Ares Capital Corporation — Form 10-K Summary
Business context and reporting period
Ares Capital Corporation is a Maryland-based, externally managed business development company and regulated investment company. It primarily provides debt and equity financing to U.S. middle-market companies, with a focus on first- and second-lien senior secured loans, unitranche loans, subordinated debt, preferred equity and selected common equity investments. The filing covers the fiscal year ended December 31, 2022, and was filed February 7, 2023.
At year-end, Ares Capital reported approximately $22.4 billion of total assets, 466 portfolio companies and $21.8 billion of investments at fair value. Software and services was the largest industry concentration at 21.9% of portfolio fair value.
Key financial metrics
| Metric | 2022 | 2021 | Change |
|---|---|---|---|
| Total investment income | $2.096 billion | $1.820 billion | +15% |
| Total expenses | $949 million | $1.050 billion | -10% |
| Net investment income | $1.092 billion | $741 million | +47% |
| Net increase in stockholders’ equity from operations | $600 million | $1.567 billion | -62% |
| Basic net increase per share | $1.21 | $3.51 | Declined |
| Net asset value per share | $18.40 | $18.96 | -3% |
| Dividends declared per share | $1.87 | $1.62 | +$0.25 |
| Total investments at fair value | $21.780 billion | $20.009 billion | +9% |
| Debt carrying value | $12.210 billion | $11.020 billion | +11% |
Interest income increased to $1.470 billion from $1.247 billion, supported by portfolio growth and higher interest rates. Dividend income increased to $424 million from $222 million, including $205 million from Ivy Hill Asset Management. Capital structuring service fees declined to $153 million from $306 million as new investment commitments and fee rates decreased.
Net investment income margin, measured as net investment income divided by total investment income, was approximately 52.1%, compared with 40.7% in 2021. The filing does not provide a conventional revenue or operating margin because Ares Capital is an investment company.
Net unrealized losses were $525 million in 2022, compared with net unrealized gains of $586 million in 2021. Net realized gains were $81 million, including $24 million of net realized gains on investments and $57 million from foreign currency and other transactions. A $48 million realized loss resulted from repaying the 2022 Convertible Notes at maturity.
Portfolio, liquidity and leverage
- Portfolio fair value increased to $21.8 billion from $20.0 billion. Amortized cost increased to $22.0 billion from $19.8 billion.
- First-lien senior secured loans represented $9.4 billion of fair value; second-lien loans represented $3.9 billion; subordinated certificates of the Senior Direct Lending Program represented $1.2 billion; and investments in IHAM represented $2.2 billion.
- Weighted average portfolio yield increased to 10.6% at fair value from 7.9% in 2021. Debt and other income-producing securities yielded 11.9% at fair value versus 8.7% in 2021.
- Loans on non-accrual status increased to 1.7% of investments at amortized cost, or 1.1% at fair value, from 0.8% and 0.5%, respectively.
- Portfolio credit quality improved modestly on the company’s internal scale: the weighted average grade increased to 3.2 from 3.1. Grade 2 and grade 1 investments represented 6.7% of fair value combined, versus 5.3% in 2021.
- Cash and cash equivalents were $303 million, with total cash, cash equivalents and restricted cash of $337 million.
- Total principal debt outstanding was $12.245 billion, compared with $11.061 billion in 2021. The weighted average stated interest rate increased to 4.2% from 3.1%, while weighted average maturity declined to 3.6 years from 4.2 years.
- Asset coverage was 177%, above the 150% statutory minimum. Debt-to-equity was 1.29:1, compared with 1.26:1.
- The company reported approximately $3.9 billion of availability for additional borrowings under its facilities, subject to borrowing-base and other restrictions.
- Net cash used in operating activities was $1.359 billion, compared with $2.459 billion in 2021, while financing activities provided $1.210 billion. Cash paid for interest was $402 million.
Material changes versus the prior comparable period
- Investment income and net investment income rose substantially as the portfolio expanded and floating-rate investments benefited from higher benchmark rates.
- Portfolio activity slowed: new investment commitments declined to $9.870 billion from $15.573 billion, while principal investments funded declined to $9.722 billion from $13.888 billion.
- New commitments funded during the year had a weighted average yield of 9.7%, compared with 7.8% in 2021. Approximately 82% of new commitments were floating rate.
- Investment fair values were pressured by wider credit spreads and higher required market returns, producing $525 million of net unrealized losses and reducing NAV per share.
- Debt increased by approximately $1.2 billion, and average debt outstanding increased to $11.530 billion from $9.411 billion. Interest and credit facility fees rose to $455 million from $372 million.
- Ares Capital issued 50.2 million common shares for net proceeds of approximately $1.001 billion. It made no repurchases under its stock repurchase program during 2022.
- Ivy Hill investment fair value increased to $2.201 billion from $936 million, and IHAM-related dividend income increased to $205 million from $93 million. Related-party loan sales to IHAM and its vehicles totaled $3.4 billion, with $20 million of net realized losses.
- GAAP capital gains incentive fee expense was reduced by $101 million in 2022, compared with $161 million of expense in 2021. No capital gains incentive fee was actually payable under the advisory agreement at December 31, 2022, although $35 million was accrued under GAAP.
Guidance, outlook, commentary, risks and unusual items
Management described 2022 credit markets as pressured by high inflation, tighter financial conditions, rising interest rates, supply-chain challenges and increased recession risk. The company expects higher rates to support net investment income because most portfolio investments are floating rate while much of its debt is fixed rate; however, rising rates also increase borrowing costs and may impair portfolio companies’ ability to service debt.
The filing does not provide formal earnings or dividend guidance. The company intends to continue quarterly distributions, but distributions remain subject to taxable income, asset coverage, liquidity, debt covenants and board approval. Estimated 2022 taxable income exceeded distributions, and approximately $675 million was expected to be carried forward for distribution in 2023; the amount was subject to finalization of the tax return.
- Interest-rate sensitivity: a 100-basis-point increase in base rates was estimated to increase annual net income by approximately $150 million before income-based fees; a 100-basis-point decrease was estimated to reduce annual net income by approximately $118 million.
- LIBOR transition: the company is transitioning investments and borrowings to SOFR and other replacement rates. Contract renegotiations, valuation effects and operational risks could affect results.
- Valuation risk: approximately $21.4 billion of investments were Level 3 assets valued using significant unobservable inputs. Higher market yields or discount rates and lower EBITDA multiples generally reduce fair values and NAV.
- Credit risk: most investments are below investment grade or unrated, portfolio companies may be highly leveraged, and non-accrual investments increased materially year over year.
- Liquidity and refinancing risk: major debt maturities include $750 million of 2023 Notes due February 10, 2023, $403 million of 2024 Convertible Notes due March 1, 2024 and $900 million of 2024 Notes due June 10, 2024.
- Unfunded commitments: net adjusted unfunded revolving and delayed-draw commitments totaled approximately $2.377 billion. The company also had $46 million of letters of credit outstanding, all scheduled to expire in 2023.
- Fee and conflict risk: the externally managed structure includes base management fees, income-based fees and capital gains incentive fees. Income-based fees may be payable on accrued income that is not ultimately collected, and related-party transactions with IHAM create potential conflicts.
- Subsequent events: in January 2023, the BNP Funding Facility was increased from $300 million to $500 million and transitioned toward SOFR-based pricing. The company also issued approximately 12.1 million shares for net proceeds of approximately $223.4 million. In February 2023, the stock repurchase program was extended to February 15, 2024.
Most important facts for investors to verify
- Whether higher interest income continues to offset higher funding costs, credit losses and portfolio valuation pressure.
- Trends in non-accrual investments, grade 1 and grade 2 exposures, PIK income and portfolio-company leverage.
- Fair-value assumptions for Level 3 investments, particularly market yields, discount rates and EBITDA multiples.
- Ability to refinance or repay the 2023 and 2024 debt maturities while maintaining asset coverage and other covenants.
- Coverage of the $1.87 per-share 2022 distribution by recurring cash income rather than accrued PIK income, realized gains or portfolio sales.
- The sustainability and concentration of income from IHAM, which represented approximately 10.1% of portfolio fair value and approximately 10.9% of investment income in 2022.
- Final 2022 taxable income, the amount carried forward for 2023 distribution and any resulting excise tax.
- Execution and economic impact of the LIBOR-to-SOFR transition and the company’s January 2023 financing amendments.