Ares Capital Corp (ARCC) Quarter in Review
Ares Capital Corp is currently the largest Business Development Company (BDC) today at $4.34 billion as of 11/23/2012. The company had a solid third quarter and paid another special dividend of 5 cents per share bringing back memories of 2006. The additional dividend will push the payout for the year to $1.59 and a realized yield of about 9% based on the current price of 17.47. This article will take a look at the Q3 results and try to point out the pros and cons. Please note that all of the figures below can be found in one of the links above or on the company 10-Q documents.
- Increased NAV to 15.74, a 23 cents/share increase over the previous quarter.
- 59 cents/share Net Income; 42 cents/share of Net Investment Income
- Over $400 million in net investment activity.
The increase in NAV was a modest increase and the company is still trading at about an 11% premium to the book value. This premium means that the company can still issue shares that are accretive to book value and may fund any additional investment activity:
- Income was not a major contributor to NAV. The Net Investment Income before taxes actually dropped from Q2 to Q3. This drop was driven by increased expenses. The two main contributors to expenses were the $11.3 million jump in Incentive fees and the $1.6m jump in Professional fees. The Professional fees are substantially higher than last quarter but are in line with last year's Q3 filing.
- As increase in asset values were a significant contributor. The unrealized loss on assets fell by just over $27 million to (240) million and the unrealized gain increased by nearly $20 million. This represents about a 19 cents/share gain to NAV and can explain part of the major jump in Incentive fees due.
Over the quarter, ARCC made over $1 billion in new investments and exited $629.4 million in investments. These exits were due to both sales of assets and portfolio repayments. Loans on non-accrual status (meaning they are not paying interest and/or principal) remain small overall at 1% of fair value and 2.6% of cost. The 2.6% of cost means the company can still take some accounting loss on these investments and hit Net Income in future quarters.
Non-Accruals as of Sep 2012:
- Orion Foods - Junior Secured Loan with a value of $16m
- CitiPostal - Senior Subordinated Loan with a value of $2m
- MVL Group - Senior Subordinated Loan with a value of $10m
- Pillar Processing - Senior Secured Loan with a value of $9.4m. This one is interesting as it has been placed on non-accrual status but is still held in the portfolio at par.
- Promo Works - Senior Secured Loan at $2.6m
- American Commercial Coatings - This is a Real Estate loan that has a cost of $1m, a par of $2.5m and is now held at $2m.
- Hot Light Brands - Another Real Estate loan, this one is likely to be written off as the par is $33m and the current holding value is $1.9m
- Reed Group - Senior Secured Loan at $10m
- Soteria Imaging Services - Junior Secured Loan at $1.3m
New Investment Activity:
- Ares makes a fair amount of money from structuring a deal and then syndicating this deal out to other investors. They benefit in two ways. First, they charge the debtor a deal origination fee. This money goes directly into the Income Statement. The second benefit involves Ares syndicating the loan and selling the loan at an attractive spread. As Michael Arougheti said in the conference call notes: "But hopefully, if we're structuring it well and we get the right partners, we could take a stretch first lien loan and by structuring and syndicating, turning into a low double-digit type of return." A more practical example is this. Ares structures a Senior Secured deal for $100 million paying a coupon of 9%. The management team decides to keep only $50 million of this security on the books and will attempt to syndicate the rest of the loan. If they are able to sell this loan to other lenders at an 8.5% coupon, this means they sold $50m of a loan for $52.9m. The extra $2.9m in income means Ares is getting a 14.8% return on the $50m it had lent out. It is a great business for the company and a major reason why the SSLP program has been a focus.
- As stated in the conference call, Ares is still pursuing first lien loans and staying out of the subordinated/mezzanine market in new originations. This means the yield on the portfolio has decreased slightly to 11.6% and follows the pattern of the past year in yields dropping.
Key Investments Exited:
- Ares sold off the entire FirstLight investment to Ivy Hill Asset Management IHAM. This represented a net loss of $26 million. This may not be a huge deal as they kept the company under the Ares umbrella as IHAM is owned by ARCC and any recovered losses will make their way back up to ARCC via dividends.
- A large gain was realized via the exit of Savers, Inc. and SAI Acquisition Corporation. This represented a $15.2 million gain and was one of ARCC's non-interest bearing Equity holdings.
ARCC is the current king of Business Development Companies. They have demonstrated the ability to navigate the "Great Recession" and come out ahead via acquisitions of Allied Capital and FirstLight. As an investor, two things do concern me. Ares is moving into larger and larger deals via their SSLP program. As Apollo Investments learned, sometimes big deals turn sour and are very expensive. The other item for concern is the premium to NAV and the temptation to tap the equity markets. Ares last issued shares in August and it is likely they will tap the markets again in 2013. Depending on the results of the Fiscal Cliff, it may be worthwhile to keep this stock on your watch list.
Disclosure: I am long ARCC.