Markets are forward looking, but that doesn't always 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 rout 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 0.07%), which currently yields more than 11% per year.
Bull: Valuation
The median BDC now trades at about 73% of book value, meaning that 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 "okay" BDCs from the spectacular BDCs, it's the ability to generate net capital gains over full cycles. Ares has done just that, and may deserve a premium to peers as 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 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 -0.70%) 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 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, and 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 9 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.
