ARCC

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 LLC. The reporting period covers the fiscal year ended December 31, 2012.

The company's investment objective is to generate current income and capital appreciation primarily through first and second lien senior secured loans, mezzanine debt, and, to a lesser extent, equity investments in U.S. middle-market companies. As of December 31, 2012, the company held approximately $6.4 billion in total assets.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total investment income increased by 17.9% to $748.0 million, driven primarily by a larger portfolio size (average amortized cost increased from $4.6 billion in 2011 to $5.5 billion in 2012) and higher capital structuring service fees.
• Expense Increases: Total expenses rose to $387.9 million from $344.6 million. This was due to higher interest and credit facility fees ($143.0 million vs. $122.5 million) and increased management and incentive fees resulting from the larger asset base and higher net investment income.
• Portfolio Composition: The portfolio fair value grew to $5.9 billion. The "Investment Funds and Vehicles" category (primarily the Senior Secured Loan Program or SSLP) represented 21.7% of the portfolio, down slightly from 23.6% in 2011. Healthcare Services remained the largest industry sector at 12.9%.
• Debt Structure: The company issued new convertible senior notes in 2012 (2017 and 2018 maturities) and unsecured notes (2022 maturity), increasing total debt principal to $2.29 billion. The weighted average stated interest rate on debt increased to 5.5% from 4.8%.

Guidance, Outlook, and Risks

Management Commentary: Management believes current market conditions present attractive opportunities due to reduced competition from traditional lenders and a large pool of un-invested private equity capital. The company continues to focus on self-originating investments in middle-market companies.

Outlook: The company intends to continue borrowing under its credit facilities and may issue additional debt or equity securities to fund growth. It expects to maintain its status as a Regulated Investment Company (RIC) by distributing at least 90% of its investment company taxable income.

Risks and Contingencies:

• Leverage Risk: The company uses leverage to enhance returns, which magnifies the potential for loss. As of December 31, 2012, asset coverage was 282%, well above the 200% regulatory minimum.
• Interest Rate Risk: Approximately 75% of the portfolio bore interest at variable rates. A 100 basis point increase in rates would increase net income by approximately $16.1 million, while a 100 basis point decrease would increase net income by $6.4 million (due to interest rate floors on assets).
• Valuation Uncertainty: Substantially all investments are valued at fair value by the Board of Directors in the absence of readily available market quotations. These valuations are inherently uncertain and may differ from realized values.
• Conflicts of Interest: The company is externally managed by an affiliate of Ares Management, creating potential conflicts regarding deal allocation and fee structures.

Key Facts for Investor Verification

• Dividend Sustainability: Verify the company's ability to maintain its $1.60 per share dividend distribution, noting that a portion of income is non-cash (PIK interest) which may require the company to raise capital or sell assets to fund cash distributions.
• Debt Maturity Profile: Review the maturity schedule of the $2.29 billion in debt, specifically the Convertible Unsecured Notes (maturing 2016-2018) and Unsecured Notes (maturing 2022-2047), to assess refinancing risks.
• SSLP Exposure: Confirm the performance of the Senior Secured Loan Program (SSLP), which represents approximately 21% of the portfolio and involves co-investment with GE.
• Portfolio Credit Quality: Monitor the weighted average portfolio grade (3.1 as of year-end) and the percentage of assets on non-accrual status (0.6% of fair value) to gauge credit deterioration risks.
• Fee Structure: Note that the investment adviser receives a 1.5% base management fee and an incentive fee based on net investment income and capital gains, which impacts net returns to shareholders.