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BDC investor Ares Capital boosts senior debt portfolio

by Taina Rosa | Published November 4, 2011 at 2:32 PM

As large leveraged financings run the gauntlet of shifting loan structures and wavering lenders, some business development companies with firepower are helping to fill the gap in the middle market with an eye toward risk mitigation.

Consider Ares Capital Corp., a Los Angeles-based BDC with $13 billion under management and a survivor of the 2008 liquidity crisis. Ares Capital recently financed Aurora Capital Group's $300 million acquisition of Industrial Container Services LLC, a Montebello, Calif., maker of reusable containers, with a $236.5 million senior secured loan. The financing was one of four that it closed during the third quarter of 2011, all involving senior secured credit facilities.

It also funded Greenbriar Equity Group LLC and Berkshire Partners LLC's $385 million refinancing of AmSafe Industries Inc., maker of safety equipment for the aerospace industries, and supported Sterling Partners' refinancings of Columbia, Md., data storage provider Cornerstone Records Management LLC and InfiLaw System, a Naples, Fla.-based consortium of independent law schools.

Ares' "conservative management team has been moving towards senior secured loans, which we believe may be a good strategy in the current volatile credit environment," said Arren Cyganovich, an equities analyst at Evercore Partners Inc.

The BDC, an affiliate of Los Angeles investment group Ares Management LLC, is among a handful of lenders that have worked their way up the capital structure to mitigate credit risks while availing themselves of improved loan prices. They are among the "haves" capitalizing on dislocations in the credit markets where larger institutions may have tightened the spigot.

BDCs have a distinct business model that relies on public capital for loan portfolio growth. In turn they are required by law to distribute a minimum of 90% of their taxable earnings each quarter in the form of dividends.

During the global financial crisis, BDCs ran into trouble when stock markets collapsed, with some trading as low as 0.3 times book value. Some of the more aggressive ones, such as American Capital Ltd. of Bethesda, Md., and Washington's Allied Capital Corp., fell below their 1-to-1 debt-to-equity coverage ratio.

American Capital, which went through a long and painful restructuring, still has the largest market capitalization, at $3 billion, but its portfolio and stock have been hurt by the drops in the equities markets. Its stock has been trading at 0.61 times book value as of Oct. 28; it closed at $7.58 on Nov. 3.

Allied was folded into Ares Capital in March 2010 through an all-stock transaction valued at $648 million.

Their problems, according to Troy Ward, an analyst with Stifel, Nicolaus & Co., were driven largely by the unwinding of leverage.

Economic uncertainties have made BDCs, like other lenders, generally much more cautious, but perhaps more so in recent months.

"I think it'll continue as long as banks are less active and there is economic uncertainty," said Dean Choksi, a UBS Securities LLC analyst.

According to Stifel Nicolaus, the percentage of senior debt on BDCs' portfolios on average has gone from 43% in 2010 to 55% as of the end of the second quarter of this year. Meanwhile, subordinated debt, has declined to 30% from 41%.

Some lenders such as Ares, as well as Golub Capital BDC Inc., have also tended to offer unitranche securities that blend senior and mezzanine debt.

"We have done an increased amount of one-stop loans, or unitranche, which are much safer than subordinated debt," said Lawrence E. Golub, CEO of New York's Golub Capital. "If we go into a recession, the senior lenders are going to block payment on the subordinated debt and that is going to be very damaging to BDCs."

Golub Capital's unitranche investments rose to 35% of total investments in the second quarter, from 29% in the first quarter.

Ares and GE Capital recently announced they are boosting the capitalization of their unitranche joint venture -- the Senior Secured Loan Program -- by $2.6 billion, to $7.7 billion. The program, co-managed by GE Commercial Finance Investment Advisory Services LLC and Ares Capital, was formed in late 2007 to invest in senior secured debt of midmarket companies.

The so-called Great Recession may have passed, but most BDCs are still trading under book value, at an average of .88 of book value, said Ward. Of the 24 BDCs that Stifel Nicholas tracks, only four besides Ares trade above book value. Main Street Capital Corp. trades at 1.27 times; Hercules Technology Growth Capital at 1.03; Golub Capital at 1.06; and Triangle Capital Corp. at 1.22.

Ares Capital, with a $2.8 billion market cap, was one of a few private equity BDC affiliates that sprouted in 2004, when BDCs were all the rage among large leveraged buyout groups. It has since emerged as a dominant lender. As of Oct. 28, its stock was trading at 1.03 times book value, at $17.50. It closed Nov. 3 at $15.47.

In the second quarter of 2010, 56% of Ares' gross commitments were first-lien debt, according to disclosures. In the corresponding quarter this year, first-lien debt made up 87% of gross commitments. In the same period, senior subordinated debt dropped from 17% of gross commitments to only 3%.

At a time when BDCs are experiencing a drop overall in origination volumes, Ares Capital's origination volumes have also accelerated. In the third quarter of 2011, Ares reported $1.1 billion in originations, up from $728 million in the second quarter.

By contrast, the BDC sector's originations as a whole, minus Ares Capital, fell by 20% during the period.

"While adequate deal flow was available in the third quarter of 2011, actual origination volume for a given BDC depended on their pipeline going into the quarter as well as their capital available for deployment," Ward said.

BDCs that trade below book value have a hard time raising capital via the stock market, he added, while some of the haves may prefer a wait-and-see attitude until markets stabilize and their book value improves.

Ward doesn't believe the drop in originations is a challenge for BDCs, though Leonard M. Tannenbaum, chairman and CEO of White Plains, N.Y.-based Fifth Street Finance Corp., said those that did not raise capital "are missing out on a good market."

Spreads on senior loans have increased about 200 basis points on average over the past six months, according to practitioners.

Senior middle-market loans were priced at LIBOR plus 550 basis points in the third quarter, up from LIBOR plus 485 basis points in the second quarter of 2011, according to David J. Chiaverini, an analyst with BMO Capital Markets Corp.

Covenants have also become stricter. "They loosened in the second quarter, when the market was kind of frothy, and then got tighter in the third quarter and are going up into the fourth quarter," UBS' Choksi said.

Analysts, however, don't expect the pace of originations to rise much for the remainder of the year and into early 2012.

"Origination volumes should be flat to up in the third quarter compared to the second quarter," Choksi said. "In the fourth quarter volumes will probably be down from the third quarter," he added.

An improvement may not come until the latter half of 2012, sources said, with a clearer outlook on the sovereign debt crisis in Europe as well as an abundance of dry powder in the hands of private equity dealmakers.

According to London research firm Preqin, private equity funds have an estimated $937 billion in dry powder, 20% of which is in funds that would have to invest the money within the next two years.

"A lot of private equity funds were raised pre-crisis. As that capital is deployed it should drive tailwinds for LBO debt demand," Choksi said.

"You do have private equity firms with an incentive to put their money to work," Stifel Nicolaus' Ward agreed. This means BDCs "will have a lot of opportunities over the next several years. If there is a lack of negative catalysts, then origination volumes will increase in 2012-13."

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