terms of where you can participate. Obviously, some sense of that is just you guys gaining market share, maybe market awareness of how you're in market and able to do things. Is there any part of that that might be tied to banks pulling back in certain categories or other competitive factors?
I think it's all of that. I think as we've done larger and larger deals, it's become obvious to people that we're capable of doing these, right? You've seen really over the last five years, just growth in private markets, right? More acceptance of private market transactions versus syndicated transactions. We're still seeing the banks active, but I think that they're active in even larger deals than the ones we're focused on. They're trying to create securities for liquid credit investors, so to speak, to buy that really have good liquidity. as you know, and others know, a billion-dollar deal just doesn't have a lot of liquidity in the aftermarket. I think it's a preference on our part, on the part of banks, on the part of companies to continue to support direct lending in larger transactions.
I think my last point would definitely be, look, uncertainty in the markets brings a desire to find partners that are willing and able, and I think we've proven that we are, right? The uncertainty that we have continued to encounter here, I think only leads to probably more large private deals going forward.
Yep. All right. That all helps. Thanks very much.
Thanks a lot, John.
Our next question comes from Finian O'Shea with Wells Fargo Securities.
Hi, good afternoon. First question, I suppose Kipp and Penni, I think you referenced 85% of assets are secured by or financed by unsecured and equity now, which we've seen that number grow over time as you've been able to access unsecured impressively. Is that something we should expect to continue given the elevated levels and assuming you want some bank financing and not too much of it? I guess second part to that is does that or will that drive any shift in your overall strategy? Would you take more risk from a security perspective or a balance sheet perspective at ARCC as that would allow?
Sure. Hey, Fin. Thanks for the question. I'm going to let Penni chime in, too. Our liability structure is not going to change our investing business, right? It's been the same for 16-ish years with a couple of nuances added on over the years with things like the SSLPs and the SDLP, Ivy Hill, et cetera. The core investing business isn't going to change at all. I'll let Penni talk a little bit more, but the only comment I'd make is we think we positioned ourselves really well with the amount of unsecured debt that we had going in. We saw some others not be so well-positioned and have to do some things that they probably didn't want to do. We're really trying to keep flexibility during an uncertain period.
I would kick it over to Penni and let her add any comments if she'd like to.
Yeah. Thanks, Kipp. Thanks, Finian. Yeah, 85% honestly is probably on the higher side for us generally, but I think the most important thing we're trying to do right now is to build a really strong balance sheet, and that's always been something that we've focused on. given the opportunity to issue in the unsecured markets during Q3, it gave us an opportunity to just increase that in thinking about having stable funding sources and laddered maturities over time. I would reiterate that when we go to the market, we look at it as trying to do it in an opportunistic way as usual, and we don't have any maturities due until 2022. this is really focused more not on refinancing needs or worrying about anything in '21, but more just continuing to build out a strong laddered capital structure.
As we move through time, that percentage may come down a little bit as we are able to roll off some of those maturities. Because they don't come till 2022, we'll probably run with a higher percentage of unsecured for a little while.
Thanks so much. Just one follow-on on a post-quarter deal, Capstone. Can you just give color on the nature of how the BDC participated? It was a syndicated deal. I think you guys have had a small revolver commitment for some time. Is that something that for the first lien syndicated, did the BDC participate in that in an investor sense or a arranger sense? Any color you could provide there would help, and that's all for me. Thank you.
Yeah. It hasn't closed yet, so we're not entirely sure how it plays out, but it's obviously an ongoing syndication where we intend to have some buy and hold in the name. Probably not appropriate with a market deal to talk about what our intentions are vis-à-vis what we plan to hold and which securities and all that if you don't mind, Fin.
Yep, understand. Thanks again.
No problem.
Our next question will come from Rick Shane with JP Morgan.
Good morning, everybody, and thanks for taking my question. I just want to talk about slides 16 and 17, investment activity post the end of the quarter and non-accruals. The $326 million that you cite as exited, is that fair value or cost?
Oh, gosh. Penni, do you have-
Sorry, this is Penni. I can help out here. It's the cost basis because that's our total committed amount that we cite as exited. therefore, to the extent it's funded, it's a cost.
Got it. When we look at the non-accruals, we should take the non-accruals at cost down by 38% of the $326 million.
That would be the right math, yeah, on a pro forma basis. Yeah. I would just add to that, the exits that we had were near the fair values at 9/30, so.
Got it. Yeah. That was actually part of my question. I'm assuming that this is all already reflected in NAV. The
Penni, I'm not sure. I didn't hear part of your response, or I wasn't sure if you were pausing to think about the response, so I apologize. When we think about the realized losses of $83 million, were those disproportionately concentrated in the 38% that were on non-accrual?
I think those were probably all of the non-accruals because what happens is when we actually exit something, then we will remove the cost basis, and then to the extent there's an embedded loss, we would record the realized loss. It really just moves the unrealized to realized. It is concentrated in those names that were on non-accrual. I would just remind everyone too, that when we exit or have some kind of restructuring event, we do need to look at anything that we exchange at fair value so that we would have to record the loss. We have the new basis effectively in anything that we exchange.
therefore, as our history would show, when we do restructures and we take upside in those companies, we have the opportunity to make that loss back where we have those potential upsides through new securities that we've exchanged into.
Got it. Okay, that's very helpful. Thank you very much.
Thanks, Rick.
Our next question comes from Devin Ryan with JMP Securities.
Thanks very much. Good afternoon. First question here, just on credit. Clearly, seeing a pretty substantial recovery here, I think better than many were anticipating a couple of quarters back early into the pandemic. I'm just curious on how much spread tightening you're seeing on new deals and deals kind of today relative to a few months back and the investments that were being made early in the quarter.
Sure, Devin. I think the NAV increase is obviously off a pretty substantial mark back from Q1, I think when there was a lot more uncertainty and obviously the liquid credit markets that we reference were in a different place. We've seen steadily improving performance. We talked about sort of the amount of upgrades versus downgrades in the portfolio, but a lot of it is that just retracement in yield. I'd say over the summer, the markets, in my estimation anyway others on the team could agree or disagree, but had probably widened two to 300 basis points, and capital from a lot of folks just really wasn't available.
I would say today we're probably in the 50-100 basis points wide of where we were pre-COVID and typically at lower leverage levels and with materially better documentation and sort of other aspects around the underwriting being better, just quality of underwriting being better.
Got it. Very helpful. Thanks. Maybe a follow-up on earlier questioning just around investment opportunities. Clearly, the M&A backdrop has recovered materially over the past few months. We're back to kind of pre-pandemic levels, and so that's providing a lot of opportunities around deal flow. It sounds like the election may be driving some pull forward just ahead of potential tax changes, depending on the election outcome. Just wanted to think about whether that's affecting how you guys are thinking about areas to lean into or avoid, just given the potential for some more structural changes, whether it be around taxes or regulations or even industries that are being viewed less favorably in a different administration.
Yeah. I think that the election is certainly increasing activity with people whether any counterparty sponsors, owners of businesses, whatever it may be, being uncertain about, I guess a Biden victory. It's not really changing our view yet in terms of the types of industries, right? For the most part, we've stuck to the same industries for a lot of years and the same types of companies. I don't think until we see what happens next week we'll really start to have a lens on whether things will shift. If we begin hearing things from potentially a new administration, obviously, that'll be part of our thinking in terms of the new investing business.
Okay, great. I'll leave it there. Thank you.
Yeah, you're welcome.
Our next question comes from Ryan Lynch with KBW.
Hey, good afternoon. Thanks for taking my questions, guys. First one I had was just on the kind of revisiting your comments on the market activity and your deal funnel. You talked about you expect to see busier quarters than what you saw in Q2 and Q3. When I look at your guys' backlog that you guys reported, you guys had $1.5 billion in a backlog currently, and if I looked at that over a year ago, it was only about $665 million. When you talk about seeing an increase in funnel of deals and more market activity, are you talking kind of deal activity being back to kind of pre-COVID levels, or are we just more looking at kind of a steady increase kind of ramping up from Q2 to Q3 and then just kind of a steady increase into Q4?
Any kind of color and kind of the magnitude of where activity is today? Would be helpful.
I think currently I would characterize this as pre-COVID levels. I wouldn't say that I think it will necessarily remain there. We are very busy. I think it's a combination of, again, pent-up demand, folks who didn't get much done for a six-month period during more severe lockdowns and closures and all of that, trying to get some things done that they wanted to get done. I think Devin's question as well about the election pulling things forward is part of it too. I think it's a little bit of catch-up from the past, a little bit of pull forward from the future, and it's hard to tell if it's sustainable at this point. That'd be my thought.
Okay. My follow-up, maybe it's better for Penni. You guys had a big increase in other income this quarter. I thought that was maybe going to be due to more amendments being made. You guys also said you had a 60% drop in new amendments this quarter. Can you just talk about what drove that big increase in other income this quarter and how sustainable are any of those items?
Yeah, we did have our other income was about double this quarter what it was last quarter, but it is still driven by kind of one-time, one-off amendment and other fees related to portfolio activities. As you know, in these environments, it lends itself to higher than normal levels of fees from various sources. I would look at it as more of a one-off increase. As the amendments start to subside, then our opportunities for making those types of fees will be reduced. That was more of a one-off thing for the quarter that you shouldn't put into the run rate.
Just on that, though, are you guys still seeing similar level of amendment activity so far in the fourth quarter and the third quarter, or has that started to trail off?
it's slowed down a lot. We talked about the decrease in this quarter. It's probably kind of steady and even at that level. I think that the question will be the significant amount of amendments that we did last quarter, I think we mentioned our approach was to keep them reasonably short, right? today it's pretty steady at those lower levels. The question will be how do companies look in terms of year-end performance and going into Q1, and what does the winter potentially hold or not hold for COVID? it's hard to tell. today it's still at that much more light or reduced level that you saw in this quarter.
Okay. Understood. Thanks for taking my questions, and really nice quarter, guys.
Thanks. Appreciate it.
Our next question comes from Casey Alexander with Compass Point.
Yeah, good morning. Good afternoon. I only have one question. Can you guess at what percentage of the backlog is from incumbent borrowers?
I'd have to go look through it. It typically is pretty consistent around that 50-ish % level, but I actually don't know. I don't think I have that number offhand. I can go see if I can pull it up for you, Casey, or see if the finance and accounting team has it here just in our notes. Yeah, Scott?
Yeah.
Yeah. It's over half. There's more new than incumbent. The estimate is around 70% of incumbent deals.
You just said more new than incumbent and then 70% incumbent deals. You confused me. I'm sorry.
Oh, sorry. Yes, I think I misread it. It's more new than incumbent, sorry. It's around 70% is new.
70% is new. Okay, great. All right.
Sorry about that.
That's what I was looking for. Terrific. Thank you. Sorry for the confusion. That's it. That's my only question. Thank you.
All right. Casey, thanks a lot for the question. Sorry for us confusing or getting our numbers backwards, but we'll be able to take the next one.
Our next question comes from Derek Hewett with Bank of America.
Good afternoon, everyone. Maybe Kipp, what are your thoughts on the rising level of PIK income, and when do you think we can see PIK peak at this point since I think it was mentioned on the call that non-accruals could potentially stabilize prospectively? I do realize that liquidity is strong given Ares' capital structure.
Yeah. Certainly as part of all that amendment activity, that's really what drove the increase in PIK. Typically, we started pre-COVID, just as a reminder, with PIK income at high single digits, kind of 8%-10% of the portfolio because some of the junior investing that we do, whether it's in sub-debt or preferred and all that tend to come with PIK coupons. Some of it's natural, but it's definitely elevated. Right? I think the good news is it really hasn't changed much in quarter-to-quarter. You saw the real increase, call it six-ish months ago with a bunch of these amendments. To your point, I don't want it to remain at that elevated level for an extended period of time. I don't think it will.
It's one of the things that we've had to allow for, is to obviously be patient and take a long-term view around the recovery of some of these more COVID-impacted names. From a liquidity perspective, I don't think it creates an issue for us. I'll say I know it doesn't create an issue for us. It is elevated, and I'd like to see it come down. The shape of the recovery will dictate how quickly that can happen.
Okay, great. One other somewhat housekeeping question. What was driving that significant increase in the SDLP yield on a cost basis quarter-over-quarter?
Are you talking about the fair value going up, or you're saying yield?
No, just the actual yield. I think it was up about 80 basis points on a quarter-over-quarter basis.
Yeah, maybe, Kipp, I can take that one. If you looked at the yield at year-end, it was around 14.5%. We reduced that-
in Q1 and Q2 to about 12.5%. Coming into COVID, maybe a little conservative on our part, just to look at the underlying performance of the companies. if you look at the way they've performed, it's been better than expected. We've had rebound in performance where then also some amendments that led to some higher yields in the underlying portfolio. if you couple that with improved cash flows and more rate, then we feel more comfortable bringing that back toward the year-end yield on SDLP. we ended-
Yeah
for Q3, we were at 13.25%.
Yeah. I hadn't really.
Okay
I think it's just sort of in line with the existing portfolio. You know what I mean? Some amendments, some additional pricing, all of that.
Okay, great. Thank you very much, everyone.
Our next question comes from Kenneth Lee with RBC Capital Markets.
Hi. Thanks for taking my question. Just given the prepared remarks, the comments on seeing potentially busier quarters going forward, wondering if you could just share any updated thoughts on how leverage could trend in the near term, and then perhaps more broadly, what factors could bring leverage either to the lower or the upper end of the targeted range. Thanks.
Sure. I think we've said in the past, and we'll echo the same comment. We feel comfortable with the leverage ratio kind of eking up from here to the one-one or one-two. At one and a quarter, we'll probably sort of evaluate it. The way that the company operates, obviously, is when we see what we think are attractive investment opportunities. I think you've heard, we think we're seeing a whole bunch these days. We're going to draw down on the credit facilities that we have and grow the liabilities a little bit to hopefully support some asset growth. That's how we see it. I don't think we'll get beyond that one and a quarter times because the company does have a lot of liquidity. We're still seeing repayments and all that, so there's a natural kind of counterbalance to a busier investment environment.
At this point, we still feel like we'll be in that one to 1.2 range for a little while here.
Great. That's all I have. Thank you very much.
No problem.
Our next question comes from Robert Dodd with Raymond James.
Hi, and congrats on the quarter. If I can go back to the amendments just briefly, Kipp. You said down 60%, which obviously is a big improvement. Can you give any color on kind of the relative materiality of those amendments? Were they more modest this quarter than they were last? If it's down 60 in count, what was it down in seriousness, if you will?
That's an interesting question. It's sort of a hard one to answer. I would say the most serious issues that we felt that we were addressing were the ones that we encountered in March, April, and maybe even into May. As a generalization, I would think that the amendments that got done this quarter were of the less serious variety. I'd have to go back and look at the list. That would be my sense.
Got it. I appreciate that color. Just, Kipp, one more on follow-up. You talked about spreads being wider by, call it, 50 to 100 basis points going forward. Obviously, I presume you mean that on kind of a like-for-like asset. Given the pipeline is, in general, much larger EBITDA businesses that normally carry lower spreads, could you give any relative color on what the total blended spread change is? Are the larger businesses going to offset the fact that spreads are wider for the same type of businesses and that effectively spreads are going to be at pre-COVID levels? Is it that the 50 to 100 applies even on the kind of larger businesses you're looking at right now? Obviously, this is separate from better docs, et cetera, et cetera. Any color on that front?
Yeah, I think the 100 is a generalization. You can think about it. I think about it sort of across a list, across the company's weighted average capital structure. I think your second point is actually more interesting, to be honest, which is we feel like there's a little bit of a sweet spot above what a lot of folks think of as the traditional middle market that probably offers the same pricing or materially better pricing in a larger deal than we'll see in lower middle market companies these days. The reality is the competition in the lower middle market, and frankly, the deal flow, I think is a little bit lesser.
Well, the deal flow is a little lesser and the competition is a little bit more staunch because in a $100 million deal, you can line a lot of folks up that can write $25 million checks and really drive terms down. When you come looking for a complete capital solution at $750 million to a billion, not a lot of people that you can go to. I would tell you, I think we're able to drive some unbelievable value in these larger companies. I don't view the increasing EBITDA size as sort of an enemy to our returns today. I actually think we may be getting better risk-adjusted returns there than we would be getting in these smaller deals where we play those deals too, and we're blown away sometimes by what the terms look like.
Your point is the right one, which is when you're financing smaller companies, you're supposed to be getting premium returns. We go in and we compete for these deals with others, and we tend to lose on pricing. We're always a bit surprised saying, "Wow, I can't believe a $20 million EBITDA company can borrow at the same cost of capital as a $100 million EBITDA company," it seems they can these days. For us-
Yes
It doesn't make a lot of sense, and we'll sort of stick to what we're doing.
I appreciate that. It does show up in your risk returns when you get a higher coupon on second lien and have lower non-accruals on second lien than the industry. Clearly, the risk return's better the way you're doing it in your market segment. thanks.
Thanks for your question.
Again, if you have a question, please press star and then one to join our question queue. Our next question will come from Chris Kotowski with Oppenheimer & Co.
Yeah. Good afternoon, and thanks. Just trying to peel back the onion on your relative optimism about the non-accruals. Just kind of looking through the bigger, chunkier names. You see two dental centers, a couple of restaurants, some oil and gas. Okay. A movie production company. Those were kind of the bigger, chunky ones, and it's obviously easy to see how a lot of them would have been impacted by COVID. I'm wondering, is your optimism based on the fact that these companies have kind of found a way to at least partially function in the COVID world? Are these companies able to function in the kind of partially opened world that we're in?
You're talking about companies that are existing non-accruals or the rest of the-
Yeah. No, your existing non-accruals. That's what I was wondering about. Was that the basis of your optimism?
Generally, yes. Of the existing non-accruals, we think, for the most part, they're all pretty darn good businesses that, to your point, are operating in industries impacted by COVID. Through a combination of equity coming into those companies and potentially us providing some concessions in the near term, they figured out how to operate. Yeah, I think there will be a path to recovery for most, if not all of them. I think it's being reasonably optimistic on the existing non-accruals. I think I'm optimistic too, around the portfolio because when you look at our non-accrual list, it's a pretty small list, right?
We've talked about the grade ones and twos kind of being, I think, in my mind, ring-fenced at this point, and that we understand where the issues are, and we think that we have them under control, as I mentioned in the prepared remarks. Definitely a lot more optimistic than I was in April.
Okay. All righty. That's it for me. Thank you.
Yeah, you're welcome.
This concludes our question and answer session, and I would like to turn the call back over to Kipp deVeer for any closing remarks.
Nothing beyond wishing everybody well and hoping we can all get back together in person one of these days. Thanks for all the questions. We'll sign off now. Thanks.
Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of the call will be available approximately one hour after the end of the call through November 10, 2020, at 5:00 P.M. Eastern Time to domestic callers by dialing 877-344-7529 and to international callers by dialing 1-412-317-0088. For all replays, please reference conference number 10147945. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of Ares Capital's website.