American Capital Strategies (ACAS)

• American Capital is heavily exposed to the general US economy due to their focus on middle-market companies. While the latest reports show a heavy concentration toward financial services and away from the "old-economy" sectors, this reflects shifting many of their portfolio investments into off-balance sheet funds managed by their affiliate companies. European exposure (via ECAS) is estimated around 17% of operations.
• Some concern that they cannibalize their customers' business. Since AmCap provides debt financing for other private equity buyouts as well as executing in-house buyouts, some competitors market ACAS' possible conflicts of interest against them.
• There is some ambiguity regarding the strength of AmCap earnings. Total earnings (& EPS) is derived from net operating income (NOI) combined with realized and unrealized capital gains/losses. The realized earnings component is very lumpy as these come from exiting portfolio investments or companies. Additionally, as the company continues moving portfolio assets off balance-sheet into funds managed by ACAS affiliates, they record those transactions as earnings. The unrealized earnings are based on subjective management valuations which has been shown to be problematic in the past (i.e. capital.com was valued at $71M one year only to be revalued at $1.6M the very next year).
• The company admittedly is a trend-follower which may work against it. There have been examples of AmCap being late to the party (see above capital.com example). Possible upcoming problems may come in the form of their late entry into the asset securitization market as well as their ramp-up of their asset management segment right as questions arise about private equity and hedge funds being robust investment vehicles.
• The company has sizable (costly) personnel infrastructure, in many cases, much larger than better-known buyout firms like KKR or Blackstone.
• By definition of their business model and excluding capital gains, the company must issue equity if it wishes to grow assets under management. Traditionally, this is viewed negatively in light of shareholder interests but this standard may not apply in the case of BDCs. It depends on whether the company can increase net asset value at a better pace than diluting shareholder equity, which can be measured by NAV/share.
• The company's rapid growth in recent years fosters concerns of possible lax discipline and mal-investment.^[1]

1. ↑ http://www.enlightened-american.com/wealth/research/acas_report_risk.htm

• Credit default risk - the economy slows down, the rate of corporate defaults would be expected to increase, thus affecting American Capital's ability to regain their investment. Sound's familiar? - Subprime crisis
• Interest rate risk - rising interest rates would increase costs and make debt more expensive. The company has $1.8B (out of ~$4B total) in revolving credit facilities.
• The asset management and private equity business generally requires highly skilled, experienced personnel who demand high compensation. This makes operating leverage very difficult, if not impossible, so expect operating expenses to rise with revenues and earnings. ACAS' stringent vetting process only exacerbates this issue.
• Market risk - American Capital depends on both capital and credit markets to finance activities. Due to strict 1:1 debt-to-equity legal requirements, ACAS depends on raising equity in the public markets as well as leveraging that equity in the debt markets for use in future investments. A freeze-up in either/both markets could prove detrimental to operations.^[1]

1. ↑ http://www.enlightened-american.com/wealth/research/acas_report_risk.htm

Judging from pricing, the market is expecting big write-downs and possibly a dividend cut. To me, a declining stock price, in and of itself, is no justification for a dividend cut. If the business is still performing (and CEO Wilkus has very forcefully reiterated this point for a few months now, if not longer), then a dividend cut will damage management’s credibility and undermine investor confidence in a stock with a heavy retail base.

There is also a significant short position in these shares, with 31.8 million shares short as of June 2008, or nearly 16% of the outstanding float of the company. On ACAS normal daily volume, this equates to a short ratio of 14.9 days. There have been arguments posted in news articles and on blog sites on ACAS' valuation strategies for some of the investments they manage. One of these arguments comes from Greenlight Capital's David Einhorn, who is short these shares. The short-side argument is that most of the assets under management by ACAS are classified as "level 3" assets, meaning they are marked to model as far as quarterly or annual valuations. With over 170 portfolio investments, questions arose out of the mid-June investor's meeting about the valuations and the methodology behind them. In early May, ACAS reported an $813 million loss, primarily driven by over $997 million in accounting writedowns on the value of investments in the portfolio. This act raised a number of questions about the value of the private equity portfolio.