Ares Capital: Investment Attractiveness Increased Despite Share Price Run Up (ARCC)

Late December last year, I issued an article comparing the largest BDC – Ares Capital (NASDAQ:ARCC) – with the second largest one, FS KKR Capital (FSK). While I was bullish on both BDCs, I preferred allocating slightly more in FSK due to the following reasons:

• FSK traded at a discount to NAV, while ARCC had an embedded premium.
• FSK’s share price had been under the pressure for quite some time due to a notable build-up of non-accruals, which according to the Management was set to change.
• FSK’s yield was several hundreds of basis points above that of ARCC.

In the meantime, the fact that ARCC had a premium and thus lower yield was, in my opinion, fully justified by its robust portfolio (consisting of diversified and high-quality names) and fortress balance sheet.

It was just that on a tactical basis, it made more sense to allocate a bit more in FSK to capture potential returns from the recovery that would materialize as the interest rates drop (minimizing the risk of non-accruals) and the portfolio improves.

However, on a YTD basis, ARCC has clearly outperformed FSK, mostly due to a subpar earnings report by FSK. In the chart, we can actually notice that up until the earnings day, FSK was performing above ARCC.

With that being said, while about two months I issued a follow-up article on FSK arguing how the BDC’s prospects are still there (and since then, FSK has generated alpha of ~7%), now it seems the right moment to provide an additional flavor on ARCC and how I see ARCC performing going forward.

Before we do that, let me highlight the most important structural elements, which have emerged since the publication of my article on ARCC in December 2023:

• The consensus for the number of interest rate cuts in 2024 has gone down from 6 to just 2, and the overall scenario of higher for longer has clearly strengthened.
• There are some early signs of a synchronized increase in non-accruals across the BDC space.
• The M&A and capital markets activity has not yet picked up and as the interest rate volatility has increased, it seems highly unlikely that 2024 will be favorable for the overall transaction activity.
• The BDC index – the VanEck BDC Income ETF (NYSEARCA:BIZD) – has continued to go up, registering ~6% in total returns on a YTD basis.

So, what these aforementioned dynamics tell is that BDCs have become a bit more expensive mostly due to the strengthening of higher for longer scenario, even though the risk of non-accrual build-up has also ticked higher and there is no strong tailwinds supporting the growth in AUM.

Here, we have to understand that growing non-accruals is only logical as during 2023 we had extremely minimal corporate bankruptcy levels and the businesses, which have started to roll over their previously issued fixed rate debt when the interest rates were low have been increasingly facing challenges on their ability to service the ballooning interest expense.

Similarly, the fact the M&A and capital markets are shallow introduces a tougher environment for BDCs to not only grow, but also maintain their existing AUM. For BDCs, it is vital to find fresh deals in order to at least compensate for the organic paydowns of their investments. Otherwise, if the total asset figure shrinks, the base from which BDC can capture spreads between investment yield and the cost of capital also becomes smaller, thereby putting a downwards pressure on the underlying NII generation.

In my opinion, the risks that are associated with higher non-accruals and slower portfolio growth (or even portfolio decrease) are very low for ARCC, which makes the BDC a great investment relative to other BDCs out there.

Here are more details why this is the case.

Thesis

When it comes to the portfolio quality and having the defense embedded in the portfolio, ARCC is one of the best in the game. It all starts with the diversification. There are three key levers in terms of the diversification, which we have to take into account that really distinguishes ARCC from the average BDC:

• ARCC is well-diversified at the asset allocation level, where it is not limited to only credit space, but also has branches in private equity, real assets and secondaries that together constitute ~40% of the conventional credit / BDC business size.
• At the industry level is also greatly diversified and, most importantly, into pockets of economy, which are inherently less sensitive to the fluctuations in the economy. For example, ARCC holds less than 2-3% of its portfolio in industries, in which typically leveraged loan transactions dominate (e.g., hotel and gaming, oil & gas, and transportation).
• At the company level, ARCC carries one of the lowest single company concentrations in the BDC sector. As of Q4, 2023, ARCC’s average position size in a single company was 0.2% with the largest investment consuming only ~2% of the portfolio.

Moreover, in the context of ARCC’s defensiveness, investors have to appreciate the conservative investment underwriting strategy that is applied by the Management (on top of the diversification aspect).

The commentary by Kort Schnabel – Co-President – during Raymond James 45th Annual Institutional Investors Conference, captures the story well:

We’re looking for leading market share businesses, companies that have dominant market shares and barriers to those market shares. Nice defensible moats around their market share. High free cash flow generation. We’re running lots of sensitivities on these businesses when we underwrite in all different rate environments and economic environments, making sure that the cash flow is going to be there to service our loan.

The results of this strategy can be nicely observed in the data of the most recent earnings report. Even though the non-accrual position has become a challenge for more and more BDCs, ARCC continues to benefit from its conservative underwriting standards.

For instance, the non-accruals at cost ended the year at 1.3%, which is below the 1.7% at year-end 2022. This is also below ARCC’s 15-year historical average of 3% in non-accruals. Namely, this confirms that ARCC could be easily considered a BDC, which is more defensive than the average BDC out there.

Also, if we look at how ARCC has performed on the net funding front, we can see that despite the fact that it is the largest BDC (which implies sizeable chunks of capital being organically paid down each quarter), the Management has actually registered growth in net fundings for already three quarters in a row.

All of this has happened, while the M&A and capital markets have remained quite inactive.

The key reason why this has been possible for ARCC lies in the combination of its size and the diversification.

When it comes to the size, ARCC has grown so big that it can now participate and compete with traditional banks in really large ticket size transactions. Again, in the Raymond James 45th Annual Institutional Investors Conference, Kort Schnabel provided a great color on this aspect:

Also allows us, by the way, when things slow down a little bit in the M&A environment like we saw in the last 18 months or so, we can then provide capital into that incumbent portfolio. It creates ballast in our origination system. We talked about the scale already. Maybe not too much more to mention there. I guess just, the ability to commit to large transactions allows us to have power in the marketplace over documentation terms, over pricing, right? We’re standing up for north of $500 million, sometimes up to a billion dollars per deal. That gives us a lot of power in the market, and it gives us access to the capital markets.

The aforementioned diversification angle stemming from the various sectors in which ARCC plays also comes in handy in providing a more stable demand for ARCC’s capital.

The bottom line

Against the backdrop of higher for longer and at the same time, increasing risk of corporate distress and a continued inactivity in the M&A and capital markets space, ARCC has become a more enticing investment, especially compared to most other BDCs.

The current premium of ~7% over the underlying NAV seems fully justified and does not damage the attractiveness of ARCC. If we assess the core of ARCC, we will notice that it has the necessary characteristics to safely weather the prevailing / aforementioned headwinds in the BDC sector.

Given the reasons above and the juicy dividend of 9.2%, I remain bullish on Ares Capital.