Ares Capital Leads the BDC Charge

Shares of Ares Capital (NASDAQ: ARCC  ) moved higher yesterday after posting better than expected results.

Investors are flocking to business development companies -- or BDCs -- in search of high yields. It can be risky. Upstarts don't resort to paying high interest rates for financing through BDCs if they are stable enough to borrow at lower rates through more conventional lenders.

Ares now has investments in 152 companies with a weighted average yield of debt and other income producing securities of 11.3%. Ares claims that its risk profile is improving, but you don't go that far out in chasing yield without taking a few chances along the way.

Ares is no small fry with $6.4 billion in assets. Its paper of choice is senior secured debt investments at 60% of its portfolio. That's followed by subordinated certificates at 21%, senior subordinated debt at 5%, and preferred equity at 4%. That leaves the 10% balance in equity and other securities.

Spreading out its risk across dozens of companies has paid off in the past. A bragging point at Ares is that it has reported net realized gains in eight of the past nine years since going public in 2004. However, investors should also know that they are paying $18.44 per share -- as of yesterday's close -- for a BDC with a net asset value (NAV) of $16.04 a share.

Income chasers will argue that the premium is worth it. They're fine overpaying for assets given the current 8.7% yield they are receiving.

Ares isn't the only BDC trading at a premium to its NAV. Prospect Capital (NASDAQ: PSEC  ) trades at a modest premium to the $10.81 NAV it was sporting when the year began. Fifth Street Finance (NASDAQ: FSC  ) trades at a slightly larger markup to its year-end NAV of $9.88 than Prospect Capital, but even Fifth Street Finance's 8% premium is just a little more than half of the 15% markup that Ares is presently commanding.

Investors know it. They accept it. It's not as if Ares is going to be liquidated tomorrow at NAV.

Heavily traded BDC American Capital (NASDAQ: ACAS  ) actually trades at a healthy discount to its NAV, but it has a unique system in place where it buys back stock instead of paying out a dividend if its shares are trading below NAV. It may be a self-fulfilling prophecy, but it's been doing more repurchasing than cutting distribution checks.

As for Areas, it points out how aggressive central bank policies and investors chasing yields have resulted in plenty of liquidity but also riskier behavior in the credit markets. This may eat into the desirability of the risk-adjusted returns in the near term. Then again, if this also means that the economy is improving -- and the underlying investments of BDCs have greater chances to succeed -- settling for lower yet steadier yields wouldn't be such a bad trade-off. 

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