The completion of the acquisition of American Capital by Ares Capital leads money manager Adrian Day to reappraise an investment in Ares, causing him to ask if investors should buy or continue to hold at this time.
Ares Offers 9% on Top BDC
Ares Capital Corp. (ARCC:NASDAQ, 16.91, 8.99%) is not only by far the largest Business Development Company (BDC), with about $12 billion in investment assets, it is also one of the best and one of the most conservative. It has a strong balance sheet, with sizeable liquidity, and one of the top platforms for new investments. Over the past three years, it has a ROE (NAV growth plus dividend) of 9.7%, almost twice the average BDC, and the growth outlook remains positive, with quarterly earnings on track to grow from last quarter’s 39 cents per share to 43 cents over the next several quarters, according to analysts. Most loans have floating rates, so the company’s income will increase as rates move up.
The acquisition of American Capital Ltd. was by far the largest M&A transaction in the BDC space ever. Given American Capital’s $1 billion in cash (with no debt), following some steady asset sales by that company since the acquisition by Ares was first announced, the transaction is modestly deleveraging for Ares. Most of the payment for American Capital was in cash$10.13 per share plus 0.483 of an Ares shareminimizing the share dilution. American Capital adds just over 100 million new shares to ARCC’s 418 million.
Is the yield safe after American Capital buy?
American Capital’s portfolio was relatively low yielding (about 7.5%) with many equity investments. Although Ares will look to monetize some of these, it won’t happen overnight; American Capital doubtless already sold much of the low-hanging fruit. So the question has been raised whether Ares can continue to pay the current dividend after the American Capital acquisition.
We believe it can. As mentioned, the equity dilution is minimal. In addition, Ares management has waived $100 million in fees over the next 10 quarters. And we expect earnings growth. So we certainly believe Ares can continue with its current dividend payout, even if it has to subsidize the dividend for a quarter or two. The current dividend is 38 cents per share. It has sufficient liquidity, including an expanded line of credit, so will not need to raise any new equity any time soon.
As mentioned, Ares’ stock has moved up, from a level just over $15 for much of the fall, and the yield has just edged below 9%. While lower than it has been for the last couple of years, it is still a very attractive yield and well in-line with the stock’s historical yield.
Low valuation given best returns
Among the major externally managed BDCs, Ares has the highest returns and currently the lowest valuation. After the recent runit was trading under $15.60 less than a month agothe stock is now just above book value. Again, this is higher than it has traded for the last couple of years, but lower than in the 20102014 timeframe. In the immediate term, the stock could continue to move now the acquisition has been completed, given the large short interest. As often happens, arbitragers and others sell an acquiring company’s stock (or even sell short) and buy the target. Once the acquisition is complete, these positions need to be unwound.
Beyond that, for income-oriented investors who do not already own the stock, I would rate this a good time to buy. If you are looking to add to existing positions, I would look for any pullbacks in the sector or broad stock market. But make no mistake: buying a 9% yield from a substantial, conservative, growing company is a solid buy for long-term investors.
Adrian Day, London-born and a graduate of the London School of Economics, heads the money management firm Adrian Day Asset Management, where he manages discretionary accounts in both global and resource areas. Day is also sub-adviser to the EuroPacific Gold Fund (EPGFX). His latest book is “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks.”
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1) Adrian Day: I, or members of my immediate household or family, own shares of the following companies mentioned in this article: Ares Capital. I personally am, or members of my immediate household or family are, paid by the following companies mentioned in this article: None. My company has a financial relationship with the following companies mentioned in this article: None. Funds controlled by Adrian Day Asset Management hold shares of the following companies mentioned in this article: Ares Capital. I determined which companies would be included in this article based on my research and understanding of the sector.
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( Companies Mentioned: ARCC:NASDAQ, )