ARCC

Ares Capital Corporation (ARCC) - 2005 Annual Report Summary

Business Context and Reporting Period

Ares Capital Corporation 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 targets 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, 2005. The company was incorporated in April 2004 and completed its IPO in October 2004.

Key Financial Metrics

Material Changes vs. Prior Period

• Portfolio Growth: Total assets increased by approximately 178% from $220.5 million to $613.6 million, driven by two add-on equity offerings in March and October 2005 raising a combined ~$397 million in net proceeds.
• Debt Reduction: Outstanding borrowings decreased significantly from $55.5 million to $18.0 million as proceeds from equity offerings were used to repay debt under the CP Funding Facility.
• Income Expansion: Total investment income grew nearly tenfold to $41.9 million, primarily due to the larger asset base and a full year of operations compared to the partial year in 2004.
• Expense Increase: Total operating expenses rose to $14.7 million from $1.7 million, reflecting higher management fees (base and incentive) due to the increased asset base and portfolio size.
• Portfolio Composition: The number of portfolio companies grew from 20 to 38. The weighted average investment grade of debt improved slightly from 3.0 to 3.1 (on a scale where 4 is lowest risk).

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management intends to continue borrowing under existing facilities and may increase facility sizes or issue debt securities to fund new investments. The company maintains a dividend reinvestment plan.
• Regulatory Inquiry: The SEC's Fort Worth District Office raised issues regarding the clarity of the language in the investment advisory agreement concerning the calculation of the capital gains portion of the incentive fee. The investment adviser agreed to use the calculation method resulting in the lowest fee until stockholders vote to amend the agreement.
• Key Risks:
  • Leverage: Borrowing magnifies potential gains and losses. As of year-end, the asset coverage ratio was 3,265%.
  • Interest Rate Risk: Approximately 57% of the portfolio is at variable rates. A 100 basis point increase in rates would increase interest income by ~$3.3 million and interest expense by ~$180,000.
  • Liquidity: Substantially all investments are in private companies and are illiquid, subject to legal restrictions on resale.
  • RIC Status: Failure to distribute at least 90% of taxable income could result in corporate-level taxation. The company paid a $158,000 excise tax on excess taxable income carried forward.
• Unusual Items: The company recorded $3.1 million in non-cash Payment-in-Kind (PIK) interest income, which must be distributed to maintain RIC status despite not being collected in cash.

Investor Verification Checklist

• Debt Covenants: Verify compliance with the 2.0:1.0 asset coverage ratio and borrowing base requirements under the new $250 million Revolving Credit Facility.
• Incentive Fee Calculation: Monitor the upcoming stockholder vote to amend the investment advisory agreement regarding the capital gains incentive fee methodology.
• Portfolio Valuation: Review the board's quarterly fair value determinations for private investments, as these are subjective and lack a ready market.
• PIK Interest: Assess the impact of non-cash PIK interest on the company's ability to fund cash dividends without raising additional capital or selling assets.
• Concentration Risk: Note that the top three industries (Health Care, Containers/Packaging, Other Services) comprised roughly 37% of the portfolio.