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A potential investor seeking current income and a need to further diversify a portfolio might want consider including Ares Capital (ARCC). ARCC currently yields approximately 10% with the possibility of further dividend growth if they are able to expand their portfolio. ARCC is also a way an investor can invest in an asset class that few retail investors have access to, and that is leveraged loans to middle market companies.

ARCC has offered strikingly positive returns during one of the most difficult financial crises in the U.S in the last 50 years. It is a testimony to management's skill. The company paid $1.40 in dividends in 2010 and $1.42 in 2011, and the company is on track to pay approximately $1.62 on a trailing twelve month basis in 2012.

Business Overview

ARCC is an externally managed closed-end fund which has elected to be regulated as a Business Development Corporation ("BDC"). At the most basic level, ARCC is a portfolio of loans partially financed through leverage where 90% of its interest income is paid out in the form of dividends. The investment objective is to generate both current income and capital appreciation. ARCC primarily focuses on U.S. middle-market companies where it believes it has an edge. Portfolio companies are generally characterized as having annual EBITDA between $10 million and $250 million. What this means is that ARCC can often get interest rate terms higher than what is found in the high yield bond market.

Investments in the Portfolio

ARCC invests primarily in first and second lien senior loans and mezzanine debt, which in some cases includes an equity component. First and second lien senior loans generally are senior debt instruments that rank ahead of subordinated debt of a given portfolio company as well as shareholders. Mezzanine debt is subordinated to senior loans and is generally unsecured. These investments have generally ranged between $20 million and $250 million each. The first and second lien senior loans generally have stated terms of three to ten years, and the mezzanine debt investments generally have stated terms of up to ten years, but the expected average life of such first and second lien loans and mezzanine debt is generally between three and seven years.

ARCC grows by periodically having secondary offerings. This is different than your typical company when a secondary is dilutive to existing shareholders. This is how the capital base is grown.

Recent Quarterly Results

During the third quarter, ARCC continued with their strategy of moving up the capital structure by investing senior debt, reflecting a focus on risk-adjusted return. More than three quarters of its commitments during the third quarter were in first-lien senior secured debt. Management thought the portfolio performed well despite the current slow growth environment. Non-accruing loans remained low at 2.6% of the portfolio on an amortized cost basis and 1% on a fair value basis. However, the company did suggest that spreads were tightening and the market was continuing to become less attractive.

The momentum continues. ARCC was successful in raising over $1 billion in capital during the third quarter and the early part of the fourth quarter. Building the portfolio will hopefully drive the dividend. On the debt capital side, it increased capital availability through the unsecured notes, convertible debt and secured bank debt markets. On the equity side, ARCC issued new shares at an attractive price, raising $427 million in net proceeds. As a result the company ended the third quarter with approximately $1.3 billion in available debt capacity, and they continue to have no debt maturities until 2016.

Consistent with long term valuation creation, ARCC expressed caution about potential geopolitical events and their potential impact on investment performance, and explained a desire to focus on defensive and recession resistant industries during the conference the call.

The basic and diluted core earnings were $0.42 per share for the third quarter of 2012, a $0.02 per share increase over the core earnings of $0.40 per share for the second quarter of 2012 and in line with the level of a year ago. Net investment income for the third quarter was $0.39 per share compared to $0.40 per share in the second quarter of 2012 and $0.48 per share in the third quarter of 2011.

Net realized and unrealized gains for the third quarter were $0.20 per share compared to $0.01 per share in the second quarter of 2012, a net loss of $0.28 per share in the third quarter of 2011. GAAP net income for the third quarter was $0.59 per share compared to $0.41 per share for the second quarter and $0.20 per share for the third quarter of 2011.

As of September 30, 2012, ARCC total assets were $6.3 billion, and total shareholders' equity was $3.9 billion, resulting in NAV per share of $15.74, up 1.5% from $15.51 at the end of the second quarter of 2012 and 4% higher than the $15.13 NAV it reported a year ago.

From a yield standpoint, the portfolio's weighted average yield on debt and other income-producing securities at amortized cost declined slightly from 11.7% to 11.6% quarter-over-quarter, primarily reflecting a greater weighting toward lower yielding and lower risk senior debt in the portfolio. In addition, the weighted average stated interest rate on debt as of the end of the quarter increased modestly from approximately 5% to 5.2% quarter-over-quarter.

Superior Five Year Historical Performance

What separates ARCC from other BDC's is historical performance. ARCC has outperformed both the broader market and industry peer group over the last five years on a total return basis. From the early beginnings of the financial crisis (that is 12/31/2006) until the end of 2011, ARCC has given investors a total return of approximately 50% including the reinvestment of dividends. Alternatively, the Standard & Poor's 500 Stock Index has offered investors nothing, and the Standard & Poor's Specialized Finance Index has offered investors a loss of more than 50% including the reinvestment of dividends. While ARCC was down more than 55% at the end 2008 where a dollar invested at the end of 2006 was worth 44 cents, it rallied back, appreciating more than 100% from its trough as it became clear that management had not made the many missteps its peers had made.

ARCC Competitive Advantages

ARCC has a number of competitive advantages. Ares advisors manage approximately $46 billion of total committed capital under management in the related asset classes of non-syndicated first and second lien senior loans, syndicated loans, high yield bonds, mezzanine debt and private equity. The size and scope of the platform provides a competitive advantage in terms of access to origination and marketing activities and diligence for Ares Capital.

Ares' senior professionals have an average of more than 22 years of experience in leveraged finance, including substantial experience in investing in leveraged loans, high yield bonds, mezzanine debt, distressed debt and private equity securities.

Ares advisors maintains that its "Disciplined Investment Philosophy" is a key to success. Their philosophy combines both a "top down" and "bottom up" approach, and focuses on the assessment of the overall macroeconomic environment and financial markets as well as company-specific research and analysis. Its investment approach emphasizes capital preservation, low volatility and minimization of downside risk, and the performance reflects this. It does this by looking for companies in industries with strong dynamics, and where companies have predictable and sustainable cash flows.

Risks to Consider

There are a number of risks to consider, many of which are beyond the scope of this article to cover, but several are worth mentioning. ARCC as well as many BDC's do not offer much transparency regarding their loan portfolio. They are often investing in private companies where financial statements are not readily available to the public. All the lending terms are not disclosed, as a consequence, the loan portfolio is often classified as "Level 3" for accounting purposes and ARCC shareholders must rely on management's representations. This can make it difficult for a shareholder to assess the operating performance. A second "big risk" is the economy. Slowing economic growth or a recession is likely to drive default rates. Loan portfolios and credit quality are likely to decline in a recession; this could result in a decline in net asset value or even worse the dividend being cancelled.

Summary

ARCC provides investors with a unique opportunity to invest in middle market companies through first lien and second lien loans in a senior position to equity and capture a 10% dividend yield. ARCC is well positioned to earn attractive returns for shareholders in the midst of tighter lending standards by financial institutions stemming from the implantation of Dodd Frank, Basel III and Volker Rules. These new financial rules have in effect restrained competitio,n creating greater opportunity for ARCC and companies like them.

Source: In Search Of Yield: Ares Capital Corporation, A 10% Yield