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Fitch Affirms Ares Capital’s Ratings Following ACAS Purchase Announcement

May 24, 2016, 07:01 AM
Filed Under: Corporate Ratings

Fitch Ratings has affirmed Ares Capital Corporation's (Ares) Long-Term Issuer Default Rating (IDR) and secured and unsecured debt ratings at 'BBB' following the announced acquisition of American Capital, Ltd. (ACAS). The Rating Outlook is Stable.

The acquisition, valued at $3.43 billion, is expected to be funded with a combination of cash (50.9%) and stock (49.1%), consisting of approximately $1.682 billion of Ares stock, based on the current stock price, $1.47 billion of cash from Ares, and $275 million of cash consideration received from the parent of Ares's external manager, Ares Management LLC (Ares Management).

The transaction excludes American Capital Mortgage Management, LLC (part of American Capital Asset Management, LLC [ACAM]) that manages American Capital Agency Corp. (AGNC) and American Capital Mortgage Investment Corp. (MTGE), both publicly-traded real estate investment trusts (REITs). The transaction is expected to close by year-end 2016 and is subject to shareholder approval.

As part of the transaction Ares Management LLC will provide an earnings support agreement in the form of a $100 million fee waiver, which will be recognized as a $10 million quarterly reduction to the income based incentive fee (Part 1 fee) for a period of 10 consecutive quarters.


The affirmation of the ratings and the Stable Rating Outlook reflect Fitch's expectation that Ares will look to opportunistically exit ACAS's controlled equity book and collateralized loan obligation (CLO) portfolio over time so that the risk profile of the combined portfolio is consistent with the firm's combined leverage ratio. Leverage is expected to remain within the 0.65x to 0.75x targeted range at transaction close, which is within the firm's targeted range, but relatively high considering that 22% of the combined portfolio will be invested in a combination of structured products, preferred equity, and other equity. Fitch believes these exposures will decline over time, via portfolio sales and repayments, and proceeds will be redeployed into more traditional, yielding, senior secured debt investments.

The rating actions also reflect Fitch's recognition of Ares's prior experience with a transaction of this type, as its acquisition of Allied Capital Corporation in 2010 resulted in a meaningful portfolio transition as equity investments and junior debt positions were exited in favour or senior debt investments. The Allied Capital Corporation transaction was highly accretive to Ares and the portfolio transition was well-managed, in Fitch's opinion.

Ares' ratings incorporate its demonstrated access to the debt and equity markets, consistent operating performance in a difficult market environment, strong asset quality, modest portfolio concentrations, strong funding flexibility, solid liquidity, experienced management team, access to deal flow and investment resources from asset manager, Ares Capital Management, LLC, and ample dividend coverage.

Rating constraints associated with the transaction include execution risk associated with the assumption of the ACAS portfolio and the associated sale or runoff of certain higher risk investments, particularly in the face of a challenging market backdrop, elevated leverage on a risk-adjusted basis, increased use of secured funding and increased non-accruals.

From a funding perspective, the cash portion of the acquisition will be funded with a combination of incremental secured revolver borrowings (on upsized revolving facilities), possible unsecured debt issuance, and ACAS cash. Assuming no unsecured debt is issued, the proportion of secured debt in the capital structure (33% at March 31, 2016) is expected to rise over the near term, although it is expected to remain below the peer average (63% at March 31, 2016). Over time, Fitch believes Ares will look to opportunistically issue unsecured term funding to improve its funding flexibility and liquidity availability on the revolvers.

Near-term debt maturities consist of $230 million of convertible notes maturing in June 2016 and $162.5 million of convertible notes maturing in March 2017. Fitch believes these maturities are manageable and will be refinanced with revolver borrowings, unsecured issuance and/or portfolio repayment proceeds.

Dividend coverage is expected to remain solid, supported by core operating performance, the Ares Management quarterly fee waiver, and approximately $0.82 per share of spillover income as of March 31, 2016.

Positively, the increased portfolio size associated with the transaction will add to the diversification of Ares' portfolio. At March 31, 2016, the top 10 investments accounted for 35.8% of Ares's investments, with the Senior Secured Loan Program (SSLP) being the largest investment at 20.8% of the portfolio. Pro forma for the combination, the top 10 investments will decline to 30% of portfolio, with the SSLP accounting for 14.3% of the combined book. Portfolio diversification is expected to improve further over time as legacy ACAS investments are exited and the SSLP winds down, although this will be partially offset by the ramp of the Senior Direct Lending Program (SDLP), which is a partnership with Varagon Capital Partners.

Non-accrual investments will tick-up following the portfolio acquisition, but Fitch believes purchase price adjustments have been made in an effort to account for potential losses on non-accruing investments. On a combined basis, non-accruals as a percentage of the portfolio at fair value are expected to remain relatively modest.


Ares's ratings could be negatively affected by an inability to execute on the integration of ACAS, such that structured product and equity exposures remain elevated for a sustained period of time or leverage does not decline commensurately. An inability to access the unsecured markets, on an economic basis, to improve funding flexibility and refinance debt maturities over the medium-term would also be viewed negatively.

Ares's ratings could also be negatively affected by outsized portfolio growth that results in a weaker portfolio credit profile. Specifically, up-ticks in underlying portfolio leverage, and/or deterioration in portfolio company interest coverage or covenants, could signal the potential for asset quality issues down the road, which would likely pressure ratings. Negative rating actions could also result from a spike in non-accrual levels and weaker cash income dividend coverage.

Upward rating momentum is viewed as limited over the outlook horizon of 12 - 24 months, particularly given the execution risk associated with the ACAS transaction and the current challenging market backdrop. Fitch believes Ares has the potential to achieve a higher rating over the longer term, although likely no higher than 'BBB+' given Ares's reliance on wholesale funding sources, the market value sensitivity of the business model combined with the illiquidity of the majority of its investments, and the limited ability to retain capital.

An upgrade would depend on strong and differentiated asset quality performance of recent vintages. This will be evaluated in combination with the stability and consistency of Ares' operating performance, asset quality, valuation, and underlying portfolio metrics, including leverage and interest coverage. The maintenance of a strong funding profile, ample liquidity, relatively low leverage, and consistent core operating performance, would also be necessary to yield positive rating actions.

Headquartered in New York, NY, Ares is an externally managed BDC, organized on April 16, 2004. As of March 31, 2016, the company had investments in 220 portfolio companies amounting to approximately $9.1 billion.

Fitch has affirmed the following ratings:

Ares Capital Corporation

  • Long-Term IDR at 'BBB';
  • Senior Secured Debt at 'BBB'; and
  • Senior Unsecured Debt at 'BBB'.

Allied Capital Corporation

  • Senior Unsecured Debt at 'BBB'.

The Rating Outlook is Stable.

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