The following information was previously provided to subscribers of Premium BDC Reports along with:
- ARCC target prices/buying points
- ARCC risk profile, potential credit issues, and overall rankings
- ARCC dividend coverage projections (base, best, worst-case scenarios)
ARCC Quick Risk Profile Update
QC Supply is a specialty distributor and solutions provider to swine and poultry markets and was the only investment added to non-accrual during Q2 2021. Total non-accrual investments decreased from 2.2% to 1.9% of fair value (2.9% of cost) of the total portfolio due to removing Sundance Energy.
Please note that ARCC has a very large portfolio with investments in 365 companies valued at over $17 billion so there will always be a certain amount of non-accruals.
As shown below, the company remains primarily invested in first and second-lien loans. Please keep in mind that many of these companies are larger middle market companies that will likely outperform in an extended recession environment. Not all first-lien and second-lien are created equal and I would expect many of ARCC’s second lien positions to outperform other BDC’s first-lien positions during worst-case scenarios.
Source: ARCC Earnings Presentation
Similar to most BDCs, ARCC has low exposure to cyclical sectors which is why they outperformed during the COVID-driven recession.
Source: ARCC Earnings Presentation
There was another improvement in the amount of ‘Investment Grade 2’ (from 11.8% to 9.4% of the portfolio) which indicates that the “risk to our ability to recoup the initial cost basis of such investment has increased materially since origination or acquisition, including as a result of factors such as declining performance and non-compliance with debt covenants; however, payments are generally not more than 120 days past due”.
ARCC Dividend Update
For Q2 2021, ARCC reported another exceptional quarter easily beating its best-case projections due to the highest level of quarterly originations in the company’s history coupled with much higher-than-expected capital structuring service fees and dividend income. ARCC remains a ‘Level 1’ dividend coverage BDC and the company announced an increase to the regular quarterly dividend from $0.40 to $0.41 per share for the third quarter.
Kipp deVeer, CEO: “We reported another quarter of strong core earnings, healthy portfolio performance, record NAV per share and our highest level of quarterly originations in the company’s history. Our company continues to operate with significant scale, sourcing and investment advantages that come from our nearly 17-year track record in the market. Based on our favorable outlook and strong competitive position, we increased our regular quarterly dividend to $0.41 per share.”
Source: ARCC Press Release
ARCC’s net asset value (“NAV”) per share increased by another 4.1% partially due to by issuing 7 million shares (accretive to NAV) through its at-the-market (“ATM”) equity distribution agreement (discussed later) as well as overearning the dividend but mostly due to unrealized portfolio gains.
Its portfolio yield (at cost) decreased from 7.9% to 7.7% due to new investments at lower yields. Through July 22, 2021, the company funded $430 million of new investments partially offset by $267 million of exits. There were additional net realized gains of around $59 million or $0.13 per share due to the exit of investments in Blue Angel and Mavis Tire Express Services.
Source: ARCC Earnings Presentation
ARCC continues to reduce its overall borrowing rates as well as laddering its maturities. On August 11, 2021, ARCC issued an additional $400 million of 2.875% notes due June 15, 2028, at a premium (102.696%) resulting in a yield-to-maturity of 2.435% which is an extremely low fixed rate for an unsecured note due 2028.
Source: SEC Filing
Recent Equity Offering & Leverage
In April 2021, the company entered into amended/restated equity distribution agreements to issue and sell shares of its common stock up to $500 million. During the three months ended June 30, 2021, ARCC issued 7.0 million shares with net proceeds of $135 million or around $19.27 per share through its at-the-market (“ATM”) program.
The ATM is a nice tool to issue some creative equity, I mentioned that I really do think coming out of COVID in into this recovery that we gained market share. And we think that there’s a reason for us to grow the company based on the investment environment being attractive. And as Mike said, on the call, or on the prepared remarks him more than investable, I mean, pretty attractive. The amount of stock that we’re actually able to issue in the ATM is quite limited. But you know, the good news is we’re doing it on a creative basis. That’s low cost that allows us to continue to grow the business.”
Source: ARCC Earnings Call
In August 2021, ARCC completed a public equity offering of 12,500,000 shares of common stock at a price of $19.6667 per share resulting in net proceeds of approximately $245.4 million:
We used the net proceeds of the August 2021 Offering to repay certain outstanding indebtedness under our credit facilities. We may reborrow under our credit facilities for general corporate purposes, which include investing in portfolio companies in accordance with our investment objectives. In addition, in connection with the August 2021 Offering, we granted the underwriters an option to purchase an additional 1,875,000 shares of common stock, which option expires on September 1, 2021.
Source: ARCC Press Release
The equity offering was slightly accretive to NAV per share by around $0.04 per share depending on the number of total shares issued. I previously projected net proceeds of around $275 million which is relatively small compared to the $3.9 billion of new investments during Q2 2021 and the recent $1.35 billion of unsecured notes:
- In June 2021, Ares Capital issued $850 million in aggregate principal amount of unsecured notes that mature on June 15, 2028, and bear interest at a rate of 2.875%.
- In May 2021, Ares Capital issued an additional $500 million in aggregate principal amount of its existing unsecured notes that mature on July 15, 2025, and bear interest at a rate of 3.250%. These notes were issued at a premium that resulted in an effective yield of 2.0% for the Additional July 2025 Notes.
As of June 30, 2021, ARCC had leverage or debt-to-equity of around 1.10 net of cash and using ~$275 million of net proceeds would have a pro-forma impact reducing it to 1.03 which is closer to the average BDC currently around 0.95 as shown below and in the “Conservative Portfolio Safely Paying Investors 7.3%: Golub Capital” article. However, BDCs with higher quality portfolios can support higher leverage which includes ARCC that has a target range of 0.90 to 1.25:
While our leverage ratio will vary over time depending on activity levels, we will continue to work to operate within our stated target leverage range of 0.90 to 1.25 times.”
Source: ARCC Earnings Call
BDCs & Interest Rates
As discussed earlier this year in “Positioning Your Portfolio For Higher Interest Rates” interest rate fears are creeping back into the market again and BDCs mostly have floating rate investments coupled with fixed-rate borrowings. Higher interest rates generally drive higher net interest margins once the rate floors are met which is different for each BDC. The following information was provided by ARCC but to be completely honest I think it is too early to start assessing how rates will impact earnings per share. I have recently noticed some negative articles discussing BDCs and interest rates mostly written by contributors that are new to the sector without the benefit of how BDCs were impacted the last two periods of rate increases. BDCs are not CEFs and typically have more involved management that can quickly adjust balance sheets if/when needed. For now, most BDCs are selectively refinancing higher-cost debt taking into account maturities and rate trends as there is a careful balance to maximize ROE to shareholders. Management does not want to take out higher-cost debt too soon as they get hit with unamortized expenses as well as potentially hold out for lower rates and/or longer periods. ARCC management is masterful at this with an ever-evolving and impressive balance sheet that even at these levels will produce positive positive results no matter what happens with changes in the underlying interest rates as shown below. However, this does not take into account an additional $400 million of unsecured notes due 2028 at a yield-to-maturity of 2.435% issued in August 2021 as discussed later.
However, if management believes that rates will trend higher sooner they can easily start to shift the balance sheet to maximize well before rates start to rise. This should also be taken into account with BDCs currently using their credit lines with lower rates waiting to shift more into fixed-rate unsecured notes which will have a material impact on their interest rate sensitivities. This means please ignore other chicken-little contributors that have not been around the block when it comes to the BDC sector.
Another Dividend Increase?
As mentioned in recent articles, historical dividend coverage is not a good indicator of upcoming coverage for many reasons so please make sure that you’re getting this information before investing in BDCs.
First, you need to assess the overall risk profile and potential credit issues along with expected dividend coverage which is directly impacted by maintaining credit quality. Once you have established both of these you can then set target prices which I will discuss in another article. This is critical when deciding if and when you should be purchasing BDCs at these levels so please do your due diligence or find a service that provides proper research.
It’s best to keep up to date on information contained in the SEC filings as well as when BDCs start to report results starting next week with ARCC which is the first to report results. Also, please make sure that your service provides detailed financial projections for each of the BDCs that you plan to invest in.
I use a “Base” case projection along with “Best” and “Worst” cases over the next three quarters. I find that going out much further than three quarters is pointless as BDC balance sheets change constantly adapting for upcoming economic conditions as mentioned earlier. I typically do not provide financial projections in public articles but below is a quick example of the base case projections for ARCC taking into account the previously discussed information including the recent equity offering, changes to borrowing rates, and net interest margin as well as expected portfolio yield. I am projecting another dividend increase for Q1 2022.
Previous ARCC Purchases and Q3 2021 Reporting Schedule
BDC pricing can be volatile and timing is everything for investors who want to get the “biggest bang for their buck” but still have a higher-quality portfolio that will deliver higher-than-average returns over the long term. The “Annualized” return shown does not use a simple average but shows the actual compounding of annual returns. This is the true return each year. Please disregard the annualized total returns for 2020 purchases as the time frame is not long enough to accurately reflect.
As mentioned earlier, I currently have 17 BDC positions including ARCC which is my third-largest position as I continue to purchase additional shares including the most recent purchase as discussed in “Ares Capital Finally A Buy: Did You Miss It?“. Please note that ARCC had a stock price of $14.36 when that article came out which still would’ve been an excellent time to purchase additional shares.
I often use ARCC as an example of how investors can improve their annualized returns simply by purchasing additional shares on the various pullbacks as discussed in “Using ‘Sell In May’ To Build Your 10% Dividend Yield Portfolio“.
The following chart shows my previous purchases of ARCC typically when its RSI is closer to 30. However, it should be noted that the best prices came shortly after an RSI of 30 was hit and then went lower.
One of the best times to purchase these stocks is just after they report results before other investors have a chance to digest the information. Many investors simply look at earnings or changes in NAV which often does not tell the full story. BDCs will begin reporting calendar Q3 2021 results next week starting with ARCC and investors should be ready to make changes to their portfolios.
What Can I Expect Each Week With a Paid Subscription?
Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.
- Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
- Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
- Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.
This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.