Ares Capital (ARCC) is a specialty finance company that caters to the financial needs of middle market companies. Ivy Hills is its asset management company, which focuses on middle-market loans. Being a Registered Investment Advisor, or RIA, Ivy Hills acquired middle-market managers and invested in collateralized loan obligations during the past U.S. downturn. This strategy has helped the company generate dividends for Ares Capital. Being a wholly owned subsidiary, Ivy Hills distributed $27 million worth of dividends in the first quarter this year, which included regular dividends of $10 million, and $17 million from a special dividend.
Based on past performance and analyzing the current scenario, Ivy Hills will continue experiencing consistent asset management fees and strong performance of securities in managed funds. Through these opportunities, the management expects the dividend run-rate of $10 million every quarter, up from $5 million per quarter, for the coming quarters.
Henceforth, the company will pay a dividend of $1.61 for 2013, which includes the special dividend of $0.05, and a dividend of $1.80 in 2014. This outperformance will help this RIA attract more capital from investors, leading to growth in its AUM in the coming year.
Let's discuss what lies ahead for the company.
Issue of convertible security notes
Recently, Ares Capital announced plans to sell unsecured convertible notes, bearing an interest rate of 4.375% per annum, which are payable semi-annually. These notes are worth $250 million, due in January 15, 2019.
There are only certain circumstances for converting these notes to cash or shares of the company's common stock. This will be possible at a conversion rate of 49.6044 shares of the company, for every $1,000 principal amount of the unsecured convertible senior notes. This will equate the company's common stock price to nearly $20.16 per share, a roughly 14% hike to its present share market price of $17.63 as on July 24, 2013.
These notes will be offered only to qualified institutional investors, or QII, along with the benefit that the company cannot redeem the notes prior its maturity.
Reason: Through the net proceedings received from the offering, the company will repay its outstanding debts. This may include repayment of its outstanding borrowings, under its debt facilities, or Ares Capital can also opt for reducing its general corporate expense. Overall, investors can expect improvement in the company's liability side in the long term.
Rating: There are chances that Fitch will rate these $250 million convertible notes as "BBB." The reason to this expectation is that in the near short-term, the notes won't showcase any drastic impact on the company's leverage levels.
The company anticipates this rating based on its existing senior unsecured debt since it will rank the new notes at similar levels in its capital structure. Fitch bases ratings on the company's past history of focus on senior debt investments, as through this activity Ares Capital will be able to increase the amount of unsecured finding in its capital structure. This indirectly reflects company's low leverage as Ares Capital's debt to equity ratio stands at 0.54 times.
Total Debt ($ million)
Total Equity ($ million)
Leverage-Based Comparison: On the competitive front, its peer competitor, Apollo Global Management (APO), has a debt to equity ratio of 1.76 times, which is much higher than industry standards. Fifth Street Finance (FSC), an industry competitor, has a debt to equity ratio of 0.71 times, including its Small Business Administration, or SBA, debentures. On excluding these debentures, and the equity raised in the previous quarter, the ratio will come down to 0.54 times, which is very much in line with the sector average, whereas its debt to EBITDA rose to 4.1 times due to two of its large transactions. Historically, Fifth Street is considered one of the under-leveraged companies in this industry. With one of the largest capacities on the balance sheet to grow its net investment income, the company's debt to equity ratio will range between 0.60 times to 0.65 times by the end of this fiscal year.
As on March 21, 2013, Ares Capital had approximately 88% of its debt considered as unsecured. Its borrowing capacity on the revolving facilities was nearly $1.6 billion. These numbers reflect its positive outlook in terms of its leverage side, along with peer-superior funding flexibility, operating consistency despite the past downturn, and its strong liquidity profile with conservative dividend strategy. Therefore, I expect the debt to equity of Ares Capital to stay at similar levels this year.
Enhanced liquidity position
Ares Capital showed continued improvement in its liquidity position. To further enhance it, the company reduced the short-term debt in the second quarter this year. It declined by 0.25%, and grew its facility size from $900 million to $930 million.
During the first quarter, Ares Capital had $1.6 billion of available liquidity. Based on 175% of assets to equity ratio, which is considered as a leverage limit for a business development company, or BDC, of Ares Capital's size, the company can access funding capacity of $850 million. The additional $100 million is assumed as cash deployment.
Henceforth, this shows that Ares Capital created a strong position to deploy capital, given the improving middle market conditions, post-recession in the U.S.
Liability side showing better story
The liability side of Ares Capital is shaping up nicely. The interest cost was flat at 5.5% in the first quarter this year. Looking at the past two years, Ares Capital has extended its liability structure, through accessing the unsecured debt market, and of this 88% is on fixed-rate basis. Henceforth, despite overall declining interest rates, the company's interest expense is almost stable.
However, there will be a point where the interest costs of the company will decline. It is in support of the recent amendments received by Ares Capital to its senior secured revolving credit facility. This includes:
● Extension of revolving period from May 2015 to May 2017
● Maturity extension from April 2016 to April 2018
● Decreased interest costs from 2.25% over LIBOR to 2% over LIBOR
Additionally, the company's management will utilize the collateralized loan obligation market for future funding through selling its loan portfolios in the international markets, which will lead to further debt cost reductions.
Continuous Yield Pressure
In the first quarter this year, the portfolio yield fell by 0.30% to 11.1%, from 11.4% in the previous quarter. The decline is very reasonable, as it experienced heavy repayment activity during the end of the fourth quarter last year. Along with this decline, the portfolio spread also fell from 6.2% to 5.3% on the quarter-over-quarter basis. It is the difference between cost and weighted average cost of funds. On the quarter-over-quarter basis, the weighted average funding costs rose by 0.6% to 5.8%. On the other side, in order to focus on longer-term debt maturities, the funding cost has also increased by 1% in the last 18-month period.
Based on the assumption for tighter middle market spreads throughout this year, I believe the yield pressure will continue, as high yielding-investment refinance, or exits, are being replaced by low-yielding secured investments.
Concern over investment income
In the first quarter this year, the company's interest income decreased by roughly 4% to $105 million quarter-over-quarter, which had a negative impact on the refinancing activity that took place in the previous quarter. This led to lower interest bearing assets and lower yields on new assets in its portfolio. However, it partially offset this drop in the interest income by the incline reflected in the regular dividend from Ivy Hill, along with a one-time dividend, which it won't disburse in the future. Additionally, the capital structuring fees were also lower, as refinancing of incumbent portfolio companies had a negative impact, which led to a lower fee in comparison to new investments.
Going forward, the interest income and Ares Capital's yields will experience pressure as per the current scenario. This is mainly due to its disciplined investment strategy and tenderness to trade yield for higher credit investments.
Given the company's preference to continue working with its existing portfolio relationships, which carry lower fees, structuring income will remain lower in the second quarter in comparison to its previous quarters.
Second quarter expectations
On June 11, 2013, Ares Capital filed for an update to its shelf registration. This development included the funding details. The company funded $929 million new investments from April 1, 2013, to May 30, 2013. This is way ahead of street estimations of $760 million-worth of originations, and there is still a month not included in the said quarter. These originations include:
● Roughly $700 million of First Lien Investments, of 75%
● About $140 million from Senior Secured Loan Program, or 15%
● Approximately $90 million of Second Lien Investments, or 10%
Since the company receives up-front fees on its investments, these originations will result in an upside movement in its earnings. With strong originations, the repayments were at normal levels at $273 million of exits.
This leads to a portfolio growth of $650 million as of the second week of last month. Overall, it expects these investments to reach $1.2 billion in the second quarter, which is way ahead of the $410 million in its previous quarter. It will also increase the net investments to $820 million from $200 million in the previous quarter. It will prove beneficial for the company on a longer-term basis. Henceforth, Ares Capital will post EPS of $0.42 in the second quarter and an overall EPS of $1.60 this year.
Ares Capital's price to book ratio is 1.10 times, while the diversified investments industry's price to book ratio stands at 1.60 times. Other companies from this industry like Apollo and Medley Capital (MCC) are trading at 1.28 times and 1.15 times, respectively. BDCs are not as interest sensitive as other yield bearing companies like mortgage REITs, undervaluing most of the BDC companies. Therefore, any rate influenced selloff will make this dividend yielding industry an attractive investment opportunity. This shows that Ares Capital proves to be an undervalued stock.
Market Price Performance
Recently, Ares Capital's stock price breached its 200-day moving average of $17.57 by reaching to $17.63 on July 23, 2013. Based on the simple moving average of the past 200 days, the share market price rose by 4.04%. This shows that the market price of the company has traded on flat-to-high levels in the past six months. Looking at the share price movement graph, every downfall in the share price is followed with an upside trend, forming a disciplined pattern. Henceforth, this proves scope for recovery, supported by better future prospects of the company as discussed above.
Analyzing on a year-to-date basis, most of the BDCs have not outperformed the S&P 500 which grew by 18.67%. On the other side, Ares Capital and Medley Capital both have displayed mere growth of 0.74% and 0.21%, respectively. With growth opportunities lying ahead for this segment, their market prices have experienced a low in the past month. I expect an upside movement for the stock price in the long-run.
In comparison to other BDCs, Ares Capital finds itself positioned well in this market, and it will receive consideration among the BDC investors, post the recent sell off. With possession of a $6 billion investment portfolio, which includes 75% of its investments related to floating rate instruments, the company should benefit from the increased M&A activities. It even has flexibility to support its quarterly dividend of $0.38 per share, along with undistributed taxable income of $0.89 per share. Ares Capital has well maintained itself throughout various cycles in the past.
There are chances that the company will experience reduction in its Net Investment Income, or NII, per share this year, but it will see an increase in 2014 to roughly $1.68 per share from $1.60 levels this year.
I recommend a buy for this stock for longer-term gains due to present ongoing yield pressure and increased competition in the middle market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.