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 invests primarily in first and second lien senior loans and mezzanine debt of U.S. middle-market companies, with a lesser focus on equity investments. The reporting period covers the fiscal year ended December 31, 2008.

Key Financial Metrics

Material Changes vs. Prior Period

• Significant Unrealized Depreciation: The company recorded net unrealized losses of $272.8 million in 2008, a sharp increase from $10.7 million in 2007. This was driven by unprecedented declines in corporate debt market prices and liquidity, resulting in a 27% drop in NAV per share.
• Investment Income Growth: Total investment income increased 27% to $240.5 million, primarily due to portfolio growth (average investments rose from $1.5 billion to $2.0 billion) and higher weighted average yields.
• Debt Expansion and Cost Reduction: Total debt increased by $227.3 million to $908.8 million. However, the weighted average interest rate on borrowings dropped significantly from 5.66% to 3.03%, reducing interest expense despite higher leverage.
• Portfolio Quality: The weighted average investment grade of the portfolio declined from 3.0 in 2007 to 2.9 in 2008. Six loans were past due or on non-accrual status as of year-end.

Guidance, Outlook, and Risks

Market Conditions and Liquidity: Management notes that severe dislocation in credit markets has limited access to capital. The company intends to adjust the pace of investments, become more selective, and pursue asset sales or recycling of lower-yielding investments to maintain liquidity. There is no assurance that these activities will be successful if market disruption worsens.

Debt Facilities: The CP Funding Facility ($350 million capacity) is scheduled to expire on July 21, 2009. The company is discussing an extension; failure to renew could force the sale of collateral. The Revolving Credit Facility was increased to $525 million in January 2009.

Risks:

• Valuation Uncertainty: Approximately 180% of net assets are invested in private companies without readily available market quotations, making fair value determinations inherently uncertain and susceptible to market volatility.
• Leverage: The company utilizes significant leverage (debt-to-equity ratio of 0.83:1). A decline in asset values could trigger covenant breaches or force asset sales at disadvantageous prices.
• Dividend Sustainability: As a Regulated Investment Company (RIC), the company must distribute at least 90% of taxable income. The company may need to sell assets or raise capital to meet distribution requirements if cash flow from operations is insufficient.

Investor Verification Checklist

• Verify the status of the CP Funding Facility extension negotiations, given the July 2009 maturity date.
• Review the specific portfolio companies contributing to the $272.8 million unrealized loss to assess the likelihood of recovery versus permanent impairment.
• Monitor the asset coverage ratio (220% as of year-end) to ensure compliance with Investment Company Act requirements (minimum 200%) amidst potential further valuation declines.
• Assess the impact of Payment-in-Kind (PIK) interest ($32.8 million recorded in 2008) on cash flow availability for dividend payments.
• Confirm the stock price discount to NAV, which widened to approximately 68% as of February 2009, limiting the ability to raise equity capital.