Last week, Ares Capital Corporation (NASDAQ: ARCC ) took to the stage for its annual presentation to investors. A range of executives spoke about the business and its future outlook in a conference lasting more than four hours.
Luckily for you, I did the watching and listening so you don't have to. Here are the seven charts I found most important for Ares Capital shareholders:
1. The downfall of competitors
Few lenders have any real, durable advantage over the competition. So it's important to keep tabs on what the competition is doing. While business development companies are chugging along and making new loans, traditional banks are focused on regulatory codes. More specifically, Ares notes that Basel III rules are distracting banks from leveraged loans -- the core business for BDCs. Banks are deleveraging their balance sheets and turning to less profitable corners of the market, including fee-based, consumer-level services.
2. Non-banks are stealing share
Business development companies and private equity groups make up the majority of leveraged loan lending. In 1994, domestic and foreign banks controlled 70% of leverage finance deals. In 2012, their market share fell to less than 15% of total lending volume.
3. Even the biggest BDC has room to grow
Ares Capital is the largest BDC on the public markets, but it's still a very small operator. The company estimates that middle-market lending totaled $240 billion in 2012. Ares originated only $3.2 billion in new loans in 2012, giving it a market share of less than 2%.
4. Sticking around pays off
In a fragmented market, relationships are everything. Ares reports that over the past five years, more than one-third of its origination volume came from existing portfolio companies. In 2012, that ratio hit 50%, as its customers went back to Ares to renegotiate terms as interest rates dropped through the year.
5. Active management works for the money
Ares stressed the importance of active management and insight into the middle-market business. History shows that its investment teams are willing to step out of riskier markets when the risk-reward opportunities no longer appear favorable. In the leveraged buyout boom of 2006-2007, Ares tightened its underwriting standards to invest in lower-risk, lower-yielding financings. But following the 2008 financial crisis, Ares was back in business, using its liquidity to bolster its high-yield subordinated debt investments.
It's important for investors to recognize that 2008's subordinated debt likely had the credit quality that 2006 and 2007's senior issuances had. When leveraged loans explode, lending standards weaken. When they contract, lending standards tighten. Taking advantage of a cycle is how active management can add value to shareholders by finding mispriced risk.
6. Quality underwriting is everything
Ares Capital is heavily focused on their underwriting quality. The company originates most of its own deal flow and takes up to six months from initial interest to investment closing. Their process is paying off, as default rates have come in lower than the high-yield index in every year since 2007. Excluding loans acquired from Allied Capital, only once in the last six years (2008) have its portfolio default rates topped the leveraged loan index.
7. Ares banks on the balance sheet
BDC executives make frequent references to the "right side" of the balance sheet -- liabilities. Ares Capital has managed to borrow a majority of its capital at fixed rates, while making new investments on a floating-rate schedule. The company's interest rate sensitivity analysis shows that a 200 basis point change (2.00%) in LIBOR rates would be accretive to earnings. Past that, the sky's the limit. It's worth noting that Ares Capital consistently raises debt financing at rates lower than any of its competitors at any duration.
The Foolish bottom line
Ares Capital is the benchmark by which all other BDCs are measured. As one of the longest operating public BDCs, and the biggest BDC by market cap, Ares Capital is a barometer for the health of the middle-market lender. Its presentations – many of which go ignored by investors – provide a treasure trove of information that investors should carefully examine, as it may lead to your next great stock pick.
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