ACAS: The Liquidity Acid Test

Tomorrow, American Capital Ltd. (ACAS) will have to show the world that, despite a market cap under $3 Billion ($207 million shares outstanding, and a price of about $14 a share today, for a market cap of about $2.9 Billion), it can pay a declared cash dividend exceeding $217 million (based on a $1.05 per-share dividend and 207 million outstanding shares).

The Jaded Consumer is among those following ACAS who have considered liquidity to be a major concern in determining its ability to continue executing successfully. Since ACAS' investments are illiquid and its leverage is circumscribed by both regulatory limits and lender covenants, ACAS could theoretically be forced to de-leverage if asset values fell in line with a dismal market. Last quarter, ACAS reported $0.95 in realized earnings, below forecast due to transactions delayed from the second quarter into the third quarter. Nevertheless, management forecast a deal flow fully adequate to satisfy ACAS' liquidity needs and revenue projections, and went so far as to forecast rolling $500 million in 2008 taxable profits into 2009. (Taxable income is the metric that drives ACAS' dividend policy, which results from the company's tax status as a BDC; this status enables it to pay dividends from pretax income rather than after-tax income.) On the basis of this deal flow, management projected adequate liquidity. ACAS' last-quarter cash flow also offered reason for optimism.

In keeping with ACAS' de-leverage program over the last year or so, in keeping with ACAS' OpEx control (ACAS consolidated its San Francisco office into its Los Angeles office), and reflecting its relatively light debt load, management announced in its last quarterly conference call that it would be reducing the size of its lines of credit. Credit line reductions have some beneficial impact to ACAS: it lowers the amount of credit on which ACAS must pay commitment fees to maintain the line of credit (an operating expense) and it reduces the capital requirements ACAS must maintain as a condition of keeping the line of credit (protecting ACAS from liquidity crisis in the event of equity value declines). ACAS subsequently shrank a $1.3 Billion secured credit facility on renweal by amending it to $500 Million (freeing from encumberance some of the debt instruments securing the line and feeing them for sale, or else reflecting their impaired market value; the unsecured credit line costs 0.50% to keep open and LIBOR+2.50% when in use, and had no borrowings outstanding under it at renewal) and shrank an unsecured $1.565 Billion line of credit to $1.409 Billion (the new cost on the secured line is 0.50% to keep open and LIBOR+3.25% to use; ACAS' tangible net worth covenant under the new agreement has been reduced to $4.5 Billion plus a fraction of new funds raised). The unsecured line of credit, though managed by Wachovia, is actually funded by 31 participating lenders. One might view the renewal as a vote of confidence by the lenders in ACAS' credit, though it's also worth noting that the commitment fee quadrupled and the spread payable on borrowings under the facility grew by nearly 28% (from 0.90% to 3.25% above LIBOR). It's possible that the cost of borrowings increased in part because of the elevated cost to financial institutions of borrowing; perhaps they themselves can't borrow at LIBOR under these financial circumstances, and are passing the cost along.

The Story Behind The Credit Reductions
ACAS surely didn't go on purpose to its banks to renegotiate its cost of borrowing up. Management explained when it shrank its secured credit line that ACAS was operating at a steady state, and could re-invest proceeds of transactions into future transactions without needing the higher prior credit limits. This sounds nice, but the truth of the matter is that (a) ACAS' ability to obtain liquidity from deals is more speculative than from established banking relationships, and (b) in 2Q2008, ACAS was already experiencing unexpected deal closure delays, moving $0.12 in net into 3Q2008. The idea that material 3Q2008 deal flow could be delayed into 4Q2008 raises liquidity concerns.

ACAS announced last quarter a Net Asset Value of $27.01 per share, for a net asset total of $5.59 Billion. Since ACAS' investments are not generally susceptible to exchange on in a liquid market, most of the reported asset values derive from models that look to the values of comparable assets. After last week, one wonders at what price comparable assets might trade, and what this might do to ACAS' debt:equity ratio.

Liquidity Nightmare At ACAS?
American Capital Ltd. uses leverage to invest -- though less than banks -- and this leverage is subject to regulatory limits. Investors might liken this to the margin limit in a brokerage account: if the asset valued dwindle, something must be done to decrease the leverage. The nightmare case is that illiquid assets in a fire sale would be liquidated for a song, leaving ACAS broke in the aftermath of a liquidity crisis.

The way a margin account works is this: the investments and borrowings against them have a certain maintenance requirement, and as the equity in the account plummets during a protracted panic, the investor gets notified that if money isn't forthcoming, the broker will begin liquidating the account's assets to bring the account into line with the maintenance limits. Looking at ACAS' last-quarter net asset values and the size of its commitment fee, one applying this model would conclude ACAS must have been in effect about one billion bucks away from a margin call. Thinking about the movement of the markets since the last quarter, and the illiquidity of ACAS' investments, one might imagine that valuations based on comparables might have dipped over 20% with the rest of the market last week, leaving ACAS well below its promised asset levels. Unable to borrow under its credit facilities, desperate for cash from operations trying to run during a recession, and possibly suffering more deal delays due to a broad-based liquidity crisis, one would conclude that ACAS is probably broke.

We know from the questions and answers in the earnings conference call for the second-quarter of 2008 that one reason ACAS sometimes has both substantial cash and substantial short-term borrowings on its books at quarter-end is that it needs cash to pay its dividend -- and often has just reinvested capital in an attractive deal. If ACAS didn't succeed in achieving its liquidity goals, or lacks the covenant-specified assets to make use of its credit facilities, ACAS won't be able to pay its dividend tomorrow.

ACAS Doesn't Have A Margin Account
American Capital Ltd. doesn't have a broker looking over its shoulder on a daily basis waiting to execute immediate forced liquidations depending how ACAS' holdings seem to be valued on a daily basis. Management has also made clear that liquidating some of ACAS' investments takes something on the order of seven months. There is no emergency liquidation market for ACAS' holdings, and no authority for external forces to cause a liquidation.

Moving $0.12 of realized income from 2Q2008 into 3Q2008 doesn't mean ACAS moved $0.12 in liquidity into 3Q2008. ACAS moved to this quarter realized net in the amount of $0.12, which means ACAS receives not only the net this quarter -- the $0.12 -- but also any of the principal ACAS didn't choose to finance. ACAS made clear that management is not desperate to finance bad deals to get them closed, but that are outbid in financing them half the time. Moreover, ACAS' deal flow is a two-way street: ACAS need not enter deals any faster than makes sense, and can sit on its hands if need be as it waits for deals to come available on terms that are adequately attractive under all known existing circumstances.

ACAS has already announced a several profitable exits this quarter ($37 Million from PaR Systems, $57 Million from Contec, and $36 Million from SSH Acquisition), presumably facilitating substantial gross receipts even after providing financing to buyers in two of the three deals. ACAS' liquidity will depend on ACAS' hunger to reinvest in its currently-available deals, which may be tremendous. On the other hand, there may be a tremendous deal in ACAS' own shares.

ACAS Attractive
If ACAS were to repurchase 15% of its outstanding shares -- at $15, this would cost $465 Million, within the remaining amount in the $500 Million share buyback authorization -- ACAS could increase operating income per share nearly 18% -- for example, from $0.71 to $0.84. The net realizations per share from investments would similarly improve. A 15% reduction in outstanding shares bought below NAV would increase the net asset value for the remaining shares, and offer substantial future magnification in gains in NAV associated with eventual improvements in the economy (and thus improvements in the trading prices by which ACAS' asset values are estimated). Because the shares trade at a discount to NAV at present but traditionally trade at a premium of 1.4x NAV, the share price impact over time should be substantial. Improving NAV from a hypothetical $25 to over $29 would be a substantial boon, given the likelihood within the course of a year or so for ACAS to trade at at or above NAV. At $15, a share buyback seems to offer both excellent medium-term return and a great opportunity to protect ACAS' coverage of the dividend.

In the first quarter of the year, when the $500 Million share buyback authorization was new, ACAS had few trading days in which it was not barred from trading. Management said on the confernce call that they wished they'd been able to buy more shares in the twenties. During the 2Q2008 conference call, ACAS' management said that during the time shares traded at a discount to NAV, there were no days ACAS' compliance officer would authorize management to make share repurchases. There's no way to tell when or if ACAS would be in a position to buy back more shares, even if there were adequate liquidity to do it. However, even a few trading days in the teens should permit meaningful share retirement. With shorts again holding positions exceeding 19% of the float, effectively flooding the market with additional shares and depressing the price at which they are exchanged, management at ACAS has an excellent opportunity to concentrate value in shares. This would improve the value of both shares held by insiders (just over 1%), and the value of the shares held by those whom management wishes to reinforce that it will continue to provide a long-term value -- the very people to whom ACAS intends offering newly-issued shares above NAV in the future.

If ACAS can pay its dividend tomorrow, we'll know ACAS isn't out of money. The people on the DRIP will be buying shares near $15, and looking forward to a quarterly dividend of over 7% next month -- a dividend that, without increase, would yield over 28% a year. If ACAS is free to buy shares near this price, and prefers it to getting over 40% annualized returns on investments that work while risking the occasional dud when it invests in an unsustainable business, investors will see some stability increase in earnings as income from portfolio companies' operations grows on a per-share basis. If ACAS' liquidity is really good, we'll see both solid deals from this quarter and a meaningful share buyback.

American Capital has been lauded by its management as the top of the heap in middle-market buyouts, and a king of private equity deals. Although its track record has been great since inception -- if it went to zero after paying the dividend tomorrow, original investors would still have doubled their money -- this financial crisis offers a situation nobody on the ACAS management has previously weathered. (Buffett is older, and said he finds the market sentiment more fearful at any time in his adult life.) American Capital has come through hard markets before and claimed in the last conference call that it was in a better position to profit from this one than it was when the Internet bubble burst.

Tomorrow, we see whether the Emperor has any clothes.