Ares Capital just posted another stellar quarter. Record NAV, strong core earnings, and a juicy dividend yield. On the surface, everything looks rosy for this private credit giant. But a closer examination of the Q1 2024 earnings call transcript reveals a subtle shift, a ghost of the past that could spell trouble for investors down the line.

This whisper from the past is the company's reliance on incumbent borrowers for new deals. In the first quarter of 2024, a whopping 70% of new commitments stemmed from existing portfolio companies, a trend mirroring the strategy of Allied Capital, a BDC that Ares acquired in 2010. While leveraging existing relationships might seem like a prudent approach in a competitive market, it can be a double-edged sword, especially in a BDC context.

Let's rewind the clock to the pre-financial crisis era. Allied Capital, once a darling of the BDC sector, built a significant portion of its portfolio through repeat business with existing borrowers. This strategy, coupled with aggressive leverage and questionable valuations, ultimately led to Allied's downfall. The company faced a liquidity crunch as credit conditions deteriorated, ultimately forcing a fire sale to Ares.

Now, fast forward to today. Ares Capital, with its seasoned management team and robust risk infrastructure, is a far cry from Allied Capital. Yet, the echo of that past strategy in the current transcript warrants attention. While the company boasts diversification with 510 companies in its portfolio, the concentration risk associated with repeat lending to the same borrowers cannot be ignored, especially in a potential economic slowdown.

Here's the hypothesis: Over-reliance on incumbent borrowers for new deal flow can create a feedback loop, masking underlying credit weakness and ultimately delaying the recognition of potential losses. As existing borrowers struggle to deleverage in a higher interest rate environment, BDCs might be tempted to extend additional credit, hoping to avoid triggering a default and preserving fee income. This can lead to a gradual buildup of risk in the portfolio, masked by seemingly healthy performance metrics.

Potential Red Flags

A deeper dive into the data reveals some potential red flags:

Revolving credit utilization ticked up in Q1: While not a drastic increase, it suggests that some portfolio companies are facing liquidity constraints, potentially turning to their credit lines to bridge the gap. PIK interest collections remain low: While not a trend, the continued low levels suggest that some borrowers might be opting to conserve cash, potentially indicating strained cash flow. Pressure on upfront fees for new deals: This subtle shift underscores the competitive dynamics in the market, potentially pushing BDCs to accept lower upfront fees to secure deals, impacting fee income generation.

While Ares Capital maintains a conservative loan-to-value ratio and its non-accrual rate remains below historical averages, these metrics could lag behind actual credit deterioration, especially if the company is actively extending additional credit to struggling borrowers.

Portfolio Composition Shift (Hypothetical)

The following chart illustrates a hypothetical shift in Ares Capital's portfolio composition, highlighting the increasing reliance on incumbent borrowers for new deals.

The parallels with Allied Capital's strategy, however distant, should serve as a cautionary tale for investors. While Ares Capital is a fundamentally strong company, excessive reliance on incumbent borrowers for new deal flow could create a hidden concentration risk, masking potential credit weakness and delaying the recognition of losses.

As the economic outlook remains uncertain and the credit cycle matures, it's crucial for investors to closely monitor the composition of Ares Capital's portfolio, paying particular attention to repeat borrowers and the potential impact of a more aggressive syndicated loan market. While the ghost of Allied Capital might not be haunting Ares Capital directly, ignoring the lessons of the past could prove costly in the long run.

Key Financial Data (Q1 2024)

"Fun Fact: The term "Business Development Company" (BDC) was created by Congress in 1980 as part of the Small Business Investment Incentive Act. BDCs were designed to provide access to capital for small and mid-sized businesses that might not qualify for traditional bank financing."