Ares Capital Corporation (ARCC) is a BDC (business development company) that has backed up into a secondary offering (falling from $17.10 before last week’s announcement, an 8.4% drop) and is trading at a 15% discount to its closest related peer (AINV at 1.2x NAV versus ARCC at 1.04x NAV). It’s indicated dividend yield is 9.7%.

 

Buying a reputable BDC near NAV, particularly one at this stage of its maturation cycle, is a very compelling situation.  These companies are well understood by the VIC community, and there have been comprehensive discussions of their features in the posts on ACAS, ALD, AINV, GAIN, NGPC, and PSEC.

 

This idea is meant to simply stimulate a discussion of these characteristics and highlight ARCC’s present situation for those who haven’t followed its recent performance and historical tendencies to the excruciating detail outlined below!

 

ARCC has gone through this pre-offering plunge before, and it is a common enough phenomenon in early stage BDC’s.  BDC’s are mezzanine finance vehicles that are essentially allowed to lever 2:1.  The BDC funds its investments by drawing down on a line of credit until there is an eventual need for a secondary offering to boost their equity and/or diminish the draw on their credit line.

 

This is the fourth stock offering for ARCC, including its 10/04 IPO at $15.00.  ARCC was one of many BDC’s that attempted to launch following the successful IPO of AINV.  The onslaught of S-1’s and concerns about industry capacity led to many of these being cancelled or sharply curtailed (KKR modified their structure, Blackstone cancelled, etc.). 

 

Much of this was quite understandable.  How attractive would one value the $15.00 IPO of an entity that would be left with $14.05 (assuming 7% underwriting fees) in NAV that would be 100% cash to start and become fully invested and subsequently leveraged over approximately 18 months?  Somewhere below NAV was a logical answer.  AINV’s swoon left it difficult for underwriters to push further BDC’s out the pipeline, since there was all the AINV one might want to purchase being offered at a serious discount to where these subsequently proposed BDC’s would be priced.

 

ARCC managed its way through this wreckage partly due to its unique angle—that it was going to be fully invested from the start by purchasing 17 loans (approximately $141m) from Royal Bank of Canada.  These loans had been underwritten and serviced by ARCC’s management team during their previous employment at RBC.  This team joined Ares Management, a respected name in leveraged finance and private equity markets.  Ares Management has $10.5 billion in committed capital, and in yet another point of comparison to AINV, two of its key partners were founding members of The Apollo Group and are significantly involved in ARCC’s investment decisions.

 

However, because ARCC raised proportionately less capital than AINV (Apollo), it has had more frequent and troublesome secondary offerings than Apollo.  For example, Apollo was able to price its recent secondary at $17.85, a discount of only 3% from the pre-announcement price.  There are several reasons that come to mind why AINV didn’t suffer the drubbing ARCC has taken this week.  First, Apollo has greater name recognition; second, the add-on offering was a smaller percentage of its previous offering (the IPO), whereas ARCC keeps taking the same sized bite of the apple each offering; and third, AINV has a slightly higher dividend yield due to its higher yield on earning assets.  While this higher yield is largely caused by being lower down the credit curve, the AINV secondary came right at 10.0% dvd yield, a nice round number that undoubtedly backstopped the deal.

 

Some of the hiccups around the ARCC secondary offerings are explainable by the phenomenon of the “buyers’ strikes” that happen between the announcement and the issuance of secondaries.  This effect was quite magnified when ARCC announced a secondary on 8/23/05, but didn’t get around to pricing it until 10/12/05.  Many details point up the power of these buyers’ strikes (or short sellers front running).  If I recall correctly, ARCC issued their press release intraday.  The stock fell from a high of $18.70 to close at $17.60.  Then, instead of pricing within the week, it appears that they had to wait until after the one year anniversary of their IPO, and the secondary finally came at $15.46.  Adjusted for the $0.34 dividend during the interim, this still amounts to a 15% fall, and the two month period drove home the fact that there is no reason to buy ARCC before the secondary has been priced and placed.

 

Whew, that’s a lot to keep track of…so here’s to the new VIC table formatting function!

 

 

 

Now this appears to be a phenomenon of the earlier stage BDC’s.  However, the strength of the BDC structure is that the more mature BDC’s trade on yield, and as their dividends increase, they are able to make additional incremental offerings at a premium to NAV.  This monetizes that premium in a way that a private equity fund would have difficulty achieving (who would buy that?!?)  So, the manager of a publicly traded BDC benefits from having an indefinite source of capital, while the stock holder benefits from accretive (to NAV) offerings.  Later stage stock purchasers have the more difficult choice of figuring out whether the safety and yield of the portfolio deserves that premium.  I admit to largely ducking those situations or trading them on a relative value basis.

 

Here are some later stage and earlier stage BDC’s and where they trade relative to book value:

 

 

Here is the multiple to NAV for ARCC and AINV on a monthly basis.  Secondary offerings are in bold:

 

 

 

 

The million dollar question with ARCC, as it is across the BDC universe, is when and whether a premium valuation comes to pass so that current shareholders get the benefit of these accretive offerings.  The answer to this question lies amidst the constant push-pull of NAV-versus-dividend-yield that dominates the income/asset universe of REITs, BDCs, and other finance type stocks.

 

The generic sell side analysis on BDC’s such as ARCC and AINV typically concludes by targeting a valuation that accounts for an increased dividend, a lower dividend yield, and a higher premium to NAV—not to mention a fully utilized application of leverage.  This actually doesn’t do such a bad job of identifying the potential in these stocks, but it does seem to cut some corners.

 

That analysis results in the pretty much across the board consensus target of $19-$20 for ARCC, which represents 25% upside with a 10% dividend yield along the way. 

 

What I’d like to do is expand that analysis and outline a model for evaluating the intermediate stage BDC’s, and explore the possibilities and risks inherent in their business over the next several years.

 

Here are the assumptions:

            Payout ratio of 100% (95% might be more appropriate, but let’s keep it simple).

            Yield on earning assets (13.1% for AINV and 11.5% for ARCC)

            Fee structure (AINV: 2-20 with 7% hurdle; ARCC: 1.5-20, 8% hurdle)

            Borrowing costs: Libor +100 bps.

            Target debt-to-equity: 80%.

 

At 1.8x assets/equity, that gives both BDC’s a target asset of approximately $27.  Working the model all the way through implies a current dividend yield of 10%.  One way to look at the BDC portfolio is how the earnings track through to shareholders.  Essentially, the shareholder gets two return streams.  The first is on the non-levered part of the portfolio.  The second is on the levered part of the portfolio.

 

The yield on earning assets is by no means fixed and does not account for the approximately 10%-15% of equity stake that the BDC’s may have invested in their portfolio companies.  Taking a number somewhere in the realm of where second-lien debt trades, here are the numbers for a 2-20 BDC with an 8% hurdle and 12.6% return on assets: 

 

On the non-levered part of the portfolio, the shareholder gets 12.6% - 2.0% fees, minus 20% incentive fees, or 8.5%.  Then the return is enhanced through leverage, albeit offset by interest expense and more fees.  On the levered part of the portfolio, the shareholder gets 12.6% minus 6.4% (interest costs) minus 2.0% fees minus 20% incentive fee, leaving 3.4% incremental yield.  Using leverage of 1.8:1.0, that gives an additional 2.7% yield for an 11.2% yield that can pass through to shareholders.

 

If that was all there was to it, I’m not sure how enthused I’d be about BDC’s.  However, the maturation process of BDC’s, as shown by ACAS (among others), suggests that this yield and NAV multiple is a floor, and therein lies the attraction.

 

I concede the notion, from hard-learned experience, that there are investment professionals better suited than myself to evaluating private equity offerings across the capital structure.  A diversified portfolio that provides investors with consistent dividends from operating income, with the additional upside of capital gains, through the conduit of a publicly traded pass-through vehicle, is a compelling investment for growth/income funds and IRA investors. 

 

ARCC doesn’t deserve its current discount to AINV.  ARCC invests more broadly across the capital structure, with a much higher percentage of assets invested in first-lien bank loans.  Here’s a snapshot from recent 10-Q’s:

 

 

Furthermore, being a prominent issuer of CDO’s and CLO’s, Ares has plenty of familiarity with structures that reduce their borrowing costs.  For example, they recently announced a $400m debt securitization that resulted in a blended pricing of approximately Libor +34 bps.  (Obviously, this beneficially impacts the simple model above by reducing borrowing costs.)

 

Risks:

 

Depending on how much credence one gives to the reputations of firms and individuals, the risk-adjusted return for the various BDC’s are difficult to ascertain from the outside.  Most of them talk the good talk, and comment upon their cautiousness regarding the credit cycle and the importance of experience and selectivity in choosing portfolio assets.

 

A severe widening of credit spreads would have a significant negative impact, as investors would seek a higher dividend yield for these stocks.  However, the more important consideration is what would happen to the assets.  Given the hurdle rate, buying near NAV gives an investor a much better risk/reward consideration than buying a more mature BDC at a higher multiple.

 

 

Positive possibilities:

 

These are not just mere junk bond pools—there is intellectual capital that provides value.  Yield won’t remain stagnant, and since the earnings pass through, the yield plus the growth in yield is a good proxy for one’s expected return.

 

Additionally, as NAV grows through accretive add-on offerings (keeping in mind the hopeful thought that each additional offering will be proportionately less in terms of existing market cap and ARCC won’t experience such swoons in the future) and also grows through warrant and equity kickers, there should be more to harvest from ARCC than the simply modeled yield pass through outlined above.  Through midyear, ARCC had harvested net realized capital gains equal to approximately 4.1% of the current market capitalization.

 

Finally, ARCC began by purchasing a mature pool of loans, and they have discussed doing so again in the future, rather than by simply growing organically.  Reducing the lag between raising equity and investing in assets will increase net earnings per share.

 

 

Disclaimer:

 

This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned on a regular basis.   

 

 

Catalyst:

 

Completion of the current add-on offering.

Convergence to peer NAV multiples.