ARES CAPITAL CORP annual report, FY2023

Ares Capital Corporation: FY2023 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 invests primarily in first- and second-lien senior secured loans, subordinated debt, preferred equity and, to a lesser extent, common equity of U.S. middle-market companies. This filing covers the fiscal year ended December 31, 2023; the filing does not provide a separate fourth-quarter income statement in the supplied text.

Total assets were approximately $23.8 billion, with 505 portfolio companies at year-end.
The portfolio was concentrated principally in Software and Services, Health Care Services, Financial Services and Commercial and Professional Services.
Ares Capital Management, an Ares Management subsidiary, provides investment management; Ares Operations provides administrative services.

Financial performance and key metrics

Metric	FY2023	FY2022	Change
Total investment income	$2.614 billion	$2.096 billion	+24.7%
Total expenses	$1.328 billion	$949 million	+39.9%
Net investment income	$1.266 billion	$1.092 billion	+15.9%
Net realized gains/(losses)	$(179) million	$81 million	Declined
Net unrealized gains/(losses)	$435 million	$(525) million	Improved by $960 million
Net increase in stockholders’ equity from operations	$1.522 billion	$600 million	+153.7%
Basic earnings per share	$2.75	$1.21	+127.3%
Diluted earnings per share	$2.68	$1.19	+125.2%

Investment income increased primarily from higher base interest rates and a larger average portfolio. Interest income rose to $1.962 billion from $1.470 billion, while dividend income increased to $501 million from $424 million. Capital structuring service fees declined to $92 million from $153 million as new investment commitments decreased.

Average portfolio size increased to $21.834 billion from $20.704 billion.
Weighted average portfolio yield increased to 11.2% from 9.0%.
Net investment income represented approximately 48% of total investment income, compared with approximately 52% in FY2022, reflecting higher financing and incentive-fee costs.
Interest and credit facility fees increased to $582 million from $455 million. Average debt was broadly stable at $11.537 billion, but the weighted average stated interest rate increased to 4.8% from 3.6%.
Cash flow provided by operating activities was $511 million, compared with $(1.359) billion in FY2022. The 2023 operating cash flow included $5.315 billion of investment proceeds and $5.804 billion of investment purchases.
Cash, cash equivalents and restricted cash totaled $564 million at year-end, including $535 million of cash and cash equivalents.
Net asset value per share increased to $19.24 from $18.40. Total stockholders’ equity increased to $11.201 billion from $9.555 billion.
The company declared $1.92 per share of dividends in 2023, versus $1.87 per share in 2022.

Portfolio, credit quality and leverage

Investments at fair value increased to $22.874 billion from $21.780 billion; amortized cost increased to $22.668 billion from $22.043 billion.
First-lien senior secured loans were $10.081 billion at fair value, and second-lien loans were $3.753 billion.
The portfolio’s weighted average yield was 11.2% at fair value, compared with 10.6% at December 31, 2022.
Loans on non-accrual represented 1.3% of investments at amortized cost and 0.6% at fair value, improving from 1.7% and 1.1%, respectively.
The weighted average investment grade was 3.1, down from 3.2. Grade 1 investments represented 0.6% of portfolio fair value; Grade 2 investments represented 5.8%.
Total principal debt outstanding was $11.905 billion, down from $12.245 billion. Debt-to-equity declined to 1.07:1 from 1.29:1.
Asset coverage was 194%, above the applicable 150% regulatory minimum. Approximately $4.9 billion was available for additional borrowing under the facilities, subject to borrowing-base and other restrictions.
Net unfunded revolving and delayed-draw loan commitments were $2.271 billion, and net unfunded equity commitments were $62 million.

Material changes versus FY2022

Higher interest rates and portfolio growth increased investment income and portfolio yields, but also materially increased borrowing costs.
Net unrealized performance reversed from a $525 million loss to a $435 million gain, largely reflecting reversal of prior-year depreciation and higher valuations on certain investments.
Realized investment performance weakened: gross realized losses were $262 million versus gross realized gains of $107 million, resulting in a $155 million net realized investment loss. The filing identifies notable losses involving ADG-related investments, Visual Edge Technology, National College of Business and Technology, Leeds IV Advisors, and other portfolio companies.
New investment commitments declined to $5.966 billion from $9.870 billion; funded investments declined to $5.820 billion from $9.722 billion. Investment commitments exited declined to $5.729 billion from $7.953 billion.
The company issued 60.5 million common shares for net proceeds of $1.154 billion. No shares were repurchased under the $1.0 billion repurchase program.
The company repaid $750 million of 2023 Notes at maturity in February 2023 and issued $900 million of January 2027 Notes in August 2023.

Guidance, outlook, commentary and unusual items

Management did not provide formal earnings guidance in the supplied filing. Management described 2023 credit markets as pressured by high interest rates, inflation, tighter financial conditions, market instability and recession risk. The company believes direct lending opportunities remain attractive because banks have reduced middle-market lending and borrowers continue to require flexible capital.

As of February 1, 2024, new investment commitments since year-end totaled approximately $705 million, of which $478 million was funded; approximately 89% was in first-lien loans.
During the same period, approximately $695 million of investment commitments were exited, producing approximately $19 million of net realized gains.
As of February 1, 2024, the investment backlog was approximately $770 million and the pipeline was approximately $340 million; completion was not assured.
In January 2024, the company issued $1.0 billion of 5.875% unsecured notes due 2029 and entered into a related interest-rate swap.
The stock repurchase authorization was extended through February 15, 2025. In February 2024, the BNP Funding Facility margin was reduced by 0.15 percentage points during and after its reinvestment period.
The 2024 Convertible Notes had $403 million principal outstanding and matured on March 1, 2024; the notes were convertible and could result in common-stock issuance and dilution.
GAAP included a $53 million capital-gains incentive-fee expense in FY2023 and an $88 million cumulative accrual at year-end, although no capital-gains incentive fee was actually payable under the investment advisory agreement at year-end.

Principal risks and contingencies

Most investments are private, illiquid and valued using significant unobservable inputs; Level 3 investments were $22.084 billion of fair value at year-end.
Portfolio companies may be highly leveraged and exposed to higher interest costs, inflation, recession, weaker operating performance and refinancing risk.
Borrowings magnify both gains and losses and create refinancing, covenant and liquidity risks. Approximately $900 million of 2024 Notes and $403 million of 2024 Convertible Notes were scheduled to mature in 2024.
Variable-rate investments generally benefit from higher rates, but portfolio-company credit quality and the company’s own floating-rate funding costs may deteriorate if rates remain high.
The company is dependent on Ares personnel, systems, deal flow and affiliated service providers. The externally managed fee structure creates potential conflicts of interest.
The company must maintain BDC and RIC status, comply with asset-coverage requirements and generally distribute at least 90% of investment company taxable income. Estimated taxable income carried forward for distribution in 2024 was approximately $635 million.
Net unfunded commitments, letters of credit and guarantees could require future cash funding if portfolio companies satisfy funding conditions or default.
No material pending legal proceedings were reported, and management reported effective disclosure controls and internal control over financial reporting. KPMG issued unqualified audit opinions; fair value of investments was identified as the critical audit matter.

Important facts for investors to verify

Reconcile the $1.522 billion increase in stockholders’ equity with the $1.266 billion of net investment income, $179 million of realized losses, $435 million of unrealized gains and $1.078 billion of declared dividends.
Review the fair-value assumptions for Level 3 assets, particularly market yields, discount rates and EBITDA multiples, and compare them with realized exits after year-end.
Assess upcoming debt maturities, refinancing activity, facility availability and compliance with asset-coverage and debt covenants.
Monitor non-accrual investments, Grade 1 and Grade 2 exposures, PIK income, and the ability of portfolio companies to service debt in a high-rate or recessionary environment.
Evaluate the sustainability of dividends relative to recurring cash investment income, taxable income, PIK accruals and required RIC distributions.
Review related-party transactions involving Ares affiliates, IHAM and the Senior Direct Lending Program, including allocation policies and asset sales to affiliated vehicles.
Confirm the subsequent treatment of the 2024 Convertible Notes, the January 2024 2029 Notes issuance, the extended repurchase authorization and the revised BNP Funding Facility terms.