ARCC

ARES CAPITAL CORP - 10-Q Summary (Period Ended Sep 30, 2008)

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, mezzanine debt, and equity securities of private middle-market companies. This report covers the quarterly period ended September 30, 2008, a period characterized by significant disruption in global capital markets and declining liquidity.

Key Financial Metrics

Material Changes vs. Prior Period

• Portfolio Valuation Decline: The most significant change is the shift from net unrealized gains in 2007 to substantial net unrealized losses in 2008. YTD 2008 saw a $128.6 million unrealized loss compared to an $8.9 million gain in the prior year. This was driven by price declines and illiquidity in corporate debt markets.
• Investment Income Growth: Total investment income increased 32% YTD 2008 compared to 2007, primarily due to a larger portfolio size (average investments at fair value increased from $1.4 billion to $2.0 billion) and higher yields on new investments.
• Expense Increases: Total expenses rose 24% YTD 2008. Base management fees increased 33% and incentive fees increased 40%, reflecting the larger asset base. However, the average cost of debt decreased significantly from 6.03% in 2007 to 3.71% in 2008 due to falling LIBOR rates.
• Debt Leverage: Total debt increased by $220.7 million to $902.2 million, with the debt-to-equity ratio rising from 0.60:1.00 to 0.72:1.00.

Guidance, Outlook, and Risks

• Market Conditions: Management highlights that capital markets remain in a period of disruption and instability. Access to debt and equity capital is limited, and pricing levels have continued to deteriorate subsequent to September 30, 2008.
• Liquidity Strategy: Due to market constraints, the company intends to adjust the pace of investments, become more selective, pursue asset sales, and recycle lower-yielding investments to maintain liquidity.
• Valuation Risks: The company notes that fair value determinations for non-publicly traded investments involve significant uncertainty. Continued market deterioration could lead to further unrealized depreciation and realized losses.
• Recent Developments:
  • Entered a $75 million interest rate swap in October 2008 to mitigate interest rate risk.
  • Established "Ivy Hill Middle Market Credit Fund II" in November 2008.
  • Applied for an SEC exemptive order to co-invest with Ares Management funds.

Investor Verification Checklist

• Unrealized Loss Drivers: Verify the specific portfolio companies contributing to the $128.6 million YTD unrealized loss (notably Courtside Acquisition Corp., Firstlight Financial Corp., and Reflexite Corp.).
• Non-Accrual Status: Confirm the 3.2% of total investments at amortized cost on non-accrual status and the adequacy of reserves.
• Debt Covenants: Review compliance with asset coverage ratios (currently 238%) and other covenants in the Revolving Credit Facility and CP Funding Facility, given the decline in Net Asset Value.
• Capital Raising Ability: Assess the feasibility of future equity offerings given the restriction on issuing stock below Net Asset Value and the current market discount.
• Commitments: Review the $275.4 million in unfunded revolving commitments and $424.0 million in unfunded private equity commitments to understand future cash outflow requirements.