Ares Capital Corp. (NASDAQ:ARCC) proved to be a capable risk manager through the 2008 financial crisis. The investment company points out that prior to the crisis it was divesting riskier assets and adding to its pile of safer, first-lien securities. That strategy played into its favor when the buyout boom of the early 2000s turned into the buyout bust of the late 2000s.
But even Ares Capital might admit that its post-crisis success wasn't purely its own doing. A 2009 deal inked with GE Capital to take over a joint venture quickly made it one of the most important players in private finance, securing the company higher returns in some of the most lucrative deals.
A unmatched duo
When Ares Capital acquired its share of the Senior Secured Loan Fund in 2009, it was relatively small fry. Ares Capital paid just $165 million for its share of the joint venture. But the fund's size says little about its importance to Ares Capital or its industry.
The deal put Ares Capital in a partnership with the behemoth GE Capital, which was the largest player in buyout financing. By some estimates, it controlled 17% of the lending market to private equity firms. Together, GE and Ares would present loans to the program, and when approved by both companies, the joint venture would fund the deal.
The Senior Secured Loan Fund (which was later named the Senior Secured Loan Program) was enormously profitable for Ares. By adding leverage to a loan portfolio that yielded just 6.7%, Ares Capital earned 13.5% annualized on its equity investment last quarter. GE Capital's low funding costs allowed it to provide the inexpensive leverage necessary to make the fund work.
But things change, and partnerships break up. As GE sought to exit the banking industry -- and thus the regulatory burden that comes with being a big bank -- its private finance arm, Antares, was sold to a Canadian pension fund. The partnership between Ares and GE was effectively killed off with an 8-K filing in which Ares quietly announced it would no longer keep up with its end of the bargain.
The one-sentence filing said simply: "On June 9, 2015, Ares Capital Corporation ("Ares Capital") notified the Senior Secured Loan Fund LLC (the "SSLP") that Ares Capital has terminated its obligation to present senior secured lending investment opportunities to the SSLP prior to pursuing such opportunities for itself."
In other words, Ares was on its own again.
Rebuilding a very profitable venture
Investors saw significant value in the joint venture with GE Capital. It corralled deal flow from two of the largest financiers into one place, and GE's low cost of capital made it possible to beat the competition for large deals.
Ares Capital plans to rebuild a senior loan fund with a new partner. The company announced it reached an agreement with Varagon Capital Partners, a middle market lender formed by AIG and Oak Hill Capital Management. The new partnership will be known as the Senior Direct Lending Program, or SDLP, and will fund similar investments as the old SSLP.
But it leaves many questions unanswered. Ares owned 87.5% of the "equity" in its joint venture with GE, but GE provided all of the low-cost leverage that amplified its returns. It's anyone's best guess as to how the new partnership will be structured, and whether it can arrange for similar leverage on favorable terms.
In addition, there's the matter of who's sourcing the deals. One of the best parts about the SSLP was that GE was actively sourcing new deals for the program. Many business development companies have similar arrangements in which the partner is nothing more than a source of capital. And while Varagon is a middle-market lender backed with the talent of Oak Hill Capital, it simply isn't a GE Capital.
A source of opportunity?
I believe the best case for the SDLP is one in which Ares receives some side benefits, like a greater share of fee income from the program. Whereas Ares received a 50% split of fee income from the SSLP (origination and prepayment fees, primarily), I'm of the opinion that it might be able to negotiate a better split this time, given that it will likely bring a majority of the deals to the table. It was generally understood that Ares and GE were equal contributors to the SSLP.
Increased revenue sharing could help Ares offset what I think will be a notable decline in the quantity (maybe even quality) of deal flow it sees. But, for now, it's purely speculation. The upcoming quarterly report and subsequent conference call may be one of the most important in recent memory. Varagon and Ares have very big shoes to fill.