This is an extract from an earlier article at Systematic Income Premium.
In this post, we discuss the latest quarterly results from the Business Development Company Ares Capital (ARCC). The company delivered a very strong 3% total NAV return over the quarter despite a drop in net income.
ARCC has ample dry powder to use over the remainder of the year, given the recent drop in leverage. This is at the same time banks are likely to reduce their lending to preserve liquidity in light of deposit concerns. The company’s focus on higher-revenue firms makes it a more natural competitor to banks than the average BDC.
Quarter Update
Q1 core net investment income came in at $0.57 or about 10% below its Q3 number, but 36% higher year-on-year.
This quarter-on-quarter drop was due primarily to the seasonality-related fall in fee income. The chart below makes clear that fee income (green bars) tends to be high in the December quarter and fall in Q1.
ARCC kept the dividend at $0.48. Coverage remains very high at 119%, leaving significant room for the Fed to cut rates. ARCC is looking through the currently high short-term rates to a more normalized rate environment in order to avoid having to cut its regular dividend in the future. The company’s spillover or the undistributed taxable income is a hefty $1.19 per share or 2.5x its regular dividend. High dividend coverage and a high spillover should support the dividend over the medium term.
The NAV registered the first increase in four quarters of 0.3%, driven by retained income.
The most notable income-related development for Q1 was the sharp drop in leverage. This fall was driven by a combination of factors.
As a result, net new investments were low relative to the run-rate of the last couple of years.
The second reason for the sharp drop in leverage was the very large amount of new share issuance over the quarter. Specifically, the company issued 25.3 m of new shares (close to 5% of outstanding shares at the end of Q4) for total net proceeds of $477m, divided roughly in half between a public offering earlier in the year and at-the-market issuance. New shares were issued at a premium to the Q1 NAV, resulting in NAV accretion.
The drop in leverage itself was not particularly surprising. As we highlighted in the Q4 update, the company was operating above its target leverage range for a number of quarters.
The capital inflow largely went to repay the maturing $750m 3.5% bonds, with the rest going to reduce one of the credit facilities. The effect of this will be a slight increase in the weighted-average cost of debt, given the 3.5% interest rate was almost 1% below the company’s cost of debt. That said, ARCC’s cost of debt remains one of the very lowest in the sector, giving it a continued competitive advantage. Bond maturities over the next two years are above the weighted-average interest rate on its unsecured debt, which should slightly reduce the overall cost of debt unless short-term rates continue to rise.
Management has guided that lending spreads remain around 1%, near their early 2022 levels. The continued turnover of BDC portfolios at higher spreads is a source of rising net income. Management indicated that roughly around 20% of growth in net income is due to the increase in spreads. This also suggests that net income could continue to push higher, though at a slower pace than over 2022, even as base rates stabilize.
ARCC remains one of the best-performing BDCs in the sector, showing significant outperformance over various horizons.
Its performance is particularly notable for its consistency. The chart below shows that the company outperformed the median BDC in our coverage for all, but one quarter in the last five years (0.50 stands for median sector performance in that quarter).
ARCC remains an attractive hold in the sector given its strong and consistent historic return and attractive valuation.
We hold ARCC in two of our Income Portfolios where we rotated to ARCC (orange line) from OCSL (blue line) in early January which has worked well.
ARCC has a number of appealing features. Its continued share issuance means the price remains relatively low for its historic performance. The recent drop in leverage also gives the company significant dry powder to use over the rest of the year, particularly as banks are likely to step away somewhat. ARCC is a more direct competitor of banks, given its above-middle-market focus.
Finally, the company has managed well over previous recessions, with the NAV rising to the pre-recessionary high in fairly short order.
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