2023-07-23 10:15:00 ET
Summary
- One of the largest mistakes that investors make is focusing on historical dividend coverage instead of projected dividend coverage.
- This article discusses historical and projected dividend coverage for ARCC, which is the largest BDC currently yielding 10% before supplemental dividends.
- Below I discuss many of the drivers used for projecting dividend coverage followed by my base, best, and worst-case projections for ARCC.
- If you're not getting this level of detail for each of your BDC investments, please consider taking a more detailed approach to due diligence each quarter.
- ARCC will be reporting Q2 2023 results this week and below are many of the positive and negative considerations for investors, most of which are discussed in this and the previous articles.
Quick Introduction To Business Development Companies
Business development companies ("BDCs") invest shareholder capital in privately-owned, small- and medium-sized U.S. companies generating income from secured loans and capital gains from equity positions, much like venture capital or private equity funds. Anyone can invest in BDCs as they're public companies traded on major stock exchanges.
The three biggest mistakes that new BDC investors make are:
- Focusing on historical dividend coverage instead of projected dividend coverage which is heavily reliant on portfolio credit quality.
- Not taking the time to dig into portfolio credit quality and assess which investments could potentially have a negative impact on earnings and NAV per share.
- Not understanding why BDCs trade at different prices and thinking that price-to-NAV is the only measure to find a "good deal." Please see the end of this article for a quick discussion of how BDCs are valued.
This article discusses dividend coverage for Ares Capital ( ARCC ) which is the largest BDC and currently has a dividend yield of around 10% before potential supplemental dividends (discussed below). Please see the previous article which discussed ARCC's portfolio credit quality:
Many readers have noticed that BDC prices have continued higher since the March 2023 lows likely for many reasons including continued strong economic data, lower inflation (CPI/PPI), higher corporate earnings, strong consumer sentiment, and a less aggressive Fed with fewer rate increases. However, I firmly expect interest rates to remain at these levels for an extended period, especially if inflation remains above 2% and the labor market remains strong.
Also, there's a good chance that BDC prices have headed higher as investors are trying to front-run the upcoming Q2 2023 earnings season which will likely be strong, similar to the previous three quarters, when the best-performing (stock prices) BDCs were the ones that recently reported results.
The following chart shows the average dividend coverage over the last 10 years with the last three quarters averaging over 120% even after taking into account the recent dividend increases. Many BDCs have opted to take a conservative approach when setting their regular dividends (just in case rates head lower) and using supplemental/special dividends to pay out excess earnings. This means that if portfolio yields decline, we will see lower amounts of supplemental/special dividends but the regular dividends will be maintained especially "Level 1" dividend coverage BDCs. Another interesting note is that the Fed funds target range declined by 2.25% (225 basis points) starting in Q3 2019 through Q1 2020 resulting in a decline in average dividend coverage from 109% to 102%.
BDC Buzz & SEC Filings
The BDCs in the chart below account for around 90% of the total assets and market capitalization for the sector.
Over the last six weeks, we discussed the portfolio credit quality and/or dividend coverage for many of them including FS KKR Capital ( FSK ), Prospect Capital ( PSEC ), Goldman Sachs BDC ( GSBD ), New Mountain Finance ( NMFC ), Oaktree Specialty Lending ( OCSL ), Hercules Capital ( HTGC ), PennantPark Floating Rate Capital ( PFLT ), PennantPark Investment ( PNNT ), TriplePoint Venture Growth ( TPVG ), Monroe Capital ( MRCC ), and BlackRock TCP Capital ( TCPC ) in the following articles:
- Oaktree or New Mountain For Solid 11% Yield?
- Better High-Yield Buy: FSK or PSEC?
- PennantPark: Big Win From Dominion/Fox Settlement
- Venture Debt Opportunity Yielding 13% To 14%: HTGC or TPVG?
- BlackRock Or PennantPark For Solid 12% Yield?
- Safer 12% Yield: Goldman Sachs BDC or Monroe Capital
As shown below, many of these BDCs are among the highest yielding:
BDC Buzz & SEC Filings
ARCC Dividend Coverage
As mentioned earlier, one of the largest mistakes that BDC investors make is focusing on historical dividend coverage instead of projected dividend coverage which is heavily reliant on portfolio credit quality. Each quarter I update the financial projections for each BDC with base, best, and worst-case scenarios to test the sustainability and/or changes to the current dividends. Below I discuss many of the drivers used for projecting dividend coverage followed by my base, best, and worst-case projections for ARCC. If you're not getting this level of detail for each of your BDC investments, please consider taking a more detailed approach to due diligence each quarter.
However, my projections err on the side of caution by using mostly conservative assumptions, and the preferred outcome is between the "Base" and "Best" cases. Worst-case scenarios for each BDC include increased portfolio credit issues, lower NAV per share, declining portfolio yields ( potentially from lower interest rates ), higher borrowing rates and operating expenses, slower portfolio growth (or portfolio declines/repayments), and lower amounts of non-interest income (from fees and dividends). Basically, the worst case is assuming a deeper and extended recessionary environment coupled with declining interest rates.
For Q1 2023, ARCC reported between my base and best-case projections, mostly due to slightly higher-than-expected fee/dividend income and portfolio yield, partially offset by a decline in the size of the overall portfolio, covering its regular dividend by 123% (excluding incentive fee credits). As expected, there was a meaningful decrease in leverage with its debt-to-equity ratio declining from 1.25 to 1.08 (net of cash) due to the issuance of 25.3 million shares (accretive to NAV) and repayments/exits exceeding new investments.
We have further strengthened our balance sheet thus far this year by reducing our leverage and increasing our available liquidity. We believe that our fortified balance sheet with leverage of less than 1.1x net debt to equity leaves us well-positioned to continue to support our existing portfolio companies and to be opportunistic investors in this environment .”
BDC Buzz & SEC Filings
ARCC has a slightly higher-than-average payment-in-kind (“PIK”) currently around 6.6% of total income or 8.7% of interest income for Q1 2023. However, there is a meaningful amount of previous PIK collected in cash each quarter including $26 million during Q1 2023 . Also, a good portion of it is related to “larger junior capital investments” as ARCC has been investing in larger middle-market companies. My opinion is that ARCC has an excellent history of credit quality and continues to invest in larger companies that would likely outperform, so a higher amount of PIK is acceptable, but I will continue to watch over the coming quarters.
Around the PIK number, we actually had pretty significant PIK interest collected this quarter . So if you actually went through and you said what percentage of the total income today, PIK is a little bit more than 15%. We feel comfortable with that number. I don't think going back a couple of years frankly we felt as comfortable with a number into the 20s, which is where we were during COVID and we had pretty explicit guidance to everybody that our goal was to manage that down and we've done that successfully. So I don't know if we're at the upper limits today. There's probably a little bit of room from here. But most of the PIK that we would, I think, take on, on a go-forward basis would be with perhaps an increase in amendment activity if we have that, and we'll just see where the rest of the year and maybe next year takes us.”
As mentioned in previous articles, I was expecting additional income from Ivy Hill Asset Management (“IHAM”) partially due to continued growth and the previously announced purchase of assets from Annaly Capital. During Q1 2023, ARCC sold another $652 million of loans to IHAM which should continue to drive higher dividend income over the coming quarters. Also, its portfolio yield increased from 10.5% to 10.8%.
We remain very optimistic about our investment in Ivy Hill. It's been a great performer for us for a 15-year period. It delivers what we think are unbelievably attractive returns relative to the risk. Again, we've talked about this in the past, but it literally generated a roughly 15% IRR to ARCC over a 15-year period. Most of Ivy Hill's investments today are actually in bilateral loan funds and only about 25% of the AUM that they invest today are in traditional CLOs that have securitizations that are reminiscent of old CLOs. The other thing that's important is if a middle market bank loan asset manager that tends to be materially less levered, both as a company as well as with its underlying funds, then the competitors you might be thinking they compete with. So it's a big investment for us. I don't expect it, frankly, to grow from here because I have some of the same thoughts around concentration , both as a percentage of the outstanding assets as well as the outstanding income that comes from Ivy Hill, I think it's reached its limit for the time being , until the company continues to grow. But we feel, again, extraordinarily good about the dividend at Ivy Hill and the cash flows that come from that investment. We run a lot of sensitivities. We spent a lot of time with them thinking about what a more uncertain market could mean for them. And I feel that we've battle tested all of the assumptions such that I feel great about it.”
SEC Filing
In January 2023, ARCC completed a public equity offering of 12.1 million shares of common stock plus another 13.2 million shares through its “at the market” ATM equity program raising a total of $477 million in net proceeds.
We deleveraged during the first quarter, and we ended the quarter with a net debt-to-equity ratio below 1.1x. We also bolstered our level of liquidity post quarter end by increasing or proactively extending out the maturities on over $4.5 billion of committed bank funding at relatively attractive pricing and terms, which is a noteworthy accomplishment given the recent banking turmoil. We did have a stated objective to deleverage the balance sheet modestly, which we accomplished, and that's 1 way to do it. We don't think the environment for investing in high-quality companies at really attractive rates of return is going away anytime soon . So we probably took a pretty patient approach to the quarter.”
SEC Filing
ARCC had around $137 million remaining available for issuance as of March 31, 2023, but recently filed for an additional $1 billion and will likely continue to issue shares at a premium to NAV to maintain leverage as shown in the projections:
Q. “I'm just wondering if you could contour the larger usage of the ATM program during the quarter, 13 million shares is way more than you guys have done in any particular quarter. Usually things like that are associated with a high level of investment activity and yet your investment activity in the quarter was relatively muted.
A. “It's there to obviously take advantage when we think there are advantageous periods to issue in small amounts more than in the past, but I think relative to the company's overall market cap, not particularly substantial. Some of it came early in the quarter when we actually did have higher leverage, and we're looking to deleverage a little bit . But probably more of that than new investing. I guess the only other thing I'd say is we did, as I mentioned, have one or two larger transactions in the quarter. And my guess is we're capital planning for those and thinking about ATM issuance, we were planning on obviously participating in a couple of transactions that fell away .”
BDCs are expected to benefit from tightened lending policies and potentially increased banking regulations, which will likely include stronger capital and liquidity standards for certain banks. BDCs have distinct advantages over banks, including “permanent equity capital” and are not subject to “runs on the bank,” which could lead to the forced liquidation of undervalued assets.
The first quarter saw a fair amount of market volatility driven by the uncertain direction of the economy that was certainly exacerbated by the recent turmoil in the banking system. We believe that the banks remain constrained on new activity due to concerns regarding both capital and liquidity and which we believe makes our broad range of flexible capital solutions even more valuable . We feel that the current environment is similar to a number of prior periods of market dislocation that have improved the opportunity set for direct lenders where Ares Capital, similar periods of disruption have historically led to increased market share, profitability and NAV growth for the company. To this end, we've already seen a 14% quarter-over-quarter increase in the number of deals we evaluated during Q1, and this deal flow represents a broad set of industries. By seeing the largest set of investment opportunities, we are able to make what we believe are the best relative value decisions when committing capital. Our selectivity rate remains consistently low through cycles and is even lower as we take market share through volatile periods. In terms of the new deal flow, our selectivity rate on new transactions in the first quarter is one of the lowest in five years. The merits of our investment - of our origination strategy and our rigorous focus on credit quality allows us to continue to invest in high free cash flow and recession-resilient businesses, and this supports our strong overall credit performance.”
Similar to other BDCs, ARCC management mentioned the “more lender-friendly environment” with better terms, including stronger covenants (safer investments) and “higher overall yields” taken into account with the best-case projections:
As a result of the constrained capital environment, the competitive dynamics and risk reward environment continues to be as attractive as we have seen in quite some time. Market lending spreads continue to be approximately 100 basis points higher year-over-year with historically strong lending documents alongside lower leverage levels. Specifically, our new first lien loan investments in the quarter had a weighted average yield in excess of 11%, and we're levered less than 4x debt to EBITDA. Additionally, we were a lead arranger on 85% of our originations in the first quarter.”
ARCC
ARCC has increased its regular quarterly dividend from $0.40 per share in Q2 2021 to the current $0.48 per share plus paid $0.12 per share of supplemental dividends in 2022. It's important to point out that $0.48 per share is adequately covered, especially given that the company has earned an average of over $0.54 per share over the last two years. As mentioned in the weekly BDC sector updates, I'm expecting fewer (and smaller) increases in the regular dividends but larger supplemental dividends over the coming quarters, as BDCs prepare for potentially lower rates. ARCC management discussed this on the previous call and is “cautious about raising the dividend” and “chose not to raise the dividend this quarter because we'd like a stronger view on where we see rates normalizing in the future." This is another example of higher-quality management.
I don't know because I don't know what the normal rate environment is going to be. I think we're working on an expectation that rates are elevated . They likely will go up from here. They likely will not stay there . We can all debate how long folks think they'll stay there or not, but our best guess would be that rates will normalize and begin coming back down. My own personal view is we're unlikely to see a 30 basis point LIBOR or SOFR again anytime soon. And that I think a lot of folks may look back is that potentially being a bit of a failed experiment. So our base case probably has rates down the line way out, normalizing down certainly from here , but my guess is as good as has as to where that is. It's been one of the reasons that we were cautious about raising the dividend as much as we did last quarter and frankly chose not to raise the dividend this quarter because we'd like a stronger view on where we see rates normalizing in the future .”
Q. “The press release indicated about 88% of the new loans contained interest rate floors. And I think you've been pretty consistent over the past few quarters, having set getting interest rate forward. Curious if that floor, if you've been able to move that up as the interest rate environment has gone higher. I'm curious if you could maybe keep kind of give an average rate of what it was in the first quarter.”
A. “We are trying to move that floor rate up to the best of our abilities and having some success, but not a huge amount of success just because obviously, the market is the market and not everyone is pushing maybe as hard as we're pushing. But back to the earlier question around how do you mitigate potential decreases in interest rates in the future. Certainly, that's one effective way , and we are trying our best.”
ARCC had around $1.19 per share of undistributed taxable (“UTI”) or “spillover” income after taking into account the new shares issued earlier this year, which is the amount of earnings in excess of what has been paid to shareholders. Management is retaining a certain amount as a cushion to support “our goal of maintaining a steady dividend throughout market cycles."
We continue to consider our taxable income and the amount of spillover when set an overall dividend. Our current estimate of undistributed taxable income, sometimes referred to as our spillover, at year-end 2022 was $650 million or approximately $1.19 per share. This 2022 spillover level is nearly 2.5x greater than our current regular quarterly dividend rate. We continue to believe that having a healthy level of spillover income is beneficial to the long-term stability of our dividend. We will continue to monitor our undistributed earnings and balance these levels against prudent capital management considerations.”
On the previous call, management mentioned that the continued increase in core earnings will likely drive “an increasing amount of undistributed earnings spillover” but “tried to pursue the increase through a regular increase rather than a special." However, there is a good chance the company will pay a similar amount of supplemental dividends in 2023, given the current amount of UTI/spillover.
ARCC Interest Rate Sensitivity Analysis
Interest rate sensitivity refers to the change in earnings that may result from changes in interest rates. As of March 31, 2023 , 69% of portfolio investments bore interest at variable rates, 11% at fixed rates, and 20% were non-interest earning or were on non-accrual status. The Revolving Credit Facility, the Revolving Funding Facility, the SMBC Funding Facility, and the BNP Funding Facility bear interest at variable rates with no interest rate floors.
ARCC Financial Projection Details
The following projections take into account the previously discussed information to project dividend coverage over the next three quarters to assess the sustainability of the current regular dividend.
As mentioned earlier, the worst-case projections include increased portfolio credit issues, lower NAV per share, declining portfolio yields (potentially from lower interest rates), higher borrowing rates and operating expenses, slower portfolio growth (or portfolio declines/repayments), and lower amounts of non-interest income (from fees and dividends).
The last line in the projected financials shows “Operating Cost as a Percentage of Available Income” which measures operating, management, and incentive fees compared to available income. BDCs with lower operating expenses can pay higher amounts to shareholders without investing in riskier assets.
- “Available Income” is total income less interest expense from borrowings and is the amount of income that is available to pay operating expenses and shareholder distributions.
BDCs with lower operating expenses can pay higher returns relative to NAV per share and the amount of income from portfolio investments.
ARCC Leverage Analysis and Dividend Potential
The following table shows various amounts of leverage with higher and lower portfolio yields to determine the impacts on dividend coverage, as well as the following:
- Dividend and fee income of $130 million (compared to an average of over $160 million over the last four quarters)
- Management guidance of upper targeted leverage of 1.25 debt-to-equity
- Changes to borrowing facilities with higher borrowing rates for the higher yield scenario
- Reduced the base management fee to 1.00% for assets in excess of 1.00 debt-to-equity
This analysis implies that the current regular quarterly dividend is stable , even after taking into account potentially lower leverage and/or investing in lower-yielding assets.
BDC Valuations
There are very specific reasons for the prices that BDCs trade driving higher and lower dividend yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). BDCs with higher-quality credit platforms and management typically have higher-quality portfolios and investors pay higher prices. This drives higher multiples to NAV and lower yields.
The charts below show a few metrics for ARCC compared to the average BDC including dividend coverage over the last four quarters, leverage or debt-to-equity, and expense ratios. As mentioned earlier, please do not focus only on historical dividend coverage especially compared to projected coverage. ARCC has better historical coverage but also slightly higher leverage (debt-to-equity) and an average expense ratio.
ARCC Important Considerations
As mentioned earlier, ARCC will be reporting Q2 2023 results this week and the following are many of the positive considerations, most of which were discussed in this article and the other one linked earlier:
- 18-year history of very low defaults/credit losses
- NAV per share has increased by almost 10% over the last five years (much better than most BDCs)
- Net realized gains of almost $1 billion or around $1.75 per share over the last 10 years
- Increased its regular quarterly dividend from $0.36 to $0.48 per share (last 11 years)
- Investment grade ratings by S&P (BBB), Moody’s (Baa3), and Fitch (BBB)
- Strong coverage ratios for its fixed-income investors
- Lower-than-average leverage due to recently issued shares (including its ATM program)
- Current dividend is adequately covered, especially given that the company has earned an average of over $0.54 per share over the last two years
- Continued increase in returns from Ivy Hill Asset Management (“IHAM”)
- Management is “cautious about raising the dividend” and chose not to raise “because we'd like a stronger view on where we see rates normalizing in the future”
- Paid supplemental dividends of $0.12 per share in 2022
- Undistributed taxable income (“UTI”) of around $1.19 per share
- 69% of borrowings are unsecured (more flexible)
- 1.3% of portfolio investments at fair value on non-accruals status
- The amount of ‘watch list’ investments remains around 9% of the portfolio at cost
- Highly diversified with mostly larger middle market companies that would likely outperform in a higher interest rate and/or an extended recessionary environment
- The top 10 investments accounting for 12% of the portfolio
- Conservatively marked portfolio (higher quality reported NAV)
- Ares Management platform is higher quality
The following are negative considerations , some of which are discussed in this article:
- Many of its healthcare positions have been negatively impacted by labor shortages and/or wage inflation combined with higher rates
- Center for Autism and Related Disorders filed for Chapter 11 in June 2023
- ADG (Great Expressions), Benefytt, Supply Source, Olympia Acquisition, CCS-CMGC Holdings, SHO Holding , and JDC Healthcare have been continuously marked lower (under 70% of cost) and account for 2% of the portfolio and 4% of NAV per share
- SelectQuote was previously amended to include PIK and remains on watch list
- CCS-CMGC (Wellpath Holdings) was downgraded by Moody’s in March 2023
- Potential dilution to common shareholders from 2024 convertible notes which are convertible at $19.62 per share beginning in December 2023
- Potentially no supplemental dividends as management are retaining as a cushion to support “our goal of maintaining a steady dividend throughout market cycles”
- $1.3 billion of upcoming maturities for its March/June 2024 unsecured notes
- Slightly higher-than-average amounts of non-cash/PIK income
- Only 41% of the portfolio is first-lien
- Lack of "total return" hurdle or "look back" provision when calculating income incentive fees to protect shareholders from capital losses
- Potentially lower NAV and higher amount of watch list investments
I would suggest that investors should not focus on some of the technical indicators such as the Relative Strength Index ("RSI") to make investment decisions as this is a relatively shorter-term indicator that is useful for identifying entry points. RSIs can remain above 50 for an extended period especially if the market is rebounding and/or there's a meaningful shift in sentiment toward a more risk-on environment. We experienced this in late 2020 when the average RSI was almost 80 and stayed above 50 through the first five months of 2021. For example, ARCC climbed from $14.00 to $17.00 in November 2020 when its RSI hit 81 and then remained above 50 with the stock eventually hitting $22.50. So the people that sold at $17.00 were not happy.
For further details see:
Ares Capital: Assessing Dividend Coverage For Its 10% Yield