Ares Capital: 40+ Big-Yield BDCs Compared (Earnings Season Edition)

4 months ago

Many income investors emotion Ares Capital (NASDAQ:ARCC) for its large dividend output and agelong past of steadfast performance. But considering the existent marketplace environment, are the shares inactive worthy owning? Or are determination amended BDC options available? In this report, we stock comparative data connected implicit 40 big-yield BDCs, and past dive deeper into Ares (including its rising non-accrual loans, slowing woody flow, involvement complaint dynamics, valuation, dividend information and risks). Next, we concisely see 2 Ares alternatives (Blue Owl Capital and Hercules Capital). Finally, we reason with our beardown sentiment astir investing successful these circumstantial big-yield BDC opportunities, particularly with BDC net play conscionable astir the corner.

40+ Big-Yield BDCs Compared

Before getting into the specifics connected Ares (plus Blue Owl and Hercules), let’s archetypal person a look astatine updated comparative information connected implicit 40 big-yield BDCs. The array is sorted by marketplace headdress (and Ares is astatine the top).

(FSK) (ORCC) (BXSL) (MAIN) (PSEC) (GBDC) (HTGC) (OCSL) (TRIN) (GAIN) (TPVG) (HRZN) (GLAD) (SAR) (BBDC) (CSWC)

A fewer things basal retired astir this data. For starters, you’ll announcement the dividend yields are ample (this is due to the fact that BDCs can debar firm taxation by paying retired income arsenic dividends). You’ll besides announcement that year-to-date full returns are reasonably beardown (and overmuch amended than galore of the 2 twelvemonth instrumentality numbers), arsenic the menace of a heavy recession seems to decrease.

Further still, the price-to-book values (a precise basal BDC valuation metric) are reasonably mixed considering immoderate commercialized astatine a premium (above one) and immoderate astatine a discount; nevertheless astir are person to the apical of their 5-year range. Lastly, short-interest is simply a spot higher for immoderate BDCs (an denotation that investors are betting against the shares). We’ll person much to accidental astir these metrics, arsenic we spell done much details connected circumstantial BDCs successful the pursuing sections.

Also worthy mentioning, BDC’s person benefited implicit the past fewer decades arsenic accepted banks person backed distant from mediate marketplace nonstop lending (due successful important portion to increasingly-stringent slope regulations, specified arsenic Dodd Frank and Basel III requirements).

And much currently, banks whitethorn beryllium backing distant from this lending again (good for BDCs), considering the existent marketplace environment. For example, present is what Ares Capital CEO Kipp DeVeer had to say astir it successful precocious April:

We judge that the banks stay constrained connected caller enactment owed to concerns regarding some superior and liquidity and which we judge makes our wide scope of flexible superior solutions adjacent much valuable.

Current Market Conditions: Fear, Credit Spreads and Interest Rates

Before getting into much item connected circumstantial BDCs, it’s worthy concisely considering the existent macroeconomic environment. For example, contempt fears that the fed’s efforts to combat ostentation (by aggressively hiking involvement rates) would thrust america into a heavy recession, the marketplace has been beardown this twelvemonth (the S&P 500 and astir BDCs are up).

BDCs are peculiarly delicate to the marketplace rhythm due to the fact that galore of the portfolio companies they supply financing excessively are smaller and don’t needfully person the heavy fiscal wherewithal to easy past an economical slowdown. As such, paying attraction to portfolio institution show during the upcoming net releases volition beryllium a captious metric to ticker (specifically, are importantly much portfolio companies going into the riskier “non-accrual” status, oregon are they weathering the economical challenges without large incident?).

As you tin spot successful these adjacent 2 charts, investors bash not look excessively acrophobic astir the marketplace close now. For example, the marketplace “fear index” (VIX) is debased by humanities standards.

And recognition spreads are besides low, which is different denotation that the marketplace isn’t excessively disquieted astir expanding defaults connected riskier loans (similar to galore of the loans made to BDC portfolio companies, spot the inverse narration beneath betwixt recognition spreads and BDCs).

Lastly, the marketplace “greed index” is elevated (see below) an denotation that investors whitethorn beryllium getting excessively confident.

And this is simply a bully crushed wherefore paying attraction to the upcoming BDC net announcements (mostly implicit the adjacent 2 weeks) volition beryllium truthful important (because we’ll spot however companies are faring successful the existent macro environment). And BDC net play volition footwear disconnected with Ares Capital connected July 25th (a precise fashionable and trusted big-yield BDC), truthful let’s person a person look astatine that 1 first.

Ares Capital (ARCC), Yield: 9.8%

Ares is the largest publicly-traded BDC successful the US, and it has a well-diversified portfolio of investments (mainly loans to businesses successful need) crossed marketplace sectors and industries, arsenic you tin spot below.

Ares besides holds chiefly archetypal lien and secured loans, which are safer than subordinated and unsecured debt.

Note: Ivy Hill Asset Management is simply a wholly owned portfolio institution of Ares Capital Corporation and a registered concern adviser.

Ares besides has an concern people recognition standing and a good tally business. The institution describes itself as:

“a patient, semipermanent capitalist with imperishable capital… capable to clasp ample positions and [with] the quality to connection sponsors and absorption teams enhanced certainty of execution.”

And arsenic compared to different BDCs, Ares stands retired for its fiscal spot and manufacture enactment presumption (such arsenic debased debt, stronger recognition rating, economies of standard and wide-reaching manufacture relationships).

Current “Non-Accrual” Loans

As a BDC investor, 1 important metric to ticker is loans successful “non-accrual” status. These are fundamentally high-risk loans wherever the borrower is NOT making involvement payments per the presumption of the agreement. The fig of non-accrual loans typically goes up erstwhile a lender does a atrocious occupation of underwriting its loans (rarely the lawsuit for a BDC similar Ares) oregon erstwhile marketplace conditions (i.e. the economy) gets peculiarly challenging.

Here is simply a look astatine Ares humanities non-accrual loans up done past quarter. And arsenic you tin spot they’ve been connected the rise, but they’re inactive comparatively debased arsenic compared to humanities standards.

Here is what Mitchell Goldstein (Co-Head of Ares Credit Group) had to say astir non-accruals astatine the extremity of past quarter:

Our nonaccrual rates proceed to beryllium good beneath humanities levels. Our nonaccrual complaint astatine costs picked up modestly to 2.3% from 1.7% past 4th but remains good beneath our 3% 15-year past mean and the KBW BDC mean of 3.8% astatine the aforesaid clip done year-end 2022.

Slowing Deal Flow Activity:

Another important metric to ticker for a BDC is the woody enactment level. Specifically, erstwhile marketplace conditions are challenging, the fig of caller deals underwritten by a BDC tin dilatory down (and this tin mean slower aboriginal growth). And successful the erstwhile quarter, Ares explained they’ve seen an summation successful the fig of deals they’ve evaluated, but the existent fig of caller deals has slowed down considerably. Specifically, present is what CEO Kipp DeVeer had to accidental connected the quarterly call:

"To this end, we've already seen a 14% quarter-over-quarter summation successful the fig of deals we evaluated during Q1, and this woody travel represents a wide acceptable of industries." However " in presumption of the caller woody flow, our selectivity complaint connected caller transactions successful the archetypal 4th is 1 of the lowest successful 5 years. The merits of our concern -- of our origination strategy and our rigorous absorption connected recognition prime allows america to proceed to put successful precocious escaped currency travel and recession-resilient businesses, and this supports our beardown wide recognition performance. Despite the much challenging marketplace backdrop, the wide maturation and profitability of our borrowers continues to beryllium steadfast with a year-over-year weighted mean EBITDA maturation complaint of 8%.

And…

Even though the caller woody enactment remains slow, we judge the size and prime of our incumbent portfolio drives differentiated entree to charismatic investments. As we person often said, we payment from originations wherever we person incumbent relationships, and this 4th was nary antithetic arsenic implicit 80% of our transactions were to existing borrowers.

Furthermore, the little woody travel is helping Ares stated nonsubjective to deleverage its equilibrium sheet, arsenic per Kipp DeVeer:

"I'd say, fig one, we did person a stated nonsubjective to deleverage the equilibrium expanse modestly, which we accomplished, and that's 1 mode to bash it." And "the 2nd constituent was to your past comment, I bash deliberation that we don't deliberation the situation for investing successful high-quality companies astatine truly charismatic rates of instrumentality is going distant anytime soon. So we astir apt took a beauteous diligent attack to the quarter."

So successful the upcoming net release, it volition beryllium truly important to see however the caller woody travel has been evolving for Ares. Specifically, is it inactive slower than mean (because this volition interaction the company's aboriginal growth).

Rising Interest Rates:

Interest rates are different important information for BDC investors, particularly considering they tin beryllium a double-edge sword. On 1 hand, rising rates tin beryllium precise bully for BDCs due to the fact that they gain a wider nett involvement borderline (i.e. the complaint they lend astatine minus the complaint they get at), particularly if they person a important magnitude of floating complaint loans. For a small perspective, present is simply a illustration from past twelvemonth showing however antithetic BDCs person structured their fixed-versus-floating complaint exposures.

On the different hand, rising rates tin make expanding accent connected portfolio companies (i.e. borrowers) due to the fact that it becomes much costly to work their debt. Here is what Ares had to accidental astir involvement rates connected their erstwhile quarterly telephone (i.e. they’ve been helped by higher rates truthful far):

"Our halfway net per stock of $0.57 accrued 36% year-over-year, chiefly driven by the payment of higher involvement rates connected caller investments." And "the weighted mean output connected full investments astatine amortized outgo was 10.8%, which accrued from 10.5% astatine December 31, 2022, and 8.1% astatine March 31, 2022. The yields connected our portfolio bespeak the continued increases successful involvement rates."

Thus acold Ares has been helped by rising rates. And it’ll beryllium important to larn astir the tradeoff betwixt higher rates and perchance higher non-accrual loans successful the upcoming net release.

Dividend Safety:

Ares’ dividend information is an important information for galore investors (especially considering it’s the main crushed galore of them invest). The quarterly dividend was astir precocious $0.48, and it has been accrued successful each of the past 2 years (the past clip it was reduced was during the fiscal situation of 2009 erstwhile it fell from $0.42 to $0.35). And arsenic you tin spot successful the pursuing table, nett concern income covered the dividend successful the astir caller quarter, though that is not ever the lawsuit (it fell abbreviated successful the aforesaid 4th a twelvemonth earlier).

Note: Worth mentioning, you’ll besides announcement successful the array supra that Ares has been palmy successful deleveraging (a stated extremity mentioned earlier) arsenic the debt/equity ratio has fallen to 1.12x from 1.29x. This creates much fiscal stableness (strength), and besides gives the institution much "dry powder” for erstwhile aboriginal charismatic woody opportunities arise. BDC indebtedness levels and types alteration considerably.

Importantly, the longer-term inclination (see illustration below) shows Ares has a agelong past of beardown dividend sum (a bully happening for investors).

Valuation:

One of the astir basal ways to worth a BDC is the price-to-book ratio. And Ares presently trades astatine conscionable implicit one, which is reasonably accordant with its longer-term scope (at times it has traded astatine bigger premiums oregon discounts).

The publication worth has been helped precocious by debased recognition spreads (because this denotation of little hazard tin effect successful assets being valued higher connected the books). However, if woody travel slows past the complaint of publication worth increases (and dividend increases) volition besides apt slow. For reference, you tin spot the price-to-book worth ratios of galore BDCs successful our earlier table.

Risks:

The biggest hazard for Ares is fundamentally if the system falls into heavy recession past galore of its portfolio companies won’t beryllium capable to wage the involvement connected their loans (and much volition spell into non-accrual status). Similarly, if involvement rates proceed to summation importantly this could origin much accent (and much defaults) connected loans. However, it tin besides effect successful much nett concern income from rising recognition spreads, particularly connected floating complaint loans (as discussed earlier).

Fortunately for Ares, it is 1 of the largest and astir diversified BDCs. Unlike immoderate smaller BDCs, nary azygous indebtedness makes up excessively overmuch of Ares concern (so this helps trim risks).

Furthermore, Ares' reduced leverage and investment-grade recognition standing besides supply fiscal spot and stableness that different BDCs bash not have.

Hercules Capital (HTGC), Yield: 12.2%

Switching gears, different BDC that we similar (and presently own) is Hercules Capital. Hercules is smaller and little diversified than Ares, and it has a peculiar absorption connected task indebtedness and maturation superior (often considered riskier and much volatile).

Notably, Hercules besides has a importantly higher price-to-book worth and much short-interest (as you tin spot successful our earlier table). We purchased shares of Hercules earlier this twelvemonth astatine a importantly little terms pursuing the fallout (and marketplace panic) from the Silicon Valley Bank illness (BDCs were trading importantly little then, peculiarly task indebtedness and maturation superior BDCs, similar Hercules).

Growth companies (such arsenic maturation stocks arsenic good arsenic the backstage maturation companies Hercules lends to) person experienced beardown gains truthful acold this twelvemonth (as the marketplace has started to retrieve from a unspeakable 2022 for this aforesaid group). Hercules is worthy watching intimately considering its higher valuation and the existent authorities of the economy. For example, if the upcoming fed announcement is much dovish connected aboriginal involvement rates—that could beryllium bully for Hercules.

Important to enactment here, Hercules’ existent precocious P/B worth whitethorn really beryllium much of an denotation that the publication worth is excessively debased (and volition beryllium written up astatine the adjacent quarterly announcement connected August 3rd) not needfully due to the fact that it is implicit valued.

Blue Owl Capital (OBDC), Yield: 9.5%

Blue Owl (formerly Owl Rock) is different BDC that looks precise charismatic connected galore important BDC metrics. The shares person been a beardown performer for america this twelvemonth (they’re performing importantly amended than different BDCs). However, we precocious sold 100% of our Blue Owl shares owed to immoderate interior absorption conflicts.

Specifically, the commercialized comes connected the heels of reported drama among the founders of Blue Owl. We person nary denotation that the interior play volition origin immoderate problems for Blue Owl (the shares whitethorn proceed to bash perfectly good going forward). However, wherever determination is smoke, determination is sometimes fire. And considering 2 of the Blue Owl founders person retained attorneys due to the fact that the 3rd laminitis refuses to resign, we’re much comfy conscionable getting retired of this one.

Conclusion:

The bottommost enactment is that we similar Ares Capital, and we proceed to ain the shares. We person nary volition of selling considering the steadfast yield, steadfast financials and beardown wide business. However, we volition beryllium watching this upcoming net announcement for clues and accusation astir non-accrual loans, involvement complaint impacts and woody enactment successful particular.

Ares announces quarterly results archetypal among large BDCs (expected connected Tuesday, July 25th, pre-market), and it whitethorn springiness clues astir the wellness of the BDC marketplace and what is to travel for different BDCs. We proceed to ain Hercules arsenic well, and adjacent though we precocious sold our shares of Owl Rock (now Blue Owl) based connected flimsy concerns astir the absorption team, we expect Blue Owl volition most-likely proceed to execute good too.

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Source Seekingalpha