Ares: Higher Risk for High Yield

04/23/2015 8:00 am EST

Focus: STOCKS

Khoa Nguyen

Investment Analyst, Investing Daily

Business development companies (BDCs) were created because the government wanted to give small and midsize companies an easier way to raise money; because of their higher risk, they pay high yields, explains Khoa Nguyen, editor of Global Income Edge.

To make BDCs more attractive, the government gave them special tax breaks. So BDCs’ taxes are minimized and they’re required to distribute 90% of profits to shareholders.

In this way, they’re set up similarly to real estate investment trusts and master limited partnerships. As with master limited partnerships, those rich distributions are taxed as ordinary income and require filing a Form 1099.

Ares Capital (ARES) lends money and takes equity stakes in companies and serves companies that can’t find capital through other means. These companies aren’t necessarily in financial distress and often have strong growth potential and strong cash flows.

Ares’s investments usually come in the form of senior and junior debt loans, ranging from $5 million to $100 million for medium-sized companies. It has also been known to take equity interests in companies.

About 56% of its portfolio is made up of senior term loans or loans that are paid off first in the case of bankruptcy. About 19% is equity stakes in companies and the remainder is debt that’s secondary to senior debt.

Over the past three years, the company’s dividend has grown at a rate of 3.6% annualized.

It currently has a 12-month payout ratio of 79%, which is healthy and likely means more hikes or special payments in the future. With a generous yield of 8.7% and possible bonus dividends, Ares Capital is a buy up to $21.

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