2023-06-21 13:11:35 ET
Summary
- Investors should consider owning both Ares Capital and Capital Southwest in their portfolios, as they are high-risk, high-reward investments that pay high yields.
- Ares Capital is externally managed and has a larger market cap, while Capital Southwest is internally managed and has a smaller market cap, but both companies invest primarily in first and second lien loans.
- We recommend waiting for a pullback in Capital Southwest before adding more shares or starting a position, as both companies are sensitive to interest rates and could see a rise in non-accruals due to the higher for longer environment.
Introduction
In this article, I give my reasons why I think investors should consider owning both Ares Capital ( ARCC ) and Capital Southwest ( CSWC ) in their investment portfolio. Both are Business Development Companies (BDCs) that invest primarily in small & medium-sized businesses, and also in distressed (businesses). They often pay yields into the double digits and are therefore considered high-risk, high-reward investments. Due to tax implications, investors typically hold these in retirement accounts like IRA's. Both are great investments for income. In this article I identify their differences, similarities, and explain why I believe they complement each other when held in a dividend portfolio.
Internally/Externally Managed
BDC's are either internally or externally managed. CSWC is internally managed, while ARCC is externally managed. Every investor should do their due diligence when considering investing in a BDC. Internally managed companies are often viewed as more shareholder friendly and therefore may appear to align more with an investor's goals. But externally managed companies enjoy some benefits as well.
capitalsouthwest.com investor presentation
Although ARCC is externally managed, it's managed by the behemoth ARES Management Corporation ( ARES ), a global alternative investment manager operating in the credit, private equity, and Real Estate markets. The company has 360 billion assets under management, and operates a diversified array of operations not only domestically, but also internationally, with operations in Europe, Asia Pacific, and the Middle East. Since ARCC is managed by ARES, this allows them to collaborate to leverage the power of the firm's platform to aim to deliver innovative solutions, and attractive risk-adjusted returns. This also provides ARCC insight into industry trends, access to significant deal flow, and the ability to assess relative value. Long story short, it enables ARCC to make safer investment decisions. Furthermore, externally managed companies have a much simpler infrastructure setup. They normally don't have requirements for offices, HR departments, a team of analysts, etc. Infrastructure expenses are outsourced to the third-party manager. But due to this, externally managed companies have higher expense ratios. Also, management sometimes receives performance incentives based on the company's profits after a certain return has been reached. This can often lead to conflicts of interest with shareholders.
Major Size Difference
One of the major differences between the two is their size. ARCC is the largest BDC with a market cap of approximately $10 billion. CSWC is on the smaller side with a market cap under a billion, at approximately $700 million. ARCC is also much more diversified with a total of 466 companies across 25 industries, primarily investing in first and second lien loans. They typically focus on companies with an EBITDA in excess of $50 million. CSWC is much smaller with a total of 85 companies across approximately the same amount of industries, normally targeting businesses with an EBITDA of $3 million to $25 million.
Additionally, during Q1 2023 earnings, ARCC reported a cash balance of $272 million and saw its portfolio value decrease slightly by $0.7 billion to $21.1 billion from $21.8 billion from the prior quarter. I see these companies as Shaq and Kobe. One is big and strong, while the smaller one has tenacity and drive to become one of the best. These two BDC's to me, are the perfect dynamic duo.
Valuation
Due to these two BDC's being high-quality, both trade at a premium to NAV. During both companies' latest earnings calls, management reported growth in NAV per share. ARCC's management reported modest growth in NAV per share to $18.45 from $18.40. CSWC also reported growth of NAV per share to $16.37 from $16.25 quarter over quarter. ARCC currently trades at a smaller premium to NAV than CSWC, therefore making it a buy.
The last time CSWC traded close to NAV was back in March. Since then, the stock has seen a price increase of nearly 20% from $16.85 back on March 15th, 2023, to a recent high of $20.21 back on June 12th. During that same period, ARCC saw a smaller increase of approximately 10% from $17.39 to $19.06. With ARCC trading closer to NAV, investors looking for a quality dividend company could start a small position at the current price.
Risks
Due to the current high-interest rate environment, investors have to be aware of this when investing in companies that are considered risky, like the mentioned BDC's. Although higher interest rates typically benefit BDC's, there are some risks associated with them. But like they say "there is no reward without risk". As stated in my previous article , ARCC did see a modest rise in non-accrual loans from 2.3% from 1.7% in the previous quarter.
For those not familiar with non-accrual loans, these are loans that principal or interest is 90 days or more past due or payment in full is not expected. Basically, the loan is no longer accruing interest after the 90-day period. While this could be of some concern for investors, this is still well below ARCC's target of 3%. Below is ARCC's debt maturity schedule:
Arescapital.com investor presentation
ARCC has no debt maturing in 2023 and although the FED has promised higher for longer interest rates, many are predicting a cut in rates later in the year . If so, rates would have minimal effect on the company. ARCC's management did also state that the slowing economy could create stress in the portfolio. But with management's track record, I expect them to expertly navigate the current environment.
Similar Dividend Pay Dates
Both CSWC and ARCC pay in the months of March, June, September, and December. They also both have an ex-dividend date approximately two weeks before the pay date. Both ex-dividend dates just passed this last week and are scheduled to pay on June 30th. This, in my opinion, is why I think they both complement each other well. Not only are they similar companies, they also pay at the same time. A great way to collect extra dividends! A 2-for-1 special. Like I stated before, I elect to not re-invest my dividends, but instead collect them and place them where I see fit. If I deem myself to have a fair amount of shares, I then use those dividends from that stock to build out undervalued or smaller positions.
ARCC reported earnings of $0.57 a share, an increase of 36% year-over-year. Earnings were well in excess of the regular quarterly dividend of $0.48. CSWC reported earnings of $0.65, a comparable increase of 30% year-over-year. The $0.65 per share, significantly out-earned the regular dividend of $0.53 as well as total dividends paid, including the supplemental dividend of $0.05. The board also declared a penny increase to the regular dividend payable on June 30th. Investors would receive a total of $0.59 from CSWC and $0.48 from ARCC for a total of $1.07 (per share) combined if both companies were held in the portfolio . I believe ARCC's management is being more conservative in preparation for the "higher for longer" environment. It is to be noted that 2022 spillover for ARCC was 2.5x greater the current dividend, so investors should not be concerned with management keeping the current dividend. I think management plays it safe, then possibly increase the dividend by a small percentage as the economy starts to stabilize later in the year.
Conclusion
I believe ARCC and CSWC are both great companies for dividend investors looking for an additional stream of income. While BDC's are sensitive to interest rates, and could potentially see a rise in non-accruals due to the higher for longer environment, both pay dividends that are safely covered, and reported a net debt-to-equity ratio below the BDC regulatory limit of two. I rate CSWC a hold, therefore suggesting investors wait for a pullback before starting, or adding to their position. With ARCC trading much closer to NAV, investors looking for income should look at starting a small position in the company or adding to their current shares. ARCC is a buy in my opinion.
For further details see:
Why Pick One When You Can Own Both? Capital Southwest And Ares Capital