Please ensure Javascript is enabled for purposes of website accessibility

Ares Capital Corporation: Bull vs. Bear

By Jordan Wathen - Jan 18, 2016 at 11:19AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Ares Capital shares have plummeted to kick off 2016. Here are the bull and bear views.

Image source: tradingacademy.

Markets are forward-looking, but that doesn't mean they're right all the time.

Is the market correctly pricing the future earnings power of high-yield business development companies? It's tough to say. It's something I've been arguing with myself ever since a market rot sent high-yield BDCs to the doghouse.

Below, I've laid out the bull and bear cases for one high-yield stalwart, Ares Capital Corporation (ARCC 0.00%), which currently yields more than 11% per year.

Bull: Valuation
The median BDC now trades at about 73% of book value, meaning Ares Capital trades at a slight 9 percentage premium to the industry.

History has shown it isn't an average BDC, however, as Ares Capital has delivered consistent income to its shareholders and managed to create capital gains in excess of its capital losses.

If there were any one factor that separates the "OK" BDCs from the spectacular BDCs, it's the ability to generate net capital gains over full cycles. Ares has done just that, and it may deserve a premium to peers since one would expect that Ares' superior underwriting will result in better book value preservation in downturns.

Bear: Valuation
Ares Capital's slight valuation premium doesn't tell the full story. Though Ares has a history of producing capital gains, its fee structure penalizes investors if it produces capital losses.

Notably, the median BDC with a favorable fee agreement (or low-cost internal management structure) trades at a 22% discount to book value, roughly in line with Ares' 18% discount.

Ares Capital is thus selling at about the same price as BDCs with friendly fee agreements without having the same advantage.

Ares' Price-to-Book Valuation vs. Group Medians

Group (BDC)

Ares Capital

BDCs with "legacy" fee agreements

BDCs with "new" fee agreements

BDC universe

P/B valuation

0.82

0.65

0.78

0.73

Source: SEC filings and company IR, with calculations by author.

An equally respected competitor, Golub Capital BDC (GBDC -0.56%) trades at a 2% premium to book, in part due to its shareholder-friendly fee arrangement. (Perhaps this bear case can turn into a bull case? Realigning incentives for its manager may lead Ares to trade at a Golub Capital BDC-like premium to book value.)

On a true apples-to-apples basis, Ares trades at 82% of book value compared to the 65% of book value for peers with similar fee arrangements. On this basis, it doesn't seem so cheap. Whether it matters or not depends on whether Ares can continue to deliver realized gains in excess of losses. If it can, the fee structure differences are moot.

Bull: Low oil & gas exposure
Last quarter, oil & gas related investments made up $288.5 million of its $9.2 billion investment portfolio. Taking leverage into consideration -- and assuming a complete loss from its oil investments -- Ares' book value would stand to fall about 5.5% if its oil & gas investments went to zero.

A complete loss seems unlikely. One of its largest oil exposures, Primexx Energy Corporation, was underwritten in the third quarter of 2015 with the assumption that oil prices would remain low. On the most recent conference call, Ares CEO Kip deVeer pointed out that its assets remain "incredibly economic even at $45 oil today."

Oil has, of course, continued to slide. But given the investment was made at a time when oil prices were falling, it should hold up much better than the average BDC oil investment made when oil was $70, or even $80 per barrel.

Even if you completely write off all of its obvious oil and gas exposures, the discount would persist. Ares shares would trade for about 13% less than book under such a scenario.

Bear: Unknown exposures exist
One of Ares Capital's largest portfolio companies goes by the name of Ivy Hill Asset Management (IHAM). It manages assets for other investors as well as Ares Capital. Little is known about the company or the exposures it might have.

Investors do know that IHAM invests in highly leveraged loan products known as CLOs, which may have oil and gas exposure. Furthermore, we know that Ivy Hill has paid Ares Capital $40 million in dividends in the first nine months of 2015, equal to about 8.1% of the company's net investment income. In addition, IHAM makes up about 4.6% of Ares' book value.

As an asset manager and principal investor, IHAM's results are leveraged to the performance of the investments it makes for other investors as well as itself. What percentage of IHAM's investments are exposed to oil? How will it affect IHAM's ability to pay dividends to Ares? Your guess is as good as mine. Its undisclosed portfolio represents an impossible-to-quantify risk.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Ares Capital Corporation Stock Quote
Ares Capital Corporation
ARCC
$20.16 (0.00%) $0.00
Golub Capital BDC, Inc. Stock Quote
Golub Capital BDC, Inc.
GBDC
$14.27 (-0.56%) $0.08

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
379%
 
S&P 500 Returns
123%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/10/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.