Ares Capital Corporation — Q2 2023 Form 10-Q Summary
Business context and reporting period
Ares Capital Corporation is a publicly traded business development company and regulated investment company. It invests primarily in first-lien and second-lien senior secured loans, unitranche loans, subordinated debt, preferred equity and selected common equity investments in middle-market companies. The company is externally managed by Ares Capital Management LLC.
This filing covers the three and six months ended June 30, 2023, compared primarily with the corresponding 2022 periods and December 31, 2022 balance-sheet data.
Key financial metrics
| Metric | Q2 2023 | Q2 2022 | Six months 2023 | Six months 2022 |
|---|---|---|---|---|
| Total investment income | $634 million | $479 million | $1.252 billion | $919 million |
| Net investment income | $314 million | $257 million | $632 million | $455 million |
| Net increase in stockholders’ equity from operations | $331 million | $111 million | $609 million | $322 million |
| Basic earnings per share | $0.61 | $0.22 | $1.13 | $0.66 |
| Diluted earnings per share | $0.59 | $0.22 | $1.10 | $0.65 |
Net investment income represented approximately 49.5% of investment income in Q2 and 50.5% for the first six months, based on reported figures. Total expenses were $314 million in Q2 and $612 million for the first six months.
- As of June 30, 2023, total investments were $21.496 billion at fair value, versus $21.780 billion at December 31, 2022.
- Net assets were $10.354 billion, versus $9.555 billion at year-end 2022. Net asset value per share increased to $18.58 from $18.40.
- Cash and cash equivalents were $411 million, with restricted cash of $42 million. Total cash, cash equivalents and restricted cash were $453 million.
- Net cash provided by operating activities for the first six months was $824 million, compared with $1.019 billion of net cash used in operating activities in the prior-year period.
- Net cash used in financing activities was $708 million, primarily reflecting $2.739 billion of debt repayments, $704 million of net equity issuance proceeds and $514 million of dividends paid.
- Total principal debt outstanding was $11.401 billion, compared with $12.245 billion at December 31, 2022. The debt-to-equity ratio declined to 1.10x from 1.29x, and asset coverage was 190% versus a 150% regulatory minimum.
- Weighted-average debt cost was 4.6%, compared with 4.2% at year-end 2022; weighted-average debt maturity was 3.5 years.
- Management reported approximately $4.4 billion of additional borrowing capacity under its facilities, subject to borrowing-base and other restrictions.
Material changes versus comparable periods
- Investment income increased 32% in Q2 and 36% for the first six months, primarily because of higher base rates and a larger average portfolio. The average portfolio at amortized cost increased to $21.558 billion in Q2 from $20.210 billion.
- Interest income from investments increased to $476 million in Q2 from $319 million, while the weighted-average portfolio yield increased to 11.0% from 8.2%.
- Interest and credit facility expense increased to $141 million in Q2 from $101 million, reflecting higher floating-rate borrowing costs and greater average debt balances.
- Income-based fees increased to $79 million in Q2 from $57 million. Base management fees increased to $79 million from $75 million.
- Net realized losses were $81 million in Q2, compared with $3 million of losses in the prior-year quarter. The principal Q2 2023 investment losses included $79 million on ADG, LLC and $12 million on DFC Global Facility Borrower III LLC.
- Net unrealized gains were $98 million in Q2, compared with $143 million of unrealized losses in Q2 2022. For the first six months, net unrealized gains were $108 million versus $140 million of losses in the prior-year period.
- The portfolio’s fair value declined modestly despite higher investment income. New investment commitments fell to $1.218 billion in Q2 from $3.109 billion, while exits and repayments were $1.197 billion versus $1.150 billion.
- During the first six months, Ares issued 37.4 million shares for $703.8 million of net proceeds. No shares were repurchased under the stock repurchase program.
- The $750 million 2023 Notes were repaid at maturity in February 2023. The company also entered into a new uncommitted letter-of-credit facility in May 2023.
Portfolio, outlook, risks and unusual items
- The portfolio was concentrated in Software and Services, Financial Services, Health Care Services, and Commercial and Professional Services. Software and Services represented 22.0% of fair value.
- Loans on non-accrual status represented 2.1% of investments at amortized cost and 1.1% at fair value, compared with 1.7% and 1.1%, respectively, at year-end 2022. The filing identifies multiple non-accrual investments, including Center for Autism and Related Disorders and certain other portfolio companies.
- Investment quality weakened modestly: Grade 1 investments increased to $294 million, or 1.4% of fair value, from $108 million, or 0.5%, at year-end. Grade 2 investments declined to 5.8% from 6.2%; the weighted-average grade declined to 3.1 from 3.2.
- Approximately 68% of investments at fair value bore variable rates, while 12% bore fixed rates, 10% were non-income producing and 9% represented the equity investment in Ivy Hill Asset Management. Approximately 95% of variable-rate investments excluding SDLP Certificates had interest-rate floors.
- Management described credit markets as pressured by inflation, tighter financial conditions, financial-market instability and recession risk. Principal risks include rising funding costs, portfolio-company defaults, illiquid and subjective Level 3 valuations, foreign-exchange exposure, banking-system stress, cybersecurity events, regulatory changes and the transition away from LIBOR.
- Approximately $20.757 billion of investments were classified as Level 3, meaning significant valuation inputs were unobservable. Fair values may differ materially from amounts ultimately realized.
- Net adjusted unfunded revolving and delayed-draw commitments were $1.841 billion, including $33 million of net adjusted unfunded equity commitments and $65 million of commitments to the SDLP. Portfolio-company letters of credit outstanding were $52 million.
- The company provided no formal earnings, dividend or portfolio-yield guidance in the filing. It declared $0.48 per share of dividends for each of the first two quarters of 2023.
- From July 1 through July 19, 2023, the company reported $211 million of new investment commitments, $118 million of exits and repayments, an investment backlog of approximately $425 million and a pipeline of approximately $45 million. These transactions remained subject to closing conditions.
Most important facts for investors to verify
- Whether higher floating-rate investment income continues to exceed higher borrowing costs and incentive fees as rates and portfolio credit quality change.
- The performance, valuation and eventual recovery prospects of Grade 1 investments, non-accrual loans and the significant realized losses on ADG and other portfolio companies.
- The sustainability of the $0.48 per-share dividend relative to net investment income, taxable income, PIK income and required RIC distributions.
- Refinancing and liquidity requirements for the $403 million convertible notes due March 2024 and the $900 million of 2024 Notes due June 2024, as well as later debt maturities.
- The effect of additional equity issuance on NAV per share, leverage and shareholder returns, including the remaining $771 million capacity under the at-the-market program.
- Whether unfunded commitments, letters of credit and SDLP obligations are drawn and how they affect liquidity and asset coverage.
- The sensitivity of NAV and earnings to Level 3 valuation assumptions, including market yields, discount rates and EBITDA multiples.