Ares Capital: A Top BDC Yielding 8.8%

Investors looking for ways to generate income can consider common stock, real estate investment trusts, bond and preferred stocks, and more. One particular type of investment that is appealing for high-yield investors is Business Development Companies, or BDCs. BDCs are closed-end investment companies, wherein they borrow capital and use that to invest in debt and/or equity securities in other companies. The target companies are generally small to mid-sized businesses that aren't publicly traded, and therefore have no access to public capital markets. BDCs fill the financing void for these companies. BDCs use this strategy to generate income, and in some cases, capital gains on equity positions. BDCs are therefore similar to private equity firms in the way they operate. In this article, we'll take a look at a BDC we think has a modest growth outlook, but a very strong current yield: Ares Capital . Business Overview and Recent Events Ares Capital is a Business Development Company that specializes in acquisition, recapitalization, restructurings, investing in mezzanine debt, rescue financing, and buyouts of middle market companies. To a lesser extent, like most BDCs, Ares also has a small portfolio of equity positions. Ares prefers manufacturing, consumer products, health care, and IT service sector targets. Ares operates nationwide and typically invests between $20 million and $200 million in any one particular target, but will go up to $400 million if the conditions are right. Ares was founded in 2004, generates $1.6 billion in annual revenue, and trades with a market capitalization of $7.9 billion. Ares reported fourth quarter and full-year earnings on Feb. 10, with results coming in quite strong. Core earnings per share rose to $0.54 from $0.45 in the year-ago period. Total investment income was $440 million, up from $386 million in the prior year fourth quarter. The company made new investments of $3.1 billion, and a further $800 million in commitments that were as-yet unfunded. Ares invested in 20 new companies, while adding to positions in 38 existing portfolio companies. Net asset value was $17.32 per share at the end of 2020, up slightly from $16.97 at the end of 2019. Ares ended the year with a portfolio value of $15.5 billion. Net investment income for the year came to $1.87 per share, down fractionally from the $1.90 per share in 2019. However, Ares posted $0.39 per share and $0.34 per share, respectively, in net realized losses and net unrealized losses. That meant that net income per share was $1.14 in 2020, down from $1.86 in 2019. Growth Catalysts Like most BDCs, Ares' growth outlook is a bit murky. The company relies upon debt financing at a low rate to then lend to a target company at a higher rate, or to make an equity investment that generally has no yield. Thus, Ares' growth is highly dependent upon the rate at which it can borrow, as well as prevailing lending rates for middle-market companies. It is worth remembering that BDCs are fiercely competitive given their products and services are largely commoditized, so customers have the upper hand in terms of pricing power. Given this, we expect ~2% annual growth in the coming years for Ares. The company relies upon its portfolio companies weathering economic weakness and continuing to service their debt, so credit risk is an ever-present issue. We note Ares made roughly the same profit in 2020 that it did in 2013, which gives investors an idea of the long-term growth prospects of a BDC. This stock really is intended to be an income investment, not a growth vehicle, and our estimates reflect that. Dividend Analysis Ares Capital is on our BDC list due to its very high yield of nearly 9%. Ares' dividend has fluctuated in recent years, moving up or down by a penny per share or two in certain quarters. However, dividends between 2013 and today have been between $1.52 and $1.60 per share on an annualized basis. The current annual payout of $1.60 per share equates to a current yield of 8.8%, which is nearly six times that of the broader market as measured by the S&P 500, so Ares is a serious income vehicle. Given that it is a BDC, Ares' payout ratio is extremely high, as BDCs must distribute substantially all of their income to shareholders. We expect $1.72 in EPS this year, and the current annualized payout is $1.60 per share, so Ares' payout ratio for 2021 is projected to be 93%. Ares has had years where its payout ratio exceeded 100%, so we don't find 93% to be indicative of a dividend that is too high. However, it is worth noting that should a sharp economic downturn occur, Ares may be at risk of falling earnings, which could certainly take the dividend with it. Expected Returns Looking ahead, we see Ares producing total annual returns of 6.8%. We derived this number using expected EPS growth of 1.9% annually, the current yield of 8.8%, and a modest headwind of 3% annually from a valuation we deem as too high. Indeed, Ares trades today at 10.5 times our expected earnings for 2021, but our fair value estimate is 9 times earnings. Should Ares' valuation drift lower over time to meet that fair value estimate, shareholders will see a 3% drag on total returns annually for the next five years. Still, with growth and the valuation roughly offsetting each other, Ares provides a decent total return outlook, and very strong levels of current income. Final Thoughts Depending upon one's specific investment goals, BDCs could certainly be a good option. For investors that was very high levels of current income, but aren't as concerned with income growth, BDCs offer exactly that. Ares is slightly overvalued today, but its dividend looks reasonably safe for a BDC, and its yield is huge. While we don't see a lot of capital appreciation potential with Ares in the coming years, given both its growth outlook and valuation, we do think the company will continue to be able to pay the dividend. For income investors, a nearly 9% yield may just be enough to be attractive.

Ares Capital: A Top BDC Yielding 8.8%

One overlooked type of investment appealing for high-yield investors is Business Development Companies.

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