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, mezzanine debt, and equity in private middle-market companies. This report covers the quarterly period ended June 30, 2008.

Key Financial Metrics

Material Changes vs. Prior Period

• Investment Income Growth: Total investment income increased 34% ($16.1 million) for the three months ended June 30, 2008, compared to the same period in 2007. This was driven by a larger portfolio size (average investments at fair value increased from $1.5 billion to $2.0 billion) and higher capital structuring service fees.
• Expense Increases: Total expenses rose 21% ($4.8 million) quarter-over-quarter, primarily due to higher base and incentive management fees resulting from the expanded asset base. Interest expense decreased slightly due to lower average borrowing costs (3.59% vs. 5.95% in 2007), offset by higher average outstanding borrowings.
• Unrealized Losses: The company reported significant net unrealized losses of $32.8 million for the quarter and $49.8 million for the six-month period. Major contributors to depreciation included investments in Courtside Acquisition Corp. ($13.8 million), Reflexite Corporation ($10.0 million), and Making Memories, Inc. ($7.3 million).
• Portfolio Yield: The weighted average yield on the portfolio decreased to 9.82% as of June 30, 2008, from 10.22% at year-end 2007, largely due to declining LIBOR rates.

Guidance, Outlook, and Risks

• Liquidity and Capital: As of June 30, 2008, the company had $77.0 million in cash and approximately $326.3 million available for additional borrowings under its credit facilities. The company completed a transferable rights offering in April 2008, raising approximately $260 million.
• Market Conditions: Management noted continued volatility in global credit markets, which has limited capital availability. However, the extension of the CP Funding Facility to July 2009 (amended July 22, 2008) was intended to minimize uncertainty regarding access to capital.
• Investment Activity: During the quarter, the company funded $252.2 million in new investments and exited $71.2 million. The weighted average yield of new debt investments funded was 13.14%.
• Risks: Key risks include the impact of interest rate changes on net investment income, the ability of portfolio companies to meet payment obligations, and the inherent uncertainty in valuing illiquid private investments. Approximately 1.3% of the portfolio at fair value was on non-accrual status as of June 30, 2008.

Investor Verification Checklist

• Valuation Methodology: Verify the fair value determinations for Level 3 assets (approx. $2.07 billion), as these rely on unobservable inputs and board discretion.
• Non-Accrual Status: Review the specific portfolio companies on non-accrual status (2.9% of amortized cost) and the adequacy of reserves.
• Debt Covenants: Confirm compliance with asset coverage ratios under the Investment Company Act and specific covenants in the Revolving Credit Facility and CP Funding Facility.
• PIK Income: Assess the sustainability of dividends given that a portion of income is derived from Payment-in-Kind (PIK) interest ($12.9 million for the six months), which is non-cash.
• Commitments: Review the $333.4 million in unfunded revolving commitments and $425.2 million in unfunded private equity commitments to understand future capital deployment obligations.