Will an Ares IPO Hurt Ares Capital Corporation?

Ares Capital Corporation (NASDAQ: ARCC  ) is a premier middle-market financier that has earned its reputation as a good investment manager.

Over its history, Ares Capital has delivered 14% compounded annual returns to shareholders, beating the returns of the S&P 500 index. Great returns come from great underwriting. Ares has consistently posted realized gains from its investments, showing the quality of its underwriting process.

But things are changing at Ares Capital. Its investment manager -- beastly Ares Management -- is going public.

Why it matters
There is always a natural conflict of interest between asset managers and their investors. Ares Management earns fees for managing Ares Capital Corporation, which are partly based on the amount of assets under management.

Thus, Ares Management makes more by growing Ares Capital Corporation. Unfortunately, Ares Capital Corporation shareholders have no such incentive. Ares Capital Corporation shareholders make (or lose) money based on the quality of Ares Management's investment strategy, which has little to do with the size of the portfolio. It's quantity vs. quality.

I don't want you to think I'm making a mountain out of a molehill, here. Ares Management plainly states in its S-1 filing that Ares Capital Corporation generates 46% of its management fee revenue, and that management fee revenue makes up 84% of Ares Management's total fee revenue in 2013.

Said another way, nearly $0.39 of every dollar of fee revenue at Ares Management comes from Ares Capital Corporation. This is despite the fact that Ares Capital makes up only about 15% of Ares Management's assets under management. Dollar for dollar, Ares Capital Corporation is Ares Management's best source for future growth.

A dose of history
Asset managers have historically been privately owned. The belief was that private owners would be better for their clients -- public shareholders would pressure firms to open new, unprofitable funds just to raise new assets to generate new fees. 

That's changed over time. First, the traditional asset managers like T. Rowe Price  (NASDAQ: TROW  ) went public. Then the nontraditional managers, like Apollo Global and Blackstone, followed suit. It's becoming somewhat normal for asset managers to have public owners. 

And though perception has changed, the economics have not. Shareholders of asset managers still favor policies that may not be in the best interest of the company's clientele. Fortunately -- or not -- BDCs can raise new funds easier than any other kind of investment fund with secondary offerings.

Raising funds one share at a time
BDCs grow by issuing new shares to the public. Ares Capital Corporation has routinely sold shares (albeit above its previously reported book value) to raise new funds for investments. In December, for instance, it sold more than 14 million new shares.

When raising capital is as simple as calling up an investment bank, it makes you wonder what will happen if Ares Management faces a weak quarter. If top-line revenue looks weak, why not call in a $200 million secondary offering to juice management fees and keep public shareholders happy?

Beyond that, what will happen to the credit culture if Ares Capital Corporation is forced to find new (potentially lower-quality) investments to put capital to work?

Now, to be fair, I'm taking a very cynical view. Bulls would said Ares Capital has been well managed (it has), and that after the IPO, insiders at Ares Management will own a very significant 70% of the company. If T. Rowe Price is any guide, asset managers can serve public shareholders and investors well (a majority of its funds have continued to beat their peers since IPO).

But there's still the nagging thought left in the back of my mind that a new group of owners will have a stake in growing Ares Capital Corporation. It's something to watch carefully, especially as Ares Management starts reporting earnings each quarter.

A better income option than BDCs?
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.


Read/Post Comments (0) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2901755, ~/Articles/ArticleHandler.aspx, 12/22/2014 2:56:48 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement