Walker Webcast: Broader Implications of the SVB Collapse: A Talk with Michael Arougheti

Michael Arougheti is the Director, Co-Founder, Chief Executive Officer and President of Ares Management, an American alternative investment manager, specializing in credit, private equity, and real estate. Ares is a publicly traded firm that manages roughly $350 billion in assets and has over 2,500 employees.

In a recent Walker Webcast, I had the chance to get Michael’s nuanced take on the current turmoil in the banking sector and SVB’s collapse.

Why Did the Value of the Bonds on SVB’s Balance Sheet Seem Inflated?

The value of the bonds on SVB’s balance sheet apparently were being held as “Hold to Maturity” and had been acquired prior to the Fed’s large rate increases. As a result, when the mismatch in deposits occurred, SVB became aware of deposits leaving for higher yields i.e., treasuries. As a result SVB needed to raise capital. This forced the bank to Mark-to-Market the value of the securities (e.g. treasuries, loans, etc.), thereby requiring that losses be recognized.

SVB was not alone in this situation but was unable to raise sufficient capital to meet withdrawal demands causing the government to step in and guarantee deposits. It will be an ongoing debate as to when Mark-to-Market vs. Hold to Maturity is appropriate.

How Will Regulation for Regional Banks Change?

Given the recent reaction from the federal government, and its decision to make all depositors whole at the banks that have collapsed, it’s unclear what the FDIC insurance policies will look like going forward. The federal government is very unlikely to insure all depositor funds during this period of time, and then revert back to its old policy once the turbulence in the banking sector is over. Arougheti’s prediction is that we are likely to see both increased depositor insurance as well as increased oversight in the banking sector.

Over time, the number of FDIC-insured banks has been steadily declining, as depositors move their money to larger institutions. Given the recent uncertainty around regional banks, we have begun to see a further consolidation, which will likely continue into the future, as depositors move their money into institutions that are perceived as “too big to fail.”

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Each week, I chat with some of the most prominent industry experts from the most influential firms in the world. When you join the Walker Webcast, you’ll get to hear nuanced takes and insights from leaders across multiple industries. See the full interview with Michael Arougheti when you check out the Walker Webcast.

Webcast Transcript

Alternative Investment Outlook with Michael Arougheti

Willy Walker: Good afternoon, everyone, on the East Coast. Good morning to those of you on Western time zones where I am today. There are certain guests that I have on who I very much look forward to having. And I've wanted to have Michael Arougheti on the Walker Webcast for quite some time. Beyond that, there's also something called timing, and there are certain guests who come on the Walker Webcast at exactly the right moment. And I honestly can't think of almost anyone that I would rather have on this week, given everything going on in the global markets, the credit markets, the banking markets, than Mike Arougheti. So first of all, Mike, thank you so much for joining me today. And let me dive into a quick bio on you, Mike, and then I want to open up our discussion.

Michael Arougheti is Co-Founder of Ares and the Chief Executive Officer and President, as well as a Director of Ares Management Corporation. He is a member of the Ares Executive Management Committee, the Ares Enterprise Risk Committee and is on the Board of Directors of the Ares Charitable Foundation. He also serves on the board of directors of Operation HOPE, a not-for-profit organization focused on expanding economic opportunity in underserved communities through education and empowerment. Additionally, Mike is a member of the PATH Organization Leadership Council. He received a B.A. in Ethics, Politics and Economics, cum laude, from Yale University.

Mike, I want to start at the beginning and talk about the building of Ares. But given all we've seen in the markets over the past week, I'm not sure I want to back up to 1997 right now. I kind of want to talk about the here and now and Silicon Valley Bank. The inflation numbers we've just seen, bank stocks, Fed tightening, etc.. So, let's start here. How do you feel about the actions of the Fed and the Treasury Department took to shore up SBB, take over signature, and what you're seeing is kind from a macro standpoint in the credit markets? Seemed like we kind of recovered yesterday and had some stability. Looks like we're diving down today. You've been around for a while. You've seen various cycles. How are you feeling today about the actions taken by the federal government earlier this week?

Michael Arougheti: Good to see you, Willy. Thanks for having me. And you're right, timing is everything. I was wondering how we were going to fill the hour, and now I'm just head spinning, trying to figure out where we're supposed to jump off here because we don't have to go back to 1997, but we probably need to go back to 2020 and think about the impact of the COVID response in the real economy and in the markets. And maybe we'll come back to this later in the conversation.

Everybody in the financial markets right now that is levered, whether you're a bank, a consumer or frankly, the Fed itself is dealing with the challenges of asset liability management, just given how ferocious the rise in rates has been. And I'd like to spend time with that later, if you don't mind, just because there's so much similarity on all of these balance sheets that we need to unpack to really understand the events of the last couple of days, but also maybe what the path forward is. I guess, in terms of the Silicon Valley Bank (SVB) response specifically. You know, this is really the confluence of frankly, really, really poor ALM (Asset Liability Management) on the part of SVB management. There's no way to really sugarcoat that. Having run public companies here at Ares for close to 20 years, if you're a financial services company, you've got to get that right and you should not be surprised. And so, I think the fact that that management team was scrambling to generate liquidity when they probably understood some of the challenges that their balance sheet presented, I think is an interesting case study and just how to manage a balance sheet and how to think about navigating interest rate hikes like we just went through.

Two, you know, it's not getting, in my opinion, enough coverage but, one of the villains here are the VCs themselves who created the run on the bank and really didn't give the bank time to navigate the challenging situation. And it's interesting because in the good old days, banks would close at noon on Friday, they'd reopen on Monday, and if you had a run on the bank, there'd be a line out the door waiting to try to figure out when you were going to get your money. And here people were withdrawing their cash from the backs of taxicabs. And we saw $42 billion leave that system in a matter of hours. So, we're in a different paradigm. I can only tell you anecdotally, obviously, we're in these markets thinking about how to be a solution provider. But when the markets are moving that quickly and information is moving that quickly, it very rapidly went from ‘this is an SVB isolated issue’ to ‘what is the confidence that the typical person can have in uninsured deposits in the banking system?’

You're reminded just how fragile the banking system and the economy can be when you factor in that confidence and behavioral psychology. So long way of saying I think the bank's response over the weekend was appropriate. I think they recognize that providing an implicit guarantee for uninsured deposits, given some of the contagion risk, was absolutely the right thing to do. I'm not quite sure, though, that it's enough. And this is where we're going to have to pay attention, because in reality, if you're a fiduciary on the institutional side or you're an individual, you know, the amount of deposit flows that are still flowing out of small and mid-sized banks to the G-SIBs (globally systemic banks) is pretty substantial. And so, while there is an implicit guarantee, I think you've got a pretty big subset of the population that's still moving money out of the system from the small banks to the large banks. And that's going to have a lot of knock-on effect that the Fed's going to continue to need to keep an eye on.

Willy Walker: So, for a second, if we do focus on SVB Mike, you mentioned there, sort of the asset liabilities mismatch and how it was just kind of, if you will, glaringly obvious that they had that. A lot of people have gone to that and said, well, then that's just isolated SVB in the sense that it's unique and not the other banks. Do you think that this situation is isolated SVB? Clearly the “run on the banks” as it relates to deposits being moved is just people being concerned and trying to go to the money center banks. But specifically, to the asset liability mismatch of SVB, do you think it is isolated to them or do you think it's a broader issue in the banking system?

Michael Arougheti: Yes and no. So, let's take a step back and really talk about what's happening in the system. And so, if you start with the Fed, right, the Fed's balance sheet now is somewhere between $8 and $9 trillion. $5 trillion of it is in treasuries. Three plus trillion is in mortgage-backed securities. If you think about the Fed's balance sheet as non-mark to market. Lots of stability. But if you are in a position where you now need to mark to market $9 trillion of treasuries and mortgage-backed securities in this rate environment - one way to think about this, starting from the zero bound, for every point of rate increase that we saw, it's about $400 billion of value off the balance sheet. And for every point, it's roughly $60 billion of income loss to the Treasury.

So, if you just start with the economics of long dated liabilities in a rapidly rising rate environment, the Fed itself is in a very challenging spot. And if you mark to market that balance sheet, it would not look very good. Now, if you look at the banking system writ large and this is why it's not just isolated to SVB, there's $23 trillion of assets in the U.S. banking system that continues to be more concentrated at the top of the pyramid, if you will. Of that $23 trillion, I know you know this, given what you all do for a living - $6 trillion of it is in real estate loans. $2.5 trillion is C&I loans. $1 trillion is consumer and $10 trillion is in securities. And those are the same securities that are owned on the Fed balance sheet. So, $3 trillion available for sale securities, $3 trillion holds maturity, $3 trillion in mortgage-backed securities and $1 trillion in Treasuries.

So, the reason I start there is any balance sheet that is levered 10 to 1 that is sitting on a significant portfolio of long dated securities in this rate environment has a similar issue. The difference between SVB and some of the larger banks is the nuance between available for sale and hold to maturity accounting within the banking system and the quality of the deposits. And so SVB got caught in that mismatch between the quality of the deposits, the concentration of the deposits and the balance sheet. But from a balance sheet construction standpoint, not all that different. And I think that's something that people need to really digest because so much as someone who plays in the private markets, there's always so much debate about mark to market, the risk and the value of it. At the end of the day, if you're not mark to market, you're good, right? But the minute you have to take that mark, you know, it gets very painful. And so maybe back to the Fed, which is why we're still in the early days of this. You know, we just went from potential QT back to QE, right? Because once we start buying par secured, lending, it's 80 cent securities a par, you're now back to QE. But the reality was given the mark to market on the Fed's balance sheet, they really couldn't be selling assets anyway, so it forced them into a position where the tool at their disposal was least painful to the Fed balance sheet was rapid rate hikes, right? Because they were as repressed as the banks were in terms of what they held. So, it's really an interesting time, just given the speed and velocity of the move in rates.

Willy Walker: So, for a moment Mike, to those people who might not be as understanding of hold the maturity as you are and your comments right there, talk for a moment about why SVB and the ten-year bonds that ended up literally tipping them over where it was that mark to market of hold maturity and being able to hold them at par. And then all of a sudden the moment they went to sell them, they had to basically mark everything to market and all of a sudden now they're upside down. Talk about that because I do think that's a very important piece as it relates to why SVB unraveled.

Michael Arougheti: Yeah, it absolutely is. It's critical and we'll try to oversimplify a fairly complex regulatory capital framework for banks. But at the end of the day, when banks own securities or make loans, they can be designated as hold to maturity, meaning we've made this loan or we're holding this security to maturity. And therefore, the economic instrument does not need to get marked to market. And the bulk of the securities within the system are held to maturity and therefore you don't see actual realized loss.

If you designate loans or securities as available for sale, you actually have to realize that loss. And so, part of what happened here to SVB is I think the rating agency started to push them towards a threatened downgrade. Therefore, in order to generate liquidity, they had to sell assets out of their available for-sale bucket. And when you do, you take that mark to market hit. So, it is something that we should all remind ourselves of when we think about liquidity, the value of liquidity, private markets versus public markets, is when you are a forced seller it's a much different place to be. And I think they got caught in a little bit of a liquidity spiral. But we should not underestimate the challenges even in the hold to maturity. So, if you aggregate accumulated losses in that hold to maturity world of bank balance sheets. There's about $770 billion of theoretical mark to market losses sitting within the banking system that are not being realized.

And so, so much of this moment in time is about duration mismatch. But who has enough liquidity to kind of hold those things to maturity without being forced? And that's very important. It gets a little wonky when you're talking about bank capital ratios, but that is a big deal. That $770 billion is a massive, massive number in relation to the equity in the banking system, which on a levered basis is about $2 trillion. So that puts it in perspective, just the impact of leverage on amplifying risk in any system, the banking system included.

I think the good news is if you look at SVB, maybe to bring it full circle on a long answer to a very simple question, Willy, is if you look at this AOCI mark to market issue relative to the equity capital of the banks, SVB stands out by a wide margin from any other bank G-SIB or not in the system in terms of that mismatch. So were it not for the behavioral psychology and confidence underpinning the banking system, SVB was absolutely an outlier and now it's all about how to make sure that everybody understands that.

Willy Walker: So, there are a couple other things on this that I'd love to just because you know so much about this, Mike and so many people are trying to kind of dissect what happened and what the broader implications are. And one of the big debates that I've been having with a number of people over the past couple of days was that now the Treasury and the Fed have basically said that all deposits over $250,000 are insured by the federal government, which clearly is not the case. But they were trying to send the message that if another bank goes under as signature did so, the Fed will step in and basically make sure that all the deposit base is insured. And clearly it has a cost. And so there are two things that might come out of this that I'm wildly concerned about.

One is that the federal government sits there and says, we're going to give you an explicit guarantee on deposits over $250,000. You got to pay for it somehow. And that's going to raise the cost of the insurance to everybody, which is going to make regional and local banking that much more expensive, which makes it less profitable, which means that you get increased flows back to the money center bank. So that's point one.

The other thing is that from a regulatory standpoint, they're probably going to raise the regulatory oversight that they have on local and regional banks, which quite honestly, I sit there and say you almost can't add more and if you are able to allow a liquid portfolio like SVB to go belly up, hard for me to think that you can go in and dive into the collateral pool. Do you find this as concerning as I do?

Michael Arougheti: Well, it's funny because the private credit market is actually a beneficiary of some of those crosscurrents that you articulated, because, again, unlike banks who are ten plus times levered and regulated because of the implicit or explicit guarantee which we'll come back to, we run unlevered or modestly levered, with match funded .... So, there is a shift that will happen here. And I think you're absolutely right.

We are already seeing deposits move from smaller banks to larger banks, even though those smaller bank balance sheets are healthy. So, you're going to continue to see an aggregation of capital within the G-SIBS, that's happened. So, all of these deposits coming out of SVB and Signature and First Republic, they have to go somewhere, and you'll begin to see that they're going to the top five banks. BofA was out yesterday saying they saw $15 billion of deposits come into their system over the last two days. And I would imagine that that's probably on the low end for what some of the other folks are seeing. So, while the guarantee was implicit, it may not have had that desired effect. Back to my earlier comment, because people are still going to move their money.

And there's also this interesting phenomenon that's happening. We saw it with Schwab over the last two days. People were not moving for fear of security. But what SVB also did is anybody who had deposits in any institution went and looked at their statement to quantify what their exposure was. And I think a lot of people realized that they were sitting in deposits that were paying them nothing in a high-rate environment. And you're also seeing people moving capital out of the banking system into money markets and other instruments where they don't have to worry about the FDIC insurance guarantee and they're generating higher returns. But without talking about my own book, without a doubt, the medium-term impact of this will be further consolidation of the banking system, further regulation, and whenever that happens, there will be further de-risking.

So, I don't want to suggest that all the banks will become utilities, but in order to afford the security and confidence that the Fed wants to project, you have to see more consolidation and that always comes with more regulation. So, I agree with you. I don't know if that's cause for concern per se, as long as the capital markets which always innovate around these types of issues, come up with other safer, more transparent ways for capital to find its way into the system.

Willy Walker: Yeah. You talked about the amount of commercial real estate loans that banks hold. And I mean, one of the big sort of conflicts that a lot of our customers have is that they rely on those local and regional banks to provide them with construction loans, for instance, which a BoA or JPM aren't going to be able to underwrite and do. And they also have deposits sitting against a lot of the existing loans that they have outstanding. And so, they're in this sort of push-pull of saying, I feel like I got to go flight to safety and put it in JP Morgan. At the same time, if I pull it out of First Republic as an example that you used earlier, that's where I have my banking relationship as it relates to my construction loan. And my big fear is that the federal regulators don't understand the necessity for those local relationships and how important they are to commercial real estate and also local economies across the country. And then the flight for quality does present some real risk as it relates to the distribution of capital. And then also, quite honestly, the risk taking that is necessary, whether it be venture capital, whether it be commercial real estate across the ecosystem that goes away when you get this flight to quality, if you will.

Michael Arougheti: You're absolutely right. I think it is a risk, not to be too negative on bank regulation. I think part of the challenge you've seen, this has been a multi-decade trend, right? So, if you look over the last 20 years, the number of FDIC insured banks in the country is already cut in half. We went from roughly 10,000 banks to now less than 5,000, and we've navigated that credit contraction okay. We're still seeing capital flow in the local market, but we've just seen consolidation. I think one of the challenges and this is what's always been a head scratcher for me – our whole business is effectively providing creative capital solutions. And a lot of what you do as well, alongside the banks, not because the banks don't want to do what we do, it's because the regulatory capital framework doesn't really allow them to do the things that we do.

So, I think the bank regulators need to be thinking about what risks are we forcing banks to take given the regulatory capital regime versus what capital we want to flow into the market and for better or for worse, just going back to what I articulated sits on bank balance sheets because of the red cap framework and the way the system is constructed, they've been effectively pulling capital out of the system anyway, right? So, because of the way that it is constructed, there's been a natural credit contraction. And I think that could warrant a rethink. You know, maybe banks aren't supposed to be 10 to 15 times levered with a repressive right cap framework. Maybe they're supposed to be five times leveraged with a little bit more autonomy over risk taking in local markets, because you can't look at the sum total of the system and say one size fits all. That a regional lender in the southeast U.S. right now is having a completely different experience than Silicon Valley Bank. And so there may be what comes out of this alongside this obvious consolidation is maybe just a rethink of what that right cap framework is in order to make sure that capital is flowing well. I am confident, though, again, that the capital markets do figure this out. Banks are obviously pretty critical, but with every crisis that you and I and others on this phone have been through, capital finds its way to opportunity, and it generally does so in an innovative way that's good for the borrower and good for the investor. And I think we're going to see the same thing happen here.

Willy Walker: So, Mike, backing out of banks and a little bit more to Fed policy. I've heard a number of your remarks recently that if I can paraphrase, we're reasonably copacetic about the tightening cycle we are in, some quotes like “It feels a lot like a normal credit cycle. We've had 5% rates before, and if you go to a 5-to-10-year outlook, it's still strong for the United States, it's still strong for the capital markets.” And the final one, “Fed is doing exactly what they said they were going to do.” Now, all of a sudden in the last week, it appears that we've had a pretty significant pivot and you just outlined it from going in a tightening cycle to doing another easing cycle. I mean, just the concept that a week ago today, because SVB hadn't gone under yet, that we would think of that pivot happening was almost, you know, I mean, most people sit there and say, not a chance that that is anywhere we'd be at a week later were there.

What's your take now as it relates to Fed policy and what's your outlook as it relates to what do you think, I mean, they're in a really tough spot, as we all know. Given inflation numbers that came out yesterday. What's your sense of what they do at the next meeting? And do you think we're still on that trajectory to a normal tightening cycle, or do you think that everything has dramatically changed last week?

Michael Arougheti: I always hated to prognosticate because this is such a fluid situation. But I'll give you a couple of things that I'm thinking about, at least in the context of what I've said before, as you highlighted.

Putting aside the events of the last week, the U.S. economy is still very, very strong and the tightness in the labor market is real and structural and will present a pretty tough inflation fight. You know, even with the events of the last couple of days and that is a combination of just the structure of the U.S. economy, the demographics of our population and immigration policy. That's all created a set up for a tight labor market. And it's hard to see how that reverses even with all of the headline layoffs you see from the big companies at Ares we have investments in 3000 middle market companies and at least as of you know, a week or two ago, they were not laying off folks or taking their foot off the gas in any way, shape, or form relative to what you see from some of the larger companies. And obviously, we're still dealing with a little bit of a COVID overhang. You know, we pushed $5 trillion of liquidity into our economy and put it in the hands of consumers with an expectation that we would have significant economic challenges. And we had one quarter of down 9% GDP and then the markets ripped.

And so, there's a lot of structural liquidity that's still in the system that is going to make it really hard to stop the tightening cycle absent a real contagion here, which doesn't feel like where we're heading to. And so, if I were the Fed, I would probably argue for a 25-basis point hike at the next meeting. Reason being, I think if you're zero, you're doing two things. One, you're going to set the markets up for a tremendous rally, relief rally. And I think that that's at odds with what the Fed is trying to do in terms of just reducing the wealth effect and slowing consumer spending. And two, that coupled with the events over the weekend, I think all of a sudden we get back into a market mindset that there's an implicit Fed put. If you stay on track, and you ignore the last couple of days and you stick with a 50. All of a sudden people are upset in the other direction. It could be pretty destabilizing.

So, if I had to guess, I would think 25 basis points, whether the world is rapidly changing, and we'll see at the next meeting kind of buys you the best probability adjusted outcomes if you're the Fed. I don't think you can stop because I don't think we know enough now to say that we've tamed inflation, given just how strongly the labor market is right now.

Willy Walker: So, you made a comment, Mike, as it relates to the middle market companies that Ares has invested in. And you also made the comment that we pumped $5 trillion of liquidity into the system. I do think one of the interesting things about SVB is that SVB was so over deposited, and they didn't have a typical loan origination program and therefore they sat there and said, Hey, we've got to deploy this capital into something. Let's go buy Treasuries. And that is one of the unique things on SVB, unlike a M&T or a Truist or some of the other regional banks that actually have loan origination capabilities and are out making loans every single day. SVB were sitting there going, I got to buy Treasuries because I don't have this loan origination capabilities.

Michael Arougheti: 100%.

Willy Walker Yeah. So, on that, you all are out there every single day underwriting credit. And what you just said as it relates to the economy is still very strong. What you're seeing in your portfolio is people continuing to invest and taking advantage of it. In a typical cycle, like GFC, we had 10% of leverage loan about spreads gapping out. So, I guess my question is, we've all been talking about some Great Recession coming, but spreads haven't priced it in there, Ares has been sitting there underwriting loans, deploying billions of dollars in capital. What's your general feeling as it relates to the underlying economy today and knowing those middle market companies that Ares is extending capital to?

Michael Arougheti: Yeah. So, it's interesting because we have a number of publicly traded vehicles where we give some pretty good transparency into what the underlying trends are. And at least again, as of our last reporting period, not factoring in the events of the last couple of weeks, we were seeing slowing growth, as you would expect, but still growth. So, if you look at our private credit portfolios at ARCC, our publicly traded BDC or private equity portfolios, we were still seeing revenue and cash flow growth in the mid to high single digits. Now that's down from low to mid-teens a year ago. So, when you go from 12% to 15% year on year growth to 5% to 10%, that feels recessionary. But you're not in an actual recession. And so, some of this is just the experience of slowing growth and comps that we need to keep in mind. But we are absolutely now beginning to see slow down.

The question for everybody is, does that slow down, flip over to real negative growth and at least as of a couple of weeks ago where our answer was probably not. You can't rule out that a recession is on the horizon. You also couldn't rule out the no landing scenario. And you got to think about all of these outcomes in terms of the bell curve. But I would have probably said you're in likelihood of soft landing to moderate recession for longer. But now liquidity is changing rapidly and that has a real impact on the behavior of the markets, the psychology in the boardroom and around the management table. And obviously, you know, the Fed may get what it hoped for, which is, you know, the slowdown. So, I do think that the calculus has changed.

One of the nice things about the markets that we both operate in is that we get almost real time information. You know, there's upwards of a month lag, but we're able to aggregate that information quickly. So, we'll get a quick sense here in the next couple of weeks of how people are feeling and what we're seeing on the consumer and corporate side. But if we're just looking back, it was probably better than people thought it was.

I think the challenge now is, it goes back to my commentary on duration, anyone who owns an asset, if it's an apartment building, a company, a solar plant, this is all about what does the new cost of capital mean for the value of my asset? What's the structure of my balance sheet? Where is my maturity and what happens if I have to resolve it and where is the liquidity going to come from? So, we've been saying for quite some time that this is all about liquidity, right? Prior cycles, we're all about credit. This cycle is really all about liquidity because the cost of capital has changed so quickly to such an extent that it's really going to begin to expose cracks on who has liquidity, who doesn't, and who's able to basically bridge to a different rate environment where the value of their asset is recoverable. And that's why I'm actually so sanguine about the opportunity in private markets, because that's where the marginal liquidity actually sits. In an environment where people need to resolve these assets, to own them longer, to get to a point where they can recoup, I think the private markets are going to have to step in here and provide creative solutions and bridges and liquidity financings to get people to a world where they can recoup basis.

Willy Walker: But Mike I've heard you say previously that people overvalue liquidity, and so help me foot what you just said as far as why this market is so focused on liquidity. Yet your previous comment that I've heard you say, or people overvalue liquidity.

Michael Arougheti: Yeah. So, when I talked about that, when I say that, a partner of mine had a great quote the other day, he said, “Forget for a second that the earth's surface is covered in 71% water. If your house is on fire, you need your water immediately and it needs to be right next to where you live.” And we fall into a trap in financial services where we think about liquidity aggregated. But when you're in markets like this, where rates are bouncing around the way that they are, liquidity has an impact in different parts of the market. You're beginning to see this. We saw it first pop up in the U.K. with the LDI issues. You see it now with SVB. So, this idea that we're talking about liquidity is real, but it's not really what I was referencing earlier.

When we were talking about liquidity not being there when you wanted it, it was really a way to help contextualize the growth in private markets. So, if you look over the last 15 to 20 years, private equity and private credit have been taking share from the liquid capital markets and the banks. And that's true in Corporates, it's true in real estate, it's true in infrastructure. And the reason that that's happening is because of everything we've been talking about for the last 45 minutes, which is when you want liquidity, it's never there at a price that you want it. And so, you had all of these institutional and retail investors that were trained to say, I'm going to construct a 60/40 portfolio and I'm going to value diversification and liquidity and when the markets are going up. You don't care about the liquidity because all you're doing is effectively buying the market. And when the market is going down, you don't want to access the liquidity at the price that you can get it.

Coming back to SVB, I don't think when they were buying those Treasuries or those Ginnie Fannie bonds that they thought, oh, you know, I'm going to have to liquidate these into this market backdrop and take a $3 billion loss against a $20 billion portfolio, because these are the most liquid securities on the planet. So, I think what's happened to my comment is sophisticated investors, retail and institutional, have gotten much better at understanding what their liquidity needs are when and not overpaying for liquidity, because again, it's not really there when they want it. Instead, what they've said is, okay, once I understand my appetite or tolerance for illiquidity, I could use that to generate excess return.

And it's been a real mind shift in the investment community to say, okay, now understanding that liquidity may not be what I want it to be or need it to be as a tool, let me make sure that I'm maximizing the return I get on the illiquid side of my portfolio. And that's been one of the big catalysts, I think, for the continued growth and consolidation in private is this idea of capturing excess return for illiquidity as opposed to having to give up return as a for seller in liquid markets.

Willy Walker: I've heard you in various interviews be asked questions of do you like Asia. Do you like the U.S. Do you like commercial real estate? Do you like this or that? And you always go to a micro view, Mike, You say, Look, tell me what the market is. Tell me what the company is. Tell me what the risk reward is. And I'll tell you whether we like it or don't like it. But these macro questions just really, you can't kind of give a response to. And so, Ares is a micro underwriting firm. We're in such a macro influenced market. How do you do your micro investment when there are these macro shifts that are happening that are kind of the shifting of tectonic plates right now where you must have a macro view?

Michael Arougheti: Yeah, it's a great question and it's something that we all have to grapple with as our markets mature, evolve and globalize. The good news is when investors are investing with Ares there are very few of them ask us to make those relative value decisions for them across all of our available opportunities. We do have some clients who want that, you know, top of the house view of where do you see the best risk adjusted return within this duration or rate? But more often than not, you have someone who says, I want exposure to Asia Pacific distressed credit, and within that appetite, go get me the best available return. And so, most of our investors to your question Willy, are macro aware but still very micro because they're being asked to identify the best risk adjusted return or deal in their specific market opportunity set.

What we bring to the table at Ares given the $350 billion we manage around the globe is a top-down view on relative value, which is simply to say, Hey, if I can generate a 12% short duration floating rate return in private bank loans, what should I have to get paid to take private equity exposure in this market? Right, if I can generate X percent on a private ABS securitization, what do I need to do? So, what we provide across the platform is that relative value lens from a macro standpoint, but it reflects itself in better pricing and structuring decisions within the individual portfolios. But it is a tough time because again, when we were all smaller and the private markets were less evolved, it was all micro. And now a lot of this is flows because liquidity is driving value. And so, if you're not macro aware and you don't understand the flows, you're missing a big part of the backdrop.

Now we're behavioral psychologists, we're macroeconomists, we're weathermen. I mean, the whole world was talking about German winter seven years ago. And the whole global economy was sitting on bated breath, waiting to see what the weather was going to be in Germany. And that was actually really important systemically, it turned out to have a great outcome, at least in terms of global market stability. But it is an interesting question you ask, because even though we're still micro, there are very huge forces at play that at a minimum, impact how capital flows to our platforms and what that means for our ability to navigate the market.

Willy Walker: And you mentioned, Mike, that you have $350 billion of the AUM and about $200 billion of that is in your private credit business. My understanding is that most of that is short term floating rate debt. And I have heard you talk about the fact that being in a senior position and getting 10 to 12% returns for that senior risk feels like a really good place for Ares to be in and that you need to get to 15 to 20% returns. You need to take so much more risk and to you all that just isn't a great risk play. Given what's going on in the markets today, is that 10 to 12 space still a good place to be, or do you think that you even pull back a little bit further from that senior position? Because it feels like that book of business is really well positioned given what has happened with rates?

Michael Arougheti: Yeah, I think that is a great place to be and I think in this market, whether you're a fixed income investor or an equity investor, everyone's just where do I go? You know, where's the port in the storm? Senior secured exposures at low double digit returns with short. That's a pretty good port to be in. It's not the only port, but it's a pretty good port in a storm. If I understand your question, I do think that given what's going on in the banking sector at this moment, private credit is going to become a lot more interesting. Because who better to understand what some of these exposures are on the illiquid side of the balance sheet? When you think about this, this gap of hold to maturity and value that we were talking about earlier, you just don't see that much pricing volatility in private loans.

So, if you're sitting on a private loan book and you underwrote it at par and you've been making 10% on it, pick your number, but you're probably able to transact on that somewhere in the nineties versus blowing out an equity book in the seventies or eighties. So ironically, even though it may be perceived to be your less liquid portfolio because of the depth of value destruction those senior loans are actually holding value too. And in some respects, they're going to give you better liquidity. So, I think it's been a good place to be, and I think it's going to become a better place to be as the banking system kind of goes through this next wave here. Because one thing we do know is we were already seeing the bank's capital constrained because of this mark to market issue. And this is not going to make it any better.

Willy Walker: So, Mike, you have 2,500 Ares colleagues around the globe, many of whom have never seen a 4% ten-year treasury and have not seen a tightening cycle like this. What are you and your colleagues doing to both recruit and train the professionals in Ares who are managing that $350 billion of capital given the relatively short time horizons that they've been investment professionals?

Michael Arougheti: Yeah, you know despite our size, this business, private investing is and always has been an apprentice business. You have to learn by doing. I think we are fortunate at Ares that our senior most folks and management team have been investing together for almost 30 years and have been through many, many cycles together. So, there's a real institutional history and institutional knowledge that is able to be transferred around the investment committee table.

But your point is a fascinating one, because I even just think about, if you think 15 years really since the GFC that we've been in a zero-interest rate environment and the best performing investors were those that were fully leveraged to market data, right. And so, you have a whole generation of investors who came out of business school when they were 30, got promoted to be a senior investor in any, pick your asset class, and for the last ten years they've been extraordinary investors because multiples in the markets were two standard deviations away from any historical average.

Now we're back to basics, right? Which is understand the micro, what's my asset worth? What's my company worth? How do I drive improvements in NOI? How do I drive improvements in cash flow? So, this skill set that you've always needed but was maybe masked by the liquidity and rate environment is back, you know, back front and center in terms of importance. And I think the good news is we've been at it a long time. I think you guys are similarly positioned just given the tenure and quality of your team. But that's worth a lot and it's worth a lot because you've seen it before. There's not a lot of anxiety that enters into the investment process. There's not a lot of emotion and we're able to transfer that knowledge. But it is going to be a real interesting shift here because a lot of what people thought was working for them is not going to work for the foreseeable future. So, the next ten years are going to be pretty different than the last ten, for sure.

Willy Walker: Last time you and I spoke, you commented to me that you were telling your colleagues that you were out of space, and you may be the one CEO that I know who is adding and not giving back space right now. How is Ares dealt with the back to office and you just mentioned a moment ago, it's an apprentice business in the sense that you go, and you learn the business from those who've gone through cycles and have seen how to react to situations like we're dealing with right now. How have you dealt with getting people both back into the office, remote, in-person, and clearly you're out of space. So, any space broker on this call know that Ares is looking for space.

Michael Arougheti: There's so many things at play with that. I guess it starts with just a philosophy and a real cultural view that in-person collaboration is what drives the business. And I think about our growth and our culture, you know a lot of our folks, you can't create that culture, that trust and camaraderie and sense of shared success remotely. You just can't, it's as simple as 80% plus of human communication is nonverbal. You need to be with people to know them. And investing is built on trust. When you're sitting around an investment committee table, those discussions are serious, and you need to be able to voice opinions in a safe place. So, we're big believers in the office.

We're not tone deaf, though. We understand that what COVID taught all of us was that there are flexibilities that we can introduce into our lives that are good for the business just in terms of the ability to collaborate at distance, the ability to drive better work life balance to our people. And so, we've incorporated a lot of that. So, we're currently having people come into the office four days a week. We've instituted things in the summer like work from anywhere for two weeks in August. We've given folks the last week of the year off. So, we're playing around with different things, trying to innovate about it.

But I believe strongly that if you are not together in the office, in our business, this may not be true for software engineers, but in our business, you have to be together. You can't learn. I think about when I was growing up in the business and I know you were the same. All of my learning happened around a conference table with a speakerphone being there when things were happening and pressing mute and trying to learn and see. And you just don't get that if you're not together.

We also, though, back to your point about space, which is fascinating. We have to rethink the space. Fewer offices, more collaboration space and more hybrid environments and tools, and more amenities. So interestingly, one of the reasons why we take out more space is, yes, our headcount is growing, but we're creating more opportunities for people to be together in different ways, which takes up more square footage. But I think that the tide has shifted a little bit. I think people are now realizing the value of being together.

And at some point, you move from deeply compassionate, which we've always been through COVID in the hybrid environment, to saying, you know, if the office is not for you, then that's okay. But maybe you're not supposed to be in an X, Y, Z career. That is part of the discussion now that I think people are willing to have with their employee base in a way that, you know, frankly, we weren't wanting to have or willing to have during COVID because that was just all about protecting your people, focusing on their health and well-being and mental health and driving the business forward. But at some point companies need to stand for something. And if you're an office-based culture, then you have to communicate that and get people back.

Willy Walker: So, Mike, I know that Ares does quite a bit on your ESG initiatives, and you've got a fantastic sustainability report. But one of the unique things that I saw on looking through it was the Ares Charitable Foundation and the fact that you've taken a part of the promotion on many of your funds and put it into the foundation. You want to talk for a moment about that, because I do think that in this world where most employees want to work for companies that stand for more than just making money, the way that Ares is focused on this is somewhat unique.

Michael Arougheti: I appreciate you bringing that up. It's one of the things I'm most proud of, at least in my tenure as CEO, is, I know you're the same way Willy, like most of our people, you don't get into private equity not to make money. So, I don't want to pretend that folks that are attracted to the investment business aren't driven by the opportunity for wealth creation. But I do think in this world and it's not just the younger generation, people want to lead a life of greater purpose and greater service.

I think for so long, folks in our business would accumulate wealth and then go do their philanthropy, kind of detached from the engine of wealth creation. And we tried to turn that on its head, which is to say, if you think about our $350 billion or 3,000 companies and our 2,000 institutional investors and our hundreds of thousands of retail investors, the number of lives that we touch, the number of pensioners and retirees that rely on our investment returns, it's a really, really profound responsibility. We've tried over the last ten years to really have our people understand that you can do well in your job. But you could do good. And they're not mutually exclusive.

And one of the ways that we actually drove that into the business was by setting up this foundation where the company itself is taking 1 to 5% of all of our promote and contributing it into the foundation to drive our philanthropy. And that philanthropy is aligned to the business of Ares. So, we've created this loop, if you will, of we do well, we then get to amplify that into the communities that we serve and then it comes back to us. What we've also now found is our employees in a very, very significant number are contributing, promote, and equity in dollars into the foundation as well to drive that. So, it's been a real cultural lightning rod for the firm. I think people now understand maybe back to your macro-micro, they understand how they connect to this broader world and what a meaningful impact they can have in understanding that, yes, our product is generating returns for our investors, but who are they and who do we serve? And we've really spent a lot of time getting people to see that it's been a real wonderful part of the culture here.

Willy Walker: So, Mike, finally, if we were sitting around the table on an all company, Ares call, and you're talking to your 2,500 colleagues around the globe as it relates to what's going on in the markets today, what are you telling them as it relates to either, the volatility we're seeing, trying to maintain a long term outlook, trying to shore up various points. What's the rallying call right now coming from Michael Arougheti across Ares as it relates to this time where so many people are desperate for information, a little bit scared about what's going on, and kind of trying to find a safe haven when there seems to be very tumultuous seas around the globe.

Michael Arougheti: It depends on the audience, to be honest with you. So, one of the things I think I'm observing just back to behavioral psychology is, if you think about this generation of investors post-GFC, the two big crises we've had were a global implosion of the financial system and a global pandemic. And again, if you've been in the market for 15 years, you have a sense that every time there's a crisis, it's catastrophic, cataclysmic. And so there is a PTSD, I think not just in the younger generation of investors, but in the markets that every time something is going to be challenging, it's going to be really, really bad. And I think that gets exacerbated by the speed with which information flows. You know, back to the run on SVB, information is flowing so fast, but it also creates a lot of information that's not really salient to the business.

The first thing we try to do is remind people that we've been here before, two, we have all the tools at our disposal, not just to protect what we own, but to be a liquidity provider into these markets. And I think we all often try to get people to focus on the signal through the noise, because I think one of the biggest challenges of investing in these markets now is there's so much information that comes at you and everyone's always trying to figure out how to digest every piece of information that's coming across their Bloomberg or the screen on CNBC that's breaking news. And the reality is 95% of that information that's coming at you probably shouldn't impact your decisioning if you're in the private market. So how do you learn how to distill relevant information and signal through the noise is something that we try to get people to focus on. And that's has served us well.

Willy Walker: It served you very well. Mike, as I started today, there are a few people that I was looking forward to talking to on the Walker Webcast as much as you, and then second, the timing of all this was exceptional. Thank you for your insights. Obviously, good luck as you manage Ares through all of this and congratulations on all you've created at Area, I look forward to seeing you soon, my friend.

Michael Arougheti: You as well. Looking forward to seeing you soon. Bye.

Willy Walker: Thanks to everyone for joining us today.

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