By Bill Alpert
As individual investors bail from many private-credit funds, Ares Capital remains an investor favorite. The fund trades at just 1% below its book value, while publicly traded credit funds average 20% discounts to book. It pays a generous dividend. And most of Wall Street rates it a Buy.
Yet its penchant for letting borrowers pay interest on their loans with noncash IOUs could set the fund up for trouble if the lending environment deteriorates.
The $30 billion Ares fund, often referred to by its ticker symbol ARCC, is the largest publicly traded business development company -- a form of private-credit fund exempt from corporate tax.
The fund has averaged 12% annualized returns since its 2004 initial offering, and has maintained or raised its dividend for 17 years running. That record helped launch the sprawling complex of funds now run by its advisor, Ares Management.
Ares Capital differs from other high-rated BDCs in riskier ways. More of its holdings are equity investments, while fewer are the first-lien senior secured loans prized by credit fund investors.
Notably, more of the investment income booked by Ares is in the form of IOUs, not cash in hand. To win loan deals in recent years, Ares allowed many borrowers to defer paying cash interest with payments-in-kind, or PIK, that get tacked on to the outstanding loan. In 2025, noncash PIK interest and dividends were nearly $490 million, or 34%, of Ares' net investment income. A decade ago, PIK was 8% of its net investment income.
In most of the past 10 years, Ares's dividend payouts haven't been covered by the cash components of its net interest and dividend income, according to the company's financial statements. Money from loan repayments, investment gains , and capital inflows helped the BDC satisfy its dividend obligations.
"It is something to be concerned about," says Robert Willens, a veteran accounting analyst focused on Wall Street. "While collections are robust, it's not something to be worried about, but when collections are not..."
Ares Capital has had few bad loans, and its approach has worked for two decades. The BDC told Barron's that its past five years of dividends were "fully covered" by cash collected as interest and dividends, along with investment gains.
"We continue to believe that ARCC's current dividend approximates the long-run underlying earnings power of our business," CEO Kort Schnabel told listeners on last week's earnings call.
The bread and butter of a direct lender like Ares Capital is lending to companies acquired by private-equity firms. These midsize businesses often take on heavy debt loads at rates that float five percentage points or more above the benchmark rates paid by investment-grade borrowers.
When the Federal Reserve began hiking rates four years ago, it buoyed private credit's floating rates as high as 11% and 12%. To make those rates bearable, credit funds structured some loans at the outset to let borrowers meet some interest obligations with noncash payments-in-kind.
Like banks, the credit funds can include these noncash PIK receipts in their GAAP earnings. Since investors prefer to get their dividends in cash, a fund that's getting more of its interest as PIK must find the cash for dividends elsewhere -- or cut the dividend.
PIK loans have become entrenched in direct lending. From 2022 to 2025, loans with some portion of PIK increased from around 10% to 18% of portfolio assets at publicly traded BDCs, according to Raymond James. Benchmark rates have cycled down, but noncash lending hasn't.
Ares Capital had been making PIK loans for many years, so it was comfortable offering noncash terms to win business from rivals like Blue Owl Capital and Blackstone. ARCC also took preferred stock from corporate borrowers and accepted PIK dividends.
The fund says it only takes equity in the best borrowers. "These minority equity investments are made selectively, generally alongside loans we originate and underwrite ourselves, allowing us to participate in the equity where we see particularly strong upside cases," ARCC President Jim Miller told last week's conference call.
That has produced a portfolio at ARCC that looks different from its big BDC peers.
To calm the nerves of individual investors, other fund managers lately have highlighted how much of their holdings are first-lien senior secured loans, which sit on top of a company's capital stack and get paid first, if a borrower comes to grief. Such loans made up 80% of the average BDC portfolio last year, says Raymond James. At the $14 billion Blackstone Secured Lending fund -- another highly valued BDC -- 98% of investments are first-lien loans.
First-lien loans were 60% of Ares's portfolio at the end of March. Another 11% were second-lien and junior loans. The remaining 29% were various kinds of equity.
Ares says that its equity selections have done well. In fact, the sale of four equity positions helped cover the March-quarter dividend.
"Over the last 10 years, our equity co-investment portfolio generated an average gross [internal rate of return] well in excess of the double-digit total return of the S&P 500 index," Miller said on the earnings call.
Portfolio yields on its first-lien loans were about 9% last year. Equity and junior debt yielded around 11%.
Unlike other BDCs, Ares hasn't paid a high price for its reliance on PIK interest. Two other listed BDCs with high levels of PIK are FS KKR Capital and Blue Owl Technology Finance. They trade at two-third s of Ares's book multiple.
Ares says it has a good record with PIK. In more than 190 PIK deals since the fund's 2004 start, Ares has made back 1.4 times its capital in those deals, Miller told last week's call.
"We have selectively used PIK over our history," Miller said. "As with all investments, PIK investments are underwritten with the same discipline as cash pay loans, with a strong focus on structure, leverage, and exit protections."
Cash-flow coverage of its dividends is another matter. Without including noncash PIK, Ares netted $1.1 billion in cash interest and dividends last year, after expenses. The fund paid $1.26 billion in dividends. Dividend payouts have exceeded cash net investment income for most of the last decade.
Ares says that isn't the right way to look at its dividend coverage.
Most BDCs have just one line on their cash-flow statement showing loan repayments. Ares has a line showing the cash received for the principal payoff, and then a separate line showing cash collected for the deferred PIK interest when loans are paid off. In 2025, for example, Ares collected about $130 million in past-period PIK interest from loans and another $150 million for previously deferred PIK dividends from preferred stock.
These PIK collections should count toward a period's dividend coverage, says the fund. So should performance fee adjustments and investment gains. Counting that way for the period since January 2021, Ares tells Barron's, "we believe our base dividends have also been fully covered by cash flow over that period."
Adding last year's $280 million of PIK collections and $100 million in investment gains to $1.1 billion of cash net investment income, the $1.26 billion in 2025 dividends were covered.
PIK collected as part of a loan payoff seems a less reliable source of dividend cash than regularly paid cash interest, says Nick Nemeth, a consultant and independent analyst who has studied private credit.
Cash interest and dividends will come in as long as borrowers have the cash flow, but PIK collection depends on investments getting repaid, refinanced or sold, he notes.
"If they collect the cash at the end of the day, then they collect the cash at the end of the day," Nemeth says. "The PIK cash flow is lower quality, to be sure."
Ares has delivered for its shareholders. But its reliance on PIK interest, junior debt, preferred stock, and investing gains could be problematic in a down market.
Write to Bill Alpert at william.alpert@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
May 06, 2026 01:00 ET (05:00 GMT)
Copyright (c) 2026 Dow Jones & Company, Inc.
Comments