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 Corporation. As of December 31, 2019, Ares Capital was the largest BDC in the United States with approximately $14.9 billion in total assets. 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.

Fiscal year ended December 31, 2019.

Key Financial Metrics

Material Changes vs. Prior Period

• Portfolio Growth: Total assets increased by approximately 15.6% to $14.9 billion, driven by new investment commitments of $7.3 billion and a portfolio average size increase from $11.9 billion (2018) to $13.6 billion (2019).
• Income Growth: Net investment income rose 16.9% to $811 million, primarily due to the larger portfolio size and increased capital structuring service fees.
• Realized Gains/Losses: The company reported a net realized loss of $65 million in 2019, a significant shift from the $419 million net realized gain in 2018. This was driven by gross realized losses of $205 million, including significant losses on exits from New Trident Holdcorp, Inc. ($96 million) and Indra Holdings Corp. ($62 million).
• Leverage Increase: Total debt principal increased by 33.3% to $7.06 billion. The debt-to-equity ratio rose to 0.95:1.00 from 0.73:1.00, following the reduction of the asset coverage requirement from 200% to 150% effective June 21, 2019.
• Fee Waiver Expiration: The $10 million quarterly income-based fee waiver associated with the American Capital acquisition expired after the third quarter of 2019, resulting in higher effective fees for the full year compared to prior periods.

Guidance, Outlook, and Risks

Management Commentary: Management highlighted a disciplined investment philosophy focusing on capital preservation and low volatility. The company continues to self-originate investments and lead the investment process to maintain control over deal terms. The weighted average grade of the portfolio remained stable at 3.0 (on a scale of 1 to 4, where 4 is the least risk).

Recent Developments (Post-Year-End):

• Issued $750 million in unsecured notes (July 2025 Notes) in January 2020.
• Increased commitments under the SMBC Funding Facility and Revolving Funding Facility.
• Extended the stock repurchase program expiration date to February 15, 2021.

Risks and Contingencies:

• Interest Rate Risk: 84% of the portfolio at fair value bears variable interest rates. A 100 basis point increase in rates is estimated to increase net income by $96 million, while a 100 basis point decrease would reduce net income by $78 million.
• Liquidity and Leverage: The company relies on debt facilities and equity issuances to fund growth. Failure to maintain asset coverage ratios could restrict borrowing and dividend payments.
• Valuation Uncertainty: Substantially all investments are valued at fair value using unobservable inputs (Level 3), creating inherent uncertainty in reported NAV.
• Legal Proceedings: The company is a defendant in a lawsuit involving DSI Renal Holdings LLC, seeking approximately $117 million in damages. Management believes the claims are without merit.

Investor Verification Checklist

• Fee Structure Impact: Verify the impact of the expired fee waiver on future net investment income and the new base management fee structure (1.0% on assets financed with leverage over 1.0x).
• Asset Coverage Compliance: Monitor the asset coverage ratio (currently 204%) to ensure it remains above the 150% regulatory minimum, especially given the increased leverage.
• Portfolio Quality: Review the quarterly credit grade distribution and non-accrual status (1.9% of amortized cost) to assess credit deterioration risks.
• Realized Losses: Investigate the specific drivers of the $127 million net realized loss on investments to understand if these were isolated events or indicative of broader portfolio stress.
• Debt Maturities: Assess the maturity profile of the $7.06 billion debt portfolio, noting significant unsecured notes maturing between 2022 and 2025.