Ares Capital Corporation

Moat: 2/5

Understandability: 4/5

Balance Sheet Health: 3/5

Ares Capital Corporation (ARCC) is a business development company (BDC) that provides financing solutions to middle-market companies, primarily in the form of debt.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

ARCC, a business development company, acts as a specialized lender, primarily offering debt financing solutions to private middle-market companies. Their performance is intrinsically linked to the credit cycle, economic conditions, and the success of their portfolio of investments. This is especially important, as middle-market companies may be more susceptible to financial risks.

Business Overview

Ares Capital Corporation (ARCC) is a publicly traded business development company (BDC). They operate as a specialty finance firm that primarily lends to middle-market companies. Unlike traditional banks, BDCs like ARCC do not take deposits. Instead, they raise capital through equity and debt offerings to fund their lending activities. ARCC aims to generate income and capital appreciation by lending to and investing in private companies, typically middle-market businesses in the US and to some extent Europe.

Revenue Generation

ARCC’s revenues primarily come from interest earned on their debt investments and also from fees associated with originations.

Their portfolio consists mainly of:

  • Senior secured loans
  • Second lien loans
  • Unsecured debt
  • Preferred and common equity

Unlike traditional lending institutions, BDCs are usually focused on private credit, which typically implies higher yields, but also higher risks.

Industry Landscape

The BDC industry is heavily influenced by a number of factors, including, regulatory changes, interest rates, and overall market sentiment. Key trends are:

  • Increasing competition: As the BDC space grows, there’s more competition among the players, putting pressure on yields and increasing default risk, especially among the smaller companies. This is reflected in the amount of equity that a company needs to maintain to stay afloat if defaults happen.
  • The credit cycle: BDCs have to be nimble and proactive in navigating volatile credit cycles. As a BDC’s loans and revenues are all dependent on its borrowers, changes in their financial standing would directly affect the returns of the BDC.
  • Regulatory scrutiny: Changes in regulations, especially with regards to leverage ratios and accounting practices may have a significant impact on BDCs.

Financials

Let’s take a closer look at the financials of ARCC and give an idea of its performance and stability. It is important to look at the latest quarterly report (Form 10-Q, for the quarter ended September 30, 2024) together with the prior earning calls for relevant information.

Balance Sheet Analysis (as of September 30, 2024)

The most important metrics are:

  • Assets: ARCC’s total assets stand at $27.1 billion, composed of:
    • Cash and cash equivalents: $1.4 billion
    • Net investment at fair value: $13.5 billion, which represents a vast array of investments that form the heart of ARCC’s business. The fair value of some investments are listed in the schedule of investments, and there are a lot of different investment holding types. Note that fair value is not necessarily their market value, but rather their fair value at this point in time. A number that will ultimately vary during the life of these securities. It is also worth noting that many investments are not at their fair value and some are not even marked to market.
    • Other Assets: $12.2 billion
  • Liabilities: Total liabilities is at $14.1 billion, and it mainly consists of:
    • Debt: $12.9 billion
    • Other liabilities: $1.2 billion.

  • Stockholders’ Equity: Stockholders’ equity is at $13 billion, which means that debt/equity is around 1.08, indicating a significant use of leverage.

  • Net Assets: The company lists a total of $10.7 billion in net assets.

As you can see, ARCC is a very leveraged business, meaning that its performance will be greatly affected by any volatility in the economy or the credit cycle.

Income Statement Analysis

For the quarter ended September 30, 2024, ARCC reported:

  • Total investment income : $443 million
  • Net income from investment operations: $231 million, which shows the profits generated from its lending activities.
  • Interest expense: a hefty $235 million shows the cost of debt is significant. - Net realized gains (losses) on investments and foreign currency and other transactions: $-192 million, shows the instability of these kinds of investments. The losses that come from the portfolio are very significant. - Net income available to stock holders $168 million

When comparing Q3 of 2024 with Q3 2023, the net income from investments have improved considerably from $38 million to $168 million. Similarly, the income from net realized gains (losses) on investments have also improved greatly, from a loss of $260 million to a loss of $192 million. The company has been improving its profitability compared to last year, which is good news.

  • Debt: ARCC’s debt obligations are mostly split between fixed rate loans, floating rate loans, and unsecured notes. - The weighted average interest rate for debt for the most recent period is about 6.6% which is up from last year’s rate. The increase will increase the interest payments for the company and is expected to lead to lower profits.

  • Non-GAAP Data: It is important to keep in mind that since ARCC is a BDC, many aspects of its business are presented differently from a normal company.

ARCC’s earnings are highly influenced by interest rates, credit markets, as well as its ability to properly manage its operations and keep costs down.

  • Rising Interest Rates: The company is benefitting from the increases in interest rates as its debt portfolio is repriced at higher rates. However, this can also increase the cost of capital, resulting in increased interest expenses in the coming quarters. Moreover, if these high rates lead to defaults, ARCC will suffer.

  • Credit Quality: It is difficult to assess the credit quality of its loans using solely the numbers provided by the company. The company only provides a general rating of its portfolio at fair value, which may be misleading because this does not represent underlying risk. Additionally, it is unclear how the company has been mitigating its exposures to risk.

  • Dividend Yield: As a BDC, a major factor in an investment thesis on ARCC is its dividend payout. The dividend is reasonably high at 10.9%, and management has always had a clear target of paying the best dividends possible to its shareholders. Although they do not seem to increase the dividends much in the last years, so it remains to be seen how well they are able to maintain their dividends in the future. It is important to note here that although dividend payout is a measure of the success of the company, that dividend payout ratio does not necessarily create value, since its a cash transfer to the investors.
- **Share Repurchase Program:** ARCC has an active share buyback program, which helps to decrease the float and increase the intrinsic value, however, if it uses it while the stock price is too high, value destruction will occur.

Economic Moat Rating

Rating: 2 / 5

Justification: ARCC possesses a narrow economic moat, but it is limited and somewhat vulnerable. Here is why:

  • Scale-Based Cost Advantages While BDCs enjoy scale advantages by accessing a diverse range of clients and raising capital at a lower cost, their larger size does not protect them much from external risk. Any changes to regulation or interest rates would drastically hurt a BDC no matter its size.
  • Switching Costs: Customers may be locked in their existing credit agreements or a lack of access to other providers. However, it is not a moat that has much pricing power, as companies can take their business elsewhere.
  • Intangible Assets: This may exist due to reputations and brand awareness, however, it is not necessarily a moat.

Due to the reasons cited above, ARCC’s moat rating is quite low as the company’s business model is mostly dependent on external factors and also has large competitors. It’s advantage, therefore, is more limited.

Risk Factors & Business Resilience

Several factors could impact ARCC’s moat and business:

  • Economic Downturns: Recessions can impair the profitability of their borrowers and greatly decrease the value of the loans, or cause massive defaults, which will result in reduced interest income and increase loan losses.
  • Increased Competition: More BDCs may offer loans to similar clients, resulting in increased competition and potentially lower returns.

  • Interest Rate Sensitivity: A sudden rise in interest rates can increase the borrowing costs and put financial stress on borrowers, leading to greater default risk. The company’s returns can also be affected because many of its assets have fixed rates.

  • Regulatory Change: Changes in laws or regulations may have a negative impact on ARCC.
  • Geopolitical Events: Unpredictable global events may lead to fluctuations in the market and could greatly affect its portfolio.
  • Credit Risk: As a major lender, defaults from borrowers could easily lower profits. Moreover, since ARCC mainly focuses on lower middle market companies, they may be inherently more risky.
  • Volatility: The company’s results are dependent on the volatility of financial markets as they affect the value of their investments.

While ARCC has a wide customer base in terms of its investments, its resilience to external factors is still unclear. This makes a detailed and continuous review of the company important for a clear investment thesis.

Understandability Rating

Rating: 4 / 5

Justification: The company’s overall business model is relatively simple to understand-it generates profit by lending to smaller companies. However, as the company invests in complex credit instruments and derivatives, and has to use accounting specific to BDCs and financial institutions, understanding the true financial health and value of the company becomes much more complicated.

Balance Sheet Health Rating

Rating: 3 / 5

Justification:

  • ARCC uses leverage extensively, with debt at approximately 1 time equity. This is above average compared to peers and can be risky, especially with volatile interest rates and an upcoming economic recession. The company’s management has stated that it is focused on deleveraging, however, this is an ongoing process.
  • The company maintains a portfolio of assets that are relatively illiquid. This, combined with leverage, could create issues during a financial downturn.
  • The company has a very wide range of asset classes, but it does provide adequate data to analyze the health of these investments as well as the true risks that they encompass.
  • The company’s management is continuously monitoring and making changes to the portfolio to adjust for market volatility.

Although not a high rating, the balance sheet is not necessarily bad, but the high leverage makes the risk of investing in this company higher, as it is more prone to volatility and market downturns.

Remember that this analysis is based on limited information, and I urge you to do your own due diligence before making any investment decision.