OREANDA-NEWS. Fitch Ratings has affirmed the Long-term Issuer Default Rating (IDR), secured debt rating, and unsecured debt rating for Ares Capital Corporation (Ares) at 'BBB'. The Rating Outlook is Stable. Today's rating actions have been taken as part of Fitch's periodic peer review of Business Development Companies (BDCs), which comprises 10 publicly rated firms.

BDC INDUSTRY OUTLOOK

Fitch's outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.

BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at an 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.

The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms' underwriting.

Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of approximately 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy if and when underwriting conditions improve, thus weakening earnings upside.

KEY RATING DRIVERS

IDRs AND SENIOR DEBT

The ratings affirmations reflect Ares' relatively low leverage, demonstrated access to the debt and equity markets historically, consistent operating performance in a difficult market environment, moderate 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 include the capital markets impact on leverage, given the need to fair value the portfolio each quarter, dependence on the capital markets to fund portfolio growth, and a limited ability to retain capital due to dividend distribution requirements. Ares transition of its leveraged investment partnership to Varagon Capital Partners (Varagon) from General Electric Capital Corporation (GECC) is viewed as posing a near-term rating constraint given the associated execution risks, potential profitability impacts and the introduction of a new underwriting partner.

Fitch continues to believe that Ares has the strongest capital structure in the BDC space, with unsecured debt accounting for 78.6% of total debt outstanding, at par, at Dec. 31, 2015, as the company has continued to opportunistically access the capital markets for term financing. Ares has also proactively extended maturities on its corporate revolving facilities, with the earliest maturity being May 2019. In April 2015, Ares received a license from the Small Business Administration to operate as a Small Business Investment Company. The $75 million of incremental borrowing capacity has a 10-year maturity and an attractive borrowing rate.

At Dec. 31, 2015, the weighted average maturity of Ares' debt was 4.5 years, while the weighted average stated interest rate was 4.425%. Fitch believes the firm's cost of funds will decline in 2016 as $805 million of convertible note maturities are refinanced with lower cost revolver borrowings and/or lower cost public term issuance. Additionally, Ares redeemed $200 million of high coupon (7.75%) retail notes in October 2015, which will also benefit funding costs in 2016.

The amount of fixed rate debt in the capital structure positions the firm to benefit from a rising rate environment, as the majority of assets are floating rate. While Fitch believes secured borrowings may increase in 2016, as it is currently the company's cheapest source of funding, unsecured debt is expected to continue to account for the majority of debt financing.

Leverage, as measured by debt to equity, amounted to 0.81x at year-end 2015, or 0.77x net of cash, which is slightly above the firm's targeted range of 0.65x to 0.75x. Fitch expects leverage to return to the targeted-range near-term to ensure proper cushions for potential valuation movements, particularly as access to the equity markets remain uncertain.

As of Dec. 31, 2015, Ares had investments in ten portfolio companies on non-accrual status, accounting for 1.9% of the debt portfolio at value and 2.8% at cost, which was relatively consistent with YE14. The average net debt to EBITDA ratio for the underlying portfolio investments was 5.3x, which is up from 4.8x a year ago, given market conditions and increased exposure to second lien investments, which represented 31.6% of the portfolio at YE15 compared to 21% at YE14. Ares' exposure to oil and gas investments amounted to $264.1 million at Dec. 31, 2015, or 2.9% of the portfolio, which is well-below the peer average.

The investment portfolio remains relatively diverse, with the top ten investments accounting for about 62.6% and 28.5% of equity, with and without the Senior Secured Loan Program (SSLP), respectively, at Dec. 31, 2015.
In August 2015, GECC sold its U.S. sponsor finance business, through which it has participated in the SSLP, to the Canadian Pension Plan Investment Board. As of Aug. 24, 2015, all principal proceeds received by the SSLP will be used to repay the senior notes, which are held by GECC, until the notes are paid in full. As a result, the SSLP's leverage, and returns, would decline over time, absent management actions to alter the repayment structure. For example, Fitch believes Ares may look to replace GECC's senior notes with other funding (potentially from banks), in order to prevent the fund from de-levering as quickly.

In June 2015, Ares and Varagon announced the establishment of a new joint venture, called the Senior Direct Lending Program (SDLP), which will make first lien loans (including stretch senior and unitranche) to middle market companies. Fitch believes the SDLP will be structured similarly to the SSLP, with the objective of realizing returns commensurate with the SSLP, once fully ramped. Despite the similarities with the prior structure, it remains a nascent, unproven partnership.
Ares' net investment income (NII) grew 8.1% in 2015, adjusting for the GAAP accrual of incentive income, as an increase in interest income overcame declines in fee and dividend revenue and modest growth in operating expenses. While Fitch believes there is some upside to interest income in 2016, particularly if market spreads widen, fee income could decline with a reduction in the SSLP, unless offset by growth in the SDLP and syndication activity. Fee income accounted for 13.1% of revenue in 2015 compared to 16.5% in 2014.

Ares' liquidity profile remains sound with $257.1 million of balance sheet cash and nearly $1.4 billion of availability on various secured revolving facilities, subject to borrowing base requirements, at Dec. 31, 2015. Cash flows from investment repayments and exits have been significant, amounting to $3.7 billion for the year, up 8.2% from 2014, although Fitch believes the pace of repayment could slow in 2016, particularly if loan yields increase.

NII coverage of the dividend, which adjusts for non-cash incentive payment accruals, net paid-in-kind income, and special dividends, was strong, amounting to 95.6% in 2015. The firm recorded $127.5 million of net realized gains in 2015, which contribute to taxable income and spillover income. Ares had approximately $0.82 of spillover income per share at year-end 2015, which Fitch believes supports dividend consistency over the near-term.

The Stable Outlook reflects Fitch's expectations for relative operating consistency, despite the decline in the SSLP, and the maintenance of solid asset quality, modest leverage, strong liquidity, and ample dividend coverage.

RATING SENSITIVITIES

IDRs AND SENIOR DEBT

Ares's ratings could be negatively affected by outsized portfolio growth which 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 an extended increase in leverage above the targeted range, resulting from increased borrowings or material unrealized depreciation, and/or a meaningful increase in the proportion of equity holdings without a commensurate decline in leverage. A spike in non-accrual levels and weaker cash income dividend coverage would also be viewed unfavorably from a ratings perspective.
Upward rating momentum is viewed as limited over the outlook horizon of 12 - 24 months, particularly given the 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 be conditioned primarily upon very 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 Dec. 31, 2015, the company had investments in 218 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';
--Senior Unsecured Debt at 'BBB'.

Allied Capital Corporation
--Senior Unsecured Debt at 'BBB'.

The Rating Outlook is Stable.