We do spend an inordinate amount of time here at the BDC Reporter analyzing the earnings of Business Development Companies, new business activity in the leveraged finance market, and other activities which impact the asset side of the balance sheet.
However, it’s worth looking at what companies are doing on the liability side. Thanks to a reviving capital markets for all kinds of debt, many BDCs are using the opportunity to reduce their cost of capital. Just as importantly, BDC managers are attempting to steer away from the plain vanilla one or two year Revolving lines of credit, which were the mainstay of most BDCs borrowings.
These Revolvers, while inexpensive, cause unmitigated trouble for many BDCs during the Great Recession when many lenders fled the market. Even lenders who remained were non supportive as the very existence of the financial system was in doubt. This caused BDCs to have to scramble for alternative capital to repay Revolvers coming due at a time when capital was very hard to come by, and/or to sell assets in a hurry to pay down debt. At the very least, even well heeled BDCs were forced to freeze any new lending as borrowing capacity shrunk.
The watchword in the halls of the BDCs is “never again”, and most of the major players have been taking steps to establish capital structures-especially where debt is concerned, which will be capable of absorbing the impact of any future recession without the attendant panic and freeze on new lending that occurred last time around. At the forefront of this trend is Ares Capital (NASDAQ:ARCC). We thought we’d use the occasion of Thursday's under the radar announcement that the company is redeeming its $300mn 2011 Unsecured Notes, as an opportunity to look at some of the actions taken by Ares in recent weeks to bolster its balance sheet.
Pay-Off the Unsecured Notes
First, let’s discuss the Notes pay-off. The Notes were assumed by Ares as part of the acquisition of Allied Capital a year ago. There are 3 different sets of Notes, each with different maturities and different pricing. In aggregate they accounted for $690mn at September 30, 2010 and accounted for nearly half all debt outstanding. Two sets of the Notes are maturing in 2011 and 2012, with the third set in 2047.
Ares has been getting its house in order to repay this debt, reduce its cost of capital and push out its maturities. The $300mn in Notes being redeemed bear interest at 6.625%, and will be retired by mid-March. The next maturity is April 2012 for $161mn, and a 6% coupon. Chances are Ares will be paying this debt off as well. In fact, Ares had already bought back $19mn of the 2011 Notes in the 9 months year-to-date through September 2010 according to its 10-Q filings, and $34mn of the 2012 Notes. Starting in 2012, Ares has the ability to prepay the 2047 Notes, which bear interest quarterly at 6.875%.
In January of this year, Ares placed $575mn (including underwriter over-allotments) of Convertible Notes at a yield of 5.75%, and a conversion price of $19.1. ARCC is trading at $17.6 today and has flirted with $18.0. By the way, Ares does not have the right to redeem the Convertible Notes, so we can imagine that the new debt will eventually be converted to equity.
The 2011 analyst consensus for Ares is $1.51 a share, so the $19.1 conversion price suggests a 12.6 multiple, which is not unlike the valuation of many other BDCs in a favorable lending environment like the one we are in. At the current dividend level, the company will be paying just 7.3% for this new capital, only a slight premium over the cost of the debt.
We didn’t write about it at the time, but Ares has also negotiated (back in mid January 2011) a very flexible funding arrangement with Wells Fargo (NYSE:WFC) on one of its two Revolvers. The company restructured its $400mn Revolver for its wholly owned subsidiary, Ares Capital Funding, LLC. The revised structure should allow Ares greater flexibility in the future if there is a recession underway or on the horizon, and market conditions become difficult.
Instead of the normal “pay me back everything you owe me on the Revolver maturity date”, the facility contains a two year amortization period. Here’s how it works: For the next 3 years Ares can use the Revolver, drawing down the borrowings and paying them back at will (subject to meeting borrowing base and covenant requirements, of course). As of January 2014 the Revolver expires.
In most cases the line will have been renewed well in advance, but if the market has turned sour and Wells wants out, the Revolver “reinvestment” period expires. However, now Ares has two more years to pay off any outstandings under the facility. Investments which get repaid by Ares’ borrowers pay down the facility, but there is no need for the company to come up with a bullet repayment in 2014.
The goal, which is largely met with this structure, is to match the company’s assets (loans with an average life of 3-4 years) with the borrowing liabilities. There’s even a provision for two annual renewals of the repayment period, but it’s by mutual agreement, which has less value in our eyes. This type of structure is not new, but the 2 year amortization period is longer than most borrowers have been able to negotiate, and the initial three years of initial use is noteworthy.
Pricing remains the same both during the first three years and during the amortization period. The current margin rate is 2.75% over LIBOR, but pricing depends on Ares’ debt ratings and amount of leverage on the books. At worst, the company pays LIBOR + 3.75%, at best LIBOR + 2.25%.
Compared to the heady days of 2006-2007 when some BDCs were able to borrow as low as 1% over LIBOR (including Ares itself ), this is somewhat elevated cost of medium term debt, but given the more flexible structure and longer “reinvestment” period, it’s a bargain. Nonetheless, we wouldn’t be surprised to see Ares or some of the better capitalized BDCs get even lower pricing, as well as borrowing structures that do not cause them to have to pay off outstandings in a hurry when the environment changes. As it will.
The last few months have allowed Ares to recast its balance sheet in a way that will have an impact for years to come. Only time will tell if the mix of Revolving debt, Unsecured Notes, Convertible Debt and fresh equity which Ares is using to finance its investment business will allow the company to steam through the next recession. The immediate benefit though, will be a lower cost of capital and the ability to take advantage of whatever market opportunities might arise.
Already, Ares has been able to stepup to the plate in January and fund a major increase in funding to its JV with GE Capital in the Senior Secured Loan Program, which has swelled from $3.6bn to $5.1bn. Ares was able to raise its contribution from $525mn to $975mn. Along similar lines, Ares was able to underwrite a $245mn second lien Term Loan, and keep $145mn on its books.
Disclosure: Author is long ARCC.