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Killing Off Ares Capital's Golden Goose

By Jordan Wathen - Sep 3, 2015 at 10:20AM

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Ares Capital's results may be weighed down by the end of a lucrative joint venture.

Ares Capital (ARCC -0.56%) is one of the publicly traded financial companies most affected by GE Capital's exit from the financial industry. For years, Ares Capital and GE Capital teamed up to provide funding to middle-market borrowers through a joint venture called the Senior Secured Loan Program, which had more than $10 billion in assets.

Investors have been trying to handicap how the end of the so-called SSLP would affect Ares Capital's results. Thanks to a recent SEC filing, investors now have a better vantage point.

The details behind the lending program
The lending program is complicated, but it's important for Ares Capital investors to understand. The SSLP was funded with about $2.4 billion of equity (of which roughly $2.1 billion was supplied by Ares) in addition to $7.6 billion of cheap debt, which was provided entirely by GE Capital.

Combined, the $10 billion of debt and equity capital was then loaned to private companies at higher interest rates. The returns from the loans would flow first to GE Capital, which would receive interest on its debt funding first. Any excess amount would then flow to Ares Capital and GE, in an 87.5%-12.5% split, as a return on their equity investments.

Ares Capital made a mint on this partnership. As of June 30, 2015, Ares Capital earned 13.8% annually on its equity investment in the lending program. And of course, it's a significant part of Ares Capital's income stream; its investment in the program made up 23% of its total assets as of June 30. 

What's next?
From details in an 8-K filed with the SEC, it becomes apparent that as the SSLP winds down, Ares Capital's returns will diminish. According to the filing, all principal proceeds received from loans made by the SSLP will first go to paying down the debt funding provided by GE Capital.

The net effect is that the SSLP will become less levered over time, reducing returns on Ares Capital's investment. The loan program is currently leveraged at about 3.3 times its equity. If 20% of the outstanding loans were repaid by their borrowers, leverage would fall to 2.4 times equity, and so on. As the leverage drops, so do returns on equity.

I estimate that in a scenario where 20% of loans are repaid, and leverage is reduced, the SSLP would generate a return on equity of about 11%, down from its current level of about just under 14% as of June 30. The impact would be fairly significant, equal to about $0.11 in net investment income per share, per year.

But all of this relies on a number of assumptions, from how non-interest expenses scale within the SSLP, how quickly the SSLP winds down (the faster the better), and whether or not Ares Capital can talk GE into allowing it to withdraw some of its equity investment as time goes on to redeploy it into new investment opportunities. Remember, as the SSLP winds down, Ares Capital has a very similar program, the SDLP, in which it can reinvest the proceeds to generate a similar return.

That's a lot of variables. But the important thing is to recognize just how important the SSLP and similar programs are to Ares Capital. Winding it down will result in a temporary drag on earnings until it can redeploy its capital elsewhere.

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