Looking for a high yield income vehicle that will actually benefit for rising interest rates? You should check out the Business Development Corp. industry. Known as BDCs, these firms lend money to privately held companies, which also have co-sponsors, such as VC and hedge funds.
Like some of its peers, Ares Capital Corp. (NASDAQ:ARCC) has the majority of its investments tied to floating rates, and interest rate floors. In ARCC’s case, 87% of its portfolio is in floating rate income producing securities.
ARCC specializes in acquisition, recapitalization, mezzanine debt, restructurings, rescue financing, and leveraged buyout transactions of middle market companies. It also makes growth capital and general refinancing. It prefers to make investments in companies engaged in the basic and growth manufacturing, business services, consumer products, health care products and services, and information technology service sectors.
ARCC is externally managed by Ares Management, which has over $300B in global assets under management, and is active in the credit, private equity, real estate, and strategic initiatives industries.
Traditional banks have been exiting from direct lending to middle market companies over the past several years, which has benefited ARCC and the BDC industry.
ARCC’s holdings consist of 71% in Senior Secured Loans, and are quite diversified, with the largest position size being less than 1.5%, and averaging 0.3%.
First Lien Senior Secured loans comprise 45% of the portfolio, followed by 21% in 2nd Lien Senior Secured loans, and 5% in its Senior Direct Lending segment and in Senior Subordinated Loans. ARCC also holds Preferreds, at 9%; 7% in its Ivy Hill Asset Management segment; and 8% in other equity:
Software & Services remained its top industry exposure, but decreased to 20% in Q1 ’22, vs. 22% in Q4 ’21; followed by Healthcare Services, at 11%. Diversified Financials increased from 7% to 10%, and Commercial & Professional Services, rose 1%, to 10%, in Q1 ’22.
Those 4 industries comprised 51% of ARCC’s portfolio, as of 3/31/22. Management has minimized ARCC’s exposure to certain sub-sectors, having less than 1% exposure than the high yield and leveraged loan industries to Hotel & Gaming, and Transportation; and under 2% exposure to Oil & Gas, and Media & Entertainment.
ARCC’s management shows a lower concentration in its top position, 1.4% vs. a BDC peer average of 4.8%; and its top 10 holdings, which were at 10.9%, vs. a BDC peer average of 25.7%, as of 3/31/22.
ARCC Benefits From Rising Rates
Management provided this chart in ARCC’s Q1 ’22 earnings presentation, which shows that ARCC will benefit from rising rates.
Why? Because its Debt is at a fixed rate, but 87% of its income producing portfolio is at floating rates.
If rates are raised by 100 basis points, ARCC management estimates a 14% rise in Core EPS of $.23. A 200 basis point rise would result in a 26% increase in Core EPS of $0.44. As the Fed just raised its rate 75 basis points, and plans another hike this summer, ARCC should be on its way to higher earnings in the 2nd half of 2022.
If ARCC actually benefits from rising rates, wouldn’t you think that Mr. Market would be showing it some love? Nahhhh, he doesn’t care, out goes the baby with the bathwater!
Although ARCC has outperformed the Financial sector and the S&P 500 so far in 2022, it’s still down nearly -16% year-to-date, and is sitting at just 2.6% above its 52-week low.
Meanwhile, it has lagged the BDC industry so far in 2022 and over the past tumultuous week, but has outperformed its industry, the Financial sector, and the S&P over the past year.
Like certain BDCs, ARCC had a good year in 2021, with total Investment Income, Core EPS, and NAV/Share all up by double digits.
Q1 ’22 saw further growth in total Investment Income, and NII turned around, with a 37.5% increase vs. Q1 ’21, which also resulted in a 24% jump in NII/Share, in spite of 16.5% growth in ARCC’s share count. NAV/Share continued to improve, rising 9% to $19.03 in Q1 ’22.
Management defines Core EPS as “the net increase (decrease) in stockholders’ equity resulting from operations less net realized and unrealized gains and losses, any capital gains incentive fees attributable to such net realized and unrealized gains and losses and any income taxes related to such net realized gains and losses, divided by the basic weighted average shares outstanding for the relevant period.” (ARCC site)
ARCC made new investment commitments of ~$2B, including $349M of new investment commitments to Ivy Hill Asset Management, of which ~$1.6B were funded. New investment commitments included 13 new portfolio companies and 36 existing portfolio companies. As of March 31, 2022, 201 separate private equity sponsors were represented in Ares Capital’s portfolio.
ARCC exited $2.6 billion of investment commitments in Q1 ’22. The weighted average grade of the portfolio at fair value was 3.1, and loans on non-accrual status represented 1.2% of total investments at amortized cost. (ARCC site)
ARCC has a long history of low losses – under 10 basis points on 1st Lien investments, and less than 20 basis points on 2nd Lien and Subordinated loans:
Management raised the quarterly dividend from $.41 to $.42 in Q1 ’22 in February, and also declared 4 quarterly additional $.03 dividends for all 4 quarters of 2022.
At its 6/15/22 $17.95 closing price, ARCC yielded 10.03%, with 5-year dividend growth of 1.38%. It should go ex-dividend next in mid-September.
ARCC’s NII/Share dividend coverage was .91X in Q1 ’22, while its Core EPS coverage factor was .93X. As you can see in this table, ARCC’s coverage factor varies quite a bit from quarter to quarter – its trailing average is 1.2X:
At $17.95, ARCC was selling at a rare 5.63% discount to NAV/share – it normally sells at a premium. That also compares favorably to the BDC industry’s average 2% discount. ARCC also looks cheaper on a Price/NII basis, at 10.32X, vs. 13.4X industry average, and on an EV/EBIT basis.
With its long history, ARCC is one of the biggest BDCs, with an $8B market cap, vs. the industry’s $1.27B average.
Debt & Liquidity
ARCC’s next debt maturity is in 2023, when $750M in unsecured notes come due. 2024 has a higher amount of maturities, at $1.3B, with $403M in convertible secured notes, and $900M in unsecured notes.
Management took advantage of the low coupon rate environment in January 2022 to issue 5-year unsecured notes at “the tightest spread in BDC history”. (ARCC site)
ARCC had $700M in cash, and $5.9B in available borrowing capacity, as of 3/31/22.
ARCC’s debt is rated investment grade by Fitch, Moody’s, and S&P Global:
Profitability & Leverage
ROA, ROE, and EBIT Margin all improved a bit in Q1 ’22, vs. Q4 ’21, but were still below Q4 ’20’s pre-pandemic figures. Debt/NAV leverage was somewhat lower than in Q4 ’21 and Q4 ’20.
ARCC’s Assets/Debt ratio and EBIT/Interest coverage both improved in Q1 ’22:
Analysts’ Upgrades & Price Targets
ARCC received 2 analysts upgrades in late April – JPMorgan raised it from neutral to overweight, with a $22.00 price target, while the Hovde Group raised it from Market Perform to Outperform. It looks like somebody is paying attention to that beneficial rising rate scenario.
Meanwhile, ARCC is 5.5% below analysts’ lowest price target of $19.00, and 20% below the $22.43 average price target.
We rate ARCC a BUY, based upon its rare deeper than average discount to NAV, its sound management, its attractive, well-covered 10% yield, and its oversold technicals.
If you’re interested in other high yield vehicles, we cover them every weekend in our articles.
All tables furnished by Hidden Dividend Stocks Plus, unless otherwise noted.