Ares Capital Corporation 10-Q Summary
Business context and reporting period
Ares Capital Corporation is an externally managed, non-diversified business development company and regulated investment company focused primarily on first- and second-lien senior secured loans, subordinated debt, preferred equity and, to a lesser extent, common equity investments in middle-market companies. The filing covers the quarter ended March 31, 2023; financial statements are unaudited.
Key financial metrics
| Metric | Q1 2023 | Q1 2022 or period-end comparison |
|---|---|---|
| Total investment income | $618 million | $440 million |
| Total expenses | $298 million | $229 million |
| Net investment income | $318 million | $198 million |
| Net increase in stockholders’ equity from operations | $278 million | $211 million |
| Basic/diluted earnings per share | $0.52/$0.51 | $0.44/$0.43 |
| Operating cash flow | $872 million | $481 million |
| Net cash change | $40 million increase | $228 million increase |
| Net investment income margin | Approximately 51.5% of investment income | Approximately 45.0% |
| Net assets | $10.049 billion | $9.555 billion at December 31, 2022 |
| Net asset value per share | $18.45 | $18.40 at December 31, 2022 |
| Investments at fair value | $21.148 billion | $21.780 billion at December 31, 2022 |
| Debt carrying value | $11.164 billion | $12.210 billion at December 31, 2022 |
| Cash and cash equivalents | $359 million | $303 million at December 31, 2022 |
Investment income increased primarily because of higher interest rates and a larger average portfolio. The average portfolio at amortized cost was $21.736 billion versus $19.559 billion in Q1 2022, while the weighted average yield increased to 10.9% from 8.1%. Interest and credit facility expense rose to $139 million from $93 million, reflecting higher average debt and floating-rate borrowing costs.
Material changes versus the prior comparable period
- Net investment income increased approximately 61% to $318 million, while total investment income increased approximately 41%.
- Net realized investment results changed from a $69 million gain to a $20 million loss. Foreign currency and other transactions produced a $30 million realized loss in Q1 2023.
- Net unrealized gains were $10 million, compared with $3 million in Q1 2022; however, the filing attributes investment valuation pressure primarily to higher market yields and weaker credit and equity market pricing.
- Investment commitments declined materially: new commitments were $766 million versus $2.001 billion, while exited commitments were $1.884 billion versus $2.551 billion.
- Debt declined by approximately $1.046 billion, principally because $750 million of 2023 Notes matured and was repaid in February 2023. The debt-to-equity ratio declined to 1.12:1 from 1.29:1.
- The company issued 25.3 million common shares for net proceeds of $477 million, including public and at-the-market offerings.
- The quarterly dividend increased to $0.48 per share from $0.45 per share in Q1 2022, although Q1 2022 included an additional $0.03 per share dividend.
Portfolio, liquidity and debt
- The portfolio was concentrated in Software and Services at 21.6% of fair value, Financial Services at 13.8%, Health Care Services at 11.3% and Commercial and Professional Services at 9.8%.
- Loans on non-accrual status represented 2.3% of investments at amortized cost and 1.3% at fair value, compared with 1.7% and 1.1%, respectively, at December 31, 2022.
- Portfolio credit grades were 23.7% Grade 4, 68.6% Grade 3, 6.1% Grade 2 and 1.6% Grade 1 at fair value. The weighted average grade declined to 3.1 from 3.2.
- Asset coverage was 189%, above the 150% regulatory minimum. Approximately $4.4 billion was available for additional borrowings under the facilities, subject to borrowing-base and other restrictions.
- Net adjusted unfunded revolving and delayed-draw loan commitments were $1.934 billion, and net adjusted unfunded equity commitments were $54 million. The company also had $49 million of portfolio-company letters of credit outstanding.
- Approximately 69% of investments at fair value bore variable rates, while 11% bore fixed rates; 94% of variable-rate investments excluding the SDLP Certificates had interest-rate floors.
Outlook, management commentary, risks and unusual items
Management described credit markets as pressured during the quarter because of inflation, tighter financial conditions, financial-market instability and increased recession risk. Rising rates supported investment income but also increased borrowing costs and contributed to lower portfolio valuations. Management cautioned that results can vary substantially because of investment exits, realized gains and losses, unrealized valuation changes and market conditions.
- Most investments lack readily available market quotations and are valued using significant unobservable inputs; fair values may differ materially from eventual realizations, particularly in a forced sale.
- Interest-rate sensitivity analysis indicates that a 100-basis-point increase in base rates would increase annual net income by approximately $129 million before income-based fees, while a 100-basis-point decrease would reduce it by approximately $99 million, assuming no portfolio or debt changes.
- Q1 2023 included a $50 million net realized loss, a $10 million net unrealized gain and a $6 million GAAP reversal of capital gains incentive fee expense. No capital gains incentive fee was payable under the investment advisory agreement, although $29 million remained accrued under GAAP.
- In April 2023, the main revolving credit facility was amended to extend selected revolving and term-loan maturities, principally to April 19, 2028. The BNP facility was increased from $500 million to $790 million and extended to April 20, 2028, with higher applicable spreads.
- In April 2023, the stock repurchase authorization was increased from $500 million to $1.0 billion. No shares had been repurchased under the program through March 31, 2023.
- From April 1 through April 19, 2023, management reported $369 million of new investment commitments, $397 million of exits and approximately $310 million of investment backlog and $190 million of pipeline. These transactions were not guaranteed to close.
- Material risks include portfolio-company defaults, non-accruals, valuation uncertainty, rising borrowing costs, liquidity and refinancing risk, dependence on bank relationships, macroeconomic deterioration, regulatory and tax changes, LIBOR transition, cybersecurity events, geopolitical risks and the ability to maintain required dividend distributions.
Most important facts for investors to verify
- Whether the increase in non-accrual investments and the higher Grade 1 exposure continue or worsen after March 31, 2023.
- The sustainability of Q1 net investment income and dividends after higher funding costs, incentive fees and potential rate declines.
- Fair-value assumptions for the $20.683 billion of Level 3 investments, including market yields, discount rates and EBITDA multiples.
- Upcoming debt maturities, refinancing terms and the effect of the April 2023 facility amendments on liquidity and borrowing capacity.
- The funding requirements and credit performance of the $1.934 billion of net adjusted unfunded loan commitments and $54 million of equity commitments.
- Whether the reported backlog and pipeline close and at what yields, leverage levels and portfolio concentrations.
- The effect of related-party activity involving Ivy Hill Asset Management, the Senior Direct Lending Program and controlled portfolio companies.