Ares Capital: One Of The Best Buys In The BDC Sector (NASDAQ:ARCC)

Earlier this year I wrote an article on Ares Capital (NASDAQ:ARCC) arguing why this BDC offers one of the best opportunities to enjoy solid returns from this specific sector.

The bottom line was that ARCC has a truly diversified portfolio (on security, sector and asset class level) coupled with a strict underwriting policy that helps keep the underlying risk level low relative to the almost double-digit yield that is provided by this BDC. In other words, ARCC offers close to double-digit yield opportunity at limited risk within a sector that is inherently associated with high volatility.

Since the publication of my article, ARCC has delivered positive and almost identical returns with the broader BDC market.

So, from the price perspective things have not changed and the uptick we can see in the chart above does not really move the needle in the context of ARCC’s investment case.

However, there have been a couple of new data points that we have to consider. In a nutshell, these new items strengthen the overall investment case further.

Let me now explain why, in my opinion, this is the case.

Thesis review

My overarching approach on BDC investing is to first take care of the risk side and understand that the fundamentals are there to support the current distributions in a sustainable manner. Once the risks are checked and BDCs that carry aggressive capital structures and / or portfolio are scoped out, only then I focus on the yield and capital appreciation aspects. In my view, it is just not worth chasing those extra 200 or 300 basis points on top of already high-yielding dividend especially given that the underlying risks are already relatively high due to the specificity of the BDC sector.

With this in mind, if we look at the key metrics from ARCC’s Q1, 2024 earnings report, we will notice clear signs of cash flow durability as well as the overall ability to support the current ~ 9.3% dividend in a sustainable fashion.

For example, ARCC reported Q1, 2024 GAAP net income per share of $0.76 compared to $0.72 in the prior quarter and $0.52 in the Q1, 2023. The core earnings per share came in at $0.59 for Q1, 2024 compared to $0.63 in the prior quarter and $0.57 in the first quarter of 2023.

Theoretically, one could pinpoint to a decreased result from the previous quarter, but peeling back the onion a bit it becomes clear that one of the key drivers behind this drop was the change in restructuring fees that decreased from Q4, 2023 given the usual seasonality aspect.

However, the key thing here is that current divined of $0.48 per share is well-covered so that even ARCC has the luxury to direct a decent amount of surplus capital in new investments. This dynamic is nicely captured by the fact that the NAV went up by 1.5% from the level recorded in the last quarter (and the increase is even higher if we compare to Q1, 2023 result).

Now, one of the main drivers for the investment case here is ARCC’s ability to source in sizeable volumes of new investments on favorable terms.

For example, while there are many BDCs out there that struggle to shield their current portfolio size due to organic repayments exceeding the new deal volumes, ARCC has managed to register positive net investment volumes for already fourth quarter in a row. Also, the level of gross commitment in Q1, 2024 increased by circa $1.2 billion from last year, keeping the upwards sloping commitment trajectory alive since the start of 2023.

Even the commentary by Kipp DeVeer – CEO – in the recent earnings call confirms that ARCC is in a solid position to grow portfolio from here:

In the first quarter of 2024, while merger and acquisition activity levels remain relatively low, our share in the business continues to remain very strong. The banks are more active again and this is generally good for all market participants as the increased availability of capital typically brings out more M&A and adds confidence to companies seeking financing for transactions.

What is equally important to note that ARCC has managed to attract and underwrite these new investments in a prudent manner without sacrificing its financial risk policy. For instance, the originations in the first quarter had a weighted average LTV below 40% at all-in yields nearly at 11%. The LTV component is even lower what ARCC has as its portfolio weighted average – LTV of 43% -, which itself could be deemed as a very conservative level.

Now, if we put this in the context of the following three aspects, I think we would arrive at a clearly justified basis for considering ARCC’s portfolio truly defensive:

• The portfolio companies have recorded an organic EBITDA growth over the TTM period of 10%.
• According to the Management, the annual EBITDA growth of the portfolio companies is more than double the annual growth of the companies in the S&P 500.
• With each quarter, ARCC grows its exposure to first-lien structures.

Finally, it is critical to underscore that ARCC ended Q1, 2024 with a debt-to-equity ratio net of available cash of 0.95x, which is (a) lower than in the prior quarter when the relevant metric stood at 1.02x, (b) it is the lowest net leverage ratio for ARCC that it has had since 2019, and (c) it is below the BDC sector average.

Speaking of the capital structure and financings, relatively recently ARCC announced that it has managed to issue unsecured notes with a maturity due in 2029 and at a yield of ~ 5.9%. This is a clear proof of how robust the capital structure is here and directly supportive for ARCC’s ability to continue capturing enticing spreads from the incremental investments (e.g., as implied by the Q1, 2024 new investment all-in yield of ~ 11%).

The bottom line

ARCC is one of the safest BDCs in the sector, offering an attractive dividend yield of ~ 9.2%. The dividend is not only supported by the ample surplus earnings generation, but also by a de-risked (conservative) portfolio investment credit risk profile.

On top of this, ARCC is in a favorable position to grow its portfolio as the benefit of scale and diversification across different investment types allows to attract sufficient amount of fresh volumes to offset the organic repayments.

Finally, in terms of the capital structure, ARCC is also in a safe position. The current leverage profile is the lowest ARCC has had since 2019 and is currently below the sector average. Also, the successful debt financing activity by securing long-dated unsecured notes at just ~ 5.9% yield reflects the situation nicely – i.e., the financial risk is low, which allows ARCC to access cheap financing that, in turn, accommodates attractive spread capture.

As a result of this, Ares Capital is, in my humble opinion, still one of the best buys in the BDC segment.