ARES CAPITAL CORPORATION The information contained in this section should be read in conjunction with our financial statements and notes thereto appearing elsewhere in this Quarterly Report. In addition, some of the statements in this Quarterly Report (including in the following discussion) constitute forward- looking statements, which relate to future events or the future performance or financial condition ofAres Capital Corporation (the "Company," "Ares Capital ," "we," "us," or "our"). The forward-looking statements contained in this report involve a number of risks and uncertainties, including statements concerning: •our, or our portfolio companies', future business, operations, operating results or prospects; •the return or impact of current and future investments; •the impact of global health crises, such as the current novel coronavirus ("COVID-19") pandemic, on our or our portfolio companies' business and theU.S. and global economy; •the impact of a protracted decline in the liquidity of credit markets on our business; •the impact of the elimination of the London Interbank Offered Rate ("LIBOR") and implementation of alternatives to LIBOR on our operating results; •the impact of fluctuations in interest rates on our business; •the impact of changes in laws or regulations (including the interpretation thereof), including the tax laws, the Coronavirus Aid, Relief and Economic Security Act of 2020 and the American Rescue Plan Act of 2021, governing our operations or the operations of our portfolio companies or the operations of our competitors; •theMarch 2022 expiration of theSecurities and Exchange Commission's ("theSEC ") temporary no action position with respect to allowing co-investments with certain other funds managed by the investment adviser or its affiliates; •the valuation of our investments in portfolio companies, particularly those having no liquid trading market; •our ability to recover unrealized losses; •market conditions and our ability to access alternative debt markets and additional debt and equity capital and our ability to manage our capital resources effectively; •our contractual arrangements and relationships with third parties; •the state of the general economy; •the impact of supply chain constraints on our portfolio companies and the global economy; •the elevating levels of inflation, and its impact on our portfolio companies and on the industries in which we invest; •uncertainty surrounding global financial stability; •the social, geopolitical, financial, trade and legal implications of Brexit; •Middle East turmoil and the potential for volatility in energy prices and its impact on the industries in which we invest; •the financial condition of our current and prospective portfolio companies and their ability to achieve their objectives; •our ability to raise capital in the private and public debt markets; •our ability to successfully complete and integrate any acquisitions; •the outcome and impact of any litigation; •the adequacy of our cash resources and working capital; •the timing, form and amount of any dividend distributions; •the timing of cash flows, if any, from the operations of our portfolio companies; and •the ability of our investment adviser to locate suitable investments for us and to monitor and administer our investments. We use words such as "anticipates," "believes," "expects," "intends," "will," "should," "may" and similar expressions to identify forward-looking statements, although not all forward-looking statements include these words. Our actual results and 126 -------------------------------------------------------------------------------- condition could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors set forth in "Risk Factors" and elsewhere in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 and in this Quarterly Report. We have based the forward-looking statements included in this Quarterly Report on information available to us on the filing date of this Quarterly Report, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we have filed or in the future may file with theSEC , including annual reports on Form 10-K, registration statements on Form N-2, quarterly reports on Form 10-Q and current reports on Form 8-K.
OVERVIEW
We are a specialty finance company that is a closed-end, non-diversified management investment company incorporated inMaryland . We have elected to be regulated as a business development company ("BDC") under the Investment Company Act of 1940, as amended (together with the rules and regulations promulgated thereunder, the "Investment Company Act").
We are externally managed by
Our investment objective is to generate both current income and capital appreciation through debt and equity investments. We invest primarily in first lien senior secured loans (including "unitranche" loans, which are loans that combine both senior and subordinated debt, generally in a first lien position) and second lien senior secured loans. In addition to senior secured loans, we also invest in subordinated loans (sometimes referred to as mezzanine debt), which in some cases includes an equity component and preferred equity. To a lesser extent, we also make common equity investments, which have generally been non-control equity investments, of less than$20 million (usually in conjunction with a concurrent debt investment). However, we may increase the size or change the nature of these investments. Since our initial public offering ("IPO") onOctober 8, 2004 throughSeptember 30, 2021 , our exited investments resulted in an asset level realized gross internal rate of return to us of approximately 14% (based on original cash invested, net of syndications, of approximately$34.7 billion and total proceeds from such exited investments of approximately$44.5 billion ). Internal rate of return is the discount rate that makes the net present value of all cash flows related to a particular investment equal to zero. Internal rate of return is gross of expenses related to investments as these expenses are not allocable to specific investments. Investments are considered to be exited when the original investment objective has been achieved through the receipt of cash and/or non-cash consideration upon the repayment of a debt investment or sale of an investment or through the determination that no further consideration was collectible and, thus, a loss may have been realized. Approximately 58% of these exited investments resulted in an asset level realized gross internal rate of return to us of 10% or greater. Additionally, since our IPO onOctober 8, 2004 throughSeptember 30, 2021 , our realized gains have exceeded our realized losses by approximately$1.0 billion (excluding a one time gain on the acquisition ofAllied Capital Corporation ("Allied Capital ") inApril 2010 (the "Allied Acquisition") and realized gains/losses from the extinguishment of debt and other transactions). For this same time period, our average annualized net realized gain rate was approximately 1.0% (excluding a one-time gain on the acquisition ofAllied Capital and realized gains/losses from the extinguishment of debt and other transactions). Net realized gain/loss rates for a particular period are the amount of net realized gains/losses during such period divided by the average quarterly investments at amortized cost in such period. Information included herein regarding internal rates of return, realized gains and losses and annualized net realized gain rates are historical results relating to our past performance and are not necessarily indicative of future results, the achievement of which cannot be assured.
As a BDC, we are required to comply with certain regulatory requirements. For
instance, we generally have to invest at least 70% of our total assets in
"qualifying assets," including securities and indebtedness of private
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in one year or less. We also may invest up to 30% of our portfolio in
non-qualifying assets, as permitted by the Investment Company Act. Specifically,
as part of this 30% basket, we may invest in entities that are not considered
"eligible portfolio companies" (as defined in the Investment Company Act),
including companies located outside of the United States , entities that are
operating pursuant to certain exceptions under the Investment Company Act, and
publicly traded entities whose public equity market capitalization exceeds the
levels provided for under the Investment Company Act.
We have elected to be treated as a regulated investment company ("RIC") under
the Internal Revenue Code of 1986, as amended (the "Code"), and operate in a
manner so as to qualify for the tax treatment applicable to RICs. To qualify as
a RIC, we must, among other things, meet certain source-of-income and asset
diversification requirements and timely distribute to our stockholders generally
at least 90% of our investment company taxable income, as defined by the Code,
for each year. Pursuant to this election, we generally will not have to pay U.S.
federal corporate-level taxes on any income that we distribute to our
stockholders provided that we satisfy those requirements.
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--------------------------------------------------------------------------------PORTFOLIO AND INVESTMENT ACTIVITY
Our investment activity for the three months ended
For the Three Months Ended September 30,
(dollar amounts in millions) 2021 2020
New investment commitments(1):
New portfolio companies $ 1,215 $ 414
Existing portfolio companies 1,895 292
Total new investment commitments(2) $ 3,110 $ 706 Less:
Investment commitments exited(3) (2,263) (352) Net investment commitments $ 847$ 354 Principal amount of investments funded: First lien senior secured loans(4)$ 1,912 $ 589 Second lien senior secured loans 111 1 Subordinated certificates of the SDLP(5) 96 - Senior subordinated loans 131 1 Preferred equity 188 31 Other equity 93 10 Total$ 2,531 $ 632 Principal amount of investments sold or repaid: First lien senior secured loans(4)$ 1,446 $ 332 Second lien senior secured loans 247 125 Subordinated certificates of the SDLP(5) 125 4 Senior subordinated loans 113 9 Preferred equity 130 5 Other equity 16 6 Total$ 2,077 $ 481 Number of new investment commitments(6) 47 24 Average new investment commitment amount $ 66 $ 29 Weighted average term for new investment commitments (in months) 77 58 Percentage of new investment commitments at floating rates 90 % 90 % Percentage of new investment commitments at fixed rates 7 % 7 %
Weighted average yield of debt and other income producing securities(7): Funded during the period at amortized cost
7.7 % 8.1 %
Funded during the period at fair value(8) 7.8 % 8.2 %
Exited or repaid during the period at amortized cost 8.6 % 8.2 %
Exited or repaid during the period at fair value(8) 8.7 % 8.1 %
_______________________________________________________________________________
(1)New investment commitments include new agreements to fund revolving loans or
delayed draw loans. See "Off Balance Sheet Arrangements" as well as Note 7 to
our consolidated financial statements for the three and nine months ended
September 30, 2021 , for more information on our commitments to fund revolving
loans or delayed draw loans.
(2)Includes both funded and unfunded commitments. Of these new investment
commitments, we funded
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(3)Includes both funded and unfunded commitments. For the three months ended
September 30, 2021 and 2020, investment commitments exited included exits of
unfunded commitments of $274 million and $39 million , respectively.
(4)For the three months ended
(5)See "Senior Direct Lending Program" below and Note 4 to our consolidated
financial statements for the three and nine months ended
(6)Number of new investment commitments represents each commitment to a particular portfolio company or a commitment to multiple companies as part of an individual transaction (e.g., the purchase of a portfolio of investments).
(7)"Weighted average yield of debt and other income producing securities" is computed as (a) the annual stated interest rate or yield earned plus the net annual amortization of original issue discount and market discount or premium earned on accruing debt and other income producing securities, divided by (b) the total accruing debt and other income producing securities at amortized cost or at fair value, as applicable.
(8)Represents fair value for investments in the portfolio as of the most recent prior quarter end, if applicable.
As ofSeptember 30, 2021 andDecember 31, 2020 , our investments consisted of the following: As of September 30, 2021 December 31, 2020 (in millions) Amortized Cost Fair Value(1) Amortized Cost Fair Value First lien senior secured loans(2) $ 8,788 $
8,656 $ 7,224
4,158 4,071 4,386 4,171
Subordinated certificates of the SDLP(3) 932 932 1,123 1,123
Senior subordinated loans 1,053 993 1,005 951
Preferred equity 1,296 1,272 1,020 926
Other equity 1,400 1,753 1,156 1,357
Total $ 17,627 $ 17,677 $ 15,914 $ 15,515 _______________________________________________________________________________
(1)As of
(2)First lien senior secured loans include certain loans that we classify as "unitranche" loans. The total amortized cost and fair value of the loans that we classified as "unitranche" loans were$4,439 million and$4,389 million , respectively, as ofSeptember 30, 2021 , and$2,909 million and$2,793 million , respectively, as ofDecember 31, 2020 .
(3)The proceeds from these certificates were applied to co-investments with
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The weighted average yields at amortized cost and fair value of the following
portions of our portfolio as of September 30, 2021 and December 31, 2020 were as
follows:
As of
September 30, 2021 December 31, 2020
Amortized Cost Fair Value Amortized Cost Fair Value
Debt and other income producing securities(1) 8.6 % 8.6 % 9.1 % 9.2 %
Total portfolio(2) 7.7 % 7.6 % 8.0 % 8.2 %
First lien senior secured loans(2) 7.3 % 7.4 % 7.7 % 8.0 %
Second lien senior secured loans(2) 8.9 % 9.1 % 8.7 % 9.1 %
Subordinated certificates of the SDLP(2)(3) 13.5 % 13.5 % 13.5 % 13.5 %
Senior subordinated loans(2) 9.0 % 9.6 % 9.0 % 9.5 %
Income producing equity securities(2) 10.6 % 10.1 % 11.2 % 10.8 %
_______________________________________________________________________________
(1)"Weighted average yield of debt and other income producing securities" is
computed as (a) the annual stated interest rate or yield earned plus the net
annual amortization of original issue discount and market discount or premium
earned on accruing debt and other income producing securities, divided by (b)
the total accruing debt and other income producing securities at amortized cost
or at fair value as applicable.
(2)"Weighted average yields" are computed as (a) the annual stated interest rate
or yield earned plus the net annual amortization of original issue discount and
market discount or premium earned on the relevant accruing debt and other income
producing securities, divided by (b) the total relevant investments at amortized
cost or at fair value as applicable.
(3)The proceeds from these certificates were applied to co-investments with Varagon and its clients to fund first lien senior secured loans.
Ares Capital Management , our investment adviser, employs an investment rating system to categorize our investments. In addition to various risk management and monitoring tools, our investment adviser grades the credit risk of all investments on a scale of 1 to 4 no less frequently than quarterly. This system is intended primarily to reflect the underlying risk of a portfolio investment relative to our initial cost basis in respect of such portfolio investment (i.e., at the time of origination or acquisition), although it may also take into account under certain circumstances the performance of the portfolio company's business, the collateral coverage of the investment and other relevant factors. Under this system, investments with a grade of 4 involve the least amount of risk to our initial cost basis. The trends and risk factors for this investment since origination or acquisition are generally favorable, which may include the performance of the portfolio company or a potential exit. Investments graded 3 involve a level of risk to our initial cost basis that is similar to the risk to our initial cost basis at the time of origination or acquisition. This portfolio company is generally performing as expected and the risk factors to our ability to ultimately recoup the cost of our investment are neutral to favorable. All investments or acquired investments in new portfolio companies are initially assessed a grade of 3. Investments graded 2 indicate that the risk to our ability to recoup the initial cost basis of such investment has increased materially since origination or acquisition, including as a result of factors such as declining performance and non-compliance with debt covenants; however, payments are generally not more than 120 days past due. An investment grade of 1 indicates that the risk to our ability to recoup the initial cost basis of such investment has substantially increased since origination or acquisition, and the portfolio company likely has materially declining performance. For debt investments with an investment grade of 1, most or all of the debt covenants are out of compliance and payments are substantially delinquent. For investments graded 1, it is anticipated that we will not recoup our initial cost basis and may realize a substantial loss of our initial cost basis upon exit. For investments graded 1 or 2, our investment adviser enhances its level of scrutiny over the monitoring of such portfolio company. The grade of a portfolio investment may be reduced or increased over time. 131 --------------------------------------------------------------------------------
Set forth below is the grade distribution of our portfolio companies as of
As of
September 30, 2021 December 31, 2020
(dollar amounts in Number of Number of
millions) Fair Value % Companies % Fair Value % Companies %
Grade 1 $ 95 0.5 % 19 5.1 % $ 117 0.7 % 25 7.1 %
Grade 2 1,116 6.3 % 25 6.7 % 2,046 13.2 % 47 13.4 %
Grade 3 14,451 81.8 % 284 76.6 % 11,756 75.8 % 244 69.8 %
Grade 4 2,015 11.4 % 43 11.6 % 1,596 10.3 % 34 9.7 %
Total $ 17,677 100.0 % 371 100.0 % $ 15,515 100.0 % 350 100.0 %
As of September 30, 2021 and December 31, 2020 , the weighted average grade of
the investments in our portfolio at fair value was 3.0 and 3.0, respectively.
The increase in the fair value of investments graded 4 was primarily due to
recognition of unrealized appreciation in certain of our equity investments. As
of December 31, 2020 , investments graded 1 and 2 included certain of our
portfolio investments with an increased risk due to the COVID-19 pandemic and
the continuing uncertainty surrounding its full duration and impact. For more
information, see "Results of Operations - Net Unrealized Gains/Losses."
As of September 30, 2021 , loans on non-accrual status represented 1.7% and 1.0%
of the total investments at amortized cost and at fair value, respectively. As
of December 31, 2020 , loans on non-accrual status represented 3.3% and 2.0% of
the total investments at amortized cost and at fair value, respectively.
Senior Direct Lending Program
We have established a joint venture with Varagon to make certain first lien senior secured loans, including certain stretch senior and unitranche loans, primarily toU.S. middle-market companies. Varagon was formed in 2013 as a lending platform by American International Group, Inc. and other partners. The joint venture is called theSenior Direct Lending Program, LLC (d/b/a the "Senior Direct Lending Program" or the "SDLP"). InJuly 2016 , we and Varagon and its clients completed the initial funding of the SDLP. The SDLP may generally commit and hold individual loans of up to$350 million . The SDLP is capitalized as transactions are completed and all portfolio decisions and generally all other decisions in respect of the SDLP must be approved by an investment committee of the SDLP consisting of representatives of ours and Varagon (with approval from a representative of each required). We provide capital to the SDLP in the form of subordinated certificates (the "SDLP Certificates"), and Varagon and its clients provide capital to the SDLP in the form of senior notes, intermediate funding notes and SDLP Certificates. As ofSeptember 30, 2021 , we and a client of Varagon owned 87.5% and 12.5%, respectively, of the outstanding SDLP Certificates. As ofSeptember 30, 2021 andDecember 31, 2020 , we and Varagon and its clients had agreed to make capital available to the SDLP of$6.2 billion and$6.2 billion , respectively, in the aggregate, of which$1.4 billion and$1.4 billion , respectively, is to be made available from us. This capital will only be committed to the SDLP upon approval of transactions by the investment committee of the SDLP. Below is a summary of the funded capital and unfunded capital commitments of the SDLP. As of (in millions) September 30, 2021 December 31, 2020 Total capital funded to the SDLP(1) $ 3,691 $ 4,772 Total capital funded to the SDLP by the Company(1) $ 932 $ 1,123 Total unfunded capital commitments to the SDLP(2) $ 194 $ 152
Total unfunded capital commitments to the SDLP by the Company(2)
$ 49 $ 37
___________________________________________________________________________
(1)At principal amount.
(2)These commitments to fund delayed draw loans have been approved by the investment committee of the SDLP and will be funded if and when conditions to funding such delayed draw loans are met.
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The SDLP Certificates pay a coupon equal to LIBOR plus 8.0% and also entitle the
holders thereof to receive a portion of the excess cash flow from the loan
portfolio, after expenses, which may result in a return to the holders of the
SDLP Certificates that is greater than the stated coupon. The SDLP Certificates
are junior in right of payment to the senior notes and intermediate funding
notes.
The amortized cost and fair value of our SDLP Certificates were $0.9 billion and
$0.9 billion , respectively, as of September 30, 2021 and $1.1 billion and $1.1
billion , respectively, as of December 31, 2020 . Our yield on our investment in
the SDLP Certificates at amortized cost and fair value was 13.5% and 13.5%,
respectively, as of September 30, 2021 and 13.5% and 13.5%, respectively, as of
December 31, 2020 . For the three and nine months ended September 30, 2021 , we
earned interest income of $33 million and $106 million , respectively, from our
investment in the SDLP Certificates. For the three and nine months ended
September 30, 2020 , we earned interest income of $32 million and $92 million ,
respectively, from our investment in the SDLP Certificates. We are also entitled
to certain fees in connection with the SDLP. For the three and nine months ended
September 30, 2021 , in connection with the SDLP, we earned capital structuring
service and other fees totaling $7 million and $13 million , respectively. For
the three and nine months ended September 30, 2020 , we earned capital
structuring service and other fees totaling $1 million and $3 million ,
respectively.
As of September 30, 2021 and December 31, 2020 , the SDLP's portfolio was
comprised entirely of first lien senior secured loans primarily to U.S.
middle-market companies and were in industries similar to the companies in our
portfolio. As of September 30, 2021 and December 31, 2020 , none of the loans
were on non-accrual status. Below is a summary of the SDLP's portfolio:
As of
(dollar amounts in millions) September 30, 2021 December 31, 2020
Total first lien senior secured loans(1)(2) $ 3,711 $ 4,483
Weighted average yield on first lien senior secured loans(3) 6.8 % 6.9 %
Largest loan to a single borrower(1) $ 343 $ 345
Total of five largest loans to borrowers(1) $ 1,541 $ 1,565
Number of borrowers in the SDLP 17 23
Commitments to fund delayed draw loans (4) $ 194 $ 152
_______________________________________________________________________________(1)At principal amount.
(2)First lien senior secured loans include certain loans that the SDLP
classifies as "unitranche" loans. As of
(3)Computed as (a) the annual stated interest rate on accruing first lien senior secured loans, divided by (b) total first lien senior secured loans at principal amount.
(4)As discussed above, these commitments have been approved by the investment committee of the SDLP.
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Selected financial information for the SDLP as of
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