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). The company invests primarily in first and second lien senior loans and mezzanine debt, with a smaller portion in equity. This report covers the quarterly period ended September 30, 2011, and the nine months ended on that date. The company is externally managed by Ares Capital Management LLC.

Key Financial Metrics

Material Changes vs. Prior Period

• Investment Income Growth: Total investment income increased to $167.4 million for the quarter (from $138.1 million in Q3 2010) and $447.4 million for the nine months (from $326.2 million in the prior year period). This growth was driven by an increase in portfolio size (average amortized cost of $4.7 billion vs. $4.0 billion in Q3 2010) and higher capital structuring service fees due to increased new investment commitments.
• Expense Increases: Total expenses rose to $68.4 million for the quarter and $252.8 million for the nine months. Interest and credit facility fees increased significantly due to higher average principal debt outstanding and the issuance of new convertible notes in early 2011.
• Unrealized Losses: The company recorded net unrealized losses of $106.5 million for the quarter and $74.3 million for the nine months, contrasting with net unrealized gains in the comparable 2010 periods. This was largely due to valuation adjustments on the legacy Allied Capital portfolio and specific portfolio company downgrades.
• Debt Extinguishment: The company recognized a realized loss of $19.3 million on the extinguishment of debt during the nine months ended September 30, 2011, following the redemption of the 2011 and 2012 Allied Unsecured Notes.

Guidance, Outlook, and Risks

• Portfolio Strategy: Management continues to rotate the legacy Allied Capital portfolio, focusing on reducing holdings of lower-yielding, non-yielding, and non-core investments to redeploy capital into higher-yielding first and second lien senior loans.
• Investment Activity: For the quarter, the company made $1.43 billion in new investment commitments and funded $1.13 billion. The weighted average yield of new debt investments funded during the period was approximately 10.0% at amortized cost.
• Capital Resources: As of September 30, 2011, the company had approximately $593.4 million available for additional borrowings under its revolving facilities. Asset coverage was 272%, well above the 200% regulatory minimum.
• Risks: Key risks include the valuation of illiquid investments, the impact of credit market liquidity, interest rate fluctuations, and the ability to successfully integrate and reposition the Allied Capital portfolio. The company notes that fair values of investments may differ materially from ultimate realized values.

Investor Verification Checklist

• Valuation of Level 3 Assets: Verify the methodology and inputs used for the $4.75 billion in Level 3 investments, which represent the vast majority of the portfolio and are subject to significant estimation uncertainty.
• Non-Accrual Status: Review the 4.0% of total investments (at amortized cost) on non-accrual status, including the specific portfolio companies involved and the likelihood of recovery.
• Debt Maturity Profile: Assess the impact of the $1.8 billion debt load, specifically the maturity dates of the 2040 and 2047 notes and the terms of the convertible notes issued in 2011.
• Legacy Allied Portfolio: Monitor the progress of exiting or repositioning the legacy Allied Capital assets, which continue to contribute to unrealized depreciation.
• Dividend Sustainability: Confirm that net investment income remains sufficient to support the quarterly dividend of $0.35 per share, considering the mix of cash and payment-in-kind (PIK) income.