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Rating Action:

Moody's assigns Baa3 rating to Ares Capital Corp.

31 Jul 2007
Moody's assigns Baa3 rating to Ares Capital Corp.

New York, July 31, 2007 -- Moody's Investors Service assigned a Baa3 long-term issuer rating to Ares Capital Corporation (ARCC). In the event ARCC issues senior unsecured debt obligations, they would be rated at the same level as the issuer rating. The outlook for the rating is stable.

The Baa3 issuer rating is supported by ARCC's robust performance as a Business Development Company (BDC). The company maintains a diversified investment portfolio, with limited individual investment exposure (ARCC's largest single exposure is approximately 5% of the total portfolio). In addition, ARCC is invested across many industries and geographies that provide sufficient diversification in the event of a regional or business sector downturn.

While the period since ARCC's IPO in 2004 can be characterized as a relatively benign credit environment, Moody's notes the company's impressive portfolio quality with only one investment valued to recover less than full principle as of the first quarter of 2007. A primary reason for this strong performance is ARCC's concerted effort to originate new investments that are senior in the capital structure. While this protection is often at the expense of margin, ARCC has demonstrated an ability to gain excess yield over the market. In Moody's view, this is due, in part, to ARCC's large portfolio of potential investments that are evaluated for the greatest return for level of risk, and its ability to provide financing to a company for all segments of the capital structure.

From a financial metrics perspective, ARCC is well positioned. This is due to the company's substantial equity base. BDC regulations require ARCC to effectively maintain leverage below one to one (debt to equity), which is a significant ratings factor. ARCC's substantial equity cushion provides its debt holders with considerable protection in the event portfolio valuations decline. In its brief history, ARCC has operated with leverage metrics well below the one-to-one threshold.

The rating is also supported by ARCC's experienced management team. The ARCC investment committee, which approves all new investments, is comprised of partners from Ares Management LLC. This is a ratings strength given the firm's historical performance. In addition, ARCC has a competitive advantage due to its ability to leverage off its relationships with the investment community through Ares Management.

Moody's said that there are a number of risks that balance these positive attributes. First, although ARCC's profitability since its 2004 IPO has been strong, the portfolio's rapid growth, lack of seasoning, and unproven performance during a more challenging economic cycle are key risks to the rating. To address Moody's view of these risks, ARCC will need to maintain strong performance coupled with limited portfolio deterioration through a more challenging credit and economic cycle.

As mentioned previously, ARCC's investments in first lien securities and the resulting secured coverage is a ratings positive. However, the yields earned on the first lien securities are substantially greater than the market. While Moody's believes that part of the excess spread is due to ARCC's investment selection and structuring, the greater yields also imply increased risk versus a typical first lien investment. Again, ARCC's ability to demonstrate continued strong credit performance during a more stressed environment would support the rating.

ARCC has exhibited substantial growth in its portfolio since its IPO. Moody's notes that this growth has come at a time when there has been very limited stress in the US economy and in corporate credit generally. While growth to date appears well managed, there is a risk that the portfolio will not perform as anticipated when conditions weaken and that the firm's resources could become strained as expansion continues. As ARCC continues to expand and invest in a greater number of portfolio companies, it will be important for its management and operations team to grow in concert with the investment base.

In Moody's opinion, there is an added risk to the reliance on Ares Management as the source of both management and operating support for ARCC. In the event an unforeseen event causes stress at Ares Management, it could lead to a disruption at ARCC, whether through increased employee turnover (due to the unforeseen event) or, at a minimum, distraction away from ARCC operations.

ARCC invests primarily debt and to a lesser extent equity in middle market, private companies. Due to the nature of these investments, portfolio valuation of its investments is subjective and difficult. This is mitigated through ARCC's current investment structure (largely first lien debt); however, an increase in equity investments would increase this risk. In addition, if ARCC operates with leverage near the one-to-one leverage restriction, there is a risk that if valuations were overestimated, it could violate BDC guidelines, impair investor confidence, reduce its ability to originate business, and diminish its competitive standing and franchise value.

ARCC, as with other BDCs, has limited internal capital generation given its requirement to pay out substantial dividends. In order to grow, ARCC needs to frequently tap the public equity market. Therefore, it is important for the company to maintain investor confidence and a solid equity valuation.

Finally, there is a risk that greater competition could impact portfolio yields or lead to adverse investment selection as more companies enter ARCC's competitive space. ARCC's ability to differentiate itself from other market participants with its product offerings and operations expertise is also significant to the rating.

What Could Change the Rating -- UP

The rating could go up if ARCC demonstrates continued strong operating performance through a credit cycle while meeting its growth objectives without stress on the resources of the company or impairment to the franchise. Moreover, maintenance of a secured investment structure with minimal deterioration in credit quality would also be positive for the rating.

What Could Change the Rating -- DOWN

The rating could decline if ARCC's portfolio performance materially weakens, if it has a substantial impairment on its investment portfolio, or if it experiences a protracted reduction in realized yields due to greater competition. Although not expected, a significant change in the company's capital structure that pressures the BDC guideline covenants could also lead to a lower rating. In addition, failure to increase and retain key personnel to accommodate the expected growth objectives could also pressure the rating.

The following rating was assigned:

Long-Term Issuer RatingBaa3

Ares Capital Corporation (NASDAQ: ARCC) is headquartered in New York, NY and reported assets of approximately $1.5 billion at March 31, 2007.

New York
Robert Young
Managing Director
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Andrew Forsyth
Analyst
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

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