BDC CREDIT REPORTER: Ares Capital: Out of The Credit Woods ? We Don’t Think So.

There was much self congratulation at Ares Capital (ARCC) after 2 Non Accrual loans changed back to Accrual in the IQ of 2016: Universal Lubricants and Competitor Group . Here is what management said on the Conference Call after reporting that non accruals at the end of the IQ 2016 account for just 1.3% of the portfolio at cost and 0.6% at FMV:

These levels [of non-accruing loans] are very low by comparison both to our own history and to the experience of other lenders and we commend our team. It’s done a fabulous job working through these situations. We believe their  ability to manage through our non-performing loans is a meaningful competitive advantage for ARCC and has help to differentiate us as one of the few BDCs that’s been able to consistently deliver NAV growth overtime.

WET BLANKET

The BDC Credit Reporter has made a first pass through the huge Ares Capital portfolio (not including the JV with GE Capital) and we’re a little less excited:

First of all, Universal Lubricants may have been on non-accrual but the Company appears to have never been in real trouble or danger of being permanently written down, even back in December 2015. As a result, Ares carried the Company at full value even while not  getting paid back in the IVQ of 2015 (see page 44 of the 10-Q ). In fact, we had the unusual situation of a non-accruing second lien loan being valued at year end at a substantial premium to cost, while not paying its lender. Every BDC manager’s dream, but not your ordinary, run of the mill situation.

CURRENT

This quarter, UL Holdings (to use its legal name) is back paying a modest $750,000  in income for the quarter, and has been valued up another $9mn as well. Interestingly, all the $5.5mn in equity and Preferred investments Ares made have been written down to zero for awhile and remains there. All the increase in value is recorded on the second lien debt which has a 3.5% interest rate. For example, the 2016 2nd Lien loan tranche with a cost of $37mn is valued at $49.2mn.  Par due is much higher at $62.3mn.

This is how Ares explained the situation at UL Holdings on the CC:

We valued our debt investment in Universal Lubricants above our cost basis, as we expect in near-term assets sales of the company to generate a meaningful pay down on our loan and we believe further recoveries from future activities to deliver incremental value. This investment is likely near a positive resolution after much hard work.

There is obviously a lot going on here which a few cursory words on the Conference Call and on the BDC Credit Reporter cannot do justice to, but we thought the subject interesting enough to bring to readers attention.

RESTRUCTURING

Turning to Competitor Group, there is yet more going on than meets the eye. According to ARCC, the Company came off non-accrual thanks to a “balance sheet restructuring in the first quarter” and  “which allows this company more operating flexibility”. ARCC continues to work with management of Competitor to “maximize the long term value of the business”.

JIGSAW PUZZLER

Behind all the euphemisms,  here is what we’ve been able to piece together: Ares had $57mn in debt outstanding to Competitor in the form of a small Revolver and a big Term Loan due in 2018. Those loans were on non-accrual at year end. ARCC also had an equity investment in Competitor of $2.5mn, but that was written down to zero.

The above mentioned restructuring appears to have involved taking $16mn of the Term Loan and converting it into Preferred (terms unknown but unlikely to be cash paying). That allows the remaining debt to return to current at a generous yield of 5.0% (low for a company that clearly has issues). The equity remains written down to zero, and the Preferred has essentially no value either. After all this chopping and changing the FMV at Competitor remains $43mn, same as at the end of the IVQ. What is different is that Ares is now in a “Control” position, which means there is some additional disclosure in the filings. This restructuring didn’t occur till late March and had no material impact on earnings in the IQ. In future quarters, income from the debt will be back on, but at a third lower level than before Competitor went on non-accrual.

NO PROBLEM

The BDC Credit Reporter has no problem with any BDC’s attempts to preserve value by restructuring an under-performing investment, or even adding more capital (lenders who’ve become owners in troubled oil deals  have been doing a lot of that in recent quarters, but we are digressing…).  We’re glad ARCC did not write up the new Preferred to par following the restructuring as some BDCs have been known to do. Without the benefit of more information, we can’t evaluate if carrying the senior debt of Competitor (even if lightened by a third) at par following such a restructuring  is appropriate or not. Time will tell us more.

NOT OVER TILL IT’S OVER

Where we demur is the suggestion on the Conference Call that either UL Holdings or Competitor Group are out of the woods from a credit perspective. The former’s valuation remains based on asset sales and other unstated developments: all in the future. The very need for a restructuring and the taking of a Control interest by Ares suggests Competitor is still very deeply in those proverbial woods.

Moreover, while both companies are going to be back paying interest on a current basis,  income to the BDC will be modest even after these two first quarter “victories”. Again, ARCC “controls” UL Holdings, which probably accounts for the “friends and family” 3.56% subsidized rate being charged on the $50mn in debt outstanding, and the 5% at Competitor. By our count, ARCC has $119mn invested at cost in these two companies, which they are valuing at $110mn, but will be generating on a pro-forma basis only $3.9mn in interest income, or a 3.2% yield at cost. That’s about a third of the average yield on the portfolio.

The BDC Credit Reporter is keeping both investments squarely on our Watch List. We have a suspicion we will be hearing about both companies before long.

BIGGER PICTURE

The BDC Credit Reporter does not only go into the minutiae of deals like the above. We also look at the Big Picture.  After reviewing the latest 10-Q filing, we added 5 more investments to our Ares Capital Watch List (including two which involve more than $100mn of exposure each).  Admittedly, these 5 companies did not drop very sharply in value and may yet recover with no harm and foul involved. Still, that brought the number of investments on our Watch List to 32 on a total portfolio of 218.  Or, put another way statistically, that means 15% of all investments are in some form of distress or under-performance. That’s an increase of 20% of companies in this category in just 3 months.

UP AND DOWN

There was a lot of movement up and down the Watch List in this last quarter. Of the 27 investments that were already being Watched at the beginning of the year, 7 increased in value, 11 remained essentially unchanged and 9 decreased further in value.  Of course, it’s that last category most investors will be worrying about. Some of the investments dropping in value (during a quarter when the credit markets as a whole were posting a rebound) are small, and won’t move the needle of the Company’s capital, either individually or collectively. However, 5 of the 9 have a cost above $10mn…

THIS WE BELIEVE

Overall,  the BDC Credit Reporter argues that-despite all the time spent on the Conference Call about the “improvement” in the non-accrual category-overall credit quality at Ares Capital continued to erode in the first quarter of 2016, continuing a process that began the year before.

IF YOU DON’T BELIEVE US JUST ASK… ARES

Just in case you’re saying to yourself the problem may lie less with Ares and more with the BDC Credit Reporter’s list making of what should or should not be on the Watch List, we’d point you to the Company’s own internal rating system. Admittedly their way of counting these issues is not identical to ours. ARCC  counts 24 under-performing investments to our 32. Nonetheless, the value of investments marked at Category 1 or 2 (their two buckets for measuring under-performers)  increased in the first 3 months of the year to $607mn. That represents a 28% increase in a quarter on a portfolio that barely changed in overall size over the period involved (0.3% !).

Also-for what it’s worth-the value of investments in ARCC’s lowest rating category (the one in which they “may realize a substantial loss upon exit) has jumped from $29mn to $128mn , a more than four fold increase. In 90 days.

Using ARCC’s own numbers, under-performing assets  are equal to 11.7% the Company’s GAAP equity, up from 9.2% at the end of last year.

UNSURPRISING

Readers and investors should not be surprised. Despite their undeniable credit skills, the Ares team are not infallible and we are in year seven of an economic expansion that has involved fierce competition for lending to some of the most leveraged companies in history. Moreover, the Company has been seeking to maintain  earnings because of the loss of the JV with GE Capital, which has meant more lending at higher yields and in subordinated or second lien positions. At the end of March 2016, three-quarters of the Company’s assets were in investments at junior levels of companies capital structures.

Into all lives some rain must fall, and Ares Capital’s management does themselves and their investors no favors by implying that they can run through the raindrops and not get wet. Still, it’s impossible to estimate what a good number might be for potential eventual credit write-offs-if any-might be from these 24-32 under-performers. It’s not just the difficulty of peering into the future, and the paucity of information about many of the deals, but also having to evaluate how well the “restructurings”,  forced asset dispositions and other tools sophisticated and well financed lenders like Ares can employ that might prevent, delay or worsen the final reckoning. We’ve had a quick look into two this quarter with UL Holdings and Competitor Group.  Imagine what the lanscape might look like with many, many more such investments in intensive care. How many will emerge unscathed ?

CONCLUSION

Ares may have cut the number of non-accrual loans on their books by two this quarter, and brought the percentage of defaulted loans down to a below average level both by comparison with its own track record and those of its peers, but the overall credit quality story continues to erode. Both by our count and theirs, the dollars involved of under-performing investments continues to rise. Nothing is written in stone and Ares pride themselves (maybe a little too much) of avoiding tight jams by staying away from certain sectors and by finding credible solutions when investments do go south. The BDC Credit Reporter wishes them well, but we expect to remain busy in the quarters ahead tracking our growing Watch List at the Company.