Ares Management might be best known for big private equity deals, such as last year’s purchase of Dallas luxury retailer Neiman Marcus Inc. But those big transactions are only a part of the company’s business today.

More than one-third of the assets of the Century City financial firm are now in loans to companies, not investments in them. It’s Ares’ fastest-growing segment and a key driver behind the meteoric rise of the company. And it drove Ares’ decision last month to raise $100 million by going public.

Regulations that followed the credit crisis have hamstrung commercial banks, particularly in lending to small and medium-size companies, sending this business to specialty finance companies such as Ares that don’t have to play by the same rules.

Adam Coffey, chief executive of Wash Multifamily Laundry Systems in El Segundo, is a different kind of Ares client, though – he turns to Ares to supplement lending he gets from commercial banks.

“Small companies are using direct lenders because their risk profile is different from a bank’s,” said Coffey, whose company rents washing machines and dryers to apartment complexes and borrows from Ares in an aggressive growth strategy that doesn’t fit into the new normal for banks. “They have looser credit requirements than the traditional senior lenders do. In many cases, a direct lender is all they can get.”

Ares was co-founded in 1997 by a group of former executives from New York private equity firm Apollo Global Management led by Antony Ressler, who is still chief executive. The firm employs 700 people in 15 offices across the United States, Europe and Asia, and is headquartered on the 12th floor of the Creative Artists Agency building on Avenue of the Stars – the one with the hole in it.

Ares divides its business into four segments: direct lending, real estate, corporate bonds and private equity. Private equity now comprises 14 percent of the company’s assets under management, compared with direct lending’s 34 percent.

According to the firm’s IPO filing, the direct-lending division has more than 400 client companies in the United States and Europe. Citing the “quiet period” imposed by the firm’s pending IPO, Ares declined to speak to the Business Journal for this article.

The firm announced March 31 that it would go public and use the money to grow the business.

Banks bow out

The direct-lending boom has come to Ares as commercial banks’ share of cash-flow loans to private middle-market companies fell to 9 percent last year, the lowest since 2007, according to data from S&P Capital IQ, a New York business analysis firm. The middle market is defined as companies with less than $50 million in earnings before interest, taxes depreciation and amortization.

Domestic banks issued less than 1 percent of these loans in the first quarter of this year, evidence that they’ve almost completely exited the business. In the early 2000s, their share was about 50 percent.

Alternative financiers have been happy to fill the void. Ares does its direct lending in the United States through its business development company, Ares Capital Corp., which is already public. These types of companies, called BDCs, are essentially publicly traded private equity funds that choose that classification for tax purposes. Their main line of business is investing in loans to middle-market companies.

According to data from New York investment bank Keefe Bruyette & Woods Inc., total investments from BDC’s have skyrocketed from a low of $2.3 billion in 2008 to $18.7 billion in 2013, growing at nearly 30 percent a year from 2011. Ares Capital is the biggest player in the space by far, with its 2013 total of $3.5 billion making it 55 percent larger than the second place company, Apollo Investment Corp., Apollo’s BDC.

In all, Ares Management has gone from $5 billion in assets under management to $73 billion in the last 10 years.

This shift in direct lending from banks to nonbanks can be traced to the threat and eventual reality of new banking regulations resulting from the 2008 financial crisis. Commercial banks now have to contend with tighter lending standards that had been looming since the crash and went into effect in May. These standards limit the amount of leverage banks can provide many businesses without raising concerns by regulators or rating agencies, which could lead to requirements to hold more capital, reducing yields. The agencies could also lower the ratings on the loans.

“For the traditional lenders, the spigot got turned off,” said Andrew Apfelberg, a partner at Century City law firm Greenberg Glusker who specializes in corporate finance in the middle market. “Between the regulation and the tight credit, some investors saw an opportunity to get creative.”

Through private equity companies such as Ares and other nonbank entities, these investors began to put their money into loans that were harder for banks to make, especially after they had their hands burned holding bad debt during the crash and were understandably cautious.

Senior debt from a specialty finance company can be at least 50 percent more expensive than a comparable product from a commercial bank, making it an attractive space for investors seeking yield.

These investment firms needed to find a way to deliver solid returns to their investors, and small businesses now spurned by their local bank were looking for financing. It was only natural that they would find each other.

“As regulations changed and the BDC’s came in, suddenly you found you had this whole other alternative,” Apfelberg said. “In some senses, those guys could be more flexible.”

The primary customers for direct loans from firms such as Ares are small companies for whom such lenders have become often the only choice.

Craig Enenstein, chief executive of private equity firm Corridor Capital in West Los Angeles, also focuses on investments in lower- to middle-market companies. He said that small businesses, particularly those with annual Ebitda of less than $3 million, have an especially tough time finding traditional financing.

“It’s very hard to find a conventional cash-flow loan,” Enenstein said. “These specialty finance companies have filled a void that’s been created by commercial banks walking away from that part of the market.”

Companies that don’t fit a certain established model or those tied to an industry such as homebuilding that went through a dramatic boom-bust market cycle have an even harder time getting bank loans, which is why many of them have led the charge toward firms such as Ares.

“These direct lenders are able to get involved in businesses that might be a little bit more hairy,” said Jeffrey Sklar, a partner at Century City law firm Sklar Kirsh who chairs the firm’s corporate practice. “A commercial lender might not be able to wrap his head around it.”

Bigger companies, too

However, it’s not only small or unusual companies that can’t get bank loans that are finding a place for specialty finance firms on their balance sheets. Coffey’s laundry business, for instance, has annual revenue of more than $1 billion and uses commercial banks to provide its senior debt. Big businesses such as Wash Multifamily Laundry use specialty lenders such as Ares to fill out their total debt picture and allow them to carry the amount of leverage that management, and not a bank credit committee or rating agency, deems appropriate.

Wash earns an annual Ebitda of more than $100 million. Rating agencies don’t like companies taking on senior debt that exceeds four-and-a-quarter times Ebitda, so Wash has that multiple – $425 million – in senior loans from a syndicate of commercial banks. But it also has $75 million in junior debt from Ares.

“Above that (4.25 multiple), you have a harder time raising it through senior lenders such as commercial banks,” Coffey said. “A company like Ares comes in and takes a second lien position behind the senior lenders. You’ll pay a little bit higher interest rate, but it’s a good way to round out your capital structure.”

Ares charges an interest rate that is roughly double what Wash pays its senior lenders, but Coffey sees it as a cost of growing the business. Being able to tap into this extra debt frees up money needed to expand the company.

“We’re a growth company,” Coffey said. “We’ve doubled in size in the last five years. Growth in its very nature consumes capital.”

Private equity firms such as Ares entered direct lending for the returns, but they’re finding the business has other perks, such as the ability to bring potential target companies into their orbits before taking an equity position.

“If a company’s in a cash-flow crunch and you’re willing to give them a loan to tide them over, you’re basically getting your hooks into them to then convert to equity later or take out by writing an equity check” Apfelberg said.

Small businesses struggling to find traditional financing are also finding upside as the big firms such as Apollo, Ares and Blackstone Group in New York are expanding their activity in direct lending.

“This is something they’re able to take advantage of now that didn’t exist in the same way 10 years ago,” Sklar said. “If the banks, for whatever reason, are not able to give them a competitive product, there’s other sources now that may be able to.”

The increased competition in this space is starting to benefit borrowers in other ways, too, as specialty finance firms are now fighting among themselves over some of the same business. A source involved in private equity deals who spoke to the Business Journal on the condition of anonymity because he works with direct lenders said they have recently started undercutting each other, as certain lenders have been offering loss-leader terms to borrowers in order to boost market share.

Commercial banks are finding a roundabout way to get in on the action, too. Ares Capital recently announced that a group of 18 banks had raised the firm’s credit line by $110 million, charging it a low interest rate.

And banks are now increasing their lending to Ares Capital to make the loans they no longer can. The banks’ risk is spread out among its entire portfolio, while Ares Capital takes on the risk of each individual loan and pockets the spread as its payment.

Apfelberg thinks this reallocation of riskier debt to direct lenders such as Ares Management is a positive consequence of the banking crisis.

“I think the role that commercial banks play in most people’s mind is conservative, safe, traditional,” he said “And that’s where maybe it does make sense to use public money or federal money to bail out some of these institutions or regulate them a little more. However, investors in these loans are not your average Joe, They’re looking for returns by assuming a higher risk.”