Better Blue-Chip High Yield Buy: Ares Capital Or Hercules Capital?

Both Ares Capital (NASDAQ:ARCC) and Hercules Capital (NYSE:HTGC) offer investors very high dividend yields. Both also boast investment grade credit ratings and impressive track records of delivering market-crushing total returns for shareholders:

In this article, we will compare them side by side and offer our take on which one is a better buy at the moment.

Ares Capital Vs. Hercules Capital – Balance Sheet

Both ARCC and HTGC enjoy investment grade credit ratings from multiple agencies.

As of the end of Q3, ARCC’s leverage is 53.62%, whereas HTGC’s is slightly lower at 52.02%. ARCC’s liquidity is $4.5 billion, whereas HTGC’s liquidity is $700.1 million.

Overall, we give the edge to ARCC here. While its leverage ratio is a tiny bit higher than HTGC’s, it has vastly superior liquidity and it also has an investment grade credit rating from S&P which HTGC lacks (it only has investment grade ratings from Fitch and Moody’s). We believe this gives ARCC superior access to capital, especially if economic conditions worsen.

Ares Capital Vs. Capital Southwest – Business Models

HTGC has much greater exposure to senior secured loans than ARCC does at 92.2% vs. 69.3%. It also has greater overall exposure to debt investments (94.9%) relative to ARCC (83.8%) and more of its debt trades at floating interest rates (94.7%) compared to ARCC’s (86.6%).

While this paints an image of HTGC being more defensively positioned than ARCC is, it does not tell the full story. That is because HTGC invests primarily in pre-IPO and innovative high-growth venture-backed companies. As a result, these companies are typically higher risk than the average company that ARCC invests in. While HTGC’s diversification and focus on investing at the senior secured debt level provides some conservatism to its investments, it does not ignore the fact that these companies are likely going to struggle more in the current environment than ARCC’s more stable, established businesses will.

In fact, ARCC has 23% exposure to software businesses that generate considerable recurring revenue and 11% exposure to recession-resistant healthcare as its top two industries.

That said, two major arguments in HTGC’s favor are:

(1) It is internally managed which means it is better aligned with shareholders and charges lower management fees.

(2) As often the only lender to these companies which are desperate for capital in the current environment, HTGC is able to command very attractive terms that often include short-term amortizing maturities and warrants in addition to the loan, giving it additional upside potential for the companies that turn out to be big winners.

These stronger terms have resulted in very strong underwriting performance thus far despite the weakening environment for speculative high-growth tech companies. As a result, its non-accrual rate is currently even lower than ARCC’s is.

Ares Capital Vs. Hercules Capital – Dividend Outlook

Both businesses are benefiting from rising interest rates and stable GDP levels, which is flowing through to the amount of dividends being paid out to shareholders.

ARCC’s management addressed this when they recently said:

We elected to raise the regular quarterly dividend from $0.43 to $0.48 per share because the company is now experiencing a higher level of core earnings, primarily due to the substantial increase in base rates. This increase, the largest quarterly increase in our company’s history, is our third increase this year and results in a regular dividend that is 17% higher than our regular quarterly dividend level at the end of 2021.

The higher base dividend that we are paying also reflects our positive outlook on our ability to generate this level of core earnings under a variety of interest rate and economic scenarios for the foreseeable future.

HTGC said something similar when they said on their latest earnings call:

Hercules continues to be positioned extremely well to navigate the current market and operating environment. Our operating platform in Q3 benefited from over $475 million of investment portfolio growth year-to-date. A rising interest rate environment and a strong balance sheet that is funded primarily with fixed rate long dated unsecured term loans.

This combination of events increase net investment income to $50 million, a 25% quarter-over-quarter increase or $0.39 per share in Q3. This was achieved by delivering another record core income combined with a more normal volume of prepayments. Credit remains strong and non-accruals continue to be less than 1% of the portfolio positioning us well to continue to generate strong operating results.

HTGC has raised its quarterly dividend from $0.47 in Q4 2021 to $0.51 in Q4 2022, reflecting substantial 8.5% year-over-year growth. ARCC grew its dividend by an even more impressive 26.2% year-over-year from Q4 2021 to Q4 2022.

Wall Street analyst consensus estimates project that ARCC will generate a 3.7% dividend per share CAGR and a 5.7% earnings per share CAGR through 2024. Meanwhile, analysts expect HTGC to generate a 3.9% dividend per share CAGR and a 7.7% earnings per share CAGR through 2024.

Ares Capital Vs. Hercules Capital – Valuation

Based on the numbers below, HTGC offers investors a higher earnings and dividend yield while ARCC is much cheaper than HTGC on a NAV basis:

Valuation Metric	HTGC	ARCC
Price to NTM Normalized Earnings	8.04x	8.76x
NTM Dividend Yield	10.8%	10.3%
P/NAV	1.28x	1.04x

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Investor Takeaway

On paper, these two stocks look pretty competitively matched as each has its strengths and weaknesses. ARCC looks to have a slightly stronger balance sheet position and its portfolio holdings are probably better situated to weather an impending recession. Its recent dividend growth momentum has also been stronger, its long-term track record is a little better than HTGC’s is, and is much cheaper relative to NAV compared to HTGC.

That said, HTGC still has an impressive long-term track record, has better current underwriting performance than ARCC has, is generating higher earnings and dividend yields at current prices than ARCC is, has a slightly better growth outlook than ARCC, and is internally managed whereas ARCC is externally managed.

Overall, we prefer ARCC at the moment given that its price to NAV ratio – the most accurate valuation metric for BDCs in our view – is nearly 25% lower than HTGC’s is and we think it will weather the upcoming recession better given its investment portfolio constituents.

You can read our full ARCC investment thesis here and see our latest in-depth analysis of the BDC (BIZD) sector along with our top picks here.