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). This Form 10-Q covers the quarterly period ended June 30, 2010. The reporting period is significantly impacted by the consummation of the "Allied Acquisition" on April 1, 2010, an all-stock merger with Allied Capital Corporation valued at approximately $908 million. Consequently, the financial results for the three and six months ended June 30, 2010, reflect the combined operations of Ares Capital and Allied Capital, whereas the 2009 comparative periods reflect only Ares Capital's standalone operations.
Key Financial Metrics
| Metric | Six Months Ended June 30, 2010 | Six Months Ended June 30, 2009 |
|---|---|---|
| Total Investment Income | $188.1 million | $115.1 million |
| Net Investment Income | $81.2 million | $62.1 million |
| Net Increase in Stockholders' Equity (Operations) | $406.6 million | $69.8 million |
| Basic & Diluted EPS | $2.57 | $0.72 |
| Total Assets | $4.07 billion | $2.31 billion (Dec 31, 2009) |
| Total Investments at Fair Value | $3.79 billion | $2.17 billion (Dec 31, 2009) |
| Total Debt (Carrying Value) | $1.24 billion | $0.97 billion (Dec 31, 2009) |
| Cash and Cash Equivalents | $138.8 million | $99.2 million (Dec 31, 2009) |
| Net Assets Per Share | $14.11 | $11.44 (Dec 31, 2009) |
Material Changes vs. Prior Period
- Revenue Growth: Total investment income increased 63% year-over-year for the six-month period, driven primarily by the acquisition of Allied Capital's portfolio. Interest income from investments rose 56% to $165.6 million.
- Expense Increase: Total expenses increased 101% to $106.3 million. This includes a $16.3 million increase in interest expense due to the assumption of Allied Capital's unsecured notes and $16.3 million in one-time professional fees related to the Allied Acquisition.
- Unusual Items: The Company recognized a non-cash gain on the acquisition of Allied Capital Corporation of $195.9 million. This gain arose because the fair value of the identifiable net assets acquired exceeded the fair value of the consideration transferred.
- Portfolio Composition: The portfolio expanded significantly, with 99 companies acquired from Allied Capital. As of June 30, 2010, 9.4% of total investments at amortized cost were on non-accrual status, compared to 2.5% at December 31, 2009.
Guidance, Outlook, and Risks
Management Commentary: Management highlighted the successful integration of the Allied Acquisition and the expansion of the portfolio. The Company continues to seek opportunities to dispose of certain equity investments acquired from Allied Capital to rotate capital into higher-yielding debt investments. The weighted average yield of the total portfolio at fair value was 10.12% as of June 30, 2010.
Liquidity and Capital Resources: As of June 30, 2010, the Company had approximately $807 million available for additional borrowings under its credit facilities and debt securitization, subject to borrowing base and leverage restrictions. The asset coverage ratio for borrowed amounts was 318%, well above the 200% requirement under the Investment Company Act.
Risks and Contingencies:
- Valuation Risk: Substantially all investments are valued at fair value determined by the Board of Directors. Due to the lack of readily available market prices, these valuations involve significant judgment and may differ materially from values realized upon liquidation.
- Interest Rate Risk: The Company is exposed to interest rate fluctuations. Approximately 52% of the portfolio was at fixed rates and 24% at variable rates as of June 30, 2010. The Company utilizes an interest rate swap agreement to mitigate some exposure.
- Legal Proceedings: Shareholder lawsuits challenging the Allied Acquisition were filed in Maryland and D.C. courts. As of the filing date, settlements had been reached and approved by the courts, dismissing the claims.
Investor Verification Checklist
- Acquisition Accounting: Verify the details of the $195.9 million gain on the Allied Acquisition and the fair value adjustments made to the acquired portfolio.
- Non-Accrual Status: Review the 9.4% of the portfolio on non-accrual status and the specific portfolio companies contributing to this figure (e.g., Firstlight Financial Corporation, Crescent Equity Corp).
- Debt Structure: Confirm the terms and interest rates of the assumed Allied Capital unsecured notes (2011, 2012, and 2047 Notes) and their impact on future interest expense.
- Unfunded Commitments: Assess the $180 million in net adjusted unfunded commitments and the $446 million in unfunded private equity commitments.
- Dividend Sustainability: Analyze the ratio of net investment income to dividends declared ($0.70 per share for the six months) to ensure coverage of future distributions.