Where Will Ares Capital Be in 3 Years?

Ares Capital (NASDAQ: ARCC) is the largest publicly traded business development company (BDC). It makes debt and equity investments in middle market companies (those with $100 million to $1 billion in annual revenue). These investments generate interest and dividend income to support the company's 9.5%-yielding dividend.

Here's a look at where the BDC appears to be heading over the next three years.

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Ares will continue to grow and diversify its portfolio

Ares Capital currently has $28.7 billion of capital invested across 587 portfolio companies, with the bulk of its portfolio (61%) being first lien senior secured loans. That's up from $21.3 billion invested across 458 portfolio companies in late 2022 (45% first lien senior secured loans).

One of the company's hallmarks is its diversification. Ares Capital currently invests capital in portfolio companies across 35 separate industries. That's more diversification than its peers, which invest capital in companies across an average of 27 industries. Ares also has much lower portfolio concentration. Its largest holding is 1.5% of its investment portfolio compared to 4.8% for the average BDC. Meanwhile, its top 10 holdings comprise 11.5% of its investment portfolio compared to 25.2% on average for its peer group.

Ares Capital is likely to continue growing and diversifying its portfolio in the future. The company made $3.9 billion of investment commitments during the third quarter across 35 new and 45 existing portfolio companies. It funded those investments by recycling capital from exited investments ($2.6 billion in the quarter) and raising $1 billion of additional debt capital. Ares has excellent relationships with banks and institutional capital providers, which should allow it to continue raising funds to grow its portfolio.

Ares will continue to move up the middle market

Middle-market companies are an underserved market. They're too large for many banks and too small for investment banks. That has enabled BDCs like Ares Capital to provide these companies with the capital they need to fund their operations and grow their businesses. The company estimates that there's a $3 trillion opportunity to provide loans to middle market companies.

Meanwhile, companies are remaining private for longer. As a result, more companies with over $1 billion in annual revenue are relying on non-traditional capital providers like BDCs for their funding needs. This market segment represents another $2.4 trillion opportunity for Ares Capital.

The BDC has been increasingly focusing on providing capital to larger companies. A decade ago, Ares' average portfolio company generated $48 million in annual earnings before interest, taxes, depreciation, and amortization (EBITDA), with a weighted average across its portfolio of $59 million. Today, the average is $177 million, and the weighted average is $305 million. This number is likely to continue rising in the future as Ares increasingly leverages its considerable scale to provide capital to larger companies.

Ares should continue to pay a sustainable dividend

Ares Capital has now delivered 16 years of stable to increasing quarterly dividends. The BDC has maintained its current quarterly rate of $0.48 per share since late 2022. Its payout is below its GAAP net income per share ($0.57 in the third quarter) and core earnings per share ($0.50). That has continued the company's long-standing trend of delivering strong dividend coverage.

The BDC is currently carrying forward $1.26 per share of excess taxable income from last year. That gives Ares plenty of cushion to maintain its dividend level if it experiences a short-term decline in earnings in the future.

Meanwhile, the company's continued investments to grow its portfolio should increase its earnings in the future. While lower interest rates will act as a headwind, as new investments will likely have a lower yield compared to exited investments, the interest rate on its debt should also decline. This positions Ares to maintain, if not grow, its dividend in the coming years.

Ares Capital should be a bigger company in three years

Ares Capital has been steadily expanding and diversifying its portfolio over the years, including increasingly investing in larger companies. These trends appear likely to continue over the next three years. That puts Ares in a strong position to continue paying a stable to growing dividend in the future.

Matt DiLallo has positions in Ares Capital. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.