Ares Capital: New Notes Issue Graded
Yesterday Ares Capital (ARCC) raised $600mn in Unsecured Notes, with a 2022 maturity.
The yield on the Notes is 3.625%, and interest is paid semi-annually.
The Notes have very few covenants, and the debt is unsecured.
However, Ares is required to repay the debt on a change of control of the Company.
Initially, the capital raised will be used to repay outstanding secured Revolver debt outstanding.
The BDC Activist says: “We wrote on September 7th that Ares Capital was going “on the road”-if only telephonically-to place the new debt with institutional investors. The success of the enterprise was never in doubt as the market is relatively favorable, Ares has a good reputation and is a multiple prior issuer of this type of debt.
We only wondered what the pricing achieved might be. From the BDC Activist’s viewpoint, the terms are critical. Many other BDC issuers-and even Ares Capital in the past-have raised debt capital at pricing that was not accretive to shareholders, or was barely so at time of issuance but became non-accretive shortly after as pressures on loan yields reduced the BDC’s income while fixed rate debt remained unchanged.
As an aside: one of the seven key issues that the BDC Activist is focused on is Capital raising at BDCs, and whether new monies raised are to the benefit of shareholders or otherwise. We look at both equity capital raised as well as debt.
In broad brush terms, if a BDC is adding investments in a competitive environment at effective yields of 9%-11%, but paying management fees of up to 2.0%, incurring incremental operating expenses of anywhere between 0.5%-1.0%, charging Incentive Fees of 20% of Net Investment Income and then raising new debt at yields of 6%-8%, the incremental benefit to shareholders at the bottom of that waterfall is minimal.
If we also consider that a good portion of many BDCs income is non-cash in form (such as Pay-In-Kind where the interest owed is just added to the principal on the loan and paid out only at maturity-if at all) yet all debt obligations are in cash form, the actual cash received from assets purchased with this unsecured debt can be lower than the payments made to service the debt, and pay all the associated costs mentioned above.
Finally, if an investor takes into account that most every BDC will incur credit losses equal to 1%-4% PER ANNUM on the assets purchased with a debt offering, and thus will have to use other assets to ultimately repay the debt at par down the road, most every unsecured debt offering of the dozens that have come to market in recent years has been non-accretive to shareholders. In plain English, that means shareholders have had no benefit in their ultimate Net Investment Income Per Share, after adjusting for non-cash items and credit losses.
Here is a pro-forma calculation that illustrates the subject:
Nominal Yield on Assets purchased with new debt: 10.0%
Less: Management Fees 2.0%
Less: Incremental Operating Costs 0.5%
Less: Yield on Notes 7.0%
Net Investment Income Subject To Incentive = 0.5%
Less: Incentive Fee at 20% 0.1%
Net Return to Shareholders Before Credit Loss = 0.4%
Credit Loss Average Per Annum 2.0%
Net Return To Shareholders After Credit Loss =-1.6%
We have not even bothered to make any deduction for non-cash income, even though many BDCs have as much as 15% of their Investment Income in PIK form. Nor have we fully factored in the one-time expenses associated with the debt raising, but which do not come cheap. Remember these are annual net costs. Over a 7 year period (the average length of most Notes), a shareholder will-nominally-lose over 10%.
Of course, the External Managers of BDCs have very different economics from debt capital raised. Both management and incentive fees increase, often adding income as we’ve shown above of 3.0-3.5% on every dollar of debt raised. Those fees are only minimally impacted as a portion of assets purchased with the debt raised are written down in value, and generate a steady stream of income for the life of the assets bought with that debt.
Remarkably the Board of Directors of BDCs do not appear to get involved in denying External Managers non-accretive debt raising, even though the economics are relatively straightforward to calculate. As a result, this has become one of the most popular ways for External Managers to increase the assets under management of the BDCs under their stewardship, without all the scrutiny and rules associated with raising EQUITY capital on a non accretive basis. (No wonder that there is a big push underway in Congress by the Best, Biggest and Brightest BDCs to increase the proportion of debt capital a BDC can raise-all done in the name of helping small business even though most of the assets purchased will be of the debt of very large private companies owned by Private Equity groups).
We would argue,though, that non-accretive debt is much more dangerous for shareholders than non-accretive debt given that a third party (the Note Holders) is inserted into the BDCs balance sheet, and is granted various protections (such as the right to force immediate repayment if certain defaults occur or to forbid distributions or the assumption of other debt, etc.).
Getting back to the current Ares Capital debt raising, the BDC Activist is pleased to report that the very low interest rate on the 6 year medium term debt should mean the transaction is modestly accretive to shareholders, and is an exception to the rule. Let’s do the numbers as best we can:
Average Yield On the ARCC Portfolio (derived from latest earnings release): 8.9%
Less: Management Fee 1.5%
Less: Estimated Incremental Operating Expenses 0.3%
Less: Interest Expense 3.6%
Net Investment Income Subject To Incentive =3.5%
Less: Incentive Fee at 20% 0.7%
Net Return To Shareholders Before Credit Loss =2.8%
We would assume average credit losses anywhere between 1.0-2.0% per annum on average. The BDC has a very good track record-aided by the occasional equity gain and buying large portfolios at a discount (Allied Capital and now American Capital)-but into every life some rain must fall where lending is concerned.
The BDC Activist concludes: “We give a thumbs up to the Ares Capital debt raise thanks to its record low interest rate. The yield Ares will pay for unsecured, six year money is lower than the all-in rate paid by some BDCs for secured Revolver debt with a shorter shelf life. Look at the recent OHA Investment (OHAI) refinancing with Apollo-owned Mid Cap Financial for an illustration, which we reviewed in a recent post.
Disclosure: Southland Capital Management-the parent of the BDC Reporter-is Long ARCC. We no longer have any position in any of the existing Notes, mostly because the yields are too low.