The high-yield Business Development Company (BDC) Ares Capital may serve as a secure investment in a turbulent market.
Ares Capital Corporation, often regarded as a dependable income investment, stands as the largest BDC globally, with a portfolio valued at $26.8 billion by the end of 2024. Primarily distributing its profits as dividends, the company boasts a forward dividend yield of 9.1% and has consistently paid dividends since its initial public offering in 2004. BDCs are required to distribute at least 90% of their taxable income as dividends to qualify for favorable tax treatment.
However, in the past year, Ares’ stock price has remained relatively unchanged while the S&P 500 experienced a 5% rise. The question remains whether it can maintain this stability and continue generating substantial dividends in the coming year.
Ares Capital’s Business Model
As a BDC, Ares Capital primarily extends loans to "middle market" companies, which earn between $10 million and $250 million annually in earnings before interest, taxes, depreciation, and amortization (EBITDA). The company typically invests $30 million to $500 million in both debt and equity in each firm within its portfolio.
Middle-market companies often face challenges in securing loans from traditional banks due to their perceived higher risk, and they are generally too small to capture interest from private investors or venture capital firms.
Ares Capital addresses this gap by providing loans at higher interest rates than conventional banks. Though this approach might seem risky, the company diversifies its investments across 550 firms. Additionally, the majority of its portfolio comprises first and second lien secured loans (63.8%), preferred equity securities (9.9%), and senior subordinated debt (5.1%), offering some protection against bankruptcies.
A key competitor, Blue Owl Capital Corporation, had a portfolio comprising 227 companies with a fair valuation of $13.2 billion by the end of 2024. Blue Owl Capital has secured 81% of its portfolio with senior secured investments.
Ares’ floating rate loans are tied to the Federal Reserve’s benchmark rate, potentially enhancing net income when rates rise. However, excessively high rates could hinder economic growth, challenge its clients, and diminish the attractiveness of its loans. Consequently, Ares requires rates to remain in a "Goldilocks" zone to attract new clients and sustain a robust investment portfolio.
Ares Capital’s Growth Trajectory
Investors typically assess a BDC using three primary performance metrics: net asset value (NAV) per share, its trading discount or premium to NAV, and its debt-to-equity ratio. From 2004 to 2024, Ares Capital’s year-end NAV per share increased from $14.43 to $19.89, supported by organic growth and acquisitions within the sector.
Currently trading at $20.40, Ares Capital’s stock is only $0.51 above its year-end 2024 NAV per share, compared to its historical $1 to $2 premium. It appears undervalued at less than 10 times its forward earnings. Nonetheless, forecasts predict a 7% decline in earnings per share (EPS) for 2025, followed by a 2% decrease in 2026, as the Federal Reserve continues reducing its benchmark rate. Despite this, the projected EPS of $2.16 for the current year is expected to adequately cover its forward annual dividend rate of $1.92 per share.
From 2014 to 2024, Ares’ year-end debt-to-equity ratio increased from 0.38 to 0.99 due to issuing more loans, though its total liabilities have not surpassed its shareholder equity. Like many other BDCs, Ares issues new shares to finance acquisitions and new investments, having expanded its outstanding share count by 118% over the past decade. While this may seem concerning, the company typically sells new shares at a premium to its NAV, enhancing its EPS.
Outlook for Ares Capital’s Stock
It is anticipated that Ares Capital’s stock will maintain its current level over the next year. While interest rate cuts may slow its near-term earnings growth, reduced rates are likely to draw more income investors away from fixed-income investments, such as certificates of deposit (CDs) and Treasury bills (T-bills), towards higher-dividend stocks like Ares. Its substantial yield and modest valuation are expected to mitigate downside risks, even as its core middle market companies face challenges from tariffs, persistent inflation, and other macroeconomic pressures.
