On the morning of 23 May 2016, at 7:44am, a joint statement from Ares Capital Corporation and American Capital hit the newswires announcing an industry-reshaping transaction in which the former would acquire the latter.
That same morning, both parties had executed what would end up being a $3.62 billion merger agreement, excluding American Capital’s mortgage management arm, which would be sold to real estate investment trust American Capital Agency Corporation (AGNC).
“We wanted something that was of scale,” says Ares chief executive Kipp deVeer. “So, the idea that we would spend a lot of effort going out to buy a $300 million market-cap business development company didn’t make much sense for us, because it wouldn’t move the needle and the return on time and capital was probably pretty low. Number two, we wanted something that we think represents real value for our shareholders.”
The announcement was the big reveal, but only one step in a process that began months before as American Capital considered strategic alternatives. Only on 3 January did the merger close. It was the latest milestone for a company that has consistently grown over the last dozen years to become an alternative lending behemoth.
In 2004, much of the current leadership moved to Ares including deVeer, co-chairman Michael Arougheti, investment committee member David Schwartz and co-president Michael Smith, joining investment committee member Kort Schnabel, who came to Ares in 2001. Co-president Mitch Goldstein arrived in 2005, while Jim Miller, who also sits on the investment committee, joined a year later. Co-portfolio manager of US direct lending Michael Dieber and investment committee member Mark Affolter were hired in 2008 and chief financial officer Penni Roll in 2010.
“We were attracted to the BDC structure since it offered permanent equity capital, and we thought that the duration of the capital would permit us to attract the best borrowers seeking growth capital,” deVeer says. “We also believed that we could grow the vehicle over time by delivering attractive and consistent returns to investors.”
In October 2004, Ares held an initial public offering that raised $165 million of equity with which it bought a portfolio of loans from RBC for $140.8 million. The next month it garnered a $150 million debt facility from institutional lenders agented by now-defunct Wachovia. One of the loans in the RBC portfolio was to Reef, the sandal and shoe company.
Publicly listed BDCs were still rare then. Before 2004 – when Prospect Capital Corporation, Apollo Investment Corporation and OHA Investment Corporation also completed IPOs – there were fewer than half a dozen traded BDCs. Today, there are roughly four-dozen public BDCs.
“And at the time, direct lending wasn’t really an established asset class. It was much more of a deal business; it was very fragmented,” deVeer says. The BDC vehicle would give Ares the base to grow the firm substantially.
In May 2015, American Capital decided on a spin-off plan in which it would create a BDC known as American Capital Income, according to the phone book-size proxy American Capital and Ares distributed to their shareholders to vote on the transaction.
According to the proxy, there was “general disappointment” among American Capital’s management and board of directors about investors’ reaction to its ACI plans after a call on 5 November 2015. Eleven days later, an activist investor would throw a wrench in the spin-off proposal.
On 16 November, American Capital received a letter from Elliott Management disclosing it now held an 8.4 percent stake in the firm and vehemently opposed the ACI spin-out. The letter said the shareholder was “convinced” the proposal would “put valuable assets at risk, serve to entrench management and significantly limit options for future stockholder value creation”.
A little over a week later, American Capital announced the start of a strategic review process that would look at alternatives for the BDC, including a sale of the firm. Then-chief executive Malon Wilkus said he was “fully supportive” of this strategic review.
Before disclosing the review, Ares Management, Ares Capital’s indirect advisor, contacted Wilkus about possible transactions. Wilkus, who could not be reached for comment for this article, responded on 25 November, noting it would be too early to begin dialogue with Ares.
“We tried staying in contact with the company to figure out if there were things we could do together,” Arougheti says. “Due to the involvement of activist shareholders, a process emerged quickly and we participated in what was a competitive process.”
“The idea that we would spend a lot of effort going out to buy a $300 million market-cap business development company didn’t make much sense for us”
Over the course of December through mid-January, Ares Capital met select American Capital shareholders, including Elliott Management, to discuss the possibility of a deal.
Meanwhile, American Capital said on 7 January 2016 it would accept offers for its whole business. Its financial advisors, Goldman Sachs and Credit Suisse, shopped American Capital’s assets through January and February. The firms contacted 136 parties, resulting in 64 confidentiality agreements. “There was a lot of interest in the company in the January/February timeframe, when everybody got into the preliminary data room and started doing work on its portfolio,” deVeer says. “We were staffing deal teams on every significant portfolio company and producing underwriting memos on nearly every asset in their portfolio.”
On 19 February, Ares submitted a non-binding letter of interest. Over the next five days, American Capital received 17 additional indications of interest: four other possible bids for the whole company, a dozen for specific parts of the business and a bid for the planned ACI assets.
Eleven of those suitors would make the cut for the next round, including four seeking to buy all of American Capital. On 15 March, two days before Wilkus stepped down as CEO, an unidentified number of bidders made the last round and were ordered to submit final bids by 8 April. AGNC CEO Gary Kain, who couldn’t be reached for comment, would take over as American Capital’s CEO.
PLAYING FOR KEEPS
After the 8 April final bid deadline, Ares and another unnamed party emerged as favourites, with both submitting cash-and-stock offers of $16.34 and $16.33, respectively.
“This team has always worked together, including on the Allied [Capital] acquisition in 2009-10,” Arougheti says, referring to Ares’ $648 million merger with New York-based Allied. “So when American Capital presented itself, we literally had an M&A playbook that we had developed across the entire Ares Management platform.” American Capital and its two pursuers exchanged revised bids multiple times until the unnamed party told American Capital on 12 May it would up the ante. The bidder would increase its on-the-table offer by $50 million if the two entered into an exclusivity agreement, meaning Ares would be out of the running. The offer stood until the end of the day.
American Capital asked Ares that same day if it would increase its offer by $75 million. Ares said it would, under the condition that American Capital also enter into an exclusivity agreement and cease its stock buyback programme.
“The process was very competitive, and it required several refreshed bids as they pushed to get our best and final offer on price,” deVeer says.
By the end of the day, American Capital would only have one suitor – it told the unnamed party it would be moving forward with Ares’ offer. The next day, 13 May, Ares submitted its final bid.
Over the next 10 days, final details were ironed out between the buyer and the seller. On 22 May, American Capital’s and Ares’ boards authorised their respective managements to ink the deal.
DeVeer says May, in the run-up to signing the merger agreement, involved working every weekend and sleepless nights. Almost seven months later, though, both companies’ shareholders would approve the transaction, which closed on 3 January.
Under the final deal, American Capital shareholders were to receive $18.06 a share in total consideration as part of the Ares merger and mortgage arm sale to AGNC. Ares would pay American Capital shareholders $14.41 per share. Cash from Ares Management contributed $1.20, while cash from the mortgage sale clocked in at $2.45 a share.
“I’ll tell you what, it was a lot of fun,” Arougheti says. “I actually think that kind of challenge makes us enjoy what we do the most. That’s why we show up every day.”
BDCs AS BORROWERS
Ares Capital would end up expanding its debt capacity by $1.3 billion to finance the transaction, a sum that speaks to capital markets’ acceptance of BDCs. It amended a facility with a group of banks and another with Bank of America Merrill Lynch and Wells Fargo, giving Ares $3.5 billion in borrowing capacity.
CFO Penni Roll, who joined Ares through the Allied Capital acquisition, says the types of debt available to the firm have increased the more it has grown.
“Scale has made a big difference in accessing the capital markets as well,” Roll says. “As we’ve grown, we’ve expanded our reach to have both secured and unsecured debt available to us.”
Banks have not completely exited the mid-market, but most industry practitioners attribute the growth of alternative lending to commercial banks’ retrenchment from lending to mid-sized businesses.
“Banks are still investing in this asset class, but they are doing it in partnership with us, not necessarily in competition with us,” Arougheti says.
“When American Capital presented itself, we literally had an M&A playbook that we had developed across the entire Ares Management platform”
Roll says the company is careful when it taps the capital markets.
“You have to pick your timing to go into the market, and I think we are very good about opportunistically accessing the market when it’s available at an attractive price,” she says. “You always want to go when you don’t need the money. You want to go when it’s the right time in the market to have the wind at your back to price at tight terms.”
“In a levered market, now that the asset class has been accepted, 50 cents of every dollar, and in some cases 67 cents of every dollar, is actually coming from a bank,” Arougheti says, explaining that about half of Ares’ leverage is bank capital, while the other half is institutional money.
“If you look at what really drove banks out of the middle market, it wasn’t Dodd-Frank. It was bank consolidation. From the late ’80s through to the financial crisis, you saw significant consolidation of the US banking industry where now 65 percent of bank assets are held by five institutions.”
Co-president Michael Smith says the firm took advantage of developments in the market. “As the banks were consolidating over the past 20 years, we made significant investments in our people, processes and in regional offices in order to meet the expected demand for the kind of lending these institutions would no longer be doing and the growth in private equity ownership of middle market companies,” he says.
Ares Capital likes to espouse the benefits of “incumbency”, the idea that future deals come from past deals, that the next transaction for the firm might be sitting right in its portfolio.
“At Ares Capital Corp, about 40 percent of our dealflow comes from the existing portfolio,” deVeer says.
On its third-quarter 2016 earnings call, deVeer told participants the firm would back Insight Venture Partners’ buyout of Lenoir City, Tennessee-based Ministry Brands, which provides software to churches, with a $1 billion first and second lien deal.
“Ministry Brands is a perfect example,” deVeer says.
“I would say we had a relatively easier time boxing out any competition, and the buyer of that company this time around put real value in having the incumbent, Ares Capital Corporation, with a completely certain financing.”
Ares previously invested in Ministry Brands via both debt and equity. Co-president Mitch Goldstein says 10-figure deal values have a history.
“A lot of the corporate transactions you hear about today were initially related to much smaller companies long before the market knew about them. The first time we invested in Ministry Brands, it was a lot smaller,” Goldstein says, noting some portfolio companies may start off with $10 million in annual EBITDA, and over a decade, grow to $70 million. The $1 billion Ministry Brands deal came after the landmark $1.08 billion unitranche deal led by Ares in June that backed Thoma Bravo’s buyout of Qlik Technologies. Golub Capital, TPG Special Situations Partners and Varagon Capital Partners also played a role in the deal.
Such large deals signal that the private debt market has more than come into its own – alternative lenders may as well now be called mainstream lenders. As a result, deal terms and pricing have changed.
“We shouldn’t sugarcoat it,” Arougheti says. “The reality is that part of the evolution of the market – with increased awareness and more efficient capital formation – is that terms get looser and pricing gets tighter. That is to be expected.”
He still anticipates private debt will trade higher than its liquid counterpart. “I think part of the evolution of the market over time is that private credit assets will continue to trade at a premium to the liquid space because of inefficiency and the illiquidity premium,” he says.
Should that be the case then Ares, with the scale afforded it by the American Capital deal, will feel confident of its prospects in the years ahead.
TIMELINE: COUNTDOWN TO A MERGER
American Capital proposes spin-off plan to create a new BDC
Elliott Management sends letter opposing BDC spin-off, American begins strategic review
Ares Capital meets select American shareholders about deal
American says it will accept bids for whole business, financial advisors begin shopping the firm’s assets
Ares submits non-binding letter of interest
Suitors submit final bids, Ares and an unnamed bidder emerge as top contenders for American’s assets
American selects Ares as final bidder, deal finalised and announced
Shareholders of both firms approve the deal
Merger closes more than 18 months after American proposed BDC spin-out.