Where will Ares Capital Corporation be in 3 years?

Over the past three years, Ares CapitalIt is (NASDAQ:ARCC) the stock rose about 6%. This gain may seem tepid, but it generated a much larger total return of 42% after including its reinvested dividends. Indeed, Ares is a business development company (BDC) that primarily focuses on paying high dividends to income-oriented investors. But will Ares continue to generate big gains over the next three years? Let’s look at its business model, growth rates, and valuations to make a decision.

What happened to Ares Capital in recent years?

As a BDC, Ares Capital makes loans to middle-market companies that generate between $10 million and $250 million in annual earnings before interest, taxes, depreciation and amortization (EBITDA). It typically invests between $30 million and $500 million in debt and equity in each company.

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BDCs have become more popular over the past two decades as traditional commercial lenders have approved fewer loans to mid-sized businesses, which are considered riskier customers than large corporations. In exchange for taking greater risk, BDCs charge higher interest on their loans than traditional banks.

To reduce this risk, Ares distributes its investments among 535 companies in more than 40 different sectors. More than 60% of its loans are first and second lien secured loans, putting it ahead of other creditors in the event of a business failure. It also ended its latest quarter with a manageable debt-to-equity ratio of 1.03. In comparison, its smaller competitor Main Street HousingI (NYSE:MAIN) invested in 193 companies and ended its most recent quarter with a slightly lower debt-to-equity ratio of 0.89.

A BDC’s financial health is generally determined by its debt ratio and net assets per share. Over the past four years, Ares Capital has controlled its debt while steadily increasing its net assets per share.

Data source: Ares Capital. *Net of available cash. 9M = nine months.

On the last trading day of 2022, Ares stock closed at $18.47, just $0.07 higher than its net assets per share. At $22, Ares is now trading at a premium to this metric. But Ares still doesn’t seem as expensive as Main Street Capital, whose current price of $58 is significantly higher than its $30.57 net assets per share.

BDCs now command higher valuations because they benefit when interest rates rise, as they have over the past two years. BDCs primarily offer variable interest rate loans tied to the federal funds rate, so high rates tend to increase their bottom line.

However, BDCs also don’t want interest rates that are too high, as that would reduce the attractiveness of their loans (which are already offered at higher rates than banks) and increase borrowers’ risk of default. High rates also reduce the attractiveness of their dividends by increasing yields on risk-free certificates of deposit and Treasury bills. So, just like banks, BDCs thrive in a Goldilocks market with high but sustainable interest rates.

What will happen to Ares Capital over the next three years?

The Federal Reserve has lowered its benchmark rates three times in 2024, but anticipates only two more rate cuts in 2025. This slowdown suggests that inflation has not yet been brought under control – and investors should expect at high interest rates for at least one year. Ares, Main Street and other BDCs could be attractive investments in this type of market.

Ares’ forward dividend yield of 9% also looks much more attractive than the 10-year Treasury’s current yield of 4%. However, investors should remember that Ares cut its dividends during both the Great Recession and the COVID-19 crash. So even though Ares now pays large dividends, we shouldn’t be surprised if it eventually has to rein in those payments.

As a BDC, Ares is required to pay out at least 90% of its pre-tax income as dividends in order to maintain a favorable tax rate. But if its revenues decline, its dividends will also decline.

From 2020 to 2023, Ares’ net assets per share grew at a compound annual growth rate (CAGR) of 4.3%, even as the pandemic, inflation, rising rates and geopolitical conflicts shook the markets. Assuming these headwinds ease and Ares grows its net assets per share at a slightly faster CAGR of 5% between 2023 and 2027, while trading at a reasonable 10% premium to this metric, its stock could rise nearly 20% to $26 over the next three years. .

That would be a decent gain, but investors will likely be more focused on its dividends, which should continue to climb as long as the macroeconomic environment remains stable. But if the market collapses again, investors should prepare for a blow as its business buckles under pressure from volatile rates and bad loans.

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Leo Sun holds positions in Main Street Capital. The Motley Fool has no position in any of the securities mentioned. The Motley Fool has a disclosure policy.