Acquisition Opportunity at Ares Capital

07/29/2016 8:00 am EST


Adrian Day

Chairman and CEO, Adrian Day Asset Management

Business Development Companies (BDCs) as group continue to trade at historically wide discounts to net asset value (NAV), around 20% for most, explains Adrian Day, money manager and editor of Global Analyst.

Ares Capital (ARCC) has agreed to buy American Capital (ACAS). As is usual in such circumstances, the stock of the acquiring company declined as the target of the acquisition rose.

We think the merger will allow Ares to unlock more value from American Capital, just as it did when it purchased troubled Allied Capital in 2008. Why have these stocks not responded positively? Several reasons.

First, the merger may not be finalized until year-end, increasing uncertainty. (Regulatory approvals take a long time for Registered Investment Company transactions.)

Second, there is a concern that ACAS may have sold its low-hanging fruit, leaving more troubled assets behind.

Though some easy-to-sell assets may have been first out of the door, I don’t believe that only troubled assets are left. Ares did very extensive due-diligence, and there is no indication that American Capital has more troubled assets than did Allied.

Third, there are concerns that the dividend may not be secure; American Capital does not pay a dividend, so Ares will have to boost the payout to maintain the yield across the combined company.

Given ACAS’s p/e and its discount, it could support a yield of around 8%, I believe.

That, plus Ares’ backlog of undistributed investment income, suggest that the Ares will likely be able to continue its payout once the merger is complete.

We may not see a dividend increasefor a little while, however. The last increase in the regular distribution was back in 2012, though Ares has paid five special dividends since then.

Ares Capital is a strong buy at these levels. It is one of the largest and most conservative of the BDCs. Net income covers the dividend, and the merger will be a positive over time.

We would buy Ares over ACAS right now because the arbitrage opportunity does not appear to be that great, while if the deal were to fall apart for some reason, Ares would recover while ACAS would decline. ARCC is a buy on current weakness.

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By Adrian Day, Editor of Global Analyst

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