Ares Capital Corporation
Ares Capital Corporation (ARCC) is a leading specialty finance company that provides financing to middle market companies. Since its formation in 2004, ARCC has elected to operate as a Business Development Company (“BDC”), a form of closed-end investment company. ARCC is by far the largest BDC with total assets of approximately $12.3 billion as of December 31, 2017 and an equity market capitalization of approximately $6.8 billion. ARCC has a highly diversified portfolio predominantly in direct loans to over 300 companies.
ARCC closed its acquisition of American Capital (“ACAS”) on January 3, 2017. ACAS had previously been the 2nd largest publicly traded BDC (after ARCC). At closing, ARCC acquired $3.6 billion of assets including investments valued at approximately $2.5 billion and $960 million of cash.
Ares Capital Corporation released strong financial results on February 13, 2018 for its 4th quarter and for the full year 2017 that exceeded street expectations (ARCC beats total investment income):
- GAAP Net Income of $0.54 per share for the 4th quarter and $1.57 per share for the year,
- Core Earnings Per Share* of $0.38 per share for the 4th quarter and $1.39 per share for the year,
- An increase in its NAV to $16.65 at December 31, 2017 – a 1.0% increase from $16.49 at September 30, 2017, and up from $16.45 at December 31, 2016.
- ARCC also announced its quarterly dividend of $0.38 payable to shareholders of record as of March 15, 2018 (to be paid on March 30, 2018).
Note: In addition to GAAP Net Income disclosures, ARCC also discloses “Core EPS”, which is non-GAAP measure that is the net per share increase (decrease) in stockholders’ equity resulting from operations less: (1) expenses incurred in connection with ACAS, (2) net realized and unrealized gains (losses) and (3) any capital gains incentive fees or taxes payable that are related to (2).
Despite the strong results and good color provided in the discussion in ARCC’s 4th quarter 2017 earnings call (ARCC Q4 2017 results earnings call transcript), ARCC currently trades at about $15.90 – about 95.5% of NAV, providing an annualized dividend yield of 9.6% (Note that ARCC has declared a $0.38 per share dividend that will be payable to shareholders as of March 15th).
Given the strength of ARCC’s business model, attractive portfolio, favorable liability structure, successful track record of building and maintaining value throughout different parts of credit cycles, and expected benefit from rising interest rates, ARCC should trade much better than its current price, which is approximately a 5% discount to NAV. ARCC should easily trade at a 10% premium to its NAV of $16.65 – which would imply a share price of approximately $18.32 – which would provide an annualized dividend yield 8.30%.
During 2017, ARCC focused on incorporating ACAS’s assets into its portfolio and at the same time resolved its approximate $1.6 billion legacy Senior Secured Loan Program (“SSLP”) program. ARCC’s 4th quarter financial results show the significant progress that has been made.
Going forward, ARCC is poised to further benefit from higher portfolio yields and future additional incremental yield enhancement initiatives, and will also benefit from future increases in interest rates due to its attractive asset/liability composition.
Kipp deVeer, ARCC’s CEO, said in the 4th quarter earnings call:
“Looking back over 2017, we’re pleased that we’ve accomplished nearly all of the goals that we set for ARCC at the beginning of the year, namely increasing our quarterly earnings through the rotation of the American Capital portfolio, resolving the wind-down of the SSLP, and investing prudently with a focus on funding incumbent borrowers.”
The table below presents a summary of Core EPS and GAAP EPS over the past 5 years. The table at the end of this article presents a summary of projected Core EPS for 2018 and 2019.
ARCC’s management has been very transparent in its presentations and earnings discussions about the many and complex steps it has focused on in order to increase its core earnings in order to meet its objective of having regular dividends covered by its core earnings. A portion of ARCC’s 2017 Investor Day Presentation (November 16, 2017 – ARCC Nov 2017 Investor Day Presentation) specifically covered the multiple areas that are part of the ARCC game plan to enhance core earnings.
ARCC has been successfully executing in all of these areas, resulting in core earnings of $0.38 per share in the 4th quarter 2017, and setting up for increases in core earnings from 4th quarter levels for future periods.
Given investor concerns about the potential impact of rising interest rates, it is important to note that ARCC has an asset sensitive balance sheet – meaning that ARCC’s net income will increase as interest rates increase since ARCC has $11.8 billion of investments (of which 81% are floating rate) and only $4.9 billion of debt (of which only 13% is floating rate). As discussed later in this article, a 1.0% increase in general interest rates could increase ARCC’s net income by approximately $0.17 per share.
Ares Management, L.P. As External Investment Advisor
ARCC is managed by its external investment advisor, Ares Capital Management LLC (NYSE:ARES), a subsidiary of Ares Management, L.P. (“Ares”), a publicly traded leading global alternative asset manager with approximately $106 billion of assets under management as of December 31, 2017. Ares’ Credit Group, with approximately 100 U.S.-based investment professionals, is a leading manager of liquid and illiquid credit strategies across the non-investment grade credit universe, with approximately $71.7 billion of such assets under management as of December 31, 2017.
As part of its credit activities, Ares is also one of the largest self-originating direct lenders to U.S. and European middle markets that it believes to be increasingly underserved by traditional bank lenders. During 2017, Ares’ Credit Group closed over $10.6 billion in commitments across 206 transactions in its U.S. direct lending strategies.
As part of the structure of ARCC’s acquisition of ACAS, Ares contributed approximately $275 million in cash consideration at closing of the transaction, and Ares also agreed to waive $10 million per quarter of income-based management fees (as long as such fees are otherwise payable such quarter before such waiver) for the 10 quarters starting in the 2nd quarter of 2017 and ending with the 3rd quarter of 2019 – for an aggregate fee waiver of $100 million. During 2017, an aggregate of $30 million of income-based fees were waived pursuant to this provision.
Acquisition Of ACAS
After closing its acquisition of ACAS on January 3, 2017, ARCC spent the year optimizing the acquired investment portfolio of approximately $2.5 billion by selling low-yielding assets and reinvesting proceeds into higher-yielding assets. The chart below (page 25 of ARCC 4th Quarter 2017 Presentation) summarizes ARCC’s extensive repositioning of the ACAS investment portfolio.
Kipp deVeer said in the 4th quarter earnings call:
“The American Capital acquisition gave us a very unique opportunity to buy a large portfolio at a discount to NAV, and since closing, we’ve generated realized gains and improved the portfolio by rotating out of non-core, lower-yielding investments and increasing core earnings by redeploying this capital into higher-yielding assets. We feel we’ve made great progress during our first year after closing. We’ve had no surprises; and in fact, we believe that we may have found more to the upside than we expected.
During 2017, we exited more than a $1 billion of assets, mostly non-core investments from the $2.5 billion portfolio and we realized $85 million of net gains on these exits. In addition, on the acquired investments that we still hold, as of year-end, we’ve shown $184 million of net unrealized appreciation during the year. We currently have $735 million invested at cost, or $910 million at fair value of targeted lower-yielding non-core assets remaining in the American Capital portfolio, with an aggregate yield of just 6.7%, all of which we are targeting for rotation. With this, we believe there is more value to extract from the acquisition going forward.”
One of the material remaining legacy ACAS investments is Alcami Holdings, LLC, a leading contract development and manufacturing organization that offers solutions tailored to small and mid-sized pharmaceutical and biotechnology companies (www.alcaminow.com). As of December 31, 2017, ARCC’s aggregate investment in Alcami was $442.3 million (versus a cost basis of $275.4 million) – composed of debt investments of $289.2 million and equity investments valued at $153.1 million (with a $0 cost basis).
Reduced Leverage Ratio
The acquisition of American Capital resulted in a reduction of ARCC’s leverage ratio – debt (net of cash)/equity from 0.73x at December 31, 2016 to 0.64x as of March 31, 2017 (end of 1st accounting period post acquisition). By December 31, 2017, the net leverage ratio had increased slightly to 0.66x. This reduction of ARCC’s leverage from previously higher levels contributed to a reduction of ARCC’s core earnings per share during the early quarters in 2017 – and provides upside to shareholders as ARCC increases its leverage to its more historic higher levels.
In its March 2018 Investor Presentation, ARCC states that as part of its prudent balance sheet management, one of its goals is to “target and maintain leverage of 0.65x to 0.75x, well below regulatory requirements.”
Resolution Of Legacy SSLP
Another significant event for ARCC in 2017 was its resolution of its legacy Senior Secured Loan Program (“SSLP”) joint venture program with GE Capital that started in 2009. ARCC was the innovator of this structure which allows it to acquire a leveraged investment in a diversified pool of loans to non-investment grade borrowers that are generally lower yielding/higher quality than its general portfolio. During the lifetime of the SSLP, the SSLP committed more than $20 billion in senior secured loans, and over the life of its investment in the SSLP, ARCC generated a gross IRR of 20%.
However, when GE Capital exited the leveraged loan business in 2015, it started to negatively impact the longer-term efficiency of the SSLP for ARCC. On July 26, 2017, ARCC effectively unwound the SSLP by buying the loans out of the SSLP and having the certificates paid off. Prior to the termination of the program, due to the run off of the SSLP portfolio ARCC’s $1.5 billion investment in the SSLP subordinated certificates yielded only 5.75%.
The loans acquired by ARCC from the SSLP yielded 7.1% – so there was a net immediate pick up in yield on ARCC’s investment of approximately 1.4% (7.1% yield on loans acquired minus the 5.7% yield on the SSLP certificates) that started to accrue in the 3rd quarter and the full effect would have been picked up fully in the 4th quarter. ARCC will also be able to enhance the yield of this assets over time by rotating them into higher yielding assets.
Expansion Of SDLP And Use Of 30% Basket
More significant than the immediate pick-up in yield is that the termination of the SSLP frees up ARCC’s 30% basket which gives ARCC the ability to invest over time in similar higher yielding structured and/or strategic investments.
Note that the “30% basket” refers to the up to 30% of total assets that a BDC may invest in “non-qualified assets” for purposes of the regulations governing BDCs. In general, pursuant to the ’40 Act, a BDC must have at least 70% of its total assets in “qualified assets” such as privately issued securities from issuers that are “eligible portfolio companies.” The 30% basket has been used by a number of BDCs to make more structured investments like the ARCC investments in SSLP and SDLP certificates that might not be considered as qualified assets.
ARCC announced simultaneously with its 4th quarter results that it had expanded the capacity of its Senior Direct Lending Program (“SDLP”) with Varagon Capital, AIG and another unnamed global insurance company to approximately $6.4 billion from $2.9 billion – with ARCC’s committed capital to the program increasing from $590 million to $1.5 billion in the form of subordinated certificates. In response to a question in the 4th quarter earnings call it was suggested that the additional capacity in the SDLP could be invested in less than a year.
As of December 31, 2017, ARCC’s investment in SDLP subordinated certificates yielded 14.5% (ARCC also earns some related fee income as the SDLP makes loan commitments). Assuming similar yields on incremental investments in subordinated certificates, this represents an approximate 5% pick-up in yield on ARCC’s general portfolio yield – (conservative estimate since would actually be used to replace ARCC’s lower yielding assets and/or funded with incremental debt).
Assuming the full incremental $900 million is invested by ARCC in the program – this conservatively would represent approximately $45 million of incremental income – which after incorporation of Ares’ 20% income based fee – would be approximately $36 million – or approximately $0.09 per share on an annualized basis.
Even after fully utilizing this expansion of the SDLP, ARCC would have significant additional capacity in its 30% basket that permits ARCC to invest in additional similar high yielding assets that will generate incremental core earnings.
ARCC Portfolio Yields Increasing
The results of ARCC’s portfolio optimization and increases in interest rates during 2017 are evident when looking at the average yields on ARCC’s portfolio quarter by quarter.
ARCC’s portfolio yield increased by approximately 0.4% from March 31, 2017 (end of 1st accounting period post acquisition) to December 31, 2017. Given that 81% of ARCC’s portfolio is floating rate, further increases in ARCC’s portfolio yield are expected (1) as ARCC completes additional portfolio rotations from low to higher yielding assets (including the SDLP mentioned above) and (2) general increases in interest rates.
ARCC’s Chief Financial Officer Penni Roll said in the 4th quarter earnings call that ARCC’s portfolio yield increased in the 4th quarter as a result of increases in LIBOR. This impact is a slight lag from the Fed’s June 2017 rate increase. The Fed’s most recent increase in the fed funds target rate was in mid-December – so the impact on ARCC’s portfolio yields and interest income would not have been material as of December 31, 2017. It would be expected that the effects of this increase will start to show in the 1st quarter of 2018.
Additional actual and anticipated Fed increases this year will work their way through the interest rate markets and will increase ARCC’s portfolio yields as rates get reset on ARCC’s assets at higher levels. It is interesting to note that 3-month LIBOR has increased from 1.70% at December 31, 2017 to 2.03% as of March 7, 2018 in anticipation of future Fed increases.
ARCC’s Attractive Liability Costs And Structure
Since 86% of ARCC’s liabilities are fixed rate, ARCC’s interest expense will not increase significantly as interest rates rise. In fact, despite the rise in interest rates during 2017, ARCC’s liability cost declined slightly during the year – to 4.1% at December 31, 2017 versus 4.2% at December 31, 2016.
ARCC has been unique among BDCs in that it has been able to consistently issue sizeable amounts of fixed rate unsecured term notes in the institutional markets at attractive rates/spreads. As examples, in August 2017 ARCC issued $750 million of 3.50% notes due February 2023 (5.5 yrs), and in January 2018 ARCC issued $600 million of 4.25% notes due March 2025 (7 yrs).
ARCC Net Income Sensitivity To Rising Interest Rates
ARCC has an asset sensitive balance sheet meaning that ARCC’s net income will increase as interest rates increase since ARCC has $11.8 billion of investments (of which 81% are floating rate) and only $4.9 billion of debt (of which only 14% is floating rate). ARCC includes a chart showing the impact of changes in interest rates on its net income in its Form 10-K (see page 89) and also included a relevant chart in its March Investor Presentation (included below).
For a 100 basis point increase in interest rates, ARCC estimates that its net income will increase by $89 million before incorporating the cost of income based fees. After including the effect of such income based fee, net income would increase by $71 million – equivalent to incremental earning per share of approximately $0.17 per share.
- Using ARCC’s 2017 GAAP EPS of $1.57 as a baseline EPS, a 100 basis point increase in interest rates would increase GAAP EPS to $1.74 – an 11% increase.
Given that the relationship between ARCC’s assets and liabilities is pretty linear, for a single 0.25% increase in interest rates, the annualized EPS impact would be approximately $0.04 per share. For each additional 0.25% increase in rates would provide another annualized EPS bump of $0.04, and so on…
Expectations For 2018 And 2019 Core Earnings
Core earnings are important since ARCC has indicated that its goal is to have core earnings above its regular dividend level. In the 4th quarter of 2017 Core EPS and the declared dividend are both $0.38 per share. Increased levels of core earnings will allow ARCC to increase its dividend level over time based on its increased earnings power.
As seen in the table at the beginning of this article, ARCC’s Core EPS declined in the 1st quarter of 2017 to $0.32 per share from $0.42 per share in the 4th quarter of 2016 as a result of lower portfolio yields and reduced balance sheet leverage. Since then, ARCC’s Core EPS has steadily increased quarter to quarter to almost 2016 levels – with Core EPS of $0.38 in the 4th quarter of 2017.
The above presents my projection of ARCC’s Core EPS for 2018 and 2019 based upon the above described assumptions:
- 2018 Core EPS is expected to be approximately $1.71 per share, and
- 2019 Core EPS is expected to be approximately $1.82 per share.
These are based upon a base-line Core EPS of $1.52 per share (equal to an annualized 4th quarter 2017 Core EPS) – which is conservative since ARCC’s 2016 Core EPS was $1.61 per share. The Table shows the assumptions made regarding (1) increases in interest rates, (2) rotation of remaining low-yielding ACAS investments into higher-yielding investments, and (3) ARCC’s incremental investment in the newly expanded SDLP program.
ARCC’s $300 Million Stock Repurchase Program
ARCC recently announced that it extended its previously existing $300 million stock repurchase program through February 28, 2019. ARCC has not been a significant buyer of its own stock through its stock repurchase program in the past few years – having acquired approximately 0.5 million shares at an average purchase price of $13.92 per share (for an aggregate of approximately $7.0 million) during the period from September 2015 to December 31, 2017, with no shares being repurchased during 2017.
When asked about the potential use of its repurchase program in the 4th quarter 2017 earnings conference call, Kipp DeVeer commented:
“… We think that it’s incredibly important to have an active buyback program in place at all times – and we just refreshed it and it’s kind of constantly being evaluated. I would tell you that with the stock in the high 15’s and book value at $16.65, I can’t make the math super, super compelling around major buybacks, but it’s a good tool that’s meant to be there to be used – and to the extent we see opportunities, we’ll use it.”
With $12.3 billion in assets and an equity market capitalization of $6.8 billion, ARCC has significant competitive advantages – including a selective direct loan origination business, asset diversification (over 300 borrowers as of December 31, 2017), favorable liability structure and debt market access not available to most BDCs.
2017 was a significant year for ARCC as ARCC closed its acquisition of ACAS on January 3, 2017, and spent the year continuing to rotate portions of the acquired portfolio into higher-yielding assets. ARCC also resolved the challenges it faced from the slow wind-down of a previously very successful investment program that it had originally established with GE Capital in 2009. ARCC terminated the program in July 2017 and since expanded a similar program with Varagon, AIG and another global insurance company.
As a result its proactive investment activity and increasing interest rates, the yield on ARCC’s investment portfolio has been steadily increasing. At the same time, ARCC’s liability cost actually declined slightly in 2017 – a reflection of ARCC’s debt management strategy.
ARCC has an asset sensitive balance sheet meaning that ARCC’s net income will increase as interest rates increase since ARCC has $11.8 billion of investments (of which 81% are floating rate) and only $4.9 billion of debt (of which only 14% is floating rate). For a 100 basis point increase in interest rates, ARCC estimates that its earnings per share will increase by approximately $0.17 per share – an increase of 11% over ARCC’s 2017 GAAP EPS of $1.57.
As described above, ARCC’s execution of its game plan to expand its core earnings produced tangible results during 2017. My above analysis suggests that Core EPS are projected to increase from $1.39 per share in 2017 ($1.52 per share based upon annualized 4th quarter 2017), to $1.71 per share in 2018, and $1.82 per share in 2019. Should ARCC achieve these projected levels of core earnings, it would be expected that ARCC would increase its dividend level over time.
These projections suggest that ARCC is undervalued at its current trading level of approximately 95% of its NAV – that produces an annualized dividend yield of 9.6%. Given the strength of ARCC’s business model, attractive portfolio, favorable liability structure, successful track record of building and maintaining value throughout different parts of credit cycles, and expected benefit from rising interest rates, ARCC should easily trade at a 10% premium to its NAV of $16.65 – which would imply a share price of approximately $18.32 – which would provide an annualized dividend yield 8.30% (at its current annualized dividend rate of $1.52 per share).
Disclosure: I am/we are long ARCC.
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.