It has been a bumpy few months for Business Development Companies (BDCs), companies that lend money to small private businesses which are passed on to investors as high dividend yields. But I like one of the strongest, as well as one of the oldest and largest, Ares Capital Corp. (ARCC), says Adrian Day, editor of Global Analyst.
The concerns are three-fold. First, as the Federal Reserve cuts interest rates, BDC returns will be reduced, given that most BDC loans have floating rates. Second, there is concern about how small businesses will hold up in a weakening economy. Third, and arguably most worrying, are concerns about private credit, following a couple of spectacular credit failures in a market that has experienced tremendous growth in recent years.
Though these concerns are all valid, there are some misunderstandings. Further, the strongest of the BDCs will overcome the problems. Let’s look at the concerns one by one.
Lower interest rates will reduce income, other things being equal. But since many BDCs have floating-rate debt as well, what they lose on one side of the ledger, they gain on the other. And in lending, the spread is most important.
Although a slower economy will make things more difficult for some small businesses, lower rates are likely to help companies in their portfolios. Moreover, in periods of economic weakness, banks pull in their reins. That leaves the strongest small business to go to alternate lenders, such as BDCs.
Private credit is an area of concern, primarily because of how the lenders are valuing their loans. Often one can find wildly different marks from different lenders on the very same loan (in a large syndicated loan, for instance).
However, the better BDCs use independent valuation firms. In the case of Ares, it uses four different valuers on a rotating basis. So, each loan is valued by four different firms at least once a year. This is the gold standard in the industry.
Ares’ portfolio has strong credit ratings, with non-accruals at 1.7% at cost, below the industry average as well as its own historical average. It is also very broadly diversified, with 587 businesses in 27 industries.
Ares has had only four quarterly losses over two decades, with fewer than 20 basis points of average annualized debt losses since inception in 2004. The track record, the diversification, its large spillover income cushion (equivalent to more than the full dividend for two quarters), and its low 1.02x leverage, should enable Ares to maintain its dividend in all but the most extreme circumstances.
That dividend yield was recently more than 9%, making Ares a nice cornerstone in an income portfolio.
Recommended Action: Buy ARCC.
