A Savage War for Investment Returns

Ares Capital (Nasdaq: ARCC  ) , certainly has an aggressive namesake to live up to; Ares is the Greek god of bloodlust or savage war. Like fellow business development company Apollo Investments (Nasdaq: AINV  ) , Ares is an offshoot of a skilled private equity investment firm (in this case, Ares Management). Ares has been an effective operator since coming public in 2004, repeatedly raising capital from the markets to build its now $1 billion portfolio. This quarter, however, delivered mixed results.

NAV growth remained essentially flat year over year. But the dividend was boosted considerably to $0.40 per share, plus an additional $0.10-per-share special dividend, versus $0.34 per share a year earlier.

Often, BDCs will issue a special dividend at year's end if their taxable income exceeds their dividend income in a given year. These are usually due to realized gains from portfolio investments, and they generally can't be counted on to reoccur year after year. BDCs will also typically carry over some excess taxable income (subject to a 4% tax) from year to year to maintain further dividend stability for the next year.

Among other sticking points, BDC investors often have trouble determining fair valuations for their investments. Currently, fair value is determined by the board of directors and frequently confirmed by independent valuation consultants. However, I've seen many analysts throw their hands up in the air when attempting to value BDCs, mainly because the businesses offer too little information to reverse-engineer the numbers and determine what type of returns can be expected from the investment.

In my opinion, these analysts are focusing on the wrong numbers. Many of the BDC players provide an incredible amount of information about their companies in all other aspects, making for fascinating 10-K and 10-Q reading. The lack of information on fair valuations, and comparable private valuations, means that Foolish investors shouldn't try to reverse-engineer "black-box" type valuations but instead focus on less conventional metrics.

Investors can get a better idea of the company's worth by checking out management's investment prowess, as seen in the company's portfolio return information. Foolish investors can also determine management's expertise through each company's net losses, not to mention the grading system that BDCs employ. The prospects for growth in the NAV and dividend can be evaluated by the relative age and seasoning of a portfolio of investments, since it takes several years for the value in most such investments to be realized, and by the level and focus of the BDC's investment activity.

There's one big challenge looming for Ares and other BDCs aiming for $1 billion-plus portfolios. The company may face more competition for funding from commercial and investment banks like JPMorgan Chase (NYSE: JPM  ) , Merrill Lynch (NYSE: MER  ) , Citigroup (NYSE: C  ) , and Goldman Sachs (NYSE: GS  ) . For most BDCs, this is not a concern, since deal sizes in the $5 million to $50 million range are often too small for the larger banks to worry about. But as Ares and American Capital seek larger transactions in the hundreds of millions, the larger banks may start to pay more attention.

For more BDC coverage at the Fool:

JPMorgan Chase is aMotley Fool Income Investorselection. Discover more dynamic dividend payers with afree 30-day trial subscription.

Fool contributor Stephen Ellis does not own shares in any companies mentioned. You canview the stocks he owns and check out his99th-percentile ranking in Motley FoolCAPS, the Fool's new stock-rating community. The Motley Fool has adisclosure policy.

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