ARCC - Ares Capital: A Fantastic Opportunity To Lock In A Hefty 10% Yield

2023-10-22 08:30:02 ET

Summary

• Ares Capital Corporation is a high-yielding business development company that pays out a distribution resulting in a 10% yield.
• Ares Capital focuses on middle market companies in the US, with investments ranging from $30 million to $500 million.
• The company has a diverse portfolio and has historically prioritized investing in secured debt, but has shifted towards equity investments for stronger returns.
• Returns have been strong enough in recent years to comfortably cover the distribution, meaning that it's sustainable so long as this trend continues.

As a general rule of thumb, rising interest rates can make life less appealing for dividend paying companies. The rationale is that if you can capture a guaranteed 5% or 6% return, why would you risk capital on a company that pays out a distribution of only 2% or 3%. Of course, there is always capital appreciation to factor into the equation. But for investors who prioritize income, most notably those who are in or near retirement, the payout and the risk assumed to get that payout, becomes a serious consideration.

For investors who are interested in higher yielding opportunities, they do exist. Most of them fall into one of three categories. They are either REITs, MLPs, or BDCs, the last of these standing for ‘business development companies’. BDCs are enterprise is that focus on taking capital and allocating it toward other companies, almost always firms that are not publicly traded companies. The rationale is that a large publicly traded firm should have a lower cost of capital to it, while a small privately held company is bound to have a higher cost of capital because of the increased risk. By attracting capital for cheaper and allocating it to various investment opportunities that are, individually, riskier, the hope is to generate strong returns that can then be paid out to shareholders.

One of the firms in this space that investors should absolutely be aware of is Ares Capital Corporation ( ARCC ). Although I have not written about it specifically, I have written about Ares Management Corporation ( ARES ), which is a global alternative investment manager that owns a subsidiary that manages Ares Capital. At this time, Ares Capital pays out a distribution that results in a yield of 10%. This is a hefty distribution and one that investors who are yield oriented should be drawn to. But one of the risks in this space is that you could end up with a situation where management is paying out more than the profits that the company generates. This is unsustainable, as I recently wrote about regarding a different high yielding opportunity. But the good news for shareholders here is that Ares Capital looks incredibly sound.

A great prospect at this time

As I mentioned already, Ares Capital is a BDC. Another way to describe this kind of enterprise is as a specialty finance company that operates as a closed-end management investment firm. While the company has done well to grow over the years, its primary objective seems to be to pay out attractive distributions for its investors. For the most part, it focuses on middle market companies in the US. Its definition of middle market includes companies with annual EBITDA of between $10 million and $250 million. And investments typically range between $30 million and $500 million apiece.

As of the end of the second quarter of the 2023 fiscal year , Ares Capital boasted a portfolio of $21.5 billion in size . This portfolio is currently divided between 475 portfolio companies. Its largest concentration involves software and services firms. Approximately 22% of its portfolio falls under this category. Another 11% falls under the health care services space, while 10% is focused on commercial and professional services. There is another investment type, known as Ivy Hill Asset Management, that accounts for yet another 10%. But I would get into that a bit more shortly.

Historically speaking, Ares Capital has always prioritized investing in secured debt. 42% of its portfolio today, by value, is comprised of first lien senior secured loans. Another 18% involves second lien senior secured loans. When you add in its Senior Direct Lending Program and its fairly small concentration of senior subordinated loans, you get another 11%. But the picture wasn't always that way. While the top two categories of senior debt currently accounts for 60% of the company’s portfolio, only five years ago it amounted to 76%. But over time, management has reduced exposure, particularly to the second lean senior secured loans, and increased exposure, mostly to equity and the aforementioned Ivy Hill Asset Management operation the business has.

For those who don't know, Ivy Hill Asset Management is an asset management services company that Ares Capital operates that manages investment vehicles and that serves other roles for one other vehicle, all on behalf of client funds. Around $2 billion of the assets in that enterprise are owned by Ares Capital. But the rest of the $13.5 billion comes from other parties. As of the most recent quarter, about 75.6% of the amortized cost and 77.3% of the fair value of the roughly $2 billion in assets that Ares Capital has invested in Ivy Hill Asset Management is in the form of equity in privately held firms. The rest is subordinated debt. The reason for this shift over the years is that, while equity is riskier than debt, it also generates stronger returns.

To be honest, it's unclear whether Ares Capital needs returns stronger than what it has already. Historically speaking, the company has done very well for itself and its investors. According to management, from the time the company went public back in 2004 through the present day, the business has turned every dollar invested in it into $8.92. This dwarfs the $5.66 invested in the S&P 500. As returns have come in strong, the fund has been able to grow. And as the portfolio has grown, the focus of the enterprise has also shifted from smaller companies to larger ones. Back in 2013, for instance, the weighted average EBITDA of a company in its portfolio was only $53 million. That number today is $308 million. So even though the firm has become more equity focused in recent years, it has been investing in companies that are more stable than the kind it used to invest in.

Has also made it a priority to diversify as much as possible. At present, the average size of a holding in a BDC is approximately 0.6%. For Ares Capital, meanwhile, that number is only 0.2%. The largest exposure that the company has amounts to only 2% of its overall portfolio. That's a little more than half the 3.9% of the average competitor. In fact, its top ten investments only account for 12.7% of the fair value of its investments. And it is invested in companies that meet the definitions of 33 different industries. Of course, what's in the portfolio is as important as what's not in it. For instance, the firm has no exposure to airlines or construction. It's not invested in shipping or shipbuilding. There are other industries it's not invested in either such as printing and publishing. Meanwhile, it's exposure to highly cyclical industries is also quite low. Examples here include hotel and gaming, oil and gas, transportation, and media and entertainment. In none of these spaces is over 2% of its portfolio allocated. And yet, they account for between 9% and 11% of the high yield loan industry.

All of this is great. But the big question that I have is whether the enterprise is paying out more than it possibly can. In the near term, stock issuances and even the growth of debt can allow a company to payout far more than it earns. But this is unsustainable and investors should cast a jaundiced eye toward any firm going through this. If we define profits as net investment income plus realized gains on investments, foreign currency, and other transactions, we can see that, in recent years, the firm has been doing quite fine. This metric has grown from $628 million in 2020 to $1.17 billion in 2022. Over the same window of time, distributions have also grown, climbing from $679 million to $912 million.

Over this three-year window of time, the profits of the company, plus the aforementioned gains, total $2.83 billion. By comparison, the company has paid out only $2.29 billion. That is a payout ratio of only 80.9%. This year has been slightly different. For the first half of the year, the profit metric that I am using came in a bit weak at $501 million. That's down from the $510 million reported one year earlier. And yet, distributions managed to grow from $431 million to $514 million. But in the grand scheme of things, particularly when you look at prior years and how much extra cash the company retained, this is not a significant disparity.

Takeaway

Historically speaking, Ares Capital has done really well for itself. Management has created a diverse enterprise that seems to be running really well. The yield is awfully high, but it does look stable. Given these factors, I have no choice but to rate the BDC a ‘strong buy’ at this time.

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