When the earnings season for BDCs comes to a close, every other BDC will wish it were Ares Capital (ARCC +0.50%). The company came out of the third quarter looking great, posting "Core EPS" of $0.41, and GAAP net investment income of $0.42 per share during the quarter. Both measures easily exceed the company's current quarterly dividend of $0.38 per share.
Furthermore, the company avoided downdrafts that are almost certain to plague many other companies in the industry. Its net asset value per share fell only a penny from the sequential quarter to $16.79 per share, and there was only one new name on the list of non-accruals. (Surprise, surprise -- it was an oil company.)
What's Ares doing now?
Ares Capital is working through some minor issues that haven't played through in its earnings reports just yet. For one, its highly leveraged senior secured loan fund is winding down, and the low-cost leverage is leaving with it. It has a plan to ramp up a new program, but with just over $2 billion dedicated to its senior secured loan fund, it's not as simple as flipping a switch.
Some would argue that Ares Capital is making some trade-offs in taking more risk to earn the same returns. Notably, 88% of its investments it exited this quarter were first lien loans, whereas 74% of its commitments were first lien. Its portfolio is slowly shifting toward "riskier" second lien and subordinated debt, which, though higher yielding, bring higher risk of loss.
The rewards are growing for second-lien lenders. TPG Specialty Lending (TSLX +0.26%) Co-CEO and Chairman Josh Easterly told an analyst on a recent call that second-lien loan spreads had actually widened by 0.27% since September 30, incenting lenders to take a little more risk. (TPG Specialty Lending generally underwrites similar loans as Ares, just to smaller companies on average.)
Ares' CEO, Kipp deVeer, doesn't exactly agree with the notion that his company is simply chasing yield, pointing out that not all first or second lien loans are created equal. That's true. But over a long enough timeline, and with a big enough sample, evidence would show second-lien loans have a higher risk of loss on average. deVeer did say, however, that "the quality would be pretty low today," referring to his broad assessment of Ares' investment opportunities.
The future for Ares Capital
Ares Capital doubled down on some of its efforts to grow recurring income. The company repeated that it expects to call its higher-cost funding to replace it at lower yields, which would add as much as $0.08 per year, per share, in net income. In addition, executives believe that volatility may present more opportunities, highlighting the fact that the big banks took losses on syndicated deals they couldn't syndicate to others in the third quarter, which may temper their aggression.
All in all, it was a good quarter for the BDC industry's biggest player. Ares has always set the standard for what BDC bonds should yield, and what a good underwriting record looks like. It just set the standard for what a good third quarter looks like, too.
