Top Picks 2018: Ares Capital (ARCC)

01/05/2018 5:00 am EST

Focus: FINANCIALS

Adrian Day

Chairman and CEO, Adrian Day Asset Management

Ares Capital (ARCC) is a Business Development Company — or BDC — lending money to small and mid-sized companies and, like REITs, distributing essentially all of their net income to shareholders, notes Adrian Day, editor of The Global Analyst.

There is concern that rising interest rates will hurt the sector, but what is important for BDCs is the spread over their cost of capital and the returns they can generate.

Ares has about 90% of its outstanding loans with floating rates, so as the Federal Reserve raises interest rates, their returns also go up. Ares is the largest and one of the most conservative of the BDC sector. 

It also has among the best returns over the years and yet is one of the cheapest right now. There is a reason. One year ago, Ares completed the purchase of American Capital (ACAS), the second largest publicly traded BDC. It was a good acquisition, buying the assets at a discount.

But ACAS had a relatively low-yielding portfolio with many equity positions, so Ares had to add on the share count without the revenue. Over the past year, it has been steadily rolling over ACAS’s low-yielding assets into the more typical high-yielding BDC loan.

The dividend is safe; it was fully covered (and more) by Ares’ net income prior to the merger, and the manager has agreed to waive up to $100 million in fees to support the dividend. 

As Ares digests its massive acquisition, we will see confidence in the dividend return, and eventually a return to steady dividend increases and bonus dividends that we saw before the acquisition. 

I do not think we should expect an increase in the coming year, but equally, I do not expect a dividend cut.  At $15.73, the yield is 9.7%, an unheard of yield for a conservative company in today’s environment. Grab it while you can.

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