Regardless of the specific motive for the short interest spike (e.g. it could be the result of hedging activity or it could be more speculative- perhaps a bet against high yield in general, or perhaps someone is short Ares and long a basket of other BDCs based on a perceived merger arbitrage opportunity), it will likely subside soon leading into the acquisition (which may close as soon as the first week of January 2017), and may put upward pressure on the stock price as shorts buy to close their positions.

For reference, here is a chart of the performance of ARCC relative to a BDC index following the acquisition announcement in May (we also included the NASDAQ- the exchange upon which ARCC trades).

Specifically, it will likely be good for Ares Capital Corporation (NASDAQ:ARCC) if/when the merger goes through because it has already sold off and the short-interest will likely return to normal levels and this may cause the stock price to increase. And if the merger falls apart, that too will likely be good for Ares stock price because with most large acquisitions (such as the American Capital acquisition) the shares of the acquirer often decline (as seems to be the case for Ares since the acquisition announcement). An abandonment of the merger could cause Ares shares to rise as well.

Risks

There are certainly other risks to Ares business that are worth considering. For example, the increasingly hawkish US Federal Reserve could impact Ares in a negative way. Ares describes this risk in their annual report as follows:

We are exposed to risks associated with changes in interest rates. General interest rate fluctuations may have a substantial negative impact on our investments and investment opportunities and, accordingly, may have a material adverse effect on our investment objective and rate of return on invested capital. Because we borrow money and may issue debt securities or preferred stock to make investments, our net investment income is dependent upon the difference between the rate at which we borrow funds or pay interest or dividends on such debt.

Additionally, low interest rates are intended to boost the economy, and raising rates could slow the economy and slow the activities of the companies to which Ares does business with.

As mentioned early, external management conflicts of interest pose a risk. Ares describes this risk in their annual report as follows:

There are significant potential conflicts of interest that could impact our investment returns. Certain of our executive officers and directors, and members of the investment committee of our investment adviser, serve or may serve as officers, directors or principals of other entities and affiliates of our investment adviser and investment funds managed by our affiliates. Accordingly, they may have obligations to investors in those entities, the fulfillment of which might not be in our or our stockholders’ best interests or may require them to devote time to services for other entities, which could interfere with the time available to provide services to us.

In addition to potential conflicts of interest, externally managed BDCs (such as Ares) also often charge higher operational and management fees because they’re not properly incentivized to keep them lower.

As another risk example, we believe Ares involves a higher than average degree of risk, as described in the company’s annual report:

Investing in our common stock may involve an above average degree of risk. The investments we make in accordance with our investment objective may result in a higher amount of risk than alternative investment options and volatility or loss of principal. Our investments in portfolio companies may be highly speculative and aggressive and, therefore, an investment in our securities may not be suitable for someone with lower risk tolerance.

Conclusion

Overall, we like Ares Capital Corporation (NASDAQ:ARCC) so much that we’ve ranked it #4 on our recent list of Four Big Dividend BDCs Worth Considering. Specifically, we like its big dividend, discounted price, and diversified business structure. We also believe short-term market activity (e.g. the proposed merger, and the recent selloff in high yield securities) has created a more attractive entry point for long-term investors. We’d have ranked Ares higher on our list if it wasn’t for the external management team and potential conflicts of interest. As an income investor, we believe Ares is worth considering for the higher risk portion of your diversified long-term portfolio. And if you are interested in additional big-dividend opportunities, consider our recent sister article: Big Dividend REITS: Ranking the Best and Worst.

Note: This article was written by Blue Harbinger. At Blue Harbinger, our mission is to help you identify exceptional investment opportunities while avoiding the high costs and conflicts of interest that are prevalent throughout the industry. We offer additional free reports and a premium subscription service at BlueHarbinger.com. If you are ever in the Naperville, IL, USA area, our founder (Mark D. Hines) is happy to meet you at a local coffeehouse to talk about investments. Please feel free to get in touch.