Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR), secured debt rating and unsecured debt rating of Ares Capital Corporation (Ares) at 'BBB'.

The Rating Outlook is Stable.

The 'A-' rating and Stable Outlook assigned to Ares Management Corporation, the parent company of Ares' external manager, Ares Capital Management, LLC, are unaffected by these actions.

Today's rating actions have been taken as part of a broader review business development companies (BDCs) which included 18 publicly rated firms. For more information on the peer review, please refer to 'Fitch Completes 2023 BDC Peer Review' available at www.fitchratings.com.

Key Rating Drivers

The rating affirmation reflects Ares' scalable platform, moderate portfolio concentrations, demonstrated access to the debt and equity markets historically, strong funding flexibility, solid liquidity, an experienced management team, and access to investment resources from its investment adviser, Ares Capital Management, LLC.

Rating constraints include above-average exposure to equity investments, including Ivy Hill Asset Management, L.P. (IHAM) and the Senior Direct Lending Program (SDLP), which could experience more valuation volatility than first lien debt investments, particularly in times of stress, and above-average paid-in-kind (PIK) balances. Ares' significant size, relative to other BDCs, also poses some potential constraints on its operational flexibility. At certain points in the cycle, Ares may be more challenged to identify sufficient investment opportunities to invest the proceeds from repayments and maturities, which could pressure dividend coverage. Ares' size may also limit capital markets' capacity to provide it with sufficient unsecured financing.

Rating constraints for the BDC sector more broadly include the market impact on leverage, given the need to fair-value the portfolio each quarter, dependence on access to the capital markets to fund portfolio growth and a limited ability to retain capital due to dividend distribution requirements. Additionally, Fitch believes BDCs will experience weaker asset quality metrics in 2023 amid macroeconomic headwinds and higher debt service burdens and slower growth prospects at portfolio companies.

As of Dec. 31, 2022, non-accrual investments accounted for 1.6% of the debt portfolio at value and 2.4% at cost; down from pandemic peaks of 3.2% and 5.1%, respectively, at 3Q20, but up from a year ago. Underlying borrowers' interest coverage metrics have declined, to 1.8x at YE22, on a weighted average (WA) basis, from 3.0x at year ago given the steady up-tick in interest rates. Fitch believes higher interest rates and a more challenging economic backdrop will lead to increased amendment activity and higher PIK income in coming quarters. Still, Ares has a peer-superior track record in credit through several economic cycles.

While Ares' portfolio remains largely focused on senior secured positions, its first lien exposures were below the peer average, at 43% of the portfolio, at value, at YE22. Total equity investments were 28.2% of the portfolio, consisting of preferred equity, other equity and the firm's investment in middle-market collateralized loan obligation manager IHAM, which grew to 10.1% of the portfolio at YE22. This is up from 4.7% a year ago due to continued investment in its growth. Fitch believes these equity investments can lead to more valuation volatility over time, but Ares has a solid underwriting track record and a portion of these investments, including IHAM, are yielding. Additionally, the WA EBITDA of the underlying borrowers increased 70% from YE21, to $275.4 million.

Ares' net investment income (NII) rose 12.4% in 2022, adjusting for the GAAP accrual of incentive income, as rising rates pushed interest income higher and dividend income nearly doubled with the larger IHAM investment and an up-tick in preferred equity. The WA yield on the debt and income producing portfolio was 11.6% at cost at YE22, up 290 basis points from a year ago. NII as a percentage of the average portfolio at cost was 4.7% in 2022, which is down from the four-year average of 5.0%, but in-line with the peer average.

Leverage, as measured by gross debt (at par) to equity, was 1.28x at YE22, or 1.25x net of cash, which was at the high-end of the firm's targeted range of 0.90x to 1.25x. This leverage level implied an asset coverage cushion of 15.5%, which was towards the lower end of Fitch's 'bbb' category capitalization and leverage benchmark range of 11%-33%. Fitch believes leverage declined modestly in early 2023 following the firm's $223.4 million equity raise in January. Fitch expects Ares to manage leverage with an appropriate cushion to account for potential credit issues and valuation volatility.

NII coverage of the dividend was 112.5% in 2022 adjusting for the noncash incentive payment accrual. Coverage would be lower (101.7%) adjusting for net non-cash interest expenses including PIK interest, the accretion of discounts on investments, and the amortization of debt issuance costs and discounts/premiums on notes payable. Net PIK income (including accrued dividends) accounted for 10.1% of investment income in 2022, up from 1.6% a year ago, given an increase in preferred equity investments with a PIK component and strong collections of PIK interest and dividends in 2021.

The Stable Outlook reflects Fitch's expectations for relative operating consistency and the maintenance of strong asset quality, ample liquidity and solid dividend coverage. The Outlook also reflects Fitch's expectation that Ares will manage leverage within the targeted range and that there will be no material change to the risk profile of the portfolio.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

An increase in leverage that is not commensurate with the risk profile of the portfolio or an inability to maintain sufficient cushion to asset coverage to account for valuation volatility could yield negative rating action. Outsized portfolio growth which results in a weaker portfolio credit profile, including meaningful up-ticks in underlying portfolio leverage and/or deterioration in portfolio company interest coverage or covenants which signal the potential for future asset quality issues, would also likely pressure ratings. Negative rating actions could also result from an inability to realize non-cash income accruals and weakened cash income dividend coverage.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Very strong and differentiated asset quality performance of recent vintages, which would be evaluated in combination with the stability and consistency of Ares' operating performance, asset quality, valuation, and underlying portfolio metrics could yield positive rating momentum over time. The maintenance of a strong funding profile, with unsecured debt maintained at-or-above 50% of total debt, ample liquidity, consistent core operating performance, and a reduction in the accrued PIK balance would also be necessary to yield positive rating action. Although not envisioned, a material reduction in leverage which was not accompanied by an offsetting increase in the portfolio risk profile could also contribute to positive rating momentum.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The equalization of the secured and unsecured debt ratings with the long-term IDR reflects solid collateral coverage for all classes of debt given that Ares has a largely unsecured funding profile and is subject to a 150% asset coverage limitation.

DEBT AND OTHER INSTRUMENT RATINGS: RATING SENSITIVITIES

The secured and unsecured debt ratings are primarily linked to the long-term IDR and are expected to move in tandem. However, a material reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of 3. This means ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity.

For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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