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 invests primarily in first and second lien senior loans and mezzanine debt of U.S. middle-market companies. This report covers the fiscal year ended December 31, 2010.
A pivotal event during the period was the acquisition of Allied Capital Corporation on April 1, 2010, in an all-stock transaction valued at approximately $908 million. This acquisition significantly expanded the company's portfolio and asset base, resulting in a recognized gain of $195.9 million due to the fair value of net assets acquired exceeding the consideration transferred.
Key Financial Metrics
| Metric | 2010 | 2009 |
|---|---|---|
| Total Investment Income | $483.4 million | $245.3 million |
| Net Investment Income | $215.8 million | $133.4 million |
| Net Realized and Unrealized Gains | $280.1 million | $69.3 million |
| Gain on Allied Acquisition | $195.9 million | — |
| Net Increase in Stockholders' Equity | $691.8 million | $202.7 million |
| Total Assets | $4,562.5 million | $2,313.5 million |
| Total Debt (Principal) | $1,435.1 million | $969.5 million |
| Stockholders' Equity | $3,050.5 million | $1,257.9 million |
| Net Asset Value (NAV) per Share | $14.92 | $11.44 |
| Dividends Declared per Share | $1.40 | $1.47 |
Liquidity and Leverage: As of December 31, 2010, the company held $100.8 million in cash and cash equivalents. The weighted average stated interest rate on borrowings was 5.2%. The company maintained an asset coverage ratio of 321% for senior securities, well above the 200% regulatory requirement.
Material Changes vs. Prior Period
- Portfolio Expansion: Total assets nearly doubled from $2.3 billion in 2009 to $4.6 billion in 2010, driven primarily by the Allied Acquisition which added $1.8 billion in investments.
- Income Growth: Total investment income increased 97% to $483.4 million. Interest income rose significantly due to the larger portfolio size and higher yields on acquired assets.
- Expense Increase: Total expenses rose to $262.2 million from $111.3 million. This increase was due to higher interest and credit facility fees ($79.4 million vs. $24.3 million), increased management fees, and $19.8 million in professional fees related to the Allied Acquisition.
- Capital Gains: The company recognized a $195.9 million gain on the Allied Acquisition. Additionally, net unrealized gains were $230.7 million, compared to $88.7 million in 2009.
- Debt Structure: The company assumed Allied Capital's unsecured notes (2011, 2012, and 2047 Notes) and issued $200 million of new 7.75% Senior Notes due 2040.
Outlook, Risks, and Management Commentary
Portfolio Rotation Strategy: Management intends to actively rotate assets acquired from Allied Capital, specifically targeting the disposal of non-yielding equity investments and lower-yielding debt to replace them with higher-yielding first and second lien senior loans and mezzanine debt. There is no assurance this strategy will be successful.
Recent Developments (Post-Year-End):
- Issued $575 million of 5.75% Convertible Senior Notes due 2016 in January 2011.
- Notified holders of the 2011 Notes ($300.6 million principal) of a redemption in March 2011.
- Amended the Revolving Funding Facility to extend the maturity date to January 2016.
Risks and Contingencies:
- Market Conditions: Volatility in capital markets could impact investment valuations and the ability to raise capital or refinance debt.
- Leverage: Borrowings magnify potential gains and losses. A decline in asset values could cause NAV to decline more sharply than if the company were unlevered.
- Regulatory: As a BDC, the company is subject to asset coverage requirements (200%) and must distribute at least 90% of taxable income to maintain RIC status and avoid corporate-level taxes.
- Valuation Uncertainty: A significant portion of the portfolio consists of private investments without readily available market quotations, requiring fair value estimates by the Board of Directors.
Key Facts for Investor Verification
- Allied Acquisition Integration: Verify the progress of rotating non-core Allied Capital assets into higher-yielding core investments and the impact on portfolio yield.
- Debt Maturity Profile: Review the upcoming maturities of the 2011 Notes (redeemed post-year-end) and the 2012 Notes, and the company's ability to refinance or repay them.
- Dividend Sustainability: Confirm that net investment income continues to cover the quarterly dividend rate of $0.35 per share, particularly given the increase in interest expense.
- Asset Coverage Ratio: Monitor the asset coverage ratio to ensure it remains above the 200% threshold required to incur additional debt or issue preferred stock.
- Convertible Notes Impact: Assess the potential dilution from the $575 million of 2016 Convertible Notes issued in January 2011.