American Capital Strategies (ACAS)

• 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

• 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

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.

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.

• The previously announced $500M rollover into 2009 has been reduced by $45M due to inability to exit investments. Additionally, ACAS siphoned off $155M as a deemed distribution, leaving $300M to be declared by June 2009.
• ACAS will now declare dividends on a quarterly basis after financial results are reviewed. Technically, this may make my post heading incorrect as the company must pay 90% of ordinary income under its current structure and its unclear to me how ACAS can simply stop paying a dividend as long as their assets are performing as CEO Wilkus has asserted all year, including yesterday. During the conference call, Wilkus made a distinction of Q4 2008 not being suspended but that the board will review the payout once the numbers are finalized in early 2009.
• The company announced an all-share takeover of its ECAS subsidiary, pending shareholder and regulatory approvals. Management estimates this will add $1.25 to NAV, helping to stabilize their leverage requirements.

Obviously, if the ship is sinking, then it is only prudent to take action to prevent that. Toward that end, management probably deserves a little slack as the market dislocations recently have been unprecedented. Credit markets were virtually shut down in mid-October. It used to be that market commentators used a VIX reading of 30+ as fearful and 40+ as a sign of impending washout but the VIX nearly hit 90 (!) in October and still sits at 60 today. For a company that is forced to mark-to-market many of its assets, this volatility can put a lot of pressure on the balance sheet.

My disappointment with management stems from a couple of sources: failure to either adequately plan or execute (it’s hard to tell which of these occurred) and failure to fully level with shareholders. ACAS entered the year with the base case of a recession, which would lead one to anticipate some decline in NAV. While I may be a bit harsh in expecting management to have seen this unprecedented market crisis coming, I discussed the possibility of this scenario back in July. I don’t have the decades of experience in this business like the company does so I’d expect them to plan out possibe scenarios better than I do. Or perhaps they didn’t execute well as their debt ratio was 0.7 back in July and now stands at 0.9. As management stated last quarter, “We’ve certainly put our self in a position where we can do that [deleverage] on a proactive basis as we see things develop rather than have a gun to our heads.” Well, this feels like a gun to the head to me.

Finally, management has been pushing its strong realized earnings performance + its capital gains rollover very hard all year. They were asked repeatedly about their leverage ratio and how they could manage it. Management gave the standard assurances with no hint of any worst-case scenarios (i.e. “While we don’t anticipate having to do so, if gun was at our head, we could take back the dividend”, etc). Now when management says that they’re not cherry-picking their private equity portfolio for exits, should we believe them now? How about their $700M+ in unrealized depreciation that they expect to flow back as cash?

Bottom line, it strikes me that retaining $155M of long-term capital gains and paying 35% tax is highly inefficient. Wouldn’t shareholders only have to pay 15% on that if it was paid out? Very expensive source of capital from a shareholder perspective (someone correct me if I’m wrong and I have a call into IR so I’ll post in the comments with an update if I’m wrong). The irony is that operations-wise, nothing has really changed with the underlying assets — NOI is still good, exits seem tighter than last quarter but still $520M in cashouts for Q3, over $700M of writedowns that they expect to bring back. The main difference is that shareholders aren’t going to get paid because management can’t adequately manage their accounting risk.