Business development corporations, also known as BDCs, invest in small and medium-sized businesses, some of which may be struggling. In addition to providing capital, BDCs help businesses grow in their early stages or in a distressed scenario and will provide assistance in regaining their financial balance. BDCs are required to invest at least 70% of their assets in US private or public companies with a market capitalization of less than $250 million. Ares Capital (NASDAQ: ARCC) is one of the largest direct lenders in the United States, providing comprehensive solutions to meet the distinct and underserved financing needs of private, middle-market businesses across a wide range of industries.
ARCC is the largest publicly traded BDC with a portfolio fair value of $19.5 billion. ARCC has 395 companies in its portfolio with a large team of over 150 investment professionals and $79 billion in origination since inception. ARCC has done an excellent job of growing its net asset value (NAV) per share since its inception and its quarterly dividend. We are currently living in a period where inflation is at its highest level since the early 1980s, and there are not many vehicles that can beat the current rate of inflation through income distribution. BDCs play an important role in the financing structure of companies, and I have started to allocate more capital to them on the income side of my portfolio. I believe ARCC is trading at a reasonable valuation and is positioned for long-term success. I am buying shares of this BDC which is yielding 8.61% and intend to reinvest any dividends that flow into my account.
ARES Capital has a strong track record of business growth and shareholder returns
I like diversification and CRAC offers a high level of diversification that I cannot achieve on my own. ARCC has a $19.5 billion portfolio focused on senior secured loans (71%) and has favored equities and other equity investments while having an asset management company. ARCC has spread its portfolio across 23 sectors, with software and services making up 20% of the portfolio and having a handle on everything from insurance services to media and entertainment. ARCC’s largest investment is less than 1.5% of its portfolio, indicating that its portfolio is structured to mitigate against unpredictable events.
The ARCC is managed externally by Management of Ares which has approximately $325 billion in assets under management. Ares Management is a global alternative investment manager that operates an integrated platform spanning credit, private equity, real assets, secondary solutions and strategic initiatives. Ares Management has 790 investment professionals in 30 global offices and is a pioneer in leveraged finance, private credit and secondaries.
BDCs are traditionally income investments, and investors do not seek capital appreciation as a top priority. Since IPO of ARCC over 17 years ago they paid out $27.10 in dividends per share. ARCC went public through an IPO at $15 per share and paid 180.67% of its original value in dividends while offering 30.07% capital appreciation, with the shares sitting at 19 $.51. ARCC has an excellent track record of creating value for its shareholders, but a track record does not necessarily mean that it will be extrapolated in the future. With respect to BDCs, I want to see their net asset value and net investment income (NII) increase over time to establish a continuing trend favorable to shareholders.
Over the past decade, ARCC has grown its net asset value from $16.04 to $19.02. On the income statement side, ARCC generated $1.87 billion in revenue in the last twelve months (TTM), an increase of 150% compared to the $748 million generated in 2012. This drove the profit ARCC’s operating revenue to $1.21 billion, a 140.08% increase from the $708 million generated in 2012. These numbers increased ARCC’s NII to $1.41 billion in the TTM, compared to $508.2 million in 2012.
Ares Capital has an attractive dividend yield and trades at a fair valuation relative to its peers
When evaluating BDCs, I like to look at some of the larger operators including FS KRR Capital Corp (FSK), Apollo Investment (AINV), Goldman Sachs BDC (GSBD), Prospect Capital Corp (PSEC), Owl Rock Capital Corp (ORCC), Barings BDC (BBDC), Golub Capital BDC (GBDC), Sixth Street Specialty Lending (TSLX), Gladstone Capital (GLAD) and Main Street Capital (MAIN) as a peer group. I use three metrics to assess ARCC against the peer group, which include NII multiple to market capitalization, price discount to NAV, and dividend yield. NII is a better metric than EPS to use for a BDC, so NII to market capitalization is a more effective metric than a P/E ratio. That’s why I use this metric to see how cheap BDCs are trading against their NII. I also like to see if there is a steep discount or premium with an assessment of BDC’s price to NAV in addition to looking at yield and dividend coverage.
ARCC is currently trading at an NII to market cap ratio of 6.87x, which is the 4th lowest among its peer group. The average NII to market cap is 8.26x, and there are 3 BDCs in the peer group trading in the double digits, with the BBDC trading at a multiple of 15.20x. Based on this valuation, ARCC appears to be trading at an attractive valuation.
There is a wide price/NAV discount range ranging from -28.77% to 46.12% within the group. ARCC trades at a premium of 2.58% to its net asset value. While there are other BDCs that trade at a deep discount, I think the ARCC is fairly valued, and paying a slight premium to its net asset value is well justified for the quality that the ARCC represents.
ARCC falls just below the 8.99% average on its dividend yield, its current forward yield being 8.61%. Although its yield is just below the midpoint, I don’t think a fully hedged 8.61% dividend yield is anything to sneeze at. There aren’t many investments that generate passive income that has exceeded the rate of inflation, and with ARCC generating $1.4 billion in net investment income, there’s more than enough of income to distribute to outpace the highest inflation rates we have seen in 40 years.
ARCC has a growing dividend which also generates special dividends
2005 was the first year in which a full year of dividends was paid. Since inception, ARCC has increased its quarterly dividend by 45%, from $0.29 to $0.42. Over the years, ARCC has established a long history of covering its dividend with a combination of core earnings and net realized gains. In many cases, when an investor sees a dividend that generates a high single-digit or double-digit forward yield, they are raising a red flag. ARCC is one of the companies where the red flags are non-existent as the big dividend is fully covered and has been for years.
The ARCC rewarded shareholders with special dividends in addition to the quarterly dividend. Since 2013, ARCC has paid 10 exceptional dividends. In the first quarter of 2022, ARCC paid its quarterly dividend of $0.42 per share and surprised its shareholders with an additional $0.03 per share in the form of a special dividend. The ARCC replicated the first quarter 2022 payout and announced that it will pay another special dividend of $0.3 per share in the second quarter of 2022. The ARCC becomes ex-dividend on 6/14/22 and will pay its quarterly dividend of $0.42 and a special dividend of $0.03 on 6/30/22.
When it comes to income investing, it’s hard to complain about ARCC’s dividend. ARCC offers investors over 12 years of growing dividends and has declared 2 quarterly dividend increases since 2019 in addition to paying special dividends. Since ARCC’s IPO, they have paid out $27.10 in dividends over 17 years. The long-term dividend history is spectacular and the short-term characteristics are impressive when it comes to ARCC’s dividend. This is definitely a BDC that income investors will want to consider, as the ARCC is expected to continue these trends for years to come.
There are many BDCs to choose from and some trade at a steep discount to NAV, but many consider the ARCC the gold standard for good reason. ARCC is the largest BDC with a market capitalization of $9.65 billion and generates $1.41 billion in net investment income. ARCC has a portfolio of $19.5 billion and is managed by Ares Management which has $325 billion in assets under management. Since May 2019, ARCC has delivered a 13% increase in basic LTM earnings per share, generated $44 million in cumulative net realized gains on investments, recorded 10.6% growth in net asset value per share and provided 2 quarterly dividend increases. Today, ARCC trades at a cheap valuation of 6.87 times its NII to market cap and is fairly priced to its net asset value while paying a dividend that outpaces inflation. I think ARCC is a great company for income investors to seek out and add to their income generating portfolios.