Ares Capital (ARCC) and Main Street Capital (MAIN) have long been feted as the blue-chip champions of the Business Development Company (BDC) sector (BIZD). However, at present, these stalwarts may not warrant the adulation they typically enjoy.
Why Ares Capital and Main Street Capital Don’t Cut It Now
ARCC and MAIN have amassed legions of devoted followers for good reason:
- They deliver attractive current dividend yields.
- Their dividends have proven remarkably resilient, even during challenging periods like the COVID-19 pandemic.
- Their total returns compared to the broader stock market (SPY) have been nothing short of spectacular.
But, in the current climate, these titans leave us wanting. As demonstrated in a recent article about ARCC, our reasoning is straightforward:
- Both carry premiums to their net asset values (NAV) and historical average price-to-NAV ratios.
- Both boast significant exposure to riskier asset classes relative to many peers.
- The economy is poised for a period where BDC net investment income (NII) and NAVs are likely to decline due to falling short-term rates and an uptick in defaults on middle-market loans.
- In past analogous environments, BDC valuation multiples have typically contracted sharply.
All signs point to a potential perfect storm for MAIN and ARCC, with outsized drawdowns on the horizon as their premium valuations give way to discounts in tandem with substantial NAV declines due to their exposure to riskier assets.
Which BDCs We Favor Instead
While we won’t disclose our full current BDC portfolio, here are several BDCs that, in our estimation, offer investors a superior risk-reward compared to ARCC and MAIN in the current environment:
- FS KKR Capital Corp (FSK) has a greater exposure (75.5%) to senior-secured loans than ARCC (65.1%) and MAIN (68.8%). This provides greater recourse for minimizing losses in the event of a spike in defaults. FSK currently trades at a more than 20% discount to its NAV, offering a much larger margin of safety than ARCC and MAIN. Its 12.86% dividend yield also eclipses those of ARCC and MAIN.
- Blue Owl Capital Corporation (OBDC) maintains an even more defensively positioned portfolio than FSK, with 82.6% exposure to senior-secured debt investments and trading at a 4.09% discount to its NAV.
- Blackstone Secured Lending Fund (BXSL) rounds out this list with the most defensive portfolio in the BDC space, boasting 97.3% of its investment portfolio in senior-secured loans, including a massive 96.9% portfolio exposure to 1st lien senior-secured loans. Despite a modest 8% premium to NAV, its significantly greater exposure to more defensive investments and a higher dividend yield make it an appealing alternative to ARCC.
Investor Takeaway
Main Street Capital and Ares Capital have undoubtedly proven to be excellent long-term compounders and reliable income generators. Nonetheless, the present may not be the optimal time to acquire these stocks, given their elevated valuations, relatively high exposure to riskier assets, and unfavorable macroeconomic trends.
Consequently, we have recently divested from ARCC and continue to steer clear of MAIN. Instead, we are of the opinion that BDCs like FSK, OBDC, BXSL, and a few others present superior risk-reward in the current environment and at current valuations.
