Business Context and Reporting Period
Ares Capital Corporation (ARCC) is a closed-end, non-diversified management investment company regulated as a Business Development Company (BDC) under the Investment Company Act of 1940. The company is externally managed by Ares Capital Management LLC, a subsidiary of Ares Management L.P. Its investment objective is to generate current income and capital appreciation primarily through first and second lien senior secured loans, mezzanine debt, and equity investments in U.S. middle-market companies.
This summary covers the fiscal year ended December 31, 2016. As of this date, Ares Capital was the largest BDC in the U.S. with approximately $9.2 billion in total assets. A significant subsequent event occurred on January 3, 2017, when the company completed the acquisition of American Capital, Ltd. in a cash and stock transaction valued at approximately $4.2 billion.
Key Financial Metrics
| Metric | 2016 | 2015 |
|---|---|---|
| Total Investment Income | $1,012 million | $1,025 million |
| Net Investment Income | $494 million | $508 million |
| Net Increase in Stockholders' Equity from Operations | $474 million | $379 million |
| Net Asset Value (NAV) per Share | $16.45 | $16.46 |
| Total Assets | $9,245 million | $9,507 million |
| Total Debt (Principal Amount) | $3,951 million | $4,197 million |
| Weighted Average Yield (Fair Value) | 9.4% | 10.3% |
| Dividends Declared per Share | $1.52 | $1.57 |
Liquidity and Leverage: As of December 31, 2016, the company held $223 million in cash and cash equivalents. Total debt outstanding was approximately $4.0 billion in aggregate principal amount. The asset coverage ratio was 230%, well above the 200% regulatory minimum required for BDCs. The weighted average stated interest rate on outstanding debt was 4.2%.
Material Changes vs. Prior Period
- Investment Income: Total investment income decreased slightly by 1.3% to $1,012 million. This was primarily due to a decrease in the weighted average yield of the portfolio (from 10.3% to 9.4%), driven largely by the declining yield of the Senior Secured Loan Program (SSLP) certificates, partially offset by an increase in the average portfolio size.
- Net Investment Income: Decreased by 2.8% to $494 million, reflecting the lower investment income and a slight increase in total expenses.
- Realized and Unrealized Gains/Losses: The company reported a net loss of $20 million on realized and unrealized gains/losses in 2016, compared to a net loss of $129 million in 2015. This improvement was driven by net realized gains of $110 million and a reduction in net unrealized depreciation.
- Portfolio Composition: The portfolio remained diversified, with "Investment Funds and Vehicles" (including the SDLP and SSLP) representing 25.2% of the portfolio at fair value. The weighted average credit grade of the portfolio was 3.1 (on a scale of 1 to 4, where 4 is the least risk).
Guidance, Outlook, and Risks
Management Commentary and Outlook: Management highlighted the completion of the American Capital Acquisition as a transformative event that increased the company's capital base and diversified its portfolio. The company intends to continue borrowing under its existing facilities and may issue additional debt or equity to fund growth. The investment adviser has agreed to waive up to $100 million in income-based fees over the first 10 quarters following the acquisition to support the transaction.
Risks and Contingencies:
- Market Volatility: The company faces risks from capital market disruptions, interest rate fluctuations, and economic downturns which could impact portfolio valuations and the ability to refinance debt.
- Leverage: The use of leverage magnifies the potential for gain or loss. A decline in asset values could cause NAV to decline more sharply than it would without leverage.
- Co-Investment Programs: The SSLP, which represented approximately 22% of the portfolio, is in a wind-down phase with no new investments expected. The yield on SSLP certificates is expected to decline as principal proceeds are directed to repay senior notes held by GE.
- Legal Proceedings: The company is involved in litigation regarding the American Capital Acquisition and a fraudulent transfer claim involving a former portfolio company (DSI Renal Holdings), though management believes these claims are without merit.
Key Facts for Investor Verification
- American Capital Acquisition Integration: Verify the successful integration of American Capital's portfolio and the realization of anticipated cost savings and synergies post-closing (January 2017).
- SSLP Wind-Down Impact: Monitor the declining yield and principal balance of the Senior Secured Loan Program (SSLP) and its impact on overall portfolio income.
- Debt Maturities: Review the schedule of debt maturities, particularly the $162 million in 2017 Convertible Notes and the $571 million outstanding under the Revolving Credit Facility, to assess refinancing needs.
- Dividend Sustainability: Confirm that net investment income continues to cover the quarterly dividend rate of $0.38 per share, especially given the reduction in portfolio yield.
- Asset Coverage Ratio: Ensure the company maintains the required 200% asset coverage ratio under the Investment Company Act, particularly if market conditions lead to further unrealized depreciation.