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's investment objective is to generate current income and capital appreciation primarily through first and second lien senior loans and mezzanine debt in U.S. middle-market companies. The reporting period covers the fiscal year ended December 31, 2007.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total investment income increased 57% to $188.9 million, driven by a 65% increase in interest income ($162.4 million) due to portfolio expansion. Average investments at fair value grew to $1.5 billion from $871.0 million in 2006.
• Expense Increase: Total expenses rose 62% to $94.8 million. This was primarily due to a 99% increase in interest expense and credit facility fees ($36.9 million) resulting from higher outstanding borrowings, and a 72% increase in base management fees ($23.5 million).
• Capital Markets Activity: The company raised $344.2 million in net proceeds from equity offerings in 2007. Total debt increased to $681.5 million, utilizing a Revolving Credit Facility ($282.5 million), CP Funding Facility ($85.0 million), and Debt Securitization ($314.0 million).
• Portfolio Performance: While net realized gains were positive at $6.5 million, the company recorded net unrealized losses of $10.7 million, compared to $14.6 million in 2006. Significant unrealized depreciation occurred in investments such as MPBP Holdings, FirstLight Financial, and Wear Me Apparel.

Guidance, Outlook, and Risks

• Outlook: Management expects to continue raising capital through debt and equity issuances to fund investment objectives. As of February 27, 2008, the company had an investment backlog of approximately $244.0 million and a pipeline of $314.4 million.
• Liquidity: The company maintains significant liquidity through cash flows from operations and access to credit facilities. The CP Funding Facility expires in October 2008, while the Revolving Credit Facility matures in December 2010.
• Key Risks:
  • Leverage: The company uses significant debt (asset coverage ratio of 265% as of Dec 31, 2007). Leverage magnifies potential gains and losses; a decline in asset values could sharply reduce net asset value.
  • Interest Rate Risk: Net investment income depends on the spread between borrowing costs and investment yields. A significant change in market rates could materially affect income.
  • Valuation Uncertainty: A large percentage of the portfolio consists of non-publicly traded securities valued by the Board of Directors, which may differ materially from values realized upon sale.
  • Regulatory Compliance: Failure to maintain RIC status or BDC compliance could result in corporate-level taxation and reduced operating flexibility.

Investor Verification Checklist

• Debt Covenants: Verify continued compliance with asset coverage ratios (minimum 200%) and borrowing base limitations under the Revolving Credit Facility and CP Funding Facility.
• Non-Accrual Status: Review the $20.7 million aggregate principal amount of loans placed on non-accrual status as of December 31, 2007, and the adequacy of fair value write-downs.
• PIK Interest: Assess the impact of $16.2 million in Payment-in-Kind (PIK) interest income, which is non-cash but requires cash distributions to maintain RIC status.
• Equity Offerings: Monitor the effectiveness of recent equity raises in funding the $244 million investment backlog and maintaining the target leverage ratio.
• Valuation Methodology: Scrutinize the Board's fair value determinations for private investments, particularly those with significant unrealized depreciation.