Next week, American Capital (ACAS), Ares Capital (ARCC 0.24%), and Apollo Investment Corp. (AINV -0.07%) will report earnings and shed more light into what's going on in the middle market.
The biggest banks reported earnings weeks ago. But now it's the small financiers' time to shine.
Party like it's the Fourth of July?
American Capital faces a few headwinds going into earnings on Nov. 5. A core holding, American Capital Asset Management, will likely take a writedown due to performance at its two mortgage REITs, American Capital Agency and American Capital Mortgage.
In the second quarter American Capital Ltd. wrote down its asset manager after weakness in the mREIT sector forced it to revise its growth estimates. Since then, things may have deteriorated further. American Capital Agency announced that it took losses on some of its mortgage-backed securities in the third quarter. When the mREITs take losses, it reduces the company's adjusted shareholders equity, which is the basis for the BDC's asset management fees.
As a portfolio company of American Capital, we don't know exactly what inputs it uses to value its asset manager. Thus, it's impossible to say that American Capital Agency's $733 million in losses on sales of MBSes will result in a certain dollar figure of valuation flux. But with its asset manager making up $981 million of its net asset value, changes in its value will likely overshadow other developments. Its asset manager is one of the biggest contributors to its operating income, after all.
The BDC beasts big payday?
Biggest BDC Ares Capital has been on a roll, posting excellent quarter after quarter. This time around, investors should pay special attention to its credit quality, which has been on a slow decline alongside its asset yields.
In a frothy market, private equity leverage is rising. Just look at this chart from Ares Capital's previous quarterly supplement:
Source: Ares Capital's second quarter earnings presentation
Portfolio company leverage, which is a pretty good proxy for risk, is on the up and up but Ares Capital isn't earning more for taking bigger risks. Ares Capital shareholders, and BDC investors as a whole, should look to its third-quarter earnings for an end to this trend.
On the plus side, Ares Capital has managed to keep defaults low and dividend coverage high. In the past year, Ares Capital has covered roughly three-fourths of its dividend with income from recurring revenue sources like interest and dividends. We'll look for Ares Capital to continue to support its dividend with high-quality, repeatable revenue sources.
Houston, we have liftoff
Apollo Investment Corp. is coming into earnings after a solid first-quarter report that showed improving credit quality for the BDC as a whole. For the first half of the calendar year, the average new credit was levered at four times EBITDA, compared to six times EBITDA in 2010, according to the last conference call.
That's an improvement, certainly.
But there were a few changes in the portfolio that investors have to balance. For one, Apollo Investment has been buying more debt on the secondary markets. Historically, one of Apollo Investment's advantages was its ability to lead its own deals, and earn returns above those on the secondary market. Apollo Investment earned 11.8% yields on direct new origination in the first quarter compared to 9.2% for debt purchased from other middle-market players.
Management stated that they weren't interested in holding their opportunistic, secondary-market purchases to maturity. But for Apollo to exit before maturity, it'd have to find a buyer. To do so profitably, it'd have to sell at a lower yield than it entered. That shouldn't be too much of a problem given Apollo was snapping up high-yielding debt when the rest of the market worried about the Fed's taper.
But stocking away cash in short-term trading-type securities reduces interest income, so this quarter investors will want to see whether or not Apollo has continued to pick up opportunities off other investors' balance sheets.
The Foolish bottom line
As private-equity outsiders, our understanding of a business development company comes through the small snapshot of quarterly earnings. Next week will provide us with more insight into the middle market, who's making money, who's losing it, and whether or not it's time to add to your portfolio.
