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, with a lesser focus on equity investments. This report covers the quarterly period ended September 30, 2012.

Key Financial Metrics

Material Changes vs. Prior Period

• Investment Income Growth: Total investment income increased 13.9% for the three months ended September 30, 2012, compared to the same period in 2011, driven primarily by a larger portfolio size (average amortized cost increased from $4.7 billion to $5.6 billion).
• Expense Increases: Total expenses rose to $99.1 million for the quarter (from $68.4 million in 2011), largely due to higher interest and credit facility fees ($35.7 million vs. $31.0 million) and increased incentive fees ($34.1 million vs. $10.2 million) resulting from higher pre-incentive fee net investment income.
• Realized Gains/Losses: The company recorded net realized gains of $27.7 million for the quarter, a significant improvement from the $48.8 million gain in the prior year quarter, though the nine-month period showed a net realized loss of $18.9 million compared to a $105.0 million gain in the prior year.
• Unrealized Gains: Net unrealized gains were $19.4 million for the quarter, reversing a net unrealized loss of $106.5 million in the prior year quarter.
• Debt Structure: The company issued $175 million in October 2022 Notes and $162.5 million in 2017 Convertible Notes during the period, increasing total debt outstanding.

Guidance, Outlook, and Risks

• Portfolio Strategy: Management continues to seek opportunities to dispose of non-yielding equity investments and controlled portfolio company investments acquired in the Allied Capital merger, rotating capital into higher-yielding first and second lien senior loans.
• Senior Secured Loan Program (SSLP): The company co-invests with GE in the SSLP. As of September 30, 2012, the SSLP had $5.9 billion in funded loans with a weighted average yield of 8.1%. The company's yield on its SSLP investment was 15.5%.
• Dividends: The company declared a fourth-quarter dividend of $0.38 per share and an additional dividend of $0.05 per share in November 2012, payable in December 2012.
• Risks: Key risks include the impact of interest rate fluctuations, the liquidity of credit markets, the valuation of illiquid portfolio investments, and the financial condition of portfolio companies. The company notes that 2.6% of total investments at amortized cost were on non-accrual status as of September 30, 2012.
• Subsequent Events: In October 2012, the company issued $230 million in 2018 Convertible Notes and contributed its entire investment in FirstLight Financial Corporation to Ivy Hill Asset Management, recognizing a net loss of $26.1 million.

Investor Verification Checklist

• Non-Accrual Status: Verify the specific portfolio companies contributing to the 2.6% of investments on non-accrual status and the potential impact on future income.
• Realized Losses: Review the details of the $46.8 million realized loss on Prommis Solutions, LLC, which was a significant driver of the nine-month net realized loss.
• Debt Covenants: Confirm continued compliance with asset coverage ratios (currently 277%) and borrowing base restrictions across the Revolving Credit Facility, Revolving Funding Facility, and SMBC Funding Facility.
• Valuation Methodology: Assess the reliance on Level 3 inputs (unobservable data) for the majority of the portfolio ($5.93 billion) and the sensitivity of fair values to changes in market yields and EBITDA multiples.
• FirstLight Contribution: Understand the implications of the subsequent contribution of the FirstLight Financial Corporation investment to Ivy Hill Asset Management and the associated $26.1 million loss.