EC 2020 BDC List And The Top 4 BDCs For High Income

Source: Investor Presentation

ARCC reported its third-quarter results on October 30th, with $0.48 in earnings-per-share beating consensus estimates of $0.46, and rising from $0.45 in the year-ago quarter. NAV also has risen to $17.26 from $17.12 at the beginning of the year. Net investment income grew considerably during the quarter to $212 million, up from $185 million in the year-ago quarter.

The company also continued to make substantial investments by deploying $2.41 billion in additional capital during the quarter, dwarfing the $1.42 billion in exits made during the same period. Its new investments were allocated as follows: 90% into first lien senior secured loans, 7% in second lien senior secured loans, 2% in other equity securities, and 1% in subordinated certificates of the SDLP (96% of which were in floating rate debt securities). As of October 24th, the company had an investment backlog of $665 billion and a pipeline of $265 million.

Ares Capital’s strong 2018 and first three quarters of 2019 investment income growth was driven by high LIBOR, improved aggregate portfolio yields, and limited credit issues. Management’s repeated dividend hikes and significant insider purchases in recent quarters backs their confident rhetoric that this level of earnings is sustainable for the foreseeable future.

Additionally, management recently extended its stock repurchase plan for another year and increased its size from $300 million to $500 million (nearly 7% of shares outstanding at current prices), with the announced intent of repurchasing shares should they drop below NAV. As a result, the share price and potentially earnings-per-share have some solid tailwinds behind them.

That said, the highly leveraged state of the economy and several signals that it may be slowing combine with the company’s choppy earnings history to make us cautious on the company’s growth prospects. As a result, we assume an annual growth rate of just 1% over the next five years.

Ares Capital is arguably the safest BDC given that it is the only one with investment-grade ratings from all three major rating agencies. Additionally, its balance sheet is in a very strong position with solid and stable asset quality and a diversified long-duration liability structure. It also has very diversified holdings (342 different companies) with weighted average interest coverage of 2.1 times, minimizing default risk. Its competitive advantage comes from its superior size and scale as one of the largest BDCs.

We view Ares stock as fairly valued. Overall, total returns are expected to slightly exceed 9% per year, comprised of 1% annual NII growth and the 8.4% dividend yield.

Final Thoughts

Business Development Companies allow everyday retail investors the opportunity to invest indirectly in small and mid-size businesses. Previously, investment in early-stage or developing companies was restricted to accredited investors, through venture capital.

And, BDCs have obvious appeal for income investors. BDCs widely have high dividend yields above 5%, and many BDCs pay dividends every month instead of the more typical quarterly payment schedule.

Of course, investors should consider all of the unique characteristics, including but not limited to the tax implications of BDCs. Investors should also be aware of the risk factors associated with investing in BDCs, such as the use of leverage, interest rate risk, and default risk.

If investors understand the various implications and make the decision to invest in BDCs, the four individual stocks on this list could provide attractive total returns and dividends over the next several years.

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