Ares Capital: A 10% Yielding Stock Benefiting From Rising Rates
In 2004, alternative investment manager Ares created Ares Capital for corporate lending activities. Today, Ares Capital is the largest U.S. business development company, or BDC.
Most BDCs in our coverage maintain speculative Dividend Safety Scores, reflecting the inherent risks of their business models.
BDCs primarily provide debt and equity capital to relatively small, highly leveraged companies that lack access to traditional financing from banks.
However, handing out loans with double-digit yields is a dangerous game that's only magnified with the use of leverage.
When the tide goes out during economic downturns, BDCs can face a wave of loan defaults that puts their dividends on the chopping block.
Despite these qualities, Ares Capital is one of the better options in this volatile industry.
As the largest BDC, Ares Capital's vast capital base enables the firm to serve private businesses of all sizes and provide financing over a company's entire life cycle, creating longer-term relationships.
The firm's sponsor and external manager, Ares, provides another advantage. Ares manages well over $300 billion of assets and operates worldwide across credit, private equity, and real estate.
Ares' substantial deal flow generation allows Ares Capital to be more selective, and the BDC leverages Ares' investment evaluation process to strengthen its own underwriting.
Most importantly, Ares Capital maintains a diversified investment portfolio comprising more than 400 companies. The firm's largest single investments have historically represented around 5% or less of the portfolio, and its portfolio companies span numerous industries.
Spreading bets across many different investments and end markets helps insulate Ares Capital from distress in any single company or industry.
Management also avoids more cyclical businesses, preferring to focus on service-oriented companies that generate consistent cash flow over cycles. Some of the firm's focus areas include software, healthcare, professional services, and food and beverage.
Around half of the firm's investments have historically been in first-lien secured loans, with second-lien loans accounting for another significant chunk of the portfolio.
First-lien loans get paid first when a borrower defaults and give Ares Capital the right to seize property if loans are not repaid. This approach reduces the risk of significant loan losses during downturns.
Ares Capital also maintains much less leverage than regulators allow, helping it earn a BBB- investment grade credit rating. And management retains a portion of gains realized upon the exit of successful investments to provide additional financial flexibility.
These realized gains (known as "spillover") provide an offset against the inevitable credit losses from making investments in non investment-grade debt securities. Spillover can be used during downturns to help keep the dividend covered.
While Ares Capital has paid continuous dividends since its founding in 2004, the firm did cut its dividend by 17% in 2009 during the financial crisis. Although the BDC's credit performance was better than most of its peers, management wanted to strengthen the balance sheet in light of lingering uncertainty in the credit market.
Ares Capital is bigger today and has access to a broader variety of capital sources, hopefully providing more support for the dividend whenever the next recession hits.
Overall, Ares Capital appears to be a well-run BDC, though it is not immune from the industry's challenges. Investors seeking a more conservative BDC play could consider Main Street Capital (MAIN), which benefits from a lower cost structure and an even higher mix of first-lien loans.
Most BDCs in our coverage maintain speculative Dividend Safety Scores, reflecting the inherent risks of their business models.
BDCs primarily provide debt and equity capital to relatively small, highly leveraged companies that lack access to traditional financing from banks.
However, handing out loans with double-digit yields is a dangerous game that's only magnified with the use of leverage.
When the tide goes out during economic downturns, BDCs can face a wave of loan defaults that puts their dividends on the chopping block.
Despite these qualities, Ares Capital is one of the better options in this volatile industry.
As the largest BDC, Ares Capital's vast capital base enables the firm to serve private businesses of all sizes and provide financing over a company's entire life cycle, creating longer-term relationships.
The firm's sponsor and external manager, Ares, provides another advantage. Ares manages well over $300 billion of assets and operates worldwide across credit, private equity, and real estate.
Ares' substantial deal flow generation allows Ares Capital to be more selective, and the BDC leverages Ares' investment evaluation process to strengthen its own underwriting.
Most importantly, Ares Capital maintains a diversified investment portfolio comprising more than 400 companies. The firm's largest single investments have historically represented around 5% or less of the portfolio, and its portfolio companies span numerous industries.
Spreading bets across many different investments and end markets helps insulate Ares Capital from distress in any single company or industry.
Management also avoids more cyclical businesses, preferring to focus on service-oriented companies that generate consistent cash flow over cycles. Some of the firm's focus areas include software, healthcare, professional services, and food and beverage.
Around half of the firm's investments have historically been in first-lien secured loans, with second-lien loans accounting for another significant chunk of the portfolio.
First-lien loans get paid first when a borrower defaults and give Ares Capital the right to seize property if loans are not repaid. This approach reduces the risk of significant loan losses during downturns.
Ares Capital also maintains much less leverage than regulators allow, helping it earn a BBB- investment grade credit rating. And management retains a portion of gains realized upon the exit of successful investments to provide additional financial flexibility.
These realized gains (known as "spillover") provide an offset against the inevitable credit losses from making investments in non investment-grade debt securities. Spillover can be used during downturns to help keep the dividend covered.
While Ares Capital has paid continuous dividends since its founding in 2004, the firm did cut its dividend by 17% in 2009 during the financial crisis. Although the BDC's credit performance was better than most of its peers, management wanted to strengthen the balance sheet in light of lingering uncertainty in the credit market.
Ares Capital is bigger today and has access to a broader variety of capital sources, hopefully providing more support for the dividend whenever the next recession hits.
Overall, Ares Capital appears to be a well-run BDC, though it is not immune from the industry's challenges. Investors seeking a more conservative BDC play could consider Main Street Capital (MAIN), which benefits from a lower cost structure and an even higher mix of first-lien loans.
