American Capital Ltd (ACAS)

Summary:

American Capital Ltd (ACAS) offers a unique opportunity for non-institutional investors to invest in private equity at a deep discount to its intrinsic value.  It is a company
going through a restructuring and appears to be a good opportunity for investors looking for value ideas.

It appears in the three valuation cases an acceptable entry price is $8.34/share or below provides a 30% margin of safety and potential appreciation of 50% at an intrinsic value of $11-12/share that could be realized in a year or two. And potentially over 100% to an intrinsic value of $15-18/share in an estimated 3-5 year time frame for the patient investor.

What are Business Development Companies?

Access to private equity as an alternative investment is typically reserved for accredited and institutional investors or hedge funds. Business Development Companies (BDC) enable non-accredited investors to invest in private equity. Although these smaller companies have been the real growth story behind the U.S. economy they are limited in access to capital. Their financing needs are often ignored by the banks. The BDCs address this need by connecting individual investors to private companies through publicly traded BDCs providing access and liquidity for what is typically an illiquid asset class. The demand for the BDC financing is usually strong.

To qualify as a BDC a company must be registered under Section 54 of the Investment Company Act of 1940. BDCs were established after the depression to encourage investments in small businesses that banks were unwilling to provide. Some BDCs elect to operate as a Regulated Investment Company (RIC) under the Internal Revenue Code of 1986. RICs do not pay corporate taxes because they profit from the investments of their shareholders and are considered not to have operations themselves. By agreeing to pass shareholder profits directly to shareholders they avoid double taxation. The BDC shareholders pay regular income tax on the dividends received, unless the investment is in a tax protected retirement account for example. To qualify as an RIC the company must derive at least 90% of its profits from investment activities, pay out 90% of its earnings as dividends, limit its debt to equity ratio to less than one to one and meet certain minimum asset diversification requirements.

BDCs operating as RICs are considered by some to be defensive investments because of the regulatory limitations placed on these companies. Because investments made by BDCs in private companies are considered illiquid BDCs do a lot of due diligence to determine which investments to make. Others view BDCs as a riskier segment of the market because they are illiquid and smaller cap companies. Because of these factors, BDCs tend to get higher returns as a provider of capital to these segments.

Although a relatively young industry BDCs are popular because they provide permanent capital to their management allowing investments using any combination of senior debt, mezzanine debt and equity. It is still a relatively small industry estimated by some at $15 billithe own from a peak $28 billion invested in approximately 1500 companies.

Company Description/Profile:

American Capital is one of the larger and older BDCs with a market cap of about $2.4 billion founded in 1986. It became a public company with an IPO in 1997 under the leadership of Malon Wilkus the founder, Chairman, and CEO.  ACAS operates as a Regulated Investment Company and is a major player in the industry.  They have made $31 billion of investments in over 520 portfolio companies since the IPO; $12 billion of that was in over 120 one-stop buyouts their trademark approach offering equity, debt and mezzanine (unsecured or subordinate) financing from one source. Another $11 billion was invested in over 225 buyouts sponsored by over 146 private equity firms. Over their history they gained extensive experience in change of control buyout transactions.

ACAS now has $57 billion in assets under management (AUM). American Capital internally manages $6 billion and the remaining $51 billion is externally managed through 4 private and 2 public funds.

Note * includes 152 ACAS and 53 ECAS companies.

Portfolio by asset type:

Source: Q3 2011 Shareholder Presentation, 11/2/11

ACAS is a global alternative asset manager of wholly-owned and third-party private and
public funds. The alternative asset management business is conducted through a wholly-owned portfolio company, American Capital, LLC.  Generally ACAS earns base management fees on the size of the funds under management and incentive income, based on the performance.

ACAS has about 205 portfolio companies that in total have about $46 billion of revenues and $8 billion of EBITDA. It is a very broad and diversified revenue base derived from either earnings or interest income or appreciation of the portfolio companies. The portfolio companies have over 47,000 employees.

Funds as of September 30, 2011:

Source: ACAS 10Q, 9/30/11

Operating History:

The graph below shows ACAS’s share price and net asset value (NAV) or book value performance. Results were good from their IPO up to the 2008-2009 credit crisis and recession.

Book value per share and dividend payments to shareholders
provide a direct measure of how shareholders fare from the financial performance
of a company because:

  1. Dividend payments are returns directly to the shareholder.
  2. Retained earnings entrusted to management if effectively invested for shareholders increase book value per share over time. Increasing book value results in increasing share price.
  3. Share re-purchases, if done wisely for the benefit of shareholders; increase book
    value too provided they are not just offsets to dilution by option awards.

The Ten Year table below measures book value growth and dividend payment
performance through the recessions of 2001 and 2008-2009. Management appears to be doing a good job prior to the 2008-2009 credit crises and recession.

 Considering that ACAS is required to pay out 90% of its earnings to shareholders as dividends, the growth in book value prior to the 2008-2009 crises is quite remarkable.
Book value growth is often derived from the retained earnings at the expense of dividend payments. Paying a strong dividend and growing book value at the same time is quite an accomplishment.

Summarizing in the table below shareholder returns are positive even after the 2008-2009 crises showing an 8%/year average return when dividend payments are considered. Looking at the seven year period prior to the crises indicates management was doing an outstanding job creating an average return for shareholders of about 24%/year.

The crisis had a severe impact on the BDC industry as it did on all financial sectors. In the BDC sector there was wide spread issues with:

  • BDC share      prices declined, some below $1.00/share and traded significantly below NAV
  • Mark to market accounting (FAS 157) increased unrealized depreciation in BDC’s portfolio assets
  • BDCs were unable to access the equity capital markets with share prices below NAV
  • Capital markets were frozen offering little or no relief at any cost
  • BDCs fell out of compliance with debt agreements and the 200% required asset coverage ratio
  • Dividend payments were decrease or are suspended further negatively impacting share prices

ACAS after many years of successful performance was still punished severely. The valuation of its equity holdings declined precipitously along with other equities and the company found itself in violation of loan covenants and facing possible bankruptcy. ACAS was levered close to the maximum 1:1 allowable level and when equity prices fell they were in technical default on the revolving line of credit, bonds and privately placed term notes and they were at the mercy of their lenders in restructuring the debt. The company was forced to suspend its dividends to improve liquidity, buy back the struggling European Capital affiliate (ECAS), and sell assets to raise cash. It spent much of 2009-2010 working to avoid bankruptcy and reach a restructuring agreement on about $2.4 billion debt. Agreement was finally reached in June 2010. Under the deal with creditors, American Capital agreed to pay off the debt over four years, continue to monetize assets and pledge essentially all of its assets as collateral. Billionaire investor John Paulson through his hedge fund Paulson & Co., bought about a 13 percent stake in American Capital equity for a capital infusion to assist the restructure.

The stock price fell from a peak in the high $40s to less than a $1/share in early 2009. It is
currently trading at about $7.23/share in the second year of the turnaround.

Graph: Stock Price, $/share

The near bankruptcy, share price decline, dilution through restructuring, dividend suspension, and shattered confidence in management continues to take its toll on investor sentiment today. When compared to a representative group of peer companies in the venture capital and private equity group. ACAS is selling at 50% of the already depressed peer BDC average price to NAV multiple even with a significantly lower Debt to Equity ratio (0.4:1) when compared to this peer group average ratio (1.1:1). Table Data Source: Morningstar

Why consider a company out of favor with investors and such a rocky performance during the crisis? One underlying premise in value investing is buying when others are fearful and selling when others are greedy. This requires a contrarian approach and an assessment to determine if the company is selling below intrinsic value and has reasonable prospects of improving. The circumstances creating the conditions for a company to be “on sale”, selling below value, are the same circumstance keeping most investors away thus making it cheap. However, we should act only if through analysis we believe the impairment is not permanent but only a temporary setback.  If we can buy the company with a sufficient margin of safety, over time it could lead to an attractive return once others recognize the true value.

The attributes discussed below are the ones needed in a turnaround to provide some assurance that it will be a successful investment and reasonably timely. Let’s examine ACAS under these attributes to see if there is a potential silver lining in this cloud. Some attributes to consider in this case include:

Management alignment with shareholders:

Over the past two years 2010-2011, insiders have sold 12 million shares of stock, purchased 82 thousand shares, and exercised options for 498 thousands shares. The bulk of the shares sold were by John Paulson’s hedge fund. This reduced the Paulson & Co. share count by about 10.9 million shares from 43.7 million shares originally purchased to 32.8 million shares.  Although this is not encouraging, stock sales by insiders can occur for many reasons such as better opportunities elsewhere or in the case of Paulson & Co., the sales may be due to redemptions at his hedge fund which had a difficult 2011.

Share purchases by insiders however are usually done for one reason only, management’s belief in improved prices ahead.  In the company’s 3Q11 10Q filing the company reported the following management compensation as of 9/30/11:

It is encouraging to see almost 40% of the employees’ compensation is stock-based; this should assure alignment with shareholder’s interest. Malon Wilkus, founder, chairman and CEO has stated in past conferences that the bulk of his personal wealth is in the company’s equity. They are eating their own cooking.

Another key measure of management alignment with shareholders is transparency. ACAS’s transparency is evident in the in depth reporting on the company and its operations. Supplemental disclosures and analysis are provided during quarterly earnings releases and presentations. On the ACAS website in the investor relations section the
quarterly and industry presentations are available. They are linked to slide presentations with detail on performance, the kind of companies in the investment portfolio, the type of investment made, the original cost and the fair value.  Fair value is reported under GAAP accounting and investors can look at the fair value of each investment made. The portfolio is marked to fair value each quarter and the entire portfolio valued by third parties each year. Experience shows management’s ongoing openness and more recently doses of humility as they publicly acknowledged the lessons learned during the crises and the things they will do different.

Improvement underway:

Let’s look at a longer time frame to get a longer term perspective. The graph below “ACAS
Balance Sheet” shows good growth in Equity, Assets and Liabilities through 2007. During the 2008-2009 crises a sharp decline in asset value and equity occurred as mark to market accounting and asset sales took a toll. Liabilities remained high as they worked through the restructuring. From the end of 2001 to year end 2010 the book value declined from $15.02/share to $11.08/share respectively for a 26% decline while the stock price (see graph above) declined from $27.13/share to $8.17/share for a 70% drop. The stock price decline is disproportionate to the book value decline likely reflecting investor ongoing uncertainty with the eventual outcome. The graph below shows improvement in the last 7 quarters from 1Q10 through 3Q11 with a consistent decline in liabilities and resultant improvement in shareholder equity. It appears things are stabilized or improving.

The BDC industry trades primarily on the dividend and the net asset value. The NAV is determined by the health of the balance sheet. Let’s look closer at the balance sheet since the restructuring agreement was reached 2Q10.

In the “Balance Sheet Improvement” chart below assets show a decline of about 9% from $6221 to $5692 million from liquidations and lower portfolio valuations during primarily in 3Q11.  The corresponding S&P 500 declined 14% during the 3Q quarter. Liabilities show
a decrease of about 46% from $3108 to $1676 million. Shareholder equity increased about 29% from $3113 to $4016 million. On a per share basis the book value increased about 30% from $9.15 to 11.92 per share, a remarkable improvement over these quarters.

Pre-crises performance was good. Perhaps one can view the crisis as a lesson for management on how to better to structure the portfolio for a severe recession. So perhaps managers will make better decisions now a severe downside scenario can be better measured.

Investment Thesis:

ACAS appears to be well underway in the restructuring. The balance sheet is showing
improvement but the company is selling at comparables significantly below its peers. The thesis proposed here is the company is being unduly punished for past issues and improvements are yet to be recognized by a generally conservative investor following. Company specific uncertainties will eventually clear and the investor’s negative views on equities in general stemming from the 2008-2009 recession will eventually dissipate. A potential appreciation for ACAS’s investors may exist.

Addressing some of the uncertainties specifically:

Third quarter 2011 results: The company’s headline results for 3Q 2011 was American Capital Reports Third Quarter 2011 Net Operating Income of $65 Million, or $0.19 Per Diluted Share, and a Net Loss of $(464) Million, or $(1.34) Per Diluted Share.”  Changes in the company’s portfolio value are reported as gains or losses each quarter (even if the gains or losses are not realized). The company had positive net operating income (NOI) of $65 million but the unrealized portfolio loss due primarily to European Capital’s valuation levels (European crises) more than offset the positive performance of the overall business. This unrealized loss will eventually be reversed into a gain once the European crisis is resolved and valuations there improve.

Dividend policy: The company voluntarily suspended dividend payments during the turnaround. The company could resume payments now but the board announced a new
policy
(7) through 2012. The policy states in part: Under the newly adopted program, quarterly, American Capital will consider setting an amount to be utilized for stock repurchases or dividends. Generally, the amount may be utilized for repurchases if the price of American Capital’s common stock represents a discount to the net asset value of its shares, and the amount may be utilized for the payment of cash dividends if the price of American Capital’s common stock represents a premium to the net asset value of its shares”.

If American Capital’s common stock trades at a discount to the net asset value the company will repurchase shares. If the stock trades at a premium to the net asset value
the company will make dividend payments. This program just makes economic sense
although some income seekers probably want dividend payments resumed immediately. But if a stock is selling near 64% of its net asset value, why would you not buy a $1.00 worth of stock for $.64 on behalf of your shareholders? The authorization of the new share buybacks or dividend payments is a very positive move that should improve investor confidence in the company.

Change in tax status: During the 3Q 2011 in the company’s 10Q filing with the SEC stated: We have determined that we will not qualify as a Regulated Investment company (“RIC”) under the Internal Revenue Code (the “Code”) for our tax year ending September 30, 2011, because we did not meet the Code’s portfolio diversification requirements as of June 30, 2011. Therefore, we will be subject to taxation under Subchapter C of the Code, which is applicable to most public corporations, rather than
Subchapter M of the Code, which is applicable to RICs. We expect that for income tax purposes, we will have a net operating loss for the tax year ending September 30, 2011. Under Subchapter C of the Code, we will be able to carry that loss forward to our succeeding tax years, which we would not be able to do if we were subject to taxation as a RIC. In addition, while subject to Subchapter C of the Code, we will not be
subject to the dividend distribution requirements applicable to RICs.

“We may again qualify as a RIC in future tax years and then elect to be subject to taxation under Subchapter M. If that were to occur, we would again be subject to the rules under Subchapter M, including those related to annual distribution requirements and the composition of our gross income and investments portfolio. This change in tax status does not affect our status as a Business development Company (“BDC”) under the
Investment Company Act of 1940, as amended (“1940 Act”), or our compliance with the portfolio composition requirements of that statute.”

Is the prospect of paying taxes as a “Subchapter C” corporation an uncertainty to be concerned about? Actually it can be considered a blessing in disguise. As of September 30, 2011, ACAS has an estimated $93 million net operating loss and $522 million capital loss
for a total of $615 million loss carry forwards for federal income tax purposes. These tax loss carry forwards can now be effectively used to for dividend payments, or share buybacks.

AGNC and MTGE growth: American Capital Agency Corp., formed in 2008 and American
Capital Mortgage Investment Corp
., formed in 2011 are diversifications initiatives undertaken shortly before and during the crises. These subsidiaries are substantially increasing the fee base of assets under management. These increases are illustrated below in the ACAS presentation made at the JPMorgan SMid Cap Conference on 12/1/11:

Share buybacks: On December 30, 2011 ACAS announced the buyback of its $58.7 million (8.4 million shares) common stock since early November at an average price of $6.97 per share. In the previous quarter the company repurchased a total of 9.1 million shares of its common stock for $75 million at an average price was $8.21 per share. The company plans additional stock repurchases or dividend payments before the end of December 2012 under the new policy.

Valuation:

The BDC industry historically relied on primarily two relative valuation metrics, the dividend and expected net asset value.

The graph below shows that the BDC industry Price/NAV is positively correlated to dividend yield. It would appear the higher multiple valuations would likely not occur until ACAS resumes payment of dividends.

Source: Derived from the Ares Capital Corporation, Acquisition of Allied Capital, Investor Presentation, March 3, 2010

The graph below “Share Price/NAV Multiple” illustrates the impact of the crisis and dividend suspension on ACAS’s multiple. ACAS’s multiple contracted from a 10 year average of 1.4 to the recent four year average of 0.7:

Case I Valuation: This assumes no improvement in NAV and considers the current discount to ACAS’s actual 10 year pre-crisis multiple and the above peer group multiple. In these two valuations, ACAS is currently selling at a significant discount to its history and the current depressed industry. One caution however is relative valuation tools are simple and intuitive but should be used with caution as the future may vary from the past.

Case II Valuation: This valuation assumes NAV improvements through several existing opportunities stemming from the turnaround and resultant multiple expansions.  No real
business growth is considered. The improvements as outlined on page 12 of management’s 3Q11 (11) shareholder presentation includes:

  • Potential to Retain Future Ordinary and Capital Income as a C Corporation
    • Benefited by net operating and capital loss carry forwards
  • Potential Accretion Due to Share Repurchases
  • Potential for appreciation in ACAS’ $634 MM Equity Investment in ECAS
    • $287 million discount to ECAS NAV
  • Potential for Appreciation with Respect to $2.0 billion Equity Portfolio as the US and European Economies Recover
    • $1.7 billion of equity assets at fair value at ACAS (excluding ECAS)
    • $341 billion of equity assets at fair value at ECAS
  • Potential for $223 million of Appreciation on Performing Debt Asset Portfolio if Repaid at Cost
    • $205 million below cost at ECAS
    • $18 million below cost at ACAS

The table below quantifies these potential impacts on per share NAV:

Case III Valuation: This valuation assumes in a highly unlikely scenario, management gives up and decides to proceed with an orderly liquidation of the company. At the end of the 3Q11 NAV was $11.92/share implying a discount of about 40% to the current share price of $7.23/share. On liquidation shareholders would receive about $11.92/share or a gain of $4.69 over the current price of $7.23. This is highly unlikely however given the
previous illustrated cases, but can be considered a pessimistic case that shows preservation of our capital.

Risks:

ACAS is a financial company and global uncertainty around financials in the U.S. and Europe could increase selling pressure until the uncertainty wanes if ever.

A European recession will have a negative impact on ECAS and another downturn in the U.S. would negatively impact the midcap companies in ACAS’s portfolio causing
underperformance and a deterioration in NAV.

BDCs are funded through the capital markets with permanent capital as opposed to
temporary capital from banks.  Although generally considered a benefit, capital market can freeze up as experienced in the financial crisis. This could constrain BDCs from a liquidity perspective. If they cannot raise capital and banks are unwilling to lend when refinancing is needed either forced liquidations or slowing growth will occur.

Investors need to have a fairly high risk tolerance due to volatility in the share prices
during the current markets. Further volatility will occur as the turnaround proceeds
and perceived uncertainties in the BDC industry and ACAS specifically continue.

Continued sales by major shareholder Paulson & Co., if they continue, will place
downward pressure on ACAS’s share price.

There is no guarantee that management will convert the company from a Subchapter C
corporation back to an RIC once the tax loss carry forwards are exhausted and RIC requirements met.

ACAS is increasing AUM and the resultant fees in their mortgage REITs, AGNC and MTGE. Future interest rate increases would result in a decline in the asset value of these
subsidiaries. Although in these cases the asset value decline would not impact ACAS directly, ACAS’s management fees are based on value of the assets in the subsidiaries, and the fees from the subsidiaries would decline.

Turnaround situation are inherently unstable and this investment should be considered a
higher risk investment and only considered by those with suitable risk tolerance, time frame and resources.

Reasons to Consider this Investment:

Current worldwide macroeconomic issues tend to create opportunities for the contrarian and value investment approach. ACAS’s equity and debt portfolio provide diversification at a deep discount to current net asset value. Management transparency, communications and the liquidation case show, in my view, good downside protection and strong upside potential over a 3-5 year time frame.

Not considered in the above valuations is the opportunity for ACAS to use proceeds to refinance costly debt, with interest over 8% per year from the restructuring, available at substantially lower interest rates.

Only potential capital gains are discussed in the valuation cases. In addition, at current net
operating income levels and assuming no income growth, a resumption of dividend
payments would result in a greater than 10% dividend yield on the current cost of the investment.

It appears in the above three valuation cases an acceptable entry price is $8.34/share or below providing a 30% margin of safety and potential appreciation of 50% at an intrinsic value of $11-12/share could be realized in a year or two and potentially over 100% to an intrinsic value of $15-18/share in an estimated 3-5 year time frame for the patient investor.

Disclosures: I am long ACAS.

The information contained herein is provided for informational purposes only, is not comprehensive, does not contain important disclosures and risk factors associated with investments, and is subject to change without notice. The author is not responsible for the accuracy, completeness or lack thereof of information, nor has the author verified information from third parties which may be relied upon. The information does not take into account the particular investment objectives or financial circumstances of any specific person or organization which may view it. Nothing contained within may be considered an
offer or a solicitation to purchase or sell any particular financial instrument. Before  making any investment, investors are advised to review such investment thoroughly and carefully with their financial, legal and tax advisors to determine whether it is suitable for them.

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