Ares Capital: Book Value Bargain

05/14/2015 8:00 am EST


Adrian Day

Chairman and CEO, Adrian Day Asset Management

The market is giving us an opportunity to buy one of the largest and highest quality of the business development companies (BDCs); right now, after a sharp drop in the stock, the BDC is trading at a discount to the sector, asserts Adrian Day, editor of The Global Analyst.

Ares Capital (ARCC) has exhibited strong operating performance, with a stable credit rating for its portfolio companies. As with many BDCs, it has been experiencing a fair amount of early pay-offs on loans.

That, together with a program of selling its lower-yielding investments, has seen the cash balances at Ares increase. With net debt at 0.63x and available credit of $2.3 billion, it has one of the strongest balance sheets.

Although earnings dipped to 37 cents in the latest quarter-that's one-penny shy of the dividend payout-the first quarter is often softer than later quarters. And the selling of loans has led to realized gains of 9 cents in the quarter, giving the company sufficient dividend coverage.

The company has one major problem, but it's temporary. What's the problem? Ares has a partnership with GE Capital and General Electric (GE) has announced it is selling or exiting the lending business.

Although GE has been a major player in the middle-market space, its Senior Secured Loan Program with Ares is the largest in the space (with $9.3 billion under management) and has been very profitable to Ares, providing leveraged returns.

GE contributes 80% to loans, Ares 20%, while the returns are split to Ares' benefit; it has been earning a 13.5% return.

GE cannot sell the underlying assets without Ares's approval. The most risky scenarios would be that GE cannot find a buyer-unlikely-and the program would wind down as loans matured. Or the new buyer would want to renegotiate the deal with Ares, at least on new loans.

Meanwhile, Ares is in discussions with several parties to buy GE's stake. It is the uncertainty-which Ares fully acknowledges-that has shaken the market, with the stock down a dollar in the last four days.

Longer-term, GE's exit-which Ares calls "a seismic shift" in middle-market lending-could be beneficial to the company.

With its large lending platform and available credit, Ares is well positioned to fill some of the gap left by GE. In addition, the exit of such a large player could lead to better pricing on loans, which has been very competitive.

With a quality portfolio, large lending platform, and strong balance sheet, it is anomalous that the stock is trading at a discount to its peers, trading below book value, and yielding 9.4%. Take advantage of that anomaly. Ares Capital is a buy.

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