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Ares Capital: High Yield in Private Equity

Here's why, as interest rates go up, so will Ares' earnings.

Ares Capital (ARCC) invests in the debt and equity of privately held companies. Its management keeps a sharp eye on its loan portfolio, explains income expert Jack Adamo, editor of Insiders Plus.

Witness that loan losses, or nonaccruing loans, are just 0.9% of the fair value of its portfolio. Assurance that attention to loan quality will remain acute is the fact that insiders own 1.9 million shares, which is a fair number for a firm its size.

Further faith in the company’s loan portfolio comes from the fact that 91% of it is floating-rate, while Ares’ funding is 82% fixed and only 18% floating. Bottom line? Management has locked in rates on their liabilities but will benefit from the uptick in interest rates. Moreover, the loan-to-value ratio of its portfolio is 54%, not 80-95%, as typically seen in mortgage lending.

As a result of its efforts, Ares has also earned an investment-grade credit rating of BBB. The company invests primarily in noncyclical businesses with attractive growth prospects and high free cash flow. It avoids volatile industries like retailing and mining and is cautious on oil and gas. About 21% of the portfolio is health care, 19% is business services, and 7% is consumer products.

The stock is a dividend play. The $0.38 per quarter dividend yields 9.6%. The dividend may vary quarter to quarter, but $0.30 is the lowest it has been since 2004 when it was listed. Recall that many companies slashed dividends brutally during the 2008 crash.

Not Ares. Recent dividend coverage is 124%, and as interest rates go up, so will Ares’ earnings. Oh, I almost forgot to mention. The stock’s trailing P/E was under 12. That’s the kind of value we’re always looking for.

Ares is a Business Development Company. Like a REIT, it has a pass-through tax structure. It must distribute at least 90% of its taxable income as dividends to investors. That means its probably taxed as ordinary income, not dividends. Check with your tax advisor. You may have a higher net return if you put it in an IRA.

The stock was recently featured in Barron’s; given Ares’ relatively small float and the thirst for income these days, this one could get out of hand. So be careful and don’t buy with a market order.

Jack Adamo is editor of Jack Adamo’s Insiders Plus.

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