For years, Ares Capital Corp (NASDAQ: ARCC) has been my go-to Business Development Company (BDC) due to its impressive total return performance and consistent dividend payouts. However, my opinion has recently shifted, and I no longer consider it my favorite BDC. In this article, I’ll discuss three key reasons why.
Why ARCC stock used to be my favorite BDC
ARCC earned its title as my favorite BDC thanks to its reliable and attractive dividend payouts, outstanding total return performance, and the competitive advantages derived from its manager, Ares Management Corporation (ARES).
One of the main reasons I favored ARCC was its consistent base quarterly dividend, which has either remained steady or even increased over the past 14 years. Unlike many of its peers who had to cut dividends, ARCC maintained its payouts through various market conditions. This impressive track record is supported by its strong core earnings and net realized gains coverage.
In addition to its dividend stability, ARCC has also outperformed the broader BDC sector in terms of total returns. It even surpassed the total return performance of the S&P 500 since its inception, an impressive feat considering the strong performance of large-cap tech stocks over that period.
ARCC’s success can be attributed to its strong underwriting skills, which is greatly enhanced by its partnership with ARES. ARES’s direct lending team, with ARCC as its main fund, boasts unmatched origination, scale, and infrastructure. Their thorough tracking and monitoring of portfolio companies, along with their savvy credit evaluation and established relationships, contribute significantly to ARCC’s success.
However, as market dynamics change and macroeconomic conditions evolve, my opinion has shifted. While I still hold a positive view of ARCC and own it in one of our portfolios, I now find other BDCs more appealing. Here are three reasons why:
1. ARCC is not as defensively positioned as it should be right now
ARCC’s allocation to first-lien senior secured loans is relatively low at just 41.7%, and its second-lien senior secured allocation is even lower at 23%. This results in a total senior secured loan exposure of 64.7%, which is less impressive compared to its more conservatively positioned peers.
For instance, Golub Capital BDC (GBDC) has a 93.6% exposure to senior secured loans, Oaktree Specialty Lending (OCSL) has an 87.1% exposure, Blackstone Secured Lending (BXSL) has a whopping 97.3% exposure, and Blue Owl Capital Corp (OBDC) has an 83.2% exposure. Even FS KKR (FSK), known for being less conservative, has a 76.4% exposure.
While ARCC does have an investment-grade credit rating and a reasonable leverage percentage, it fails to stand out in terms of conservative positioning compared to several other BDCs with similar metrics. The potential for higher non-accrual rates during economic downturns is a concern.
2. ARCC’s dividend outlook is not as robust as some of its peers’
ARCC has a strong track record of covering its dividend per share with net investment income. However, several other BDCs, including OBDC, FSK, BXSL, GBDC, and Main Street Capital (MAIN), boast similar or even stronger quarterly dividend coverage ratios.
During its latest earnings call, ARCC’s management was asked about the possibility of raising its quarterly base dividend further, but they mostly sidestepped the question. In contrast, other BDCs such as BXSL, OBDC, MAIN, FSK, and GBDC have been growing their dividends and/or paying substantial special dividends, indicating a more promising dividend outlook.
3. ARCC’s valuation is not particularly attractive right now
Considering the fairly high management fee charged by ARES, ARCC’s current premium to NAV makes it less appealing compared to other well-run funds like GBDC, OBDC, and FSK, which are trading at significant discounts to NAV. Additionally, given ARCC’s defensive positioning concerns and lack of dividend growth plans, the current valuation does not seem justified.
Investor takeaway
While ARCC has been an exceptional income investment with a stellar track record, it no longer stands out compared to other BDCs. In an environment where defensiveness should be prioritized, there are other BDCs with greater exposure to senior secured loans, similar balance sheet strength, better dividend coverage, growth potential, and more appealing valuations. Consequently, ARCC is no longer my favorite BDC, and I currently prefer other BDCs discussed in this article.
