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 extent of equity investments. This report covers the quarterly period ended June 30, 2011, and includes the results of the combined company following the April 1, 2010, acquisition of Allied Capital Corporation.

Key Financial Metrics

Material Changes vs. Prior Period

• Investment Income Growth: Total investment income increased by approximately 49% compared to the prior year period, driven by a larger portfolio size (average amortized cost of $4.4 billion vs. $4.0 billion) and increased capital structuring service fees due to higher new investment commitments.
• Expense Increases: Total expenses rose to $184.5 million from $106.3 million. This increase was primarily due to higher interest and credit facility fees (reflecting higher debt levels and rates) and increased incentive management fees resulting from higher net investment income and portfolio appreciation.
• Realized Gains: The company reported net realized gains of $56.2 million for the six months ended June 30, 2011, compared to $7.4 million in the prior year. This included approximately $109.2 million in net realized gains from investments acquired in the Allied Capital acquisition.
• Debt Extinguishment Losses: The company recognized a realized loss of $19.3 million on the extinguishment of debt, resulting from the redemption of the 2011 Notes and 2012 Notes.
• Unrealized Gains: Net unrealized gains decreased significantly to $32.2 million from $122.4 million in the prior year, largely due to net unrealized depreciation in the legacy Allied Capital portfolio.

Guidance, Outlook, and Risks

• Portfolio Strategy: Management intends to continue rotating and repositioning the legacy Allied Capital portfolio, focusing on reducing holdings of lower and non-yielding investments, non-accrual assets, and non-core investments to rotate them into higher-yielding first and second lien senior loans.
• Debt Capital Activities: The company issued $575 million of February 2016 Convertible Notes and $230 million of June 2016 Convertible Notes in early 2011. The weighted average stated interest rate on indebtedness increased to 5.1% as of June 30, 2011.
• Liquidity: As of June 30, 2011, the company had approximately $851.2 million available for additional borrowings under its Revolving Funding Facility and Revolving Credit Facility, subject to borrowing base and leverage restrictions.
• Risks: Key risks include the impact of a protracted decline in credit market liquidity, fluctuations in interest rates, the valuation of illiquid investments, and the ability to successfully integrate and rotate the Allied Capital portfolio. The company notes that 3.5% of total investments at amortized cost were on non-accrual status as of June 30, 2011.

Investor Verification Checklist

• Debt Extinguishment Costs: Verify the impact of the $19.3 million loss on extinguishment of debt on net income and future capital structure.
• Non-Accrual Assets: Review the specific portfolio companies on non-accrual status (3.5% of amortized cost) and the adequacy of reserves.
• Convertible Notes: Assess the dilution risk and interest expense associated with the $805 million in newly issued convertible notes.
• Allied Capital Portfolio Rotation: Monitor the progress of exiting legacy Allied Capital assets and the yield on new investments replacing them.
• Management Fee Accruals: Note the $55.4 million GAAP accrual for capital gains incentive fees, which may not be payable under the agreement until realized gains are confirmed.