It wasn’t until the Great Recession that the BDC industry started to flourish, nearly thirty years after President Carter signed the Small Business Development Center Act “SBDC” in 1980, which laid the sector’s foundations, including tax exceptions and distribution requirements. Three-quarters of all functional BDCs on the market today went public after 2007. Why the delay? Some would say a search for yield.
In my opinion, changes in big banks’ lending patterns, initially to clean their balance sheets, and then compulsory regulatory mandates of the Dodd-Frank Act, limited capital access for Small and Medium Enterprises “SME.” This, in turn, created a market gap, which BDCs filled. If interest rates were the primary factor, BDCs would have been popular in the 2000s, after the dot-com bubble burst and interest fell. In any case, the industry’s evolution started by an external catalyst/s rather than an endogenous growth from forces internal to the SME industry. Whether a search for yield or tighter regulations, these catalysts were essential to compensate for BDCs’ inherent liquidity limitations, which put them in a disadvantaged position than other organizational structures.
BDCs’ distribution requirements have been a blessing and a curse, attracting capital but holding management hostage to investors’ expectations of stable dividends. Loan defaults are inevitable, and most BDCs prefer to borrow or issue new shares to compensate for lost revenue instead of messing with shareholders’ much-appreciated distributions. This is why most BDCs record deflating NAV per share in the long term, intermitted by periodic fresh-capital revenue boosts before defaults catch up again. In finance, longer maturities are always coupled with higher coupons, compensating for growing uncertainties as time passes, including changes in the issuers’ competitive environment.
The limited track record of BDCs and their continued reliance on debt and equity capital are red flags for passive investors. There is no room for complacency in the sector, and the false sense of security from dividends makes the industry more dangerous. This is a feast or famine kingdom, and investors will either make money or lose it. It all depends on a BDC’s success in enhancing the value of its portfolio and playing the game how it was meant to be when the 96th Congress of the United States created the sector.
The act explicitly requires management to provide management advice for their portfolio companies. Capital appreciation and active trading of portfolio companies are the only way to compensate for lost income from defaults unless management is willing to adjust distributions with default write-offs.
Ares Capital (ARCC) is a rare breed in the BDC sector, with a solid long-term record extending to 2004. Its NAV per share did fluctuate across the years. Still, it always rebounded, as management found ways to compensate for loan defaults and bankruptcies, primarily through capital-gain realizations, mirroring its robust origination platform and excellent management.
Although BDCs can invest in either the debt or equity of non-listed SMEs, most choose a fixed-income portfolio with a smaller equity allocation. ARCC’s portfolio consists of
- 10% common equity
- 83% debt securities,
- 7% preferred equity.
Thus, interest income represents a significant portion of ARCC revenue, rendering it susceptible to changes in interest rates. So the question is, how will rising interest affect the company? The answer is trickier than many think, so let us lay down more detailed facts first:
- 67% of ARCC portfolio is tied to a floating-rate debt investment
- 16.6% represent debt securities with a fixed rate covenant
- 17% are non-interest-paying securities such as common and preferred stock
- 90% of the floating rate debt investments contain LIBOR floor covenants, with a weighted average of 1%
What does that mean in terms of rising interest rates? Well, it depends on the asset class and the pace and magnitude of the Fed’s policy shift.
Rising interest rates will not directly impact the fair values of common and preferred equity because ARCC uses EBITDA market multiples to estimate the value of these holdings. This applies to 17% of the portfolio and touches on a unique phenomenon we see in the market today. Many BDC stocks trade on premiums to NAV, supported by strong SME sector activity, pushing valuation higher, brushing fears over higher discount rates.
Another 61% of the portfolio is tied to a LIBOR above 1% on a weighted average basis. The current LIBOR stands at 0.26% last time I checked. It will take all three expected 0.25% hike increments for this part of the portfolio to show the slightest response to rising interest rates.
I expect the 16.6% of debt instruments with fixed-rate coupons to depreciation in value. Bond prices have an inverse correlation with rates. This finance principle mirrors the opportunity cost of investing in new, higher-yielding securities instead of debt priced in periods of rising interest rates.
Finally, the remaining 5.4% or so debt securities currently with LIBOR floors at or below current rates will create an immediate revenue tailwind as interest rates rise.
While past performance isn’t indicative of future results, ARCC’s record at least shows management’s ability to navigate through BDCs’ regulatory mandates, including distribution and debt limits. Its association with Ares Management (ARES) allows access to a robust origination platform. ARCC’s moderate leverage, asset quality, and performance are mirrored in Moody’s investment-grade rating, making it one of the few BDCs with such designation.
Like many BDCs, ARCC maintained a relatively flat dividend over the past decade, realizing the importance of distribution sustainability among its shareholders. What sets it apart is its success in keeping dividends while maintaining NAV and leverage.
Yesterday, the company announced it was issuing 10 million shares, translating to $220 million in fresh capital. This comes on top of the $500 million 2.875% notes. Together, these two capital raises represent 4.2% of AUM. However, one should note that two of ARCC’s existing debts mature this year; $386 million convertible notes and $600 million unsecured notes. This means that ARCC doesn’t necessarily plan to expand its portfolio but perhaps is refinancing its debt. In any case, the rate it locked on its unsecured notes is reasonable, and shares are at an all-time high, trading above NAV value. Thus, these capital-raises bring value to ARCC’s shareholders from a financial perspective.
Most of ARCC debt have a fixed rate covenant, protecting it from rising interest rates. Below is a table showing all ARCC’s debt tranches:
|Debt||Amount (millions $)||Interest|
|Revolving Credit Facility||$874||L + 1.75%|
|Revolving Funding Facility||$763||L + 2.00%|
|2022 Convertible Notes||$386||3.750%|
|2024 Convertible Notes||$394||4.625%|
|March 2025 Notes||$596||4.250%|
|July 2025 Notes||$1,261||3.250%|
|January 2026 Notes||$1,142||3.875%|
|July 2026 Notes||$988||2.150%|
Source: Table created by the author. Data compiled from ARCC quarterly reports.
Last year, four BDCs went public, the most in half a decade, mirroring a strong private equity market activity fuelled by a renewed interest in alternative assets. ARCC is one of the best BDCs on the market today, with a long-term performance record, including dividend, NAV, and leverage stability. This is not an easy task, and investors shouldn’t take this for granted.
The company’s association with ARES, its external advisor, opens the door for a tried and tested origination platform. Its asset quality helped it become one of the few BDCs with an investment-grade rating from Moody’s. If you are worried about market volatility, it makes sense adding dividend-paying stocks to your holdings, and I doubt you’ll find a better 7.7% dividend-paying stock than ARCC.