Adrian Vidal/iStock via Getty Images

Adrian Vidal/iStock via Getty Images

Business Development Companies, otherwise known as BDCs, invest in small to medium-sized companies, some of which may be distressed. In addition to providing capital, BDCs help companies grow in their initial stages or in a distressed scenario and will provide assistance in regaining their financial footing. BDCs are required to invest at least 70% of their assets in private or public U.S. firms with market caps under $250 million. Ares Capital ( NASDAQ:ARCC ) is one of the largest direct lenders in the U.S as they deliver comprehensive solutions to meet the distinct and underserved financing needs of private middle-market companies across a wide range of industries.

ARCC is the largest publicly traded BDC with a portfolio fair value of $19.5 billion. ARCC has 395 companies within its portfolio with a large team of 150+ investment professionals and $79 billion in originations since inception. ARCC has done an excellent job of growing its Net Asset Value (NAV) per share since inception and its quarterly dividend. We're currently living in a period where inflation is at its highest levels since the early 80s, and there aren't many vehicles that can outpace the current rate of inflation through income distribution. BDCs play an important role in the corporate financing structure, and I have begun to allocate more capital on the income side of my portfolio toward them. I believe ARCC is trading at a reasonable valuation and is positioned for long-term success. I am buying shares of this 8.61% yielding BDC and plan on reinvesting all of the dividends that flow into my account.

I love diversification, and ARCC provides a large level of diversification that I can't achieve on my own. ARCC has a $19.5 billion portfolio geared toward senior secured loans (71%) and has preferred equity and other equity investments while having an asset management company. ARCC has spread its portfolio across 23 industries, with software & services representing 20% of the portfolio and having their hands in everything from insurance services to media & entertainment. ARCC's largest investment is less than 1.5% of its portfolio which indicates that its portfolio is structured to mitigate unpredictable events.

ARCC is externally managed by Ares Management which has approximately $325 billion in assets under management. Ares Management is a global alternative investment manager which operates an integrated platform across credit, private equity, real assets, secondary solutions, and strategic initiatives. Ares Management has 790 investment professionals across 30 global offices and is a pioneer in leveraged finance, private credit, and secondaries.

BDCs are traditionally income investments, and investors are not seeking capital appreciation as their first priority. Since ARCC's IPO over 17 years ago, they have paid $27.10 in dividends per share. ARCC went public through an IPO at $15 per share and has paid 180.67% of its initial value in dividends while providing 30.07% in capital appreciation as shares are sitting at $19.51. ARCC has an excellent track record of providing value to its shareholders, but a track record doesn't necessarily mean it will be extrapolated out to the future. When it comes to BDCs I want to see their NAV and Net Investment Income (NII) grow over time to establish an ongoing trend that's favorable to shareholders.

Over the past decade, ARCC has grown its NAV from $16.04 to $19.02. On the income statement side, ARCC has generated $1.87 billion in revenue over the trailing twelve months (TTM), which is a 150% increase from the $748 million generated in 2012. This has increased ARCC's operating income to $1.21 billion, which is a 140.08% increase since the $708 million generated in 2012. These figures have driven ARCC's NII to $1.41 billion in the TTM from $508.2 million in 2012.

When evaluating BDCs I like to look at some of the largest operators, including FS KRR Capital Corp (FSK), Apollo Investment (AINV), Goldman Sachs BDC (GSBD), Prospect Capital Corp (PSEC), Owl Rock Capital Corp (ORCC), Barings BDC (BBDC), Golub Capital BDC (GBDC), Sixth Street Specialty Lending (TSLX), Gladstone Capital (GLAD), and Main Street Capital (MAIN) as the peer group. There are three metrics I use to evaluate ARCC against the peer group, which include the NII to market cap multiple, price to NAV discount, and the dividend yield. NII is a better metric than EPS to utilize for a BDC so the NII to market cap is a more effective measure than a P/E ratio. This is why I utilize this metric to see how cheap BDCs are trading against their NII. I also like to see if there is a steep discount or a heavy premium with a BDCs price to NAV valuation in addition to looking at the yield and dividend coverage.

ARCC is currently trading at a 6.87x NII to market cap ratio, which is the 4th lowest in its peer group. The average NII to market cap is 8.26x, and there are 3 BDCs in the peer group that trade into the double digits, with BBDC trading at a 15.20x multiple. From this valuation, ARCC looks to be trading at an enticing valuation.

There is a wide range in the price to NAV discount that ranges from -28.77% to 46.12% within the group. ARCC trades at a 2.58% premium to its NAV. While there are other BDCs that trade at a steep discount, I believe ARCC is fairly valued, and paying a slight premium over its NAV is well warranted for the quality that ARCC represents.

ARCC falls just under the average of 8.99% on its dividend yield as its current forward yield is 8.61%. While its yield is just under the midpoint, I don't believe an 8.61% dividend yield that is fully covered is anything to look down upon. There aren't many investments that generate a passive income that has outpaced the rate of inflation, and with ARCC generating $1.4 billion in net investment income, there is more than enough income to distribute to outpace the highest rates of inflation that we have seen in 40 years.

2005 was the first year of paying a full year of dividends. Since its inception, ARCC has increased its quarterly dividend by 45%, from $0.29 to $0.42. Over the years, ARCC has established a long track record of covering its dividend through a combination of core earnings and net realized gains. In many cases, when an investor sees a dividend that generates a forward yield in the high single or double digits, it raises a red flag. ARCC is one of the companies where the red flags are non-existent as the large dividend is fully covered and has been for years.

ARCC has rewarded shareholders with special dividends in addition to the quarterly dividend. Since 2013, ARCC has paid 10 special dividends. In Q1 of 2022, ARCC paid its $0.42 per share quarterly dividend and surprised its shareholders with an additional $0.03 per share in the form of a special dividend. ARCC has replicated the Q1 2022 payout and announced that they would pay another $0.3 per share special dividend in Q2 2022. ARCC goes ex-dividend on 6/14/22 and will pay its quarterly dividend of $0.42 and a special dividend of $0.03 on 6/30/22.

When it comes to income investments, it's hard to find things to complain about with ARCC's dividend. ARCC offers investors 12+ years of growing dividends and has declared 2 quarterly dividend increases since 2019 in addition to paying special dividends. Since ARCC's IPO, they have paid $27.10 in dividends across 17+ years. The long-term dividend track record is spectacular, and the short-term characteristics are impressive regarding ARCC's dividend. This is definitely a BDC that income investors will want to look into, as ARCC should continue these trends for years.

There are many BDCs to choose from and some trade at a steep discount to NAV, but many consider ARCC the gold standard for a good reason. ARCC is the largest BDC with a market cap of $9.65 billion, and it generates $1.41 billion in net investment income. ARCC has a $19.5 billion portfolio and is managed by Ares Management which has $325 billion in assets under management. Since May of 2019, ARCC has generated a 13% increase in LTM core earnings per share, generated $44 million on cumulative net realized gains on investments, seen 10.6% NAV per share growth, and provided 2 quarterly dividend increases. Today ARCC is trading at a cheap valuation of 6.87x its NII to market cap and is fairly valued against its NAV while paying a dividend that outpaces inflation. I think ARCC is a great company for income investors to research and add to their income-producing portfolios.

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This article was written by

I am focused on growth and dividend income. My personal strategy revolves around setting myself up for an easy retirement by creating a portfolio which focuses on compounding dividend income and growth. Dividends are an intricate part of my strategy as I have structured my portfolio to have monthly dividend income which grows through dividend reinvestment and yearly increases. Feel free to reach out to me on Seeking Alpha or https://dividendincomestreams.substack.com/

Disclosure: I/we have a beneficial long position in the shares of ARCC, MAIN, FSK, GSBD, BBDC, ORCC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: I am not an investment advisor or professional. This article is my own personal opinion and is not meant to be a recommendation of the purchase or sale of stock. Investors should conduct their own research before investing to see if the companies discussed in this article fit into their portfolio parameters.