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 is externally managed by Ares Capital Management LLC, a subsidiary of Ares Management L.P. The reporting period covers the fiscal year ended December 31, 2014.

The company's investment objective is to generate current income and capital appreciation primarily through first and second lien senior secured loans, mezzanine debt, and, to a lesser extent, equity investments in U.S. middle-market companies. As of December 31, 2014, the company held approximately $9.5 billion in total assets.

Key Financial Metrics

Material Changes vs. Prior Period

• Portfolio Growth: Total assets increased by approximately 16.7% from 2013 to 2014, driven by new investment commitments of $4.6 billion and equity issuances totaling $257.7 million in 2014.
• Income Growth: Total investment income rose 12.2% year-over-year, primarily due to an increase in the average portfolio size (from $6.7 billion to $8.1 billion at amortized cost) and higher capital structuring service fees.
• Realized Gains: Net realized gains on investments increased significantly to $93.9 million in 2014 compared to $63.7 million in 2013. Notable gains included exits from Insight Pharmaceuticals ($33.1 million) and The Dwyer Group ($21.1 million).
• Expense Increases: Total operating expenses increased to $532.9 million from $437.2 million. This was driven by higher interest and credit facility fees ($216.0 million vs. $171.5 million) due to increased debt levels, and higher capital gains incentive fees ($29.5 million vs. $11.6 million) resulting from higher net gains.
• Debt Structure: The company issued $400 million in 3.875% Senior Notes due 2020 in November 2014. The weighted average stated interest rate on outstanding debt decreased to 4.9% in 2014 from 5.3% in 2013.

Guidance, Outlook, and Risks

Management Commentary: Management highlighted a disciplined investment philosophy focusing on capital preservation and low volatility. The company maintained a weighted average portfolio grade of 3.0 (on a scale of 1-4, where 4 is lowest risk), with 86.9% of the portfolio at fair value graded as 3. The Senior Secured Loan Program (SSLP) co-investment with GE represented approximately 23% of the total portfolio at fair value.

Risks and Contingencies:

• Legal Proceedings: The company is a defendant in a lawsuit filed by the bankruptcy trustee of DSI Renal Holdings LLC, alleging fraudulent transfer. The complaint seeks damages of approximately $117 million attributable to Ares Capital. Management believes the claims are without merit and intends to vigorously defend the action.
• Liquidity and Leverage: As a BDC, the company is subject to a 200% asset coverage ratio requirement. As of December 31, 2014, the asset coverage ratio was 235%. The company relies on access to capital markets to fund growth and refinance debt.
• Interest Rate Risk: Approximately 82% of the portfolio at fair value bore variable interest rates. The company utilizes interest rate floors on 71% of these variable rate investments to mitigate downside risk.
• Valuation Uncertainty: Substantially all investments are valued at fair value by the Board of Directors in the absence of readily available market quotations, introducing inherent uncertainty.

Key Facts for Investor Verification

• Dividend Sustainability: Verify the company's ability to maintain the $1.57 per share dividend distribution, particularly given the requirement to distribute 90% of investment company taxable income to maintain RIC status.
• SSLP Concentration: Assess the risk associated with the Senior Secured Loan Program (SSLP), which comprised 23% of the portfolio and 35% of total investment income in 2014.
• Debt Maturity Profile: Review the maturity schedule of the $4.0 billion in debt, noting that $986.3 million is due within 1-3 years and $1.8 billion within 3-5 years.
• Legal Exposure: Monitor the status of the DSI Renal Holdings litigation, which could result in material damages if the plaintiff prevails.
• Fee Structure: Note that the investment adviser receives a base management fee (1.5% of total assets), an income-based fee (20% of net investment income above a hurdle), and a capital gains incentive fee (20% of net capital gains).