ARCC

Ares Capital Corp. 2006 Annual Report (10-K) Summary

Business Context and Reporting Period

Company: Ares Capital Corporation (ARCC)
Reporting Period: Fiscal year ended December 31, 2006
Business Model: A closed-end, non-diversified management investment company regulated as a Business Development Company (BDC). The Company invests primarily in first and second lien senior loans and long-term mezzanine debt of U.S. middle-market companies, with a secondary focus on equity investments. It is externally managed by Ares Capital Management LLC.

Key Financial Metrics

Material Changes vs. Prior Period

• Portfolio Growth: Total assets more than doubled from $613.6 million in 2005 to $1.35 billion in 2006, driven by significant equity capital raises and increased leverage.
• Leverage Expansion: Total debt increased from $18.0 million to $482.0 million. This included the establishment of a $250 million Revolving Credit Facility ($193 million drawn) and a $400 million debt securitization ($274 million outstanding).
• Income Growth: Total investment income rose 187% to $120.0 million, primarily due to the larger portfolio size. Interest income increased 190% to $98.3 million.
• Expense Increase: Total expenses increased 301% to $58.5 million. Interest expense and credit facility fees surged 1,175% to $18.6 million due to higher borrowings. Management fees also increased significantly.
• Unrealized Losses: Unlike 2005, the Company recorded a net unrealized loss of $14.6 million in 2006, largely due to the reversal of prior period appreciation on specific investments (e.g., CICQ) and depreciation in others (e.g., Berkline).

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management expects to continue borrowing under existing facilities and issuing debt securities to fund new investments. The Company intends to maintain its status as a Regulated Investment Company (RIC) to avoid corporate-level taxes.
• Key Risks:
  • Leverage Risk: Borrowings magnify potential gains and losses. A 1% increase in interest rates would increase interest income by ~$8.0 million but interest expense by ~$4.8 million.
  • Valuation Uncertainty: A large percentage of the portfolio is not publicly traded; fair values are determined by the Board and independent firms, which may differ from realized values.
  • Interest Rate Risk: Net investment income depends on the spread between borrowing costs and investment yields. Approximately 50% of the portfolio is at variable rates.
  • Conflicts of Interest: The Investment Adviser manages other funds and may have competing interests in allocating investment opportunities.
• Unusual Items:
  • Payment-in-Kind (PIK) Interest: $6.3 million of interest income was non-cash PIK, which must be distributed to maintain RIC status despite not being collected in cash.
  • Excise Tax: The Company accrued approximately $570,000 in federal excise tax for 2006 (vs. $158,000 in 2005) on taxable income carried forward.

Investor Verification Checklist

• Debt Covenants: Verify compliance with the 2.0:1.0 asset coverage ratio required by the 1940 Act and the borrowing base limitations on the Revolving Credit Facility.
• Portfolio Quality: Review the weighted average investment grade (3.0 as of Dec 31, 2006) and the specific performance of "Grade 2" and "Grade 1" loans, which represent increased risk.
• Liquidity Position: Confirm the availability of the $350 million CP Funding Facility and the $250 million Revolving Credit Facility to meet funding needs and distribution requirements.
• Dividend Sustainability: Assess the ability to fund the $1.64 per share dividend distribution given the portion of income derived from non-cash PIK interest.
• Valuation Methodology: Scrutinize the fair value determinations for private investments, particularly those with significant unrealized depreciation.