Sunday, September 28, 2008

ACAS: Like A Bank, But Different

American Captial Ltd. (ACAS) first appeared on The Jaded Consumer in the context of a post blasting stock analysts' opinions as shallow -- failing to provide more than the most trivial hip-shooting evaluations of companies and, like Yahoo, often telling a misleading story. Rather than tell the story of ACAS in contrast to an entertainer's hip-shot claims, it seemed useful to explain how ACAS differs from other financial institutions more familiar to readers: banks.

As Bush pointed out recently, no depositor in an FDIC-insured bank account has lost a cent in an insured account since the program went live three-quarters of a century ago. What he didn't mention (and that recent events have brought into sharp contrast) is that banks have lost quite a bit of money, have been disassembled for sale in parts like junkyard wrecks, and have been wound down by regulators or seized and sold. (Because creditors such as depositors and bond holders must be paid before anything is left for shareholders, liquidation by regulators is basically lights-out for equity investors.) Protecting creditors (such as depositors) isn't the same as protecting shareholders. What we want to know is what life is like for the equity owners.

The Business Concept
Banks and Business Development Companies (BDCs) like ACAS occupy a similar ecological niche. In the financial world, there are basically two kinds of players. The first has a plan to develop profits from capital, but needs capital. The second has capital but needs good opportunities to turn a profit. Banks and BDCs both occupy a niche that requires skill in matching these needs together: they employ people to allocate managed capital among available opportunities to obtain a suitable risk-adjusted return for their investors.

Where The Money Comes From
ACAS manages permanent equity raised when shareholders bought into the company in an issuance, and it manages any funds borrowed against either this equity or their existing book of business. While lines of credit can be renegotiated at expiration -- which might reduce credit (causing a liquidity issue) or increase the cost of borrowings (narrowing the spread, that is, reducing net returns from equivalent gross profits on investments), these credit-related expirations don't come by surprise and are subject to planning. BDCs like ACAS are regulated in the amount of leverage they can use in making investments; the debt-to-equity ratio of an entity wanting to enjoy tax status as a BDC must be 1:1 or less, a low level of leverage that moderates risk. BDCs don't pay interest on capital contributed by shareholders, and never need pay it back unless they want to conduct a share repurchase.

Banks may open their doors with investor capital -- needed to buy a branch location and fund initial payroll and overhead -- but the funding put to work in a mature bank comes largely from depositors. Depositors are the people who put money into demand accounts -- accounts that are payable on demand like checking and savings accounts -- or accounts payable at a fixed future time like certificates of deposit. Depositors do not contribute permanent capital and banks do not own the contents of depositors' accounts. The other way banks get funds is the way BDCs do, as ordinary creditors: banks issue non-deposit debt instruments such as commercial paper or bonds. Because virtually all a bank's assets under management are in fact borrowings from others -- FDIC-insured deposits are just a form of bank debt whose principal is guaranteed to depositors through a federal agency's guarantee program -- banks are financially precarious by nature, depending strongly on depositor confidence for their immediate-term solvency. Banks are thus stringently regulated with a variety of measurements, such as loan-to-deposit ratios, designed to ensure banks don't over-leverage deposits and find themselves unable to make timely payments that would collapse confidence and cause a run, then trigger runs on other banks, then panic the entire banking system.

As an accounting curiosity, banks' evaluation for solvency under the regulatorily-imposed ratio analysis allows banks to value their outstanding loans at face value regardless their liquidity or market value so long as the loans are performing, as banks are presumed to be in the business of holding loans until maturity for the purpose of receiving contracted-for interest, rather than being in the business of buying and selling securities.

The investment banks we used to have in this country, like Merrill Lynch, levered equity in the neighborhood of 40x to obtain high returns on equity. Investment banks didn't hold depositor funds and were not regulated like retail banks and didn't offer FDIC-insured deposit accounts, and they were not allowed to carry loans at face value while they continued to perform but had to mark them to market values on their financial statements in accordance with FAS-157. Investment banks made money both by brokering big commercial deals and by participating with the firm's own equity in the deals they nurtured (participating often both as debt holders and equity owners).

Unless I'm missing a firm someplace, the United States no longer has investment banks. Still-independent firms like Goldman Sachs are apparently submitting to regulation as commercial banks. These firms may have to restructure to enable their business to continue without impairment in the face of regulation designed in the 1930s for retail banks making home loans. As for firms like Merrill Lynch that became banks through purchase by a bank ... well, the merger committee at Bank of America over its new acquisition Merrill Lynch isn't scheduled to meet until 2010. The Jaded Consumer suggests observers prepare for business as usual for a while yet.

The Relative Risk of Runs
If you've seen It's A Wonderful Life, you understand the idea of a bank run.

A bank run is a special class of liquidity crisis brought on by depositors' unanticipated demand for deposits -- whether by non-renewal of fixed-time deposits in favor of superior investments, or by immediate demand for delivery of demand deposits in cash. In the best case, the bank merely suffers inability to plow expiring loans into new investment, as it is required to pay funds to depositors; in such a mild case -- hardly a run -- the business simply shrinks as the money leaves. As severity worsens, the bank may be unable to meet its own interest payments, payroll, or other overhead ... and in the ultimate extreme has a long line of depositors with outstanding demands, but no cash to meet lawful demands and no way to raise it.

Bank runs exist because banks' investments are not chiefly made with permanent capital contributed by shareholders who cannot make withdrawals, but by funds raised from special creditors called depositors (who can call their debt in without notice) and other creditors holding commercial paper or bonds. A decline in enthusiasm for the bank (or simple cash demand as might be caused by a bad business cycle) will tend to draw out demand deposits, and prevent a bank's replacement of maturing loans with new investment; this kind of withdrawal tends to shrink the bank's funds under management, and thus its capacity to generate returns. The chief problem with this is that banks' obligations to their creditors may have a much longer duration than the obligations of banks' borrowers to the bank.

Changes in interest rate can cause banks' spread -- the money kept by the bank when it lends money for more than its own cost to borrow -- to shrink or go negative. One of the reasons it's so important that a secondary market exist for home mortgages is to get long-lived debts off the books of retail banks so they don't tie up capital sourced from short-term obligations like CDs and commercial paper, or banks would quickly be tapped out of the funds they are willing to invest in long-term risks, and no more such loans would be available. After all, how many are keen to lend their local banks money for thirty years at a fixed rate at single-digit interest?

With A Lever You Can Move The Balance Sheet
Making money on the spread between banks' borrowings and their lendings has two basic possibilities, each with its own risks: huge spreads or high leverage. Huge spreads on something like a home loan would suggest horrific credit, which isn't to the appetite of a well-run bank, as it violates the first and second rules of obtaining acceptable long-term returns. So, the answer most banks turn to is leverage. Banks are often not levering just equity, though, but deposits -- that is, they're using cheap debt like demand deposits and fixed-term certificates of deposit as if it were capital against which to lever other debt like commercial paper and bonds. Yahoo claims that most of the banks I checked out had a "not applicable" debt-to-equity ratio. Deposits might make regulators happy about local confidence in a bank, but it's just debt and leads to crazily high debt-to-equity ratios at banks. I understand a 10:1 ratio of debt to equity is not thought of as particularly remarkable or alarming in a bank.

The risk of leverage is that if liquidity is impaired -- either because of surprise non-performance of debt held by the bank (you can ask Donald Trump's bankers how that's worked) or because of a run by depositors -- insolvency quickly follows. Even avoiding insolvency, the ratios by which the firms are regulated can get crazily out of whack. In the case of a bank, a run would cause loan-to-deposit ratios to push the bank into regulatory takeover. Banks don't have their money in a safe, they have it in various businesses and homes in which they've made loans. If depositors withdrew their money, banks simply couldn't cover it. The only thing that keeps banks running is confidence that banks will keep running.

ACAS: Immune To Runs
BDCs can't accept deposits and can't be subjected to a bank-style depositor run. Firms that have open-ended mutual-fund-like investment pools like Goldman Sachs' Global Alpha might create a liquidity risk by contracting to allow withdrawal of investment from a pool which may be filled with potentially illiquid assets (is there a secondary market for derivative instruments like total return swaps? even during a panic? who are the counterparties?), which could create a run-like environment in which withdrawal demands can outpace liquidity and, in the worst case, bust the fund. If the contracts for investment in the fund are not designed to protect the firm -- for example, fund assets aren't firewalled from firm assets -- the company could theoretically be imperiled by such a 'run' simply because panic-induced fire sales could cause terrible loss realizations and premature exits from performing investments that generate value. Barring terrible asset management plan design, BDCs don't face a run risk because they face no demand deposit risk.

ACAS has pointed out that its funds under management are generally permanent funds, which suggests that a withdrawal crisis as faces open-ended mutual funds is not a risk.

Since BDCs don't face run risks, they're safer from market panics than banks. A bank in a confidence crisis can quickly be turned over to regulators, whose priority is depositors and not general creditors -- and certainly not equity owners who used their shareholders' vote to install management that led to a bank failure. Regulators are interested in protecting the market and in protecting designated classes of creditors (the FDIC loves insured depositors to the extent of their insured principal, and the FHFA loves holders of guaranteed mortgages to the full value of the timely payment of unlimited principal and interest; in insurance-land, policyholders are the most beloved creditor, and enjoy certain protections under state-managed conservatorship and insolvency programs, and under state-run safety-net programs). Bank regulators have no special interest in either general creditors or equity owners. BDCs like ACAS may have share price impacted by panics that involve margin-related liquidations by investors, but the companies themselves are not at special risk and anyone solvent enough to keep their shares in a panic can continue to enjoy the dividends and the long-term returns.

In a panic, banks may be afraid to loan money (or may be too illiquid to loan money) which actually creates a fantastic opportunity for a BDC like ACAS. Not subject to depositor withdrawals, levered less than 1:1 (debt:equity), and enjoying permanent capital to invest, ACAS is in a position to make some of its most attractive purchases when blood is running in the street. Remember what Mr. Buffett said: be fearful when others are greedy and greedy when others are fearful.

Because it doesn't face depositor panics and has remained liquid in the current crisis, ACAS is in a good position to enter investments when others are too afraid or illiquid to enter deals.

How They Make Money
Financial companies of all sorts have the same goal as any other for-profit firm: to make a return that exceeds the cost of capital.

For banks, this is easy to describe: banks loan money for more than they borrow it, and keep the spread less their expenses. Banks also perform services, like those associated with credit cards, that provide some fee income atop any interest income associated with the activity. The basic idea isn't that banks get rich on ATM fees, though -- it's that banks charge more for home loans than they pay in interest to depositors and bond holders. If the loan performs, the bank keeps the spread. If the loan underperforms, the bank is on the hook to the extent of the underperformance. The bank always owes its own creditors what those creditors are due, though, even if its own customers aren't paying.

The story at ACAS is similar. ACAS invests money in applicants' businesses with the plan of obtaining a return that exceeds ACAS' cost of capital and its operating expenses. ACAS also offers services for which it collects regular fees. The difference is that the ACAS, after doing its due diligence on a deal, can tell applicants for its managed funds that the cost of the money will be a series of senior secured notes, a series of senior unsecured notes, a series or two of subordinated debt (some of which might have conversion features), some preferred stock, and a large stake in the common stock of the company. Banks may tell you they are your partner in business, but with ACAS this claim is not puffery but a literal truth; ACAS will send an operational team to tweak performance at portfolio companies, and sit on the board to oversee ACAS' interests. ACAS can afford to risk investment in illiquid non-public investments for an indefinite multi-year time frame because it's got permanent capital that can't be withdrawn. As a holder of high-interest portfolio-company debt, ACAS can get paid without need of liquidation -- and when profits at portfolio companies are good, it can as owner of the common stock pay itself a dividend.

When business is good, ACAS stands to benefit from its' portfolio companies' future financial business (after all, it controls its portfolio companies), so winners will become repeat customers. In the event of failure, ACAS' position as debt holder enables it to get paid first -- and its position as the controlling investor ensures it is in a better position even than a bank to determine how to respond to challenges, how to build or wind down business, and how to derive the best total return from a portfolio company. (Banks with defaulting customers would have to get a United States Trustee in bankruptcy to overtake and turn around operations, and even then the bank would not control operations directly; ACAS just casts a vote and does what it pleases, and need not wait for a federally-recognizeable state of insolvency to intervene to add operational improvements.) In the event of success, ACAS can add to customers' fixed interest payments the benefit of equity upside as high as the equity can go -- and obtain returns far beyond the lawful limits on loan interest. Moreover, because of balance sheet consolidation, ACAS shows portfolio companies' own earnings as ACAS earnings -- something no bank can do, and something that diversifies ACAS' revenues into every business sector and every geography and every currency in which ACAS (or its ECAS subsidiary in Europe) makes investments.

And that's really the bottom line on the business model: Banks and BDCs both stand to lose money if an investment fails, and each stands prepared to use security features and debt-holder status to minimize risk. However, if an investment idea turns out to be spectacularly good a bank is capable of earning no more than the spread on the interest rate in its loan documents. In other words, a bank's return gets better and better as a loan customer's financial position approaches solvency, at which point the bank's return is capped. By contrast, ACAS participates not only in the solvency-enabled contractual debt repayments, but as a controlling equity owner can ride an investment's success its the entire extent.

Even following ACAS' share price plummet from its all-time-high in the high forties, ACAS has offered a double-digit total return and continues to raise its dividend while offering a double-digit dividend.

Getting Paid
Your power to get dividends from an investment is based on both a company's inclination to pay dividends (like Apple doesn't), and the power of its cash flow to sustain dividends. In the current panic, banks have been slashing dividends due to liquidity problems, while ACAS has continued to pay dividends and to increase them according to a pre-announced schedule. Indeed, ACAS anticipates rolling into 2009 approximately $500 million in 2008 profits for payment of future dividends.

The Jaded Consumer realizes that people inclined to make investments often assume the future will be rosy, however, and are not inclined to look at the bad case in making an investment decision. Therefore, a little diversion into tax law is warranted. Most corporations must pay dividends from after-tax profits, if at all. Warren Buffett, who is offended at the tax-inefficiency of paying taxable dividends from profits that have been taxed once already, makes a point to pay no dividend at all from shareholders' profits at Berkshire Hathaway, but to reinvest to avoid double taxation (which is why Berkshire Hathaway's common stock price after Buffett's management of the company since the 1960s looks like this; you don't need a dividend to get an outstanding return). However, banks -- like utility companies -- are often regarded as income stocks. People expect good dividend income from banks, and banks regularly appear (well, before they cut their dividends) on lists of high-dividend stocks.

Enter ACAS. ACAS, as a BDC, has a peculiar tax status that allows it to pay dividends from pretax profits, provided it pays more than ninety percent of its profits to shareholders. Shareholders who want to reinvest can particupate in the DRIP, and those who want periodically to receive income need not liquidate shares as must shareholders of Berkshire Hathaway.

What does this mean? A bank that pays a dividend as high as ACAS is paying it from after-tax profits, meaning that it must make quite a bit more money than ACAS does. Corporate taxes in the United States, after all, are over a third of net profits. A bank paying an ACAS-like dividend is thus required to make about 50% more pretax profit per share in order to have the capacity to keep even with ACAS' dividend, after paying taxes.

Thinking back to high-risk investments and scary leverage levels as the principal magnifiers of returns, do you really want to own a bank stock that offers a dividend yield anything like ACAS' yield? And just how secure would such a dividend be over time, given what is known about the operation, risks, and leverage of banks?

ACAS has paid an increasing dividend every year since going public, and has never missed a quarter or lowered a quarterly dividend. ACAS has permanent capital and need fear no bank run. ACAS has business diversified across continents and currencies, and it doesn't need dangerous levels of debt on its balance sheet to produce the returns it has demonstrated year after year.

Conclusion: ACAS Beats Banks on Safety and Soundness
Unlike a bank, whose return is capped by usury laws and fierce competition for loan business, ACAS need not over-lever its balance sheets to achieve attractive returns. Serious competition for middle-market buyout opportunities is scarce, and ACAS is allowed to achieve significant returns over an investment's life from the complex, multi-tiered debt and equity investment structures through which ACAS protects its interests and oversees the use of its capital. ACAS offers illiquid private companies a single stop for investment needs, leading to an enormous volume of proposed business through which management can cherry-pick the very best deals in the middle market. Illiquidity discounts mean that operating earnings are more cheaply purchased, and ACAS has the patience to enjoy those operating earnings until a reasonable exit opportunity materializes. ACAS offers superior per-deal returns without greater risk than facing a bank (both can lose everything less their security), enabling a lower-leverage and thus liquidity-advantaged solution to achieving reasonable returns on deployed capital.

Why buy common stock in a bank, and hope for levered spreads on interest from a lender's financially sound customers, when you can buy ACAS and enjoy the interest, the quarterly earnings, and the capital gains on the shares of lenders' best customers? And do so without scarily-levered balance sheets?

The case for ACAS may sound like a generalized case for BDCs, but ACAS' position as the largest operating in its market segment places it in the position to invest at all levels up and down a portfolio company's balance sheet, enables it to obtain superior results by acting as the controlling investor, and saves it from being a speciality investment vehicle with interest solely in debt instruments or the like. I'd love to hear from readers about other BCDs situated as ACAS is, but so far ACAS appears sui generis.

I hope the market's current panic makes the DRIP purchase price awfully low, as I plan leaving it running. And the longer the panic continues, the longer ACAS will have to buy the best middle-market opportunities at the most attractive possible prices, enabling the best possible yields. ACAS' willingness to walk away from turkeys assures us that ACAS won't accept lousy deals just to be making deals, even when it causes a short-term black eye. How different this is from banks that churned out terrible loans just to make their quarterly fee numbers!

ACAS is looking out for the long-term, and I love it.


Anonymous said...

Thanks for your blog, and this outstanding explanation of ACAS and their business model.

I own ACAS and couldn't have appreciated this post more. Great.

Anonymous said...

Thanks for the oustanding post on banks, BDCs and ACAS in particular. The benefits of owning ACAS you describe are accurate and consistent with my thinking. I have been long on ACAS some time and buying more at these great prices. My concern has been with the stock plummeting, am I missing something that others aren't. Your explanations and affirmation of this great company and it's shareholder friendly management team is greatly appreciated.


maestro said...

This one of the most well-articulated reasonings on any stock in any market I have ever read. I recently came across your blog and am grateful for it. I have owned ACAS for about a year and have neither read nor heard an argument for (or against) this stock as well said as yours. Thank you.

Anonymous said...

One question . . . if ACAS avoids taxes by paying out at least 90% of all yearly profits, how is the $500M in 2008 profits being 'rolled into 2009' going to be treated? I see where it will shore up the '09 dividend, but doesn't that come with a significant tax hit? Would seem unavoidable unless $500M represents only 10% of ACAS' profits, which seems unlikely.

Great information overall though. Thanks.

Jaded Consumer said...

In prior conference calls, ACAS' management explained that non-distributed taxable income was subject to an excise tax of something like 4%. Considering ACAS' management's view that dividends are a hard-results meter whose numbers cannot be restated, and its announced policy of never setting a dividend management thought it would ever have to reduce, I think it's clear why ACAS would pay the excise tax to keep funds in-hand for the future: it wants to smooth out for shareholders a revenue stream that is exceedingly lumpy by virtue of its dependence on exits from deals involving not-publicly-traded enterprises.

To get an idea of just how significant this tax is, we can look at the annual report and its statements about tax expenses. As a shareholder, it is interesting to wonder whether the price management pays to maintain its reputation for steady execution (by paying predictable, steady dividends) is worth the benefit. On the other hand, since DRIP purchases clearly move the stock price when the stock price is below NAV (and shares are bought on the market rather than being issued), maybe preventing huge irregular dividends is a benefit to DRIP participants, too.

TR said...

Hi Jaded Consumer,

Wondering what your thoughts are on ACAS' bomb of a earnings report/dividend pause. The optimists think ACAS management will be able to weather this without deleveraging, and return to the dividend in 2009. At $6.75 I'm tempted to average down on my shares.