|Shares Out. (in M):||314||P/E||10.5x||10.5x|
|Market Cap (in $M):||5,300||P/FCF||10.5x||10.5x|
|Net Debt (in $M):||3,000||EBIT||11||11|
|TEV (in $M):||8,300||TEV/EBIT||10.5x||10.5x|
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Ares Capital Corporation (ARCC) is a way to earn a reasonably safe 9% yield with some interest rate protection in a today's generally overvalued stock and bond market.
At a high level, Ares Capital Corporation - referred to simply as ARCC throughout the writeup to avoid confusion with their relationship with other Ares entities - was created as a vehicle to lend to middle market corporations, with the vast majority borrowing on a floating rate basis. To enhance ARCC’s payout to shareholders and to help offset the various fees ARCC pays to Ares’ affiliated management entities, they utilize a reasonable amount of leverage and have a unique joint venture with GE Capital.
ARCC was created in late 2004 by Ares Management as a closed-end pot of permanent capital to earn management fees and to provide an income stream to interested investors. Overall it has worked as expected with an annualized total return of about 8% since the initial IPO about decade ago. Additionally, because the default program is for automatic dividend reinvestment - unless you opt-out - the total return inclusive of the dividend investment was closer to 13% per year.
As one of the oldest BDCs around, ARCC is managed by a seasoned team at Ares Capital Management LLC, the investment adviser of the BDC. From ARCC shareholders’ perspective, their affiliation with Ares Management accomplishes two main things; (a) it leads to better loan-sourcing opportunities for ARCC and (b) it lends credibility to ARCC in the bond market’s eyes, which allows for ample borrowing capacity.
ARCC’s “Big Picture” Financial Model:
To start with the model, here is the breakdown of their expenses as % of total assets:
- management fees are about 3.25% of total assets, as described above.
- debt financing costs them about 2.3% of total assets
- operating expenses are about 0.5% of total assets.
= Total expenses are about 6% of assets.
In total ARCC makes about 9% in interest income on their loans plus another approximate 3.5% from various fees paid by their borrowers. Factoring in the above 6% in expenses results in a spread of around 6.5% on total assets.
With their asset-to-equity ratio of about 160% (the mandated max is 200%), this results in about a 10% return on equity for ARCC shareholders. To remain a BDC for tax purposes, they must pay out about 90% of their net income.
This more or less reconciles the approximate 9% yield today.
ARCC paid a dividend of 38 cents per share each quarter with a special 5 cent dividend, bringing the payout to $1.57 per share. On today’s price of $16.93, this represents a yield of about 9.3%.
ARCC’s Loan Portfolio Makeup:
They have lent to about 200 separate borrowers with an average annual EBITDA of about $50 million. The typical maturity is 3 to 10 years in length. The vast majority of loans are done on a floating rate basis and the loans come with a good level of fees earned by ARCC.
For added ability to monitor credit issues, of these borrowers ARCC has the right to board representation for about 50% of them (which represents about 65% of dollars invested.) Further, there are reasonable diversification mandates in place as a registered investment company.
About 45% of their loans have a first lien senior secured position to company assets and another 25% are first lien loans within the GE Capital SSLP joint venture (again, where ARCC sits behind GE in exchange for the higher 15% yield on 7%-to-8% loans). To this, there is another nearly 20% in second lien position loans. The small balance of around 10% of total investments is represented by senior subordinated debt, preferred stock and equity securities.
ARCC has recently described its loan book accrual status. As of the end of 2013, loans in non-accrual status represented 2.1% of their total investments, valued at fair value. On this same measure, this was 0.6% as of the end of 2012. More recently, their first and second quarter 2014 Qs indicated that non-accrual loans represent 1.9% and 1.2% of loans, respectively.
They highlight their loan selectivity by stating that their acceptance rate is about 7% to 10% of all investment reviewed. Of this, their formal commitment process winnows it down further to about 5% to 7% of all investments reviewed.
They also describe their credit risk monitoring system on a scale of 1 to 4. A loan at its initial funding date gets a rating of a 3. Today, their portfolio ranking system shows a 3.1 aggregate average rating, a slight improvement from the 3.0 rating as of the end of 2013.
ARCC’s Fee Arrangements with Ares:
ARCC pays Ares Capital Management in three primary ways.
Base fee: ARCC pays a 1.5% “base” management fee to Ares Capital Management, the investment adviser wholly owned by Ares Management.
Pre-incentive net investment income fee: ARCC pays 100% of the net investment income between 1.75% and 2.1875% and, once that band is exceeded, they get 20% of any net income above that 2.1875%. Net investment income is calculated before taking into consideration incentive fees to Ares Capital Management, thus the name, pre-incentive net investment income.
Capital gains fee: ARCC pays out 20% of realized capital gains.
Roughly-speaking, ARCC’s payments to their investment adviser, Ares Capital Management, makes up about 50%-55% of their overall expenses. The other 37%-40% is simply interest expense on their debt funding and about 8%-10% is made up of various operating costs.
ARCC’s Joint Venture with GE Capital (SSLP):
As I see it, their partnership GE Capital in the SSLP program makes ARCC a bit unique and helps support their high yield. Basically, it allows for partial mitigation of the income and capital gains that are naturally diverted to Ares Capital Management in return for their management services to ARCC.
The GE Capital joint venture, referred to as “The Senior Secured Loan Program” (SSLP), represents about 25% of their assets of ARCC and the program generates an oversize 33% of ARCC’s investment income. Under their arrangement, Ares provides about 20% of the capital to the SSLP vehicle and in return they receive a junior right to receive payments of about 14% to 15% of the partnership’s assets. Of their current $8 billion in total loans, ARCC has a current investment of about $1.9 billion in this SSLP joint venture with GE Capital.
Viewed at a high level, ARCC’s excess interest received from the SSLP program is about 5% to 6% greater than their normal first-lien position loans in their regular direct portfolio (14.5% versus 9%). It must be said, however, that through their “SSLP Certificate” ownership interest in SSLP, this deal structure does basically transform ARCC’s position in the partnership's first-lien loans into a pseudo second-lien position.
The GE Capital SSLP partnership's underlying loan book is made to about 50 portfolio companies with an average yield of about 7%. To give you sense of the portfolios loan performance today, only 1% of the total of about $8.7 billion owned by SSLP in aggregate was in non-accrual status as of the end of 2013.
Recent ARCC Equity Offerings:
There is always the risk in equity dilution in a vehicle like this that incentivizes management to grow assets and thus, their own fees. However, their history of equity issuances over recent years does offer some comfort.
Using rough book value estimates at the time of the offering:
In 2012, they issued shares in January and August at prices of $15.41 (BV = $15.34) and $16.55 (BV = about $15.50) per share, respectively.
In 2013, they issued shares in April, October and again in December at prices of $17.43 (BV = about $16), $16.98 (BV = $16.35) and $17.47 (BV = about $16.40).
In 2014, they’ve issued shares at $16.41 (BV = about $16.50) very recently in July.
In general, they raise on average about $300 million each time at an average premium to NAV of about 4%. It should be said, however, they do have the authorization to issue up to 25% of equity at a discount to NAV.
ARCC Debt Financing:
ARCC has funded about 35% to 40% of their loans with borrowed funds. In total, they’ve borrowed about $3 billion from the markets, half in five separate convertible bond issuances and the other half in five separate senior unsecured debt issuances.
In total, they pay about 5.3% on this $3 billion in debt financing.
Their convertible senior unsecured notes range of maturities from 2016 to 2018 with conversion prices ranging from $18.71 to $20.10.
Their senior unsecured notes have a maturity range of 2018 (their biggest note) and a few in maturing out in 2022 and then a couple in 2040 and 2047.
In addition, they have various nearly untapped credit and funding facilities with borrowing capacity of about $2 billion.
Thoughts on Appreciation via Book Value Growth and Today's Entry Price:
Since I know somebody will ask, their book value did fall about 25% from late 2007 to late 2009. However, by the start of 2011, it had fully recovered. Over the past decade, book value per share has grown at about 1.5% per year. Over the past two years, book value per share has grown by about 3%.
In my view, on a semi-theoretical level, a nearly flat book value is the expectation given that nearly all of the profit is distributed to shareholders. Perhaps there should be some expectation of savvy buying and selling of loans as well as timely portfolio repositioning, especially as lending conditions tighten and loosen. This could naturally lead to some gains over and above profits derived simply from interest income and fees. In this vien, for example, they have made about 1% per year since inception in capital gains.
Nonetheless, I do not consider book value per share growth as part of my overall investment thesis for ARCC.
Today’s price represents a small premium to book value of about 2.5%. This isn’t a discount, which is the best entry point, in my book. However, the trading premium in recent years has hovered around 5% to 10%, so this represents a reasonable entry point.
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