Hi YXI friends,

Why bother investing in US Treasuries, when you can get an uninterrupted, 9-10% dividend yield instead? What’s the catch?

That’s the question we face today, as we review Ares Capital Corporation (ARCC)’s Q2 Results. Because Ares has a number of other investment vehicles, we will simply reference "ARCC” throughout this note.

ARCC is a Business Development Company (BDC). A quick definition of BDC in Ares’ own words:

BDCs must keep an asset coverage ratio of at least 150%. They also need to distribute at least 90% of their taxable income to shareholders to avoid paying corporate income tax on the distributed taxable income.

The emergence of BDCs (and Private Credit as an asset class) has coincided with consolidation and tighter regulatory requirements in the banking sector. There are now fewer banks in competition, making BDCs an important source of credit provider to the middle-market companies. Compared with banks, BDCs have enhanced deal flexibility, lower regulatory risks, and a lower cost structure (by nearly half).

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DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. Think of ARCC as a treadmill

Stay with me on this one.

The way ARCC makes money is mainly through interest rate income (although they may sell their assets at profits / losses or convert it into an equity position if required). This means they want as high interest rates as possible. This is like speed on a treadmill.

On the other side of the equation, ARCC also funds its investment through a mix of equity and debt (around 50:50). This means ARCC has to keep the cost of its own debt low. Treat this like a resistance on a treadmill.

The quality of companies they lend to is like the running surface or the treadmill belt. If the portfolio companies default, there would be holes in the running belt, and the portfolio would wobble. Therefore, ARCC has to perform very careful due diligence on individual deals as well as wide wide diversification in terms of geographies and sectors.

Finally, as borrowings mature, ARCC needs to keep a healthy pipeline of deals to keep the running distance as long as possible. This can be from new investments and existing portfolio companies (in Q2, it’s roughly a 40:60 split).

What does winning look like? Run as fast as possible, in the face of ever-changing resistance, without stepping on holes, and just keep the game going for as long as possible.

And that is precisely what ARCC has done over the past decade. We will dive into all these important factors now.

2. Q2 2024 Highlights

The Q2 Revenue of $755m showed showed a healthy acceleration from the previous two quarters, increased by 19.1% YoY.

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