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 March 31, 2012.

Key Financial Metrics

Material Changes vs. Prior Period

• Investment Income Growth: Total investment income increased by 23.6% to $167.7 million, driven primarily by a larger portfolio size (average amortized cost of $5.1 billion in 2012 vs. $4.3 billion in 2011) and higher capital structuring service fees.
• Realized Losses: The company reported a net realized loss of $7.7 million, a significant shift from the $62.6 million net realized gain in Q1 2011. The loss was primarily due to exits from Huddle House, Inc. ($1.7 million) and LVCG Holdings LLC ($6.6 million).
• Expense Increases: Total expenses rose to $88.0 million from $85.8 million. This included higher interest and credit facility fees ($32.8 million vs. $30.2 million) due to increased average debt outstanding, and higher base management fees ($20.0 million vs. $16.7 million) reflecting the larger asset base.
• Debt Extinguishment: Unlike Q1 2011, which included an $8.9 million loss on the extinguishment of debt, Q1 2012 had no such loss.

Guidance, Outlook, and Risks

• Portfolio Composition: As of March 31, 2012, the portfolio was 84.9% Grade 3 (neutral risk) and 10.0% Grade 4 (favorable risk). Only 1.6% of the portfolio was Grade 1 (substantial risk of loss). Non-accrual loans represented 1.0% of total investments at fair value.
• Liquidity and Capital: The company raised $252.4 million in a public equity offering in January 2012. It maintains significant borrowing capacity, with approximately $945.8 million available under its credit facilities as of March 31, 2012.
• Recent Developments: In May 2012 (subsequent to the period end), the company amended its Revolving Credit Facility to increase the commitment size to $900 million, extend the maturity to 2016, and reduce the interest rate spread.
• Risks: Key risks include the valuation of illiquid investments, interest rate fluctuations (though 68% of the portfolio is variable rate), and the financial condition of portfolio companies. The company notes that forward-looking statements are subject to uncertainties regarding the U.S. economic recovery and European sovereign debt issues.

Investor Verification Checklist

• Valuation Methodology: Verify the board's fair value determinations for Level 3 assets, which constitute the vast majority of the portfolio, as these rely on unobservable inputs and management judgment.
• Non-Accrual Status: Monitor the 1.0% of investments on non-accrual status to assess potential future credit losses.
• Debt Covenants: Confirm continued compliance with asset coverage ratios (currently 270%) and borrowing base restrictions across the Revolving Credit Facility, Revolving Funding Facility, and SMBC Funding Facility.
• Realized Loss Drivers: Review the specific circumstances surrounding the $6.6 million loss on LVCG Holdings LLC and the $1.7 million loss on Huddle House, Inc.
• Capital Gains Fee Accrual: Note the GAAP accrual of $54.7 million for capital gains incentive fees, which may not be payable under the investment advisory agreement until realized.