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Ares Capital (NASDAQ:ARCC)
Q3 2020 Earnings Call
Oct 27, 2020, 12:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good afternoon. Welcome to the Ares Capital Corporation September 30, 2020 earnings conference call. [Operator instructions] I will now turn the call over to Mr. John Stilmar, managing director of investor relations.

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 in 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. 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 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 operations, 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, and 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 Q3 '20 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.

Kipp DeVeer -- Chief Executive Officer

Thanks John. Hello to 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 earnings 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 31, 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 they 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. And we are also now seeing an acceleration of M&A activity in our deal flow. Businesses are increasingly seeking acquisitions to reposition their business models or to capitalize on new growth verticals in a post-COVID world. In addition, there is pent-up demand from a very slow period this spring and summer.

Many transactions that were being considered pre-COVID are now returning to the foreground and seem actionable. Furthermore, some sponsors are seeking to lock in gains for 2020, especially ahead of the upcoming elections. And 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 reemergence 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 continue to see net revolver repayments from our portfolio companies. Revolver drawings are now back to drawing levels that are near pre-COVID. 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, 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 is followed with partial or complete reopenings of many businesses.

For the more COVID-impacted names which we largely see in our grade 1 and grade 2 names, we believe we have an informed view of their path to recovery. But 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 $0.40 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.

Penni Roll -- Chief Financial Officer

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 30, 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 to 1.25 times and is essentially unchanged from 1.08 times at June 30. 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 30. Specifically, we issued an aggregate $1.15 billion of three and seven-eights 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 30, 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 with -- us with significant overcollateralization 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 30, 2020, to stockholders of record on December 15, 2020. Now, I will turn the call over to Mitch to discuss our third-quarter investment activities and our portfolio positioning in more detail.

Mitch Goldstein -- Co-President

Thanks Penni, and good afternoon. During the third 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. Our 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 crisis. We have also found compelling fee opportunities in today's market as our senior loan restructuring 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 nonaccrual rate.

During the third quarter, one net new company was added to nonaccrual. This resulted in a modest increase to our nonaccruals 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, nonaccrual 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 1 through October 21, 2020, we made new investment commitments totaling $419 million, of which $340 million were funded. As of October 21, 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. And with that, I'll turn the call back over to Kipp.

Kipp DeVeer -- Chief Executive Officer

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.

Questions & Answers:


Operator

[Operator instructions] Our first question will come from John Hecht with Jefferies.

John Hecht -- Jefferies -- Analyst

Good 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. So 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?

Kipp DeVeer -- Chief Executive Officer

Yeah. Hey, John. It's Kipp. Can you hear me OK?

John Hecht -- Jefferies -- Analyst

I can.

Kipp DeVeer -- Chief Executive Officer

All right. Good. Yes, 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 mean, I would tell you, I think I am a little bit more optimistic. It's hard not to be versus seven months ago. And 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. And we don't see any negative migration.

As we mentioned in the past, we kind of think we have our arms around the situations that need extra attention. And then, yes, in terms of optimism going forward, it's a much, much busier environment. It's much more constructive around getting new deals done. And 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 has picked up substantially. So 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, Ryan. But 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.

So 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.

John Hecht -- Jefferies -- Analyst

All right. Thanks. That's helpful. And then you also cited that the average size of the 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 the market and able to do things. But is there any part of that that might be tied to banks pulling back in certain categories or other competitive factors?

Kipp DeVeer -- Chief Executive Officer

I think it's all of that. I mean I think we -- 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. So they're trying to create securities for liquid credit investors, so to speak, to buy that really have good liquidity.

And as you know and others know, a $1 billion deal just doesn't have a lot of liquidity in the aftermarket. So 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 enable, and I think we've proven that we are, right? So the uncertainty that we have continued to encounter here I think only leads to probably more large private deals going forward.

John Hecht -- Jefferies -- Analyst

Yup. Right. That all helps. Thanks very much.

Kipp DeVeer -- Chief Executive Officer

Thanks a lot John.

Operator

Our next question comes from Finian O'Shea with Wells Fargo Securities.

Finian O'Shea -- Wells Fargo Securities -- Analyst

Hi. Good afternoon. First question, I suppose Kipp and Penni, I think you referenced 85% of assets are secured by -- or financed by unsecured 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? And then 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?

Kipp DeVeer -- Chief Executive Officer

Sure. Hey Fin, thanks for the question. I'm going to let Penni chime in too, but I'll -- so 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, the Ivy Hill, etc. But the core investing business isn't going to change at all.

And 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. So we're really trying to keep flexibility during an uncertain period. But I would kick it over to Penni and let her add any comments if she'd like to.

Penni Roll -- Chief Financial Officer

Yeah. Thanks, Kipp. Thanks, Finian. So 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 very strong balance sheet, and that's always been something that we focused on.

And 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. So 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 and as we move through time.

That percentage may come down a little bit as we are able to roll off some of those maturities, but because they don't come until 2022, we'll probably run with a higher percentage of unsecured for a little while.

Finian O'Shea -- Wells Fargo Securities -- Analyst

Thanks so much. And then just one follow-on on the 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 ranger sense? Any color you could provide there would help. And that's all for me. Thank you.

Kipp DeVeer -- Chief Executive Officer

Yeah. I mean 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 at the outline, Fin.

Finian O'Shea -- Wells Fargo Securities -- Analyst

Yup. Understand. Thanks again.

Kipp DeVeer -- Chief Executive Officer

No problem.

Operator

Our next question will come from Rick Shane with JP Morgan.

Rick Shane -- J.P. Morgan -- Analyst

Good morning everybody and thanks for taking my question. I just wanted to talk about Slides 16 and 17, investment activity post the end of the quarter and nonaccruals. The $326 million that you cite is exited, is that fair value or cost?

Kipp DeVeer -- Chief Executive Officer

Oh gosh, Penni?

Penni Roll -- Chief Financial Officer

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.

So therefore, to the extent it's funded, it's at cost.

Rick Shane -- J.P. Morgan -- Analyst

Got it. And so when we look at the nonaccruals, we should take the nonaccruals at cost down by 38% of the $326 million?

Penni Roll -- Chief Financial Officer

That would be the right math, yes, on a pro forma basis. Yes. And I would just add to that, the exits that we had were near the fair values at 9/30. So.

Rick Shane -- J.P. Morgan -- Analyst

Got it. Yeah, that was actually part of my question. I'm assuming that this is all already reflected in NAV. The -- and Penni, I'm not sure -- I didn't hear a part of your response or I wasn't sure if you were pausing to think about the response, so I apologize.

But when we think about the realized losses of $83 million, were those disproportionately concentrated in the 38% that were on nonaccrual.

Penni Roll -- Chief Financial Officer

I think those were probably all of the nonaccruals. Because what happens is when we actually exit something, then we will remove the cost basis. And then to the extent there is an embedded loss, we would record the realized loss. So it really just moves the unrealized to realized.

So it is concentrated in those names that were on nonaccrual. I would just remind everyone too, that when we exit or have some kind of restructuring event, we often also -- or we do need to look at anything that we exchange at fair value so that we would be able to we would have to record the loss, but then we have the new basis effectively and anything that we exchange. So 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.

Rick Shane -- J.P. Morgan -- Analyst

Got it. OK, that's very helpful. Thank you very much.

Kipp DeVeer -- Chief Executive Officer

Thanks Rick.

Operator

Our next question comes from Devin Ryan with JMP Securities.

Devin Ryan -- JMP Securities -- Analyst

Thanks very much. Good afternoon. First question here, just on credit. Clearly, you've seen 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.

Kipp DeVeer -- Chief Executive Officer

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 credits -- the liquid credit markets that we referenced were in a different place. So 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 200 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 to 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, good quality of underwriting being better.

Devin Ryan -- JMP Securities -- Analyst

Got it. Very helpful. Thanks. And then 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 that the election may be driving some pull forward just ahead of potential tax changes dependent on the election outcome. And just wanted to think about whether that's affecting how you guys are thinking about areas to lean into or move away 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.

Kipp DeVeer -- Chief Executive Officer

Yeah. I mean -- so I think the election is certainly increasing activity with people, whether any counterparty sponsors, owners of business, 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. So 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 will be part of our thinking in terms of the new investing business.

Devin Ryan -- JMP Securities -- Analyst

OK, great. I'll leave it there. Thank you.

Kipp DeVeer -- Chief Executive Officer

Yeah. You're welcome.

Operator

Our next question comes from Ryan Lynch with KBW.

Ryan Lynch -- KBW -- Analyst

Hey. Good afternoon. Thanks for taking my question guys. First one I have is just on 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. But when I look at your guys' backlog that you guys reported, you guys had $1.5 billion in the backlog currently. And if I look at that over a year ago, it was only about $665 million. So 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 2Q to Q3 and then just kind of a steady increase into Q4? Any kind of color on kind of the magnitude of where activity is today would be helpful.

Kipp DeVeer -- Chief Executive Officer

I mean, I think currently, I would characterize this as at pre-COVID levels. I wouldn't say that I think it will necessarily remain there, right? So we are very busy. I think it's a combination of again pent-up demand. Folks who didn't get much done for a 6-month period during more severe lockdowns and closures and all of that trying to get some things done that they wanted to get done.

And I think Devin's question as well about the election pulling things forward is part of it too. So 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 would be my thought.

Ryan Lynch -- KBW -- Analyst

OK. And then I just -- 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, but you guys also said you had a 60% drop in new amendments this quarter.

So can you just talk about what drove that big increase in other income this quarter and how sustainable are any of those items?

Penni Roll -- Chief Financial Officer

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 onetime one-off amendment and other fees related to portfolio activities. And as you know, in these environments, it lends itself to higher-than-normal levels of fees from various sources. So I would look at it as more of a one-off increase.

And as the amendments start to subside, then our opportunity for making those types of fees will be reduced. But that was more of a one-off thing for the quarter that you shouldn't put into the run rate.

Ryan Lynch -- KBW -- Analyst

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?

Kipp DeVeer -- Chief Executive Officer

So it's slowed down a lot. We talked about the decrease in this quarter, and it's probably kind of steady and even at that level. I mean 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? So 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 winner potentially hold or not hold for COVID, so it's hard to tell. But today, it's still at that much more light or reduced level that you saw in this quarter.

Ryan Lynch -- KBW -- Analyst

OK, understood. Thanks for taking my questions. And really nice quarter, guys.

Kipp DeVeer -- Chief Executive Officer

Thanks. Appreciate it.

Operator

Our next question comes from Casey Alexander with Compass Point.

Casey Alexander -- Compass Point -- Analyst

Yeah. Good morning or good afternoon. I only have one question. What percentage -- can you guess at what percentage of the backlog is from incumbent borrowers?

Kipp DeVeer -- Chief Executive Officer

I'd have to go look through it. I mean it typically is pretty consistent around that 50-ish percent level, but I actually don't know. I don't think I have that number off hand. 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.

You have that?

Casey Alexander -- Compass Point -- Analyst

Yeah.

Penni Roll -- Chief Financial Officer

Yeah, it's around -- it's over half. There's more new than incumbent. So the estimate is around 70% of incumbent deals.

Casey Alexander -- Compass Point -- Analyst

I'm not sure -- you just said more new than incumbent and then 70% incumbent deals. So you confused me.

Penni Roll -- Chief Financial Officer

Sorry, I guess I think I misread it. It's more new than incumbent, sorry. So it's -- around 70% is new.

Casey Alexander -- Compass Point -- Analyst

So 70% is new. OK. Great. All right.

That's what I was looking for. Terrific. Thank you. Sorry for the confusion.

That's it. That's my only question. Thank you.

Kipp DeVeer -- Chief Executive Officer

Hey. Casey, thanks a lot of questions. Sorry for us confusing or getting our numbers backward, but we'll be in to take the next one.

Operator

Our next question comes from Derek Hewett with Bank of America.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

Good afternoon everyone. What are your -- 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 nonaccruals could potentially stabilize prospectively? And I do realize that liquidity is strong given Ares' Capital structure.

Kipp DeVeer -- Chief Executive Officer

Yeah. I mean, certainly, as part of all that amendment activity, that's really what drove the increase in PIK. I mean typically, we started pre-COVID, just as a reminder, with PIK income at high single digits, kind of 8% to 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. So 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. And 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. But it's one of the things that we've had to allow for to obviously be patient and take a long-term view around the recovery of some of these more COVID-impacted names.

So 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. But it is elevated, and I'd like to see it come down, and the shape of the recovery will dictate how quickly that can happen.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

OK, great. And then one other somewhat housekeeping question. What was driving that significant increase in the SDLP yield on a cost basis quarter over quarter?

Kipp DeVeer -- Chief Executive Officer

Are you talking about the fair value going up or you're saying...

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

No. Just the actual yield. I think it was up about 80 basis points on a quarter-over-quarter basis.

Penni Roll -- Chief Financial Officer

Yeah. Maybe, Kipp, I can take that one. We -- if you looked at the yield at year-end, it's around 14 and a half percent. We reduced that in Q1 and Q2 to about 12 and a half percent coming into COVID, maybe a little conservative on our part, just to look at the underlying performance of the companies.

But if you look at the way they performed, it's been better than expected. We've had rebound in performance, where -- and then also some amendments that led to some higher yields in the underlying portfolio. So 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. So we ended -- for Q3, we were at 13 and a quarter percent.

Kipp DeVeer -- Chief Executive Officer

I hadn't really -- 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.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

OK, great. Thank you very much everyone.

Operator

Our next question comes from Kenneth Lee with RBC Capital Markets.

Kenneth Lee -- RBC Capital Markets -- Analyst

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 some -- 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.

Kipp DeVeer -- Chief Executive Officer

Sure. I mean I think we've said in the past, and we're still -- 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. And at one and a quarter, we'll probably sort of evaluate it. But the way that the company operates obviously is when we see what we think are attractive investment opportunities, and 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.

So that's how we see it. But 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.

So at this point, we still feel like we'll be in that one to 1.2 range for a little while here.

Kenneth Lee -- RBC Capital Markets -- Analyst

Great. That's all I have. Thank you very much.

Kipp DeVeer -- Chief Executive Officer

No problem.

Operator

And our next question comes from Robert Dodd with Raymond James.

Robert Dodd -- Raymond James -- Analyst

Hi and congrats on the quarter. I mean, if I can go back to the amendments, just briefly, Kipp. I mean 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.

So I mean, if it's down 60 in count, was it down in seriousness, if you will?

Kipp DeVeer -- Chief Executive Officer

That's an interesting question. It's kind 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. So as a generalization, I would think that the amendments that got done this quarter were of the less serious variety.

But I'd have to go back and look at the list, but that would be my sense.

Robert Dodd -- Raymond James -- Analyst

Got it. I appreciate that color. And 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. And 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 changes is, i.e., are the larger business is 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 or is it the 50 to 100 applies even on the kind of larger businesses you're looking at right now? And obviously, this is a -- it's separate from better docs, etc., etc. But any color on that one?

Kipp DeVeer -- Chief Executive Officer

Yeah. I mean 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 -- 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. But when you come looking for a complete capital solution at $750 million to $1 billion, not a lot of people that you can go to. And I would tell you, I think we're able to drive some unbelievable value in these larger companies. So 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, right? Your point is the right one which is when you're financing smaller companies, you're supposed to be getting premium returns. And 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, well, I can't believe a $20 million EBITDA company can borrow at the same cost of capital as $100 million EBITDA company. But it seems they can these days.

So for us, it doesn't make a lot of sense, and we'll sort of stick to what we're doing.

Robert Dodd -- Raymond James -- Analyst

I appreciate that. It does show up in your risk returns when you get a higher coupon on second lien and have lower nonaccruals on selling in the industry. Clearly, the risk return is better the way you're doing it in your market segment. So I appreciate the answer.

So thanks.

Kipp DeVeer -- Chief Executive Officer

Thanks for your question.

Operator

[Operator instructions] The next question will come from Chris Kotowski with Oppenheimer & Co.

Chris Kotowski -- Oppenheimer and Company -- Analyst

Good afternoon and thanks. Just trying to peel back the onion on your relative optimism about the nonaccruals. Just kind of looking through the bigger, chunkier names, you see two dental centers, a couple of restaurants, some oil and gas, OK, a movie production company. I mean those are kind of the bigger, chunky ones, and it's obviously easy to see how a lot of them would have been impacted by COVID.

And I'm wondering, is your optimism based on the fact that like these companies have kind of found a way to, at least partially function in the COVID world or is it just that -- well, yes, are these companies able to function in the kind of partially open world that we're in?

Kipp DeVeer -- Chief Executive Officer

You're talking about companies that are existing nonaccruals or the rest of the rest of the ones?

Chris Kotowski -- Oppenheimer and Company -- Analyst

Yeah. No, your existing nonaccruals. That's what I was wondering about. Is that -- was that the basis of your optimism?

Kipp DeVeer -- Chief Executive Officer

Generally, yes. Of the existing nonaccruals, we think for the most part, they're all pretty darn good businesses that, to your point, our operating industry is impacted by COVID and 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. But yes, I think there will be a path to recovery for most if not all of them. So I think it's being reasonably optimistic on the existing nonaccruals.

But I think I'm optimistic too around the portfolio because it's -- when you look at our nonaccrual list, it's a pretty small list, right? And we've talked about the grade 1s and 2s kind of being I think in my mind, ring-fenced at the 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. So definitely a lot more optimistic than I was in April.

Chris Kotowski -- Oppenheimer and Company -- Analyst

OK. All right. That's it for me. Thank you.

Kipp DeVeer -- Chief Executive Officer

Yeah. You're welcome.

Operator

This concludes the question-and-answer session. And I would like to turn the call back over to Kipp Deveer for any closing remarks.

Kipp DeVeer -- Chief Executive Officer

Nothing beyond wishing everybody well and hoping we can all get back together in person one of these days. But thanks for all the questions. We'll sign off now. Thanks.

Operator

[Operator signoff]

Duration: 55 minutes

Call participants:

John Stilmar -- Managing Director of Investor Relations

Kipp DeVeer -- Chief Executive Officer

Penni Roll -- Chief Financial Officer

Mitch Goldstein -- Co-President

John Hecht -- Jefferies -- Analyst

Finian O'Shea -- Wells Fargo Securities -- Analyst

Rick Shane -- J.P. Morgan -- Analyst

Devin Ryan -- JMP Securities -- Analyst

Ryan Lynch -- KBW -- Analyst

Casey Alexander -- Compass Point -- Analyst

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

Kenneth Lee -- RBC Capital Markets -- Analyst

Robert Dodd -- Raymond James -- Analyst

Chris Kotowski -- Oppenheimer and Company -- Analyst

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