Description

“Our industry has low barriers to entry… but high barriers to success” (ARCC Investor Day 2019.5)

• Introduction to ARCC
• ARCC is a simple-to-understand business, which through strong leadership and scale benefits has enjoyed sustainable best-in-class performance over the past fifteen years
• I personally have been a large holder of ARCC (in varying sizes) continuously for over a decade, and have recommended the stock to a countless number of people. However, we have never written up ARCC on VIC, until today…
• Now on our 17^th write-up, and late in the cycle, its time to give ARCC its due. So without further adieu
• What is ARCC?
• ARCC is a specialty finance company that is structured as a closed-end investment company, and regulated as a Business Development Company (“BDC”)
• ARCC is externally managed by Ares Capital Management (“Ares”)
• Ares is a $140bn global alternative asset manager, investing in credit (~$100b), PE (~$25bn), and RE (~$15bn)
• ARCC is the largest BDC in the US, with $14bn in assets, and over $7bn in equity
• What does ARCC do?
• ARCC makes direct investments in middle-market companies in the US
• ARCC defines middle market as companies with annual EBITDA between $10mm and $250mm
• ARCCs primary investments are senior secured loans and subordinated debt, which in some cases include equity
• 74% of ARCCs portfolio is in senior secured loans; 11% is in subordinated debt, and 15% is in equity
• ARCCs business model is very straightforward
• ARCC generates income on its investments, and its primary expenses are its cost of capital, and the management fee paid to Ares Capital
• The vast majority of the earnings are paid out as dividends. The current run-rate dividend is $1.68 per share annually, which represents a ~9.5% dividend yield on the current share price
• What makes ARCC Attractive?
• Two things make ARCC attractive from our perspective; strong leadership, and scale advantages
• Leadership and Scale generate positive selection for ARCC, which has led to superior financial results, and market-beating stock returns over the last fifteen years as a public company
• Why is scale important?
• Scale leads to positive selection for ARCC. This positive selection allows for ARCC to originate higher quality assets at better prices than its competition. A few key differentiators / benefits of scale include:
• Direct Originations
• ARCC has 110 ppl working on direct originations (largest origination team in BDC world) and the affiliation that ARCC has with Ares generates a significant information advantage for ARCC
• Sponsor Breadth / Relationships
• ARCC has done deals with 377 different sponsors since inception
• Flexibility
• ARCC has the reach to be the “total solution provider” to its partners with flexibility on products, transaction types and investment sizes
• Incumbency
• ARCC has the largest existing portfolio among BDCs, and over 50% of originations coming from repeat borrowers since 2016
• What have been the financial results?
• The positive selection noted above has manifested itself in consistently superior financial results
• ARCC has enjoyed best-in-class investment performance versus its BDC peers
• ARCC has averaged 1.2% annualized net gains on its investments (since 2004); versus 1.6% annualized net losses for the BDC industry
• This means that on average, every year, ARCCs investments consistently perform nearly three full percentage points better than its peers… in a commoditized lending environment, we would argue that is pretty special
• ARCC has an enviable balance sheet and an industry-low cost of capital
• Balance Sheet
• ARCCs balance sheet is duration-matched (ie its liabilities re-price in line with its assets)
• There are very limited near term maturities, and ARCC has very strong access to the unsecured market
• ARCC has $2bn of available borrowing capacity, and borrowing relationships with 35 banks
• Cost of capital
• ARCC has industry-low cost of capital
• ARCCs 5 year unsecured note spread of ~170bps for ARCC, versus ~285bps for BDC average
• ARCC also has an investment grade rating by S&P, Moody’s and Fitch
• Best-in-class investment performance, and industry-leading balance sheet, have led to superior returns on equity (ROE)
• ARCC has achieved an 11% annualized ROE since crisis, vs ~4% for BDCs, and 3% for smid-cap banks
• This stat has a great deal of survivorship bias, because it only includes banks that were in business in 2008 and still in business today!
• ARCC has proven their results through the Financial Crisis
• ARCC has grown book value per share and has made accretive acquisitions opportunistically during dislocations
• Coming out of Great Recession, ARCC purchased Allied (“ALD”), repositioned and sold various assets, and enjoyed large gains as a result
• In 2017, ARCC purchased American Capital (ACAS), employed a similar strategy to ALD, and the transaction has proved highly accretive
• We believe it is only a matter of time before we get another dislocation, and ARCC can once again do something that is opportunistic, smart, and ultimately accretive to generate value for its holders.
• The financial results have been good, but what about the stock?
• Since its IPO over fifteen years ago, ARCC’s stock returns have handily beaten the market
• ARCC shareholders have experienced a 12% cumulative annualized return since IPO in 2004
• This equates to a ~450% total return over that fifteen year period
• This is more than double the return of the S&P 500 over the same period!
• Why invest in ARCC now?
• So all of this is great, but many people have been burnt by investing in good companies at inopportune times. Fortunately, we think now is a good time to invest in ARCC
• ARCC is experiencing favorable market trends for direct investments, and will likely benefit from two legal / regulatory changes that could be a material positive tailwind to its franchise value
• Also, ARCC is trading at what we believe to be a very attractive valuation
• Finally, if some of these catalysts play out (and the stock moves forward), there is the potential for a virtuous cycle which we haven’t seen in BDC world in some time…
• Here are some of the opportunities….
• Favorable Market Trends
• Banks continue to pull back from direct lending (acting more as arrangers versus lenders)
• There is a general trend toward private markets v public markets for operating companies, driven by lower regulatory costs, lower volatility, etc
• There has been, and we believe will continue to be, growth in PE dry powder
• This is the pipeline for future sponsor loans for ARCC, which will fuel future growth
• Legal / Regulatory
• There are legal / regulatory events that can be further catalysts for ARCC
• Small Business Credit Availability Act (“SBCAA”)… Signed 3/23/18
• BDCs are regulated entities, partly governed by the Investment Company Act of 1940 (“1940 Act”)
• The SBCAA amends the 1940 Act to reduce asset coverage requirements for BDCs from 200% to 150%
• This ratio is calculated as Assets / Debt
• This means that if the BDC were required to have $20 in assets; $10 in debt; and $10 equity before the SBCAA, it would then only be required to have $15 in assets; $10 in debt; $5 in equity post the SBCAA
• This means that the debt to equity maximum for BDCs goes from 1 to 1, up to 2 to 1
• This means BDCs can double the amount of leverage they can take on!
• ARCC announced that their target leverage (debt to equity) would increase from a range of 0.65x – 0.75x up to a range of 0.90x – 1.25x
• Part of being a well-run company is being conservative… (hence not going up to 1.75x!)
• This is an increase of 0.25x – 0.50x in leverage
• We estimate this could meaningfully accretive to EPS (20c to 40c at a 4% margin on incremental assets)
• This would be ~12% to ~24% accretive to run-rate Core EPS
• Acquired Funds Fees and Expenses (“AFFE”)
• This is an SEC rule (enacted in 2006) that required registered funds (mutual funds, index funds, etc) to include a separate line item for AFFE in the “Fees and Expenses” table in their disclosures
• Therefore, any fund that owns BDCs must add the BDCs fees to the funds fees in their disclosure
• Funds don’t like this, because this artificially inflates their expense ratio (and makes them look worse to investors)
• In 2014, S&P and Russell removed BDCs from the indices they administer because of funds being concerned about the AFFE Rule impact on their expense ratios
• This forced selling by ETFS, and led to a steep underperformance for BDCs
• ARCC traded down from $18 to $15 during that time period for “no reason” other than what was likely this forced selling
• The SEC is now proposing to change this rule to exempt BDCs from being deemed “acquired funds”… these rule changes are now in comment period
• If enacted, this change could open the door for BDCs to be included back into the S&P and Russell indices they were kicked-out of in 2014
• We would expect material ETF buying (and a positive reversal of the 2014 selling) if this were to be the case
• Attractive Valuation
• Despite being a scale player, with a great management team, best-in-class historical performance, and some potential meaningful catalysts, ARCC has a very modest valuation
• ARCC has $17.21 book value per share, which values it about 1.05x BV
• ARCC also is paying out $1.68 per share (all funded through core earnings), which equates to nearly a 10% yield on the current price
• “Virtuous Cycle”
• I am probably dating myself here, because it has been a long, long time since this phenomenon existed
• Basically, if a BDC trades at a premium to BV, the math works out that they can issue stock above book value, and then accrete BVPS to holders…
• Example: A BDC has two shares outstanding and $10 per share of BV… if it raises a third share at $16, then it has three shares outstanding with $12 of BVPS… this capital raise immediately accretes 20% of book value to existing holders
• If a BDC keeps doing that, it keeps accreting BVPS, and investors keep being rewarded with a higher BVPS (and a higher premium to BVPS as analysts start to bake this in)… it is a beautiful thing when it happens… it has happened before, and can definitely happen again!
• Summary
• ARCC is a simple-to-understand business, which through strong leadership and scale benefits has enjoyed sustainable best-in-class performance over the past 15 years
• Past performance does not guarantee future success, but we think it’s a decent bet that ARCC will continue to perform and long-term patient investors will continue to reap the benefits, and actually may be pleasantly surprised!

DISCLAIMER

The author of this posting and related persons or entities ("Author") currently holds a long position in the securities mentioned above. The Author makes no representation that it will continue to hold positions in these securities. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note.

Catalyst

see write-up